FOOT LOCKER, INC. - Quarter Report: 2014 November (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended: November 1, 2014

For the transition period from __________ to __________

Commission File Number: 1-10299

FOOT LOCKER, INC.

(Exact name of Registrant as specified in its charter)

112 West 34^th Street, New York, New York 10120

(Address of Principal Executive Offices)

(212) 720-3700

(Registrant’s telephone number, including area code) 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   Yes  þ   No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  þ   No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yes  o   No  þ

The number of shares of the Registrant’s Common Stock, par value $0.01 per share, outstanding as of November 28, 2014 was 142,086,468

FOOT LOCKER, INC.

TABLE OF CONTENTS

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

FOOT LOCKER, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in millions, except shares)

FOOT LOCKER, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(in millions, except per share amounts)

See Accompanying Notes to Condensed Consolidated Financial Statements.

FOOT LOCKER, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

(in millions)

See Accompanying Notes to Condensed Consolidated Financial Statements.

FOOT LOCKER, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in millions)

See Accompanying Notes to Condensed Consolidated Financial Statements.

FOOT LOCKER, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying condensed consolidated financial statements contained in this report are unaudited. In the opinion of the management of Foot Locker, Inc. (the “Company”), the condensed consolidated financial statements include all adjustments, which are of a normal recurring nature, necessary for a fair presentation of the results for the interim periods of the fiscal year ending January 31, 2015 and of the fiscal year ended February 1, 2014. Certain items included in these statements are based on management’s estimates. Actual results may differ from those estimates. The results of operations for any interim period are not necessarily indicative of the results expected for the year. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the Notes to Consolidated Financial Statements contained in the Company’s Form 10-K for the year ended February 1, 2014, as filed with the U.S. Securities and Exchange Commission (the “SEC”) on March 31, 2014.

Recent Accounting Pronouncements

In April 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-08, Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity. The amendments in this update change the requirements for reporting discontinued operations. A discontinued operation may include a component of an entity or a group of components of an entity. A disposal of a component of an entity or a group of components of an entity is required to be reported in discontinued operations if the disposal represents a strategic shift that has (or will have) a major effect on an entity’s operations and financial results and when the component or group of components meets the criteria to be classified as held for sale, is disposed by sale or is disposed of by other than by sale. ASU 2014-08 is effective prospectively for fiscal years, and interim reporting periods within those years, beginning after December 15, 2014, with earlier adoption permitted. The adoption of this guidance did not have a significant effect on our consolidated financial position, results of operations or cash flows.

In May 2014, FASB issued ASU 2014-09, Revenue from Contracts with Customers, issued as a new Topic, Accounting Standards Codification Topic 606. The core principle of this amendment is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period, with earlier adoption not permitted. ASU 2014-09 can be adopted either retrospectively to each prior reporting period presented or as a cumulative-effect adjustment as of the date of adoption. The adoption of this guidance is not expected to have a significant effect on our consolidated financial position, results of operations or cash flows.

In June 2014, FASB issued ASU 2014-12, Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could be Achieved after the Requisite Service Period. ASU 2014-12 affects entities that grant their employees share-based payments in which terms of the award provide that a performance target that affects vesting could be achieved after the requisite service period. The amendments in ASU 2014-12 require that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. As such, the performance target should not be reflected in estimating the grant-date fair value of the award. ASU 2014-12 is effective for annual reporting periods beginning after December 15, 2015, including interim periods within that reporting period, with earlier adoption permitted. The adoption of this guidance is not expected to have a significant effect on our consolidated financial position, results of operations or cash flows.

Other recently issued accounting pronouncements did not, or are not believed by management to, have a material effect on the Company’s present or future consolidated financial statements.

FOOT LOCKER, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

2. Impairment and Other Charges

During the first quarter of 2014, the Company recorded a charge of $1 million to fully write down the tradename related to the Company’s stores in the Republic of Ireland, reflecting historical and projected underperformance. Additionally, during the second quarter of 2014, the Company announced a plan to shut down its e-commerce skate business, CCS.com, and transition customers to its Eastbay brand. Accordingly, an impairment charge of $2 million was recorded to write down the value of the CCS tradename. The liquidation was substantially completed during the third quarter ended November 1, 2014. This closure does not meet the definition of a discontinued operation as it is not considered a strategic shift that will have a major effect on operations.

3. Segment Information

The Company has determined that its reportable segments are those that are based on its method of internal reporting. As of November 1, 2014, the Company has two reportable segments, Athletic Stores and Direct-to-Customers. The Company evaluates performance based on several factors, of which the primary financial measure is division profit. Division profit reflects income before income taxes, corporate expense, non-operating income, and net interest expense. Sales and division profit for the Company’s reportable segments for the thirteen weeks and thirty-nine weeks ended November 1, 2014 and November 2, 2013 are presented below.

FOOT LOCKER, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

4. Goodwill and Other Intangible Assets

Annually during the first quarter, or more frequently if impairment indicators arise, the Company reviews goodwill and intangible assets with indefinite lives for impairment. The annual review of goodwill performed during the first quarter of 2014 did not result in impairment charges as the fair value of each of the reporting units substantially exceeded its carrying value. During the second quarter of 2014, in connection with the shutdown of the CCS e-commerce business, the Company recorded a non-cash impairment charge of $2 million to write down the value of the CCS tradename. Additionally, during the first quarter of 2014, the Company recorded a non-cash impairment charge of $1 million to fully write down the remaining value of the tradename related to the Company’s stores in the Republic of Ireland, reflecting historical and projected underperformance.

The following table provides a summary of goodwill by reportable segment. The change represents foreign exchange fluctuations.

The components of finite-lived intangible assets and intangible assets not subject to amortization are as follows:

The $11 million change in goodwill and other intangible assets for the thirty-nine week period ended November 1, 2014, included $5 million of amortization expense, $3 million related to the impairment charges noted above, and a $4 million decrease related to foreign currency exchange fluctuations. This was offset by $1 million of lease acquisition additions related to Foot Locker Europe, which are being amortized over a weighted-average life of 9 years.

FOOT LOCKER, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

4. Goodwill and Other Intangible Assets – (continued)

Future expected amortization expense for finite life intangible assets is estimated as follows:

5. Accumulated Other Comprehensive Loss

Accumulated other comprehensive loss was comprised of the following:

The changes in accumulated other comprehensive loss for the thirty-nine weeks ended November 1, 2014 were as follows:

FOOT LOCKER, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

5. Accumulated Other Comprehensive Loss – (continued)

Reclassifications from accumulated other comprehensive loss for the thirty-nine weeks ended November 1, 2014 were as follows:

6. Financial Instruments

The Company operates internationally and utilizes certain derivative financial instruments to mitigate its foreign currency exposures, primarily related to third-party and intercompany forecasted transactions. As a result of the use of derivative instruments, the Company is exposed to the risk that counterparties will fail to meet their contractual obligations. To mitigate this counterparty credit risk, the Company has a practice of entering into contracts only with major financial institutions selected based upon their credit ratings and other financial factors. The Company monitors the creditworthiness of counterparties throughout the duration of the derivative instrument. Additional information is contained within Note 7, Fair Value Measurements.

Derivative Holdings Designated as Hedges

For a derivative to qualify as a hedge at inception and throughout the hedged period, the Company formally documents the nature of the hedged items and the relationships between the hedging instruments and the hedged items, as well as its risk-management objectives, strategies for undertaking the various hedge transactions, and the methods of assessing hedge effectiveness and ineffectiveness. In addition, for hedges of forecasted transactions, the significant characteristics and expected terms of a forecasted transaction must be specifically identified, and it must be probable that each forecasted transaction would occur. If it were deemed probable that the forecasted transaction would not occur, the gain or loss on the derivative instrument would be recognized in earnings immediately. No such gains or losses were recognized in earnings for any of the periods presented. Derivative financial instruments qualifying for hedge accounting must maintain a specified level of effectiveness between the hedging instrument and the item being hedged, both at inception and throughout the hedged period, which management evaluates periodically.

The primary currencies to which the Company is exposed are the euro, British pound, Canadian dollar, and Australian dollar. For option and foreign exchange forward contracts designated as cash flow hedges of the purchase of inventory, the effective portion of gains and losses is deferred as a component of Accumulated Other Comprehensive Loss (“AOCL”) and is recognized as a component of cost of sales when the related inventory is sold. The amount reclassified to cost of sales related to such contracts was not significant for any of the periods presented. The effective portion of gains or losses associated with other forward contracts is deferred as a component of AOCL until the underlying transaction is reported in earnings. The ineffective portion of gains and losses related to cash flow hedges recorded to earnings was also not significant for any of the periods presented. When using a forward contract as a hedging instrument, the Company excludes the time value of the contract from the assessment of effectiveness. At each quarter-end, substantially all of the Company’s hedged forecasted transactions are less than twelve months, and the Company expects substantially all derivative-related amounts reported in AOCL to be reclassified to earnings within twelve months.

FOOT LOCKER, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

6. Financial Instruments – (continued)

The net change in the fair value of foreign exchange derivative financial instruments designated as cash flow hedges of the purchase of inventory was a $1 million loss for both the thirteen and thirty-nine weeks ended November 1, 2014. The net change in fair value was not significant for the prior-year periods.

The notional value of the contracts outstanding at November 1, 2014 was $77 million, and these contracts extend through January 2016.

Derivative Holdings Designated as Non-Hedges

The Company enters into foreign exchange forward contracts that are not designated as hedges in order to manage the costs of foreign currency-denominated merchandise purchases and intercompany transactions. Changes in the fair value of these foreign exchange forward contracts are recorded in earnings immediately within selling, general and administrative expenses. The net change in fair value was not significant for the thirteen weeks ended November 1, 2014 and resulted in $1 million of income for the thirty-nine weeks ended November 1, 2014. The net change in fair value was not significant for the prior-year periods. The notional value of the contracts outstanding at November 1, 2014 was $18 million and these contracts extend through December 2014.

The Company mitigates the effect of fluctuating foreign exchange rates on the reporting of foreign-currency denominated earnings by entering into currency option contracts. Changes in the fair value of these foreign currency option contracts, which are designated as non-hedges, are recorded in earnings immediately within other income. The realized gains, premiums paid, and changes in the fair market value recorded were $1 million for the thirteen and thirty-nine weeks ended November 1, 2014 and were not significant for the prior-year periods. The notional value of the contract outstanding at November 1, 2014 was $31 million and this contract extends through January 2015.

Fair Value of Derivative Contracts

Many of the Company’s agreements allow for a netting arrangement. The following, presented on a gross basis, by type of contract, represents the fair value of the Company’s derivative contracts:

7. Fair Value Measurements

The Company’s financial assets recorded at fair value are categorized as follows:

FOOT LOCKER, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

7. Fair Value Measurements – (continued)

The following tables provide a summary of the Company’s recognized assets and liabilities that are measured at fair value on a recurring basis:

Available-for-sale securities are recorded at fair value with unrealized gains and losses reported, net of tax, in other comprehensive income, unless unrealized losses are determined to be other than temporary. The Company’s short-term investments matured during the second quarter of 2014. In the prior periods presented, these investments represented corporate bonds with maturity dates within one year from the purchase date. These securities were valued using model-derived valuations in which all significant inputs or significant value-drivers were observable in active markets and, therefore, were classified as Level 2 instruments.

The fair value of the auction rate security is determined by using quoted prices for similar instruments in active markets and accordingly is classified as a Level 2 instrument.

The Company’s derivative financial instruments are valued using market-based inputs to valuation models. These valuation models require a variety of inputs, including contractual terms, market prices, yield curves, and measures of volatility.

There were no transfers into or out of Level 1, Level 2, or Level 3 assets and liabilities for any of the periods presented.

The carrying value and estimated fair value of long-term debt and obligations under capital leases were as follows:

The fair value of long-term debt and obligations under capital leases is determined by using model-derived valuations in which all significant inputs or significant value-drivers are observable in active markets and, therefore, is classified as Level 2.

The carrying values of cash and cash equivalents, short-term investments, and other current receivables and payables approximate their fair value.

FOOT LOCKER, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

8. Earnings Per Share

The Company accounts for and discloses earnings per share using the treasury stock method. Basic earnings per share is computed by dividing reported net income for the period by the weighted-average number of common shares outstanding at the end of the period. Restricted stock awards, which contain non-forfeitable rights to dividends, are considered participating securities and are included in the calculation of basic earnings per share. Diluted earnings per share reflects the weighted-average number of common shares outstanding during the period used in the basic earnings per share computation plus dilutive common stock equivalents.

The computation of basic and diluted earnings per share is as follows:

The number of options excluded from the computation was not significant for the thirteen and thirty-nine weeks ended November 1, 2014. Options to purchase 1.1 million and 0.9 million shares of common stock were not included in the computation for the thirteen and thirty-nine weeks ended November 2, 2013, respectively. These options were not included because the effect would have been antidilutive. Contingently issuable shares of 0.4 million have not been included as the vesting conditions have not been satisfied as of both November 1, 2014 and November 2, 2013.

9. Pension and Postretirement Plans

The Company has defined benefit pension plans covering certain of its North American employees, which are funded in accordance with the provisions of the laws where the plans are in effect. In addition to providing pension benefits, the Company sponsors postretirement medical and life insurance plans, which are available to most of its retired U.S. employees. These medical and life insurance plans are contributory and are not funded.

The following are the components of net periodic pension benefit cost and net periodic postretirement benefit income, which is recognized as part of SG&A expense:

FOOT LOCKER, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

9. Pension and Postretirement Plans – (continued)

During the first quarters of both 2014 and 2013, the Company made contributions of $2 million to the Canadian qualified plan. No pension contributions to the U.S. qualified plan were made during the thirty-nine weeks ended November 1, 2014 and November 2, 2013. The Company continually evaluates the amount and timing of any future contributions. Additional contributions will depend on the plan asset performance and other factors.

10. Share-Based Compensation

Total compensation expense and the associated tax benefits recognized related to the Company’s share-based compensation plans is as follows:

Tax deductions in excess of the cumulative compensation cost recognized for share-based compensation arrangements were $11 million for the thirty-nine weeks ended November 1, 2014 and $8 million for the thirty-nine weeks ended November 2, 2013 and are classified as a financing activity within the Condensed Consolidated Statements of Cash Flows.

Valuation Model and Assumptions

The Company uses a Black-Scholes option-pricing model to estimate the fair value of share-based awards. The Black-Scholes option-pricing model incorporates various and highly subjective assumptions, including expected term and expected volatility.

The following table shows the Company’s assumptions used to compute the share-based compensation expense:

Compensation expense related to the Company’s stock option and stock purchase plans was $3 million and $9 million for both the thirteen and thirty-nine weeks ended November 1, 2014 and November 2, 2013, respectively. As of November 1, 2014, there was $10 million of total unrecognized compensation cost, related to nonvested stock options, which is expected to be recognized over a weighted-average period of 1.02 years.

FOOT LOCKER, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

10. Share-Based Compensation – (continued)

The information in the following table covers options granted under the Company’s stock option plans for the thirty-nine weeks ended November 1, 2014.

On May 21, 2014, the Foot Locker 2007 Stock Incentive Plan was amended to increase to 14 million shares the number of shares of the Company’s common stock reserved for all awards.

The total intrinsic value of options exercised (the difference between the market price of the Company’s common stock on the exercise date and the price paid by the optionee to exercise the option) is presented below:

The aggregate intrinsic value for stock options outstanding and for stock options exercisable (the difference between the Company’s closing stock price on the last trading day of the period and the exercise price of the options, multiplied by the number of in-the-money stock options) is presented below:

The cash received from option exercises for the thirteen and thirty-nine weeks ended November 1, 2014 was $4 million and $17 million, respectively. The cash received from option exercises for the thirteen and thirty-nine weeks ended November 2, 2013 was $4 million and $19 million, respectively. The total tax benefit realized from option exercises for the thirteen and thirty-nine weeks ended November 1, 2014, was $2 million and $7 million respectively, and was $1 million and $5 million for the corresponding prior-year periods.

FOOT LOCKER, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

10. Share-Based Compensation – (continued)

The following table summarizes information about stock options outstanding and exercisable at November 1, 2014:

Restricted Stock and Units

Restricted shares of the Company’s common stock and restricted stock units may be awarded to certain officers and key employees of the Company. Awards made to executives outside of the United States and to nonemployee directors are made in the form of restricted stock units. Each restricted stock unit represents the right to receive one share of the Company’s common stock provided that the vesting conditions are satisfied. There were 734,295 and 997,542 restricted stock units outstanding as of November 1, 2014 and November 2, 2013, respectively.

Generally, awards fully vest after the passage of time, typically three years. However, restricted stock unit grants made in connection with the Company’s long-term incentive program vest after the attainment of certain performance metrics and the passage of time. Restricted stock is considered outstanding at the time of grant and the holders have voting rights. Dividends are paid to holders of restricted stock that vest with the passage of time; for performance-based restricted stock, dividends will be accumulated and paid after the performance criteria are met. No dividends are paid on restricted stock units.

Compensation expense is recognized using the fair market value at the date of grant and is amortized over the vesting period, provided the recipient continues to be employed by the Company. The Company recorded compensation expense related to restricted stock awards, net of forfeitures, of $3 million for both the thirteen weeks ended November 1, 2014 and November 2, 2013, and $9 million and $10 million for the thirty-nine weeks ended November 1, 2014 and November 2, 2013, respectively. As of November 1, 2014, there was $14 million of total unrecognized compensation cost related to nonvested restricted awards.

Restricted shares and units activity for the thirty-nine weeks ended November 1, 2014 are summarized as follows:

FOOT LOCKER, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

10. Share-Based Compensation – (continued)

The weighted-average grant-date fair value per share was $45.24 and $34.59 for the thirty-nine weeks ended November 1, 2014 and November 2, 2013, respectively. The total value of awards for which restrictions lapsed during the thirty-nine weeks ended November 1, 2014 and November 2, 2013 was $14 million and $9 million, respectively.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

BUSINESS OVERVIEW

Foot Locker, Inc. (the “Company”), through its subsidiaries, operates in two reportable segments – Athletic Stores and Direct-to-Customers.

The Athletic Stores segment is one of the largest athletic footwear and apparel retailers in the world, with divisions that include Foot Locker, Lady Foot Locker, Kids Foot Locker, Champs Sports, Footaction and SIX:02, as well as the retail stores of Runners Point Group, including Runners Point, Sidestep, and Run², which was acquired during the second quarter of 2013.

The Direct-to-Customers segment is multi-branded and multi-channeled. This segment sells, through its affiliates, directly to customers through its Internet websites, mobile sites, and catalogs. Eastbay, one of the affiliates, is among the largest direct marketers in the United States. The Direct-to-Customers segment operates the websites for eastbay.com, final-score.com, eastbayteamsales.com, as well as websites aligned with the brand names of its store banners (footlocker.com, ladyfootlocker.com, kidsfootlocker.com, champssports.com, footaction.com, and six02.com). Additionally, this segment includes the direct-to-customer subsidiary of Runners Point Group, which operates the websites for runnerspoint.com, sidestep-shoes.com, and sp24.com.

STORE COUNT

At November 1, 2014, the Company operated 3,474 stores as compared with 3,473 and 3,510 stores at February 1, 2014 and November 2, 2013, respectively. During the thirty-nine weeks ended November 1, 2014, the Company opened 76 stores, remodeled or relocated 229 stores and closed 75 stores.

A total of 73 franchised stores were operating at November 1, 2014, as compared with 73 and 72 stores at February 1, 2014 and November 2, 2013, respectively. Revenue from the franchised stores was not significant for any of the periods presented. These stores are not included in the Company’s operating store count above.

SALES AND OPERATING RESULTS

All references to comparable-store sales for a given period relate to sales of stores that were open at the period-end and have been open for more than one year. The computation of comparable-store sales also includes the sales of the Direct-to-Customers segment. Stores opened or closed during the period are not included in the comparable-store base; however, stores closed temporarily for relocation or remodeling are included. Computations exclude the effect of foreign currency fluctuations.

Sales from acquired businesses that include inventory are included in the computation of comparable-store sales after 15 months of operations. Accordingly, sales of Runners Point Group were included in the computation of comparable-store sales beginning October 2014.

The following table summarizes results by segment:

Sales increased by $109 million, or 6.7 percent, to $1,731 million for the thirteen weeks ended November 1, 2014, from $1,622 million for the thirteen weeks ended November 2, 2013. For the thirty-nine weeks ended November 1, 2014, sales of $5,240 million increased 11.2 percent from sales of $4,714 million for the thirty-nine week period ended November 2, 2013. Excluding Runners Point Group, which was acquired during the second quarter of 2013, total sales for the year-to-date period increased 7.8 percent.

Excluding the effect of foreign currency fluctuations, total sales for the thirteen and thirty-nine week periods increased 7.7 percent and 10.9 percent, respectively, as compared with the corresponding prior-year periods. Comparable-store sales increased by 6.9 percent and 7.1 percent for the thirteen weeks and thirty-nine weeks ended November 1, 2014, respectively.

GROSS MARGIN

Gross margin, as a percentage of sales, increased to 33.2 percent for the thirteen weeks ended November 1, 2014 as compared with 33.1 percent in the corresponding prior-year period driven by the occupancy and buyers compensation expense rate, which decreased by 50 basis points reflecting improved leverage of primarily fixed costs. This was partially offset by a 40 basis point increase in the cost of merchandise rate, which reflected the result of the liquidation of CCS merchandise. The liquidation of CCS merchandise negatively affected the gross margin rate by 20 basis points. Further, the merchandise margin rate continued to be negatively affected by lower initial markups driven by vendor and category mix, and lower shipping and handling margin, offset by lower markdowns.

For the thirty-nine weeks ended November 1, 2014, gross margin, as a percentage of sales, increased to 33.3 percent as compared with 32.9 percent in the corresponding prior-year period. The occupancy and buyers compensation expense rate decreased by 70 basis points and was partially offset by a 30 basis point increase in the cost of merchandise rate. The increase in the cost of merchandise rate primarily reflects the continued effect of the factors noted in the paragraph above.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

Selling, general and administrative expenses (“SG&A”) increased by $13 million, or 3.8 percent, for the thirteen weeks ended November 1, 2014 as compared with the corresponding prior-year period. For the thirty-nine weeks ended November 1, 2014, SG&A increased by $82 million, or 8.5 percent, as compared with the corresponding prior-year period. The SG&A increase for the thirty-nine weeks ended November 1, 2014 is primarily reflective of a full nine months of Runners Point Group expenses as compared with only four months in the prior year.

Excluding the effect of foreign currency fluctuations, SG&A increased by $17 million, or 5.0 percent, and $79 million, or 8.2 percent, for the thirteen and thirty-nine weeks ended November 1, 2014, respectively, as compared with the corresponding prior-year periods.

The SG&A rate improvements reflected continued effective expense management, including store wages, which benefited from the utilization of hiring and scheduling tools, as well as associate training.

DEPRECIATION AND AMORTIZATION

Depreciation and amortization expenses decreased by $1 million for the thirteen weeks ended November 1, 2014 to $34 million, as compared with the corresponding prior-year period of $35 million. The decrease was primarily the result of capital accrual adjustments made during the third quarter of 2014, which reduced depreciation and amortization expense. For the thirty-nine weeks ended November 1, 2014, depreciation and amortization increased by $9 million to $106 million as compared with $97 million for the thirty-nine weeks ended November 2, 2013. The increase in depreciation for the thirty-nine weeks ended November 1, 2014 reflects increased capital spending for store improvements and technology, as well as the addition of Runners Point Group for a full period in the current year as compared with a partial period in the prior year.

INTEREST EXPENSE

Interest income increased by $1 million for both the thirteen and thirty-nine weeks ended November 1, 2014 reflecting income earned on higher cash and cash equivalent balances.

INCOME TAXES

The Company recorded income tax provisions of $67 million and $211 million, which represent effective tax rates of 35.8 percent and 36.1 percent, for the thirteen weeks and thirty-nine weeks ended November 1, 2014, respectively. For the thirteen weeks and thirty-nine weeks ended November 2, 2013, the Company recorded income tax provisions of $56 million and $174 million, which represented effective tax rates of 35.0 percent and 36.1 percent, respectively. The Company’s interim provision for income taxes is measured using an annual effective tax rate, adjusted for discrete items that occur within the periods presented.

The Company regularly assesses the adequacy of its provisions for income tax contingencies in accordance with the applicable authoritative guidance on accounting for income taxes.  As a result, the Company may adjust the reserves for unrecognized tax benefits considering new facts and developments, such as changes to interpretations of relevant tax law, assessments from taxing authorities, settlements with taxing authorities, and lapses of statutes of limitation. 

Included in the effective tax rate for the thirteen weeks ended November 1, 2014 is a tax reserve release of approximately $1 million due to the expiration of a foreign statute of limitation. Included in the thirteen weeks ended November 2, 2013 were tax reserve releases of $3 million due to foreign tax audit settlements.

The thirty-nine weeks ended November 1, 2014 includes tax benefits of $2 million from reserve releases due to settlements of federal, state, and foreign tax examinations and lapses of foreign statutes of limitation, as compared with the reserve releases of $5 million offset by state tax expense of $1 million as a result of an audit recognized in the corresponding prior-year period. Additionally, for the thirty-nine weeks ended November 2, 2013, in connection with the purchase of Runners Point Group, the Company recorded a discrete item of $1 million representing non-deductible acquisition costs.

The effective tax rate, excluding the reserve releases and other discrete items, for the thirteen weeks and thirty-nine weeks ended November 1, 2014 decreased as compared with the corresponding prior-year periods, due primarily to the effect of full implementation of international tax planning strategies.

The Company currently expects its fourth quarter and full year tax rate to approximate 36.5 percent, excluding the effect of any nonrecurring items that may occur. The actual tax rates will primarily depend on the level and mix of income earned in the United States as compared with its international operations. 

NET INCOME

For the thirteen weeks ended November 1, 2014, net income increased by $16 million, or 15.4 percent, to $120 million as compared with the corresponding prior-year period. For the thirty-nine weeks ended November 1, 2014, net income increased by $66 million, or 21.4 percent, to $374 million as compared with the corresponding prior-year period. The improved performance represents a 24.8 percent and 19.6 percent flow-through of increased sales to pre-tax income, for the thirteen and thirty-nine week periods ended November 1, 2014, respectively, reflecting leveraging of fixed costs, and controlling operating expenses.

RECONCILIATION OF NON-GAAP MEASURES

The Company provides non-GAAP information to assist investors with the comparison of the Company’s results period over period. The non-GAAP financial measure is provided in addition to, and not as an alternative to, the Company’s reported results prepared in accordance with GAAP. Presented below are GAAP and non-GAAP results for the thirteen and thirty-nine weeks ended November 1, 2014 and November 2, 2013, respectively.

The Company has excluded the following charges and costs to arrive at its non-GAAP results:

The Company estimates the tax effect of the non-GAAP adjustments by applying its marginal tax rate to each of the respective items.

For the thirteen and thirty-nine weeks ended November 1, 2014, the Company recorded after-tax expenses of $1 million and $2 million, respectively, for costs associated with the acquisition of Runners Point Group.

In the second quarter of 2014, the Company recorded an after-tax charge of $1 million, or $0.01 per diluted share, related to the impairment of the CCS tradename, resulting from the transition of its skate business from CCS to its Eastbay brand. During the first quarter of 2014, the Company recorded an after-tax impairment charge of $1 million to fully write down the remaining value of the tradename related to the Company’s stores in the Republic of Ireland.

For the thirteen and thirty-nine weeks ended November 2, 2013, the Company recorded $1 million, after-tax, and $4 million, after-tax, for costs associated with the acquisition of Runners Point Group, respectively. The Company also recorded $1 million, after-tax, or $0.01 per diluted share of costs related to the CCS store closures for the thirty-nine weeks ended November 2, 2013.

During the thirteen weeks ended November 2, 2013, the Company recorded benefits of $3 million or $0.02 per diluted share, to reflect the settlement of a foreign tax audit, which resulted in a reduction in tax reserves established in prior periods.

SEGMENT ANALYSIS

Athletic Stores

Athletic Stores segment sales increased by 5.3 percent to $1,521 million for the thirteen weeks ended November 1, 2014, as compared with the corresponding prior-year period. Excluding the effect of foreign currency fluctuations, Athletic Stores segment sales increased 6.4 percent for the thirteen weeks ended November 1, 2014, as compared with the corresponding prior-year period. Comparable-store sales increased by 5.8 percent.

For the thirty nine-weeks ended November 1, 2014, Athletic Stores segment sales increased by 9.9 percent to $4,646 million as compared with the corresponding prior-year period. Excluding the effect of foreign currency fluctuations, Athletic Stores segment sales increased 9.7 percent and comparable-store sales increased by 6.1 percent. The results for the year-to-date period of 2014 include incremental sales of $141 million related to the Runners Point Group stores, which were acquired in the second quarter of the prior year. As of October 2014, the sales attributable to Runners Point Group are included in the computation of comparable-store sales.

Excluding Runners Point Group which was included in comparable sales for the month of October only, all divisions within this segment experienced comparable-store sales gains for both the quarter and year-to-date periods, led by domestic Foot Locker, Kids Foot Locker, and Footaction. Champs Sports experienced a slight increase in comparable-store sales for both the quarter and year-to-date periods. This division’s results continued to be negatively affected by a decline in apparel sales and a high number of stores being closed for remodels.

Basketball, lifestyle running, and children’s footwear were strong drivers of sales increases. Sales of basketball footwear were driven by Jordan and key marquee player styles, while lifestyle running shoes from Nike and Adidas had strong results. Additionally, children’s footwear continued to perform well across multiple divisions. Apparel sales were challenging primarily in Foot Locker Europe and Champs Sports, as customers have shifted away from certain lifestyle and licensed apparel programs, which had previously driven strong results.

Lady Foot Locker experienced a comparable-store sales increase for both the thirteen and thirty-nine weeks ended November 1, 2014. The shift into more performance-oriented assortments has been resonating with customers, as both footwear and apparel grew on a comparable-sales basis. Overall sales for Lady Foot Locker for both the quarter and year-to-date periods declined, as compared with the corresponding prior-year periods, primarily reflecting a net decline of 44 stores. The Company continues to test and evaluate merchandise assortments and store layouts focused on athletically active women.

In addition, the Athletic Stores segment continues to benefit from strong banner differentiation, which has created unique store designs and product assortments which have resonated with the customer and enhanced the shopping experience.

Athletic Stores division profit for the thirteen weeks ended November 1, 2014 increased to $181 million, or 11.9 percent, as a percentage of sales, as compared with division profit of $159 million, or 11.0 percent, as a percentage of sales, for the thirteen weeks ended November 2, 2013. For the thirty-nine weeks ended November 1, 2014 division profit increased to $577 million, or 12.4 percent, as a percentage of sales, as compared with division profit of $486 million, or 11.5 percent, as a percentage of sales, for the corresponding prior-year period.

Included in the results of the Athletic Stores segment for the thirty-nine weeks ended November 1, 2014 was a $1 million impairment charge related to the tradename for our stores operating in the Republic of Ireland, reflecting historical and projected underperformance. Included in the corresponding prior-year period of 2013 was a charge of $2 million recorded in connection with the closure of all CCS stores.

Overall, the improvement for both the quarter and year-to-date periods primarily reflected higher sales and effective control over variable expenses, such as store wages.

Direct-to-Customers

Direct-to-Customers sales increased by 18.0 percent to $210 million for the thirteen weeks ended November 1, 2014, as compared with the corresponding prior-year period. Comparable sales increased by 15.5 percent. Sales at each of the U.S. store-banner websites increased significantly, increasing collectively approximately 40 percent.

For the thirty-nine weeks ended November 1, 2014, sales increased by 22.2 percent to $594 million as compared with the corresponding prior-year period. Comparable sales were 15.9 percent. Direct-to-Customers sales included $19 million of incremental sales related to the e-commerce division of Runners Point Group, as the prior-year period included only a partial year. Excluding these sales, increases were primarily the result of continued strong sales performance of the Company’s U.S. store-banner websites.

Sales for both the quarter and year-to-date periods of the current year were led by sales of basketball and lifestyle running footwear.

Direct-to-Customers division profit for the thirteen and thirty-nine weeks ended November 1, 2014 increased by $5 million to $25 million and increased by $14 million to $67 million, respectively, as compared with the corresponding prior-year periods. Division profit, as a percentage of sales, was 11.9 percent and 11.3 percent for the thirteen and thirty-nine weeks ended November 1, 2014, respectively, as compared with 11.2 percent and 10.9 percent for the corresponding prior-year periods. Included in the results of the Direct-to-Customers segment for the thirty-nine weeks ended November 1, 2014 was a $2 million impairment charge related to the CCS tradename, which was triggered by the Company’s decision to transition the skate business to the Eastbay banner.

Gross margin for the Direct-to-Customers segment for both the quarter and year-to-date periods was negatively affected by the liquidation of CCS merchandise and the effects of providing additional free shipping offers. Notwithstanding this, the increase in division profit was the result of strong flow-through of sales to profits. In addition, catalog expenses were lower due to a shift in the timing of certain catalogs to the fourth quarter as compared with the prior year.

Corporate Expense

Corporate expense consists of unallocated selling, general and administrative expenses, as well as depreciation and amortization related to the Company’s corporate headquarters, centrally managed departments, unallocated insurance and benefit programs, certain foreign exchange transaction gains and losses, and other items. The allocation of corporate expense to the operating divisions is adjusted annually based upon an internal study; accordingly, the allocation increased by $1 million and $3 million for the thirteen and thirty-nine weeks ended November 1, 2014, respectively, thus reducing corporate expense. Excluding this change, as compared with the corresponding prior year periods, corporate expense increased by $3 million and $6 million for the thirteen and thirty-nine weeks ended November 1, 2014, respectively.

Acquisition and integration costs related to Runners Point Group were $1 million and $2 million for the thirteen and thirty-nine weeks ended November 1, 2014, respectively. This is compared with the corresponding prior-year periods of $1 million and $4 million for the thirteen and thirty-nine weeks ended November 2, 2013, respectively.

Excluding the allocation change and costs associated with Runners Point Group, corporate expense increased primarily related to increased incentive compensation and legal costs. During the first quarter of 2014, the Company increased its legal reserves by $2 million.

LIQUIDITY AND CAPITAL RESOURCES

The Company’s primary source of liquidity has been cash flow from operations, while the principal uses of cash have been to: fund inventory and other working capital requirements; finance capital expenditures related to store openings, store remodelings, Internet and mobile sites, information systems, and support facilities; make retirement plan contributions, quarterly dividend payments, share repurchases, and interest payments; and fund other cash requirements to support the development of its short-term and long-term operating strategies. The Company generally finances real estate with operating leases. Management believes its cash, cash equivalents and future cash flow from operations will be adequate to fund these requirements.

From time to time the Company may also seek to retire or purchase outstanding debt through open market purchases, privately negotiated transactions, or otherwise. Share repurchases and retirement of debt, if any, will depend on prevailing market conditions, liquidity requirements, contractual restrictions, and other factors. As of November 1, 2014, approximately $196 million remained on the Company’s $600 million share repurchase program.

Any material adverse change in customer demand, fashion trends, competitive market forces, or customer acceptance of the Company’s merchandise mix and retail locations, uncertainties related to the effect of competitive products and pricing, the Company’s reliance on a few key vendors for a significant portion of its merchandise purchases and risks associated with global product sourcing, economic conditions worldwide, the effects of currency fluctuations, as well as other factors listed under the heading “Disclosure Regarding Forward-Looking Statements,” could affect the ability of the Company to continue to fund its needs from business operations.

Operating Activities

Net cash provided by operating activities was $439 million and $327 million for the thirty-nine weeks ended November 1, 2014 and November 2, 2013, respectively. These amounts reflect net income adjusted for non-cash items, non-cash impairment charges, and working capital changes. The improvement reflects the Company’s earnings strength and working capital improvements, partially offset by a $77 million increase in cash paid for income taxes during the thirty-nine weeks ended November 1, 2014.

Investing Activities

Net cash used in investing activities was $129 million and $221 million for the thirty-nine weeks ended November 1, 2014 and November 2, 2013, respectively. The current year reflects $138 million in capital expenditures partially offset by $9 million for the maturities of short-term investments. Capital expenditures in the current year were $19 million lower as compared with the corresponding prior-year period, representing a shift in the timing of projects. The Company’s full year forecast for capital expenditures is $207 million, which includes $172 million related to the remodeling or relocation of existing stores and approximately 88 new store openings, as well as $35 million for the development of information systems, websites, and infrastructure. The prior year included $81 million for the purchase of Runners Point Group, net of cash acquired.

Financing Activities

Net cash used in financing was $240 million and $226 million for the thirty-nine weeks ended November 1, 2014 and November 2, 2013, respectively. The Company repurchased 3,547,553 shares of its common stock for $174 million during the thirty-nine weeks ended November 1, 2014, this represents an increase of $7 million as compared to the corresponding prior-year period. During the first three quarters of 2014 and 2013, the Company declared and paid dividends of $96 million and $89 million, respectively. These represent quarterly rates of $0.22 and $0.20 per share for 2014 and 2013, respectively. Additionally, the Company received proceeds of $22 million from the issuance of common stock in connection with employee stock programs for both the thirty-nine weeks ended November 1, 2014 and November 2, 2013. In connection with stock option exercises and share-based compensation programs, the Company recorded excess tax benefits of $11 million and $8 million as a financing activity for the thirty-nine weeks ended November 1, 2014 and November 2, 2013, respectively.

CONTRACTUAL OBLIGATIONS AND COMMITMENTS

For a description of our contractual obligations and other commercial commitments as of February 1, 2014, see our 2013 Annual Report on Form 10-K. During the thirty-nine weeks ended November 1, 2014, there were no material changes outside the ordinary course of business.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

There have been no significant changes to the Company’s critical accounting policies and estimates from the information provided in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” included in the 2013 Annual Report on Form 10-K.

RECENT ACCOUNTING PRONOUNCEMENTS

Descriptions of the recently issued accounting principles, if any, and the accounting principles adopted by the Company during the thirty-nine weeks ended November 1, 2014 are included in Note 1 to the Condensed Consolidated Financial Statements.

DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS

This report contains forward-looking statements within the meaning of the federal securities laws. Other than statements of historical facts, all statements which address activities, events, or developments that the Company anticipates will or may occur in the future, including but not limited to such things as future capital expenditures, expansion, strategic plans, financial objectives, dividend payments, stock repurchases, growth of the Company’s business and operations, including future cash flows, revenues, and earnings, and other such matters, are forward-looking statements. These forward-looking statements are based on many assumptions and factors which are detailed in the Company’s filings with the Securities and Exchange Commission, including the effects of currency fluctuations, customer demand, fashion trends, competitive market forces, uncertainties related to the effect of competitive products and pricing, customer acceptance of the Company’s merchandise mix and retail locations, the Company’s reliance on a few key vendors for a majority of its merchandise purchases (including a significant portion from one key vendor), pandemics and similar major health concerns, unseasonable weather, deterioration of global financial markets, economic conditions worldwide, deterioration of business and economic conditions, any changes in business, political and economic conditions due to the threat of future terrorist activities in the United States or in other parts of the world and related U.S. military action overseas, the ability of the Company to execute its business and strategic plans effectively with regard to each of its business units, and risks associated with global product sourcing, including political instability, changes in import regulations, and disruptions to transportation services and distribution.

For additional discussion on risks and uncertainties that may affect forward-looking statements, see “Risk Factors” disclosed in the 2013 Annual Report on Form 10-K. Any changes in such assumptions or factors could produce significantly different results. The Company undertakes no obligation to update forward-looking statements, whether as a result of new information, future events, or otherwise.

Item 4. Controls and Procedures

The Company’s management performed an evaluation under the supervision and with the participation of the Company’s Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), and completed an evaluation as of November 1, 2014 of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as that term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)). Based on that evaluation, the Company’s CEO and CFO concluded that the Company’s disclosure controls and procedures were effective to ensure that information relating to the Company that is required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC rules and forms, and is accumulated and communicated to management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.

During the quarter ended November 1, 2014, there were no changes in the Company’s internal control over financial reporting (as defined in Rules 13a-15(f) of the Exchange Act) that materially affected or are reasonably likely to affect the Company’s internal control over financial reporting.

PART II - OTHER INFORMATION

Item 1. Legal Proceedings

Legal proceedings pending against the Company or its consolidated subsidiaries consist of ordinary, routine litigation, including administrative proceedings, incidental to the business of the Company or businesses that have been sold or disposed of by the Company in past years. These legal proceedings include commercial, intellectual property, customer, environmental, and employment-related claims.

Certain of the Company’s subsidiaries are defendants in a number of lawsuits filed in state and federal courts containing various class action allegations under federal or state wage and hour laws, including allegations concerning unpaid overtime, meal and rest breaks, and uniforms.

The Company is a defendant in one such case in which plaintiff alleges that the Company permitted unpaid off-the-clock hours in violation of the Fair Labor Standards Act and state labor laws. The case, Pereira v. Foot Locker, was filed in the U.S. District Court for the Eastern District of Pennsylvania in 2007. In his complaint, in addition to unpaid wage and overtime allegations, plaintiff seeks compensatory and punitive damages, injunctive relief, and attorneys’ fees and costs. In 2009, the Court conditionally certified a nationwide collective action. During the course of 2010, notices were sent to approximately 81,888 current and former employees of the Company offering them the opportunity to participate in the class action, and approximately 5,027 have opted in.

The Company is a defendant in additional purported wage and hour class actions that assert claims similar to those asserted in Pereira and seek similar remedies. With the exception of Hill v. Foot Locker filed in state court in Illinois, Kissinger v. Foot Locker filed in state court of California, Cortes v. Foot Locker filed in federal court in New York, and McGlothin v. Foot Locker filed in state court in California, all of these actions were consolidated by the United States Judicial Panel on Multidistrict Litigation with Pereira under the caption In re Foot Locker, Inc. Fair Labor Standards Act and Wage and Hour Litigation. In Hill v. Foot Locker, in May 2011, the court granted plaintiffs’ motion for certification of an opt-out class covering certain Illinois employees only. The Company and plaintiffs have entered into a proposed settlement agreement to resolve the consolidated cases, Hill and Cortes, that is subject to court approval.

The Company and the Company’s U.S. retirement plan are defendants in a purported class action (Osberg v. Foot Locker, filed in the U.S. District Court for the Southern District of New York) in which the plaintiff alleges that, in connection with the 1996 conversion of the retirement plan to a defined benefit plan with a cash balance formula, the Company and the retirement plan failed to properly advise plan participants of the “wear-away” effect of the conversion. Plaintiff asserted claims for: (a) breach of fiduciary duty under the Employee Retirement Income Security Act of 1974 (ERISA); (b) violation of the statutory provisions governing the content of the Summary Plan Description; (c) violation of the notice provision of Section 204(h) of ERISA; and (d) violation of ERISA’s age discrimination provisions. In September 2009, the court granted the Company's motion to dismiss the Section 204(h) claim and the age discrimination claim. In December 2012, the court granted the Company’s motion for summary judgment on the remaining two claims, dismissing the action. Plaintiff appealed to the U.S. Court of Appeals for the Second Circuit, which issued a Summary Order on February 13, 2014 that affirmed the judgment of the District Court in part, and vacated and remanded in part. In September 2014, the District Court certified the class and reinstated the claim alleging violation. Additionally, the District Court certified a class with respect to Plaintiff’s breach of fiduciary duty claim and also reinstated the claim alleging violation of the statutory provisions governing the content of the Summary Plan Description. The district court thereafter issued a second ruling certifying a class for the Summary Plan Description Claim. The Company is seeking leave to appeal both class certification rulings to the U.S. Court of Appeals for the Second Circuit.

Management does not believe that the outcome of any such legal proceedings pending against the Company or its consolidated subsidiaries, including In re Foot Locker, Inc. Fair Labor Standards Act and Wage and Hour Litigation, Hill, Cortes, Kissinger, McGlothin, and Osberg, as described above, would have a material adverse effect on the Company’s consolidated financial position, liquidity, or results of operations, taken as a whole. Litigation is inherently unpredictable, and judgments could be rendered or settlements entered that could adversely affect the Company’s operating results or cash flows in a particular period.

Item 1A. Risk Factors

There were no material changes to the risk factors disclosed in the 2013 Annual Report on Form 10-K.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

The following table provides information with respect to shares of the Company’s common stock that the Company repurchased during the thirteen weeks ended November 1, 2014.