Zumiez Inc - Quarter Report: 2009 October (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.

 

FORM 10-Q

 

 

Commission file number 000-51300

 

ZUMIEZ INC.

(Exact name of registrant as specified in its charter)

 

 

6300 Merrill Creek Parkway, Suite B, Everett, WA 98203

 (Address of principal executive offices)  (Zip Code)

 

Registrant’s telephone number, including area code:  (425) 551-1500

 

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 x  No o

 

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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o  No o

 

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 definition of “accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act).  (Check one):

 

 

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

 

Number of shares of Common Stock outstanding as of December 7, 2009 was 30,254,949 shares.

 

 

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ZUMIEZ INC.

FORM 10-Q

TABLE OF CONTENTS

 

Part I.		Financial Information
		Item 1.		Condensed Consolidated Financial Statements
				Condensed Consolidated Balance Sheets at October 31, 2009 (unaudited) and January 31, 2009		3
				Condensed Consolidated Statements of Operations for the three and nine months ended October 31, 2009 and November 1, 2008 (unaudited)		4
				Condensed Consolidated Statement of Changes in Shareholders’ Equity for the nine months ended October 31, 2009 (unaudited)		5
				Condensed Consolidated Statements of Cash Flows for the nine months ended October 31, 2009 and November 1, 2008 (unaudited)		6
				Notes to Condensed Consolidated Financial Statements		7
		Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations		17
		Item 3.		Quantitative and Qualitative Disclosures About Market Risk		34
		Item 4.		Controls and Procedures		34
Part II.		Other Information				34
		Item 1.		Legal Proceedings		34
		Item 1A.		Risk Factors		34
		Item 2.		Changes in Securities; Use of Proceeds and Issuer Purchases of Equity Securities		34
		Item 3.		Defaults Upon Senior Securities		34
		Item 4.		Submission of Matters to a Vote of Security Holders		34
		Item 5.		Other Information		34
		Item 6.		Exhibits		35
Signature						36
Exhibit 31.1
Exhibit 31.2
Exhibit 32.1

 

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ZUMIEZ INC.
CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share amounts)

 

		October 31, 2009			January 31, 2009
		(Unaudited)
Assets
Current assets
Cash and cash equivalents		$	10,489		$	33,057
Marketable securities		71,315			45,525
Receivables		7,879			4,555
Inventory		76,381			51,974
Prepaid expenses and other		6,404			5,614
Deferred tax assets		2,995			2,588
Total current assets		175,463			143,313
Leasehold improvements and equipment, net		71,819			73,932
Goodwill and other intangibles		13,198			13,236
Marketable securities - long-term		832			1,767
Deferred tax assets		4,595			1,101
Total long-term assets		90,444			90,036
Total assets		$	265,907		$	233,349
Liabilities and Shareholders’ Equity
Current liabilities
Trade accounts payable		$	33,748		$	15,909
Accrued payroll and payroll taxes		6,133			4,739
Income taxes payable		2,705			238
Current portion of deferred rent and tenant allowances		3,368			2,682
Other accrued liabilities		8,315			7,653
Total current liabilities		54,269			31,221
Long-term deferred rent and tenant allowances, less current portion		27,632			24,000
Other long-term liabilities		1,310			177
Total long-term liabilities		28,942			24,177
Total liabilities		83,211			55,398
Commitments and contingencies (Note 3)
Shareholders’ equity
Preferred stock, no par value, 20,000,000 shares authorized; none issued and outstanding		—			—
Common stock, no par value, 50,000,000 shares authorized; 30,254,949 shares issued and outstanding at October 31, 2009, 29,533,067 shares issued and outstanding at January 31, 2009		80,227			75,789
Accumulated other comprehensive income		95			117
Retained earnings		102,374			102,045
Total shareholders’ equity		182,696			177,951
Total liabilities and shareholders’ equity		$	265,907		$	233,349

 

See accompanying notes to condensed consolidated financial statements

 

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ZUMIEZ INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except share and per share amounts)
(Unaudited)

 

		Three Months Ended						Nine Months Ended
		October 31,			November 1,			October 31,			November 1,
		2009			2008			2009			2008
Net sales		$	113,192		$	112,245		$	275,169		$	283,205
Cost of goods sold		73,093			72,982			188,527			189,279
Gross profit		40,099			39,263			86,642			93,926
Selling, general and administrative expenses		31,742			28,879			86,950			78,004
Operating profit (loss)		8,357			10,384			(308		)	15,922
Interest income, net		161			576			825			1,660
Other Income		5			36			5			36
Earnings before income taxes		8,523			10,996			522			17,618
Provision for income taxes		3,450			4,178			193			6,711
Net income		$	5,073		$	6,818		$	329		$	10,907
Basic net income per share		$	0.17		$	0.23		$	0.01		$	0.37
Diluted net income per share		$	0.17		$	0.23		$	0.01		$	0.37
Weighted average shares used in computation of earnings per share:
Basic		29,562,733			29,172,869			29,457,792			29,086,196
Diluted		30,243,944			29,373,990			30,038,982			29,394,416

 

See accompanying notes to condensed consolidated financial statements

 

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ZUMIEZ INC.
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY

(in thousands)
(Unaudited)

 

							Accumulated
							Other
		Common Stock					Comprehensive			Retained
		Shares		Amount			Income (Loss)			Earnings			Total
Balance at January 31, 2009		29,533		$	75,789		$	117		$	102,045		$	177,951
Common stock issued through employee stock benefit plans, including tax benefit of $671		722		1,407			—			—			1,407
Stock-based compensation expense		—		3,031									3,031
Unrealized losses, net of tax benefit of $14		—		—			(22		)	—			(22		)
Net income										329			329
Balance at October 31, 2009		30,255		$	80,227		$	95		$	102,374		$	182,696

 

See accompanying notes to condensed consolidated financial statements

 

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ZUMIEZ INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

 

		Nine Months Ended
		October 31, 2009			November 1, 2008
Cash flows from operating activities:
Net income		$	329		$	10,907
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		16,255			14,168
Deferred tax expense		(3,886		)	(2,634		)
Stock-based compensation expense		3,031			3,252
Loss on disposal of assets		143			155
Gain from sales of marketable securities, net		—			(36		)
Excess tax benefit from stock options		(671		)	(756		)
Impairment of long-lived assets		713			—
Changes in operating assets and liabilities:
Receivables		(1,068		)	(1,920		)
Inventory		(24,407		)	(33,126		)
Prepaid expenses and other		(790		)	(1,495		)
Trade accounts payable		17,839			22,240
Accrued payroll and payroll taxes		1,394			(602		)
Income taxes payable		3,138			5,295
Other accrued liabilities		834			(2,033		)
Deferred rent and tenant allowances		4,318			6,412
Net cash provided by operating activities		17,172			19,827
Cash flows from investing activities:
Additions to leasehold improvements and equipment		(15,238		)	(26,295		)
Purchases of marketable securities		(61,028		)	(82,607		)
Sales and maturities of marketable securities		35,119			87,948
Net cash used in investing activities		(41,147		)	(20,954		)
Cash flows from financing activities:
Change in book overdraft		—			(3,337		)
Proceeds from exercise of stock options		736			1,012
Excess tax benefit from stock options		671			756
Net cash provided by (used in) financing activities		1,407			(1,569		)
Net decrease in cash and cash equivalents		(22,568		)	(2,696		)
Cash and cash equivalents, beginning of period		33,057			11,945
Cash and cash equivalents, end of period		$	10,489		$	9,249
Supplemental disclosure on cash flow information:
Cash paid during the period for interest		$	10		$	9
Cash paid during the period for income taxes		944			4,115
Non-cash investing activity - refundable use tax on leasehold improvments and equipment		(2,256		)	—
Non-cash investing activity - asset retirement obligations in other long-term liabilities		961			—

 

See accompanying notes to condensed consolidated financial statements

 

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ZUMIEZ INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

1. Nature of Business and Basis of Presentation

 

Basis of Presentation—The accompanying unaudited  condensed consolidated  financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements.

 

In the opinion of management, the unaudited condensed consolidated financial statements contain all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of the condensed consolidated balance sheet as of October 31, 2009, the condensed consolidated statements of operations for the three and nine months ended October 31, 2009 and November 1, 2008, the condensed consolidated statement of changes in shareholders’ equity for the nine months ended October 31, 2009 and the condensed consolidated statements of cash flows for the nine months ended October 31, 2009 and November 1, 2008.

 

The financial data at January 31, 2009 is derived from audited financial statements which are included in the Company’s Annual Report on Form 10-K for the year ended January 31, 2009, and should be read in conjunction with the audited financial statements and notes thereto.  Interim results are not necessarily indicative of results for the full year.

 

Principles of Consolidation—The unaudited  condensed consolidated financial statements include the accounts of Zumiez Inc. and its subsidiary, Zumiez Nevada, LLC, (collectively, “the Company”).  All significant inter-company transactions and balances are eliminated in consolidation.

 

Use of Estimates—The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenues and expenses during the reporting period.  These estimates can also affect supplemental information disclosed by the Company, including information about contingencies, risk, and financial condition.  In preparing the financial statements, the Company makes routine estimates and judgments in determining the net realizable value of accounts receivable, inventory, leasehold improvements and equipment, marketable securities, goodwill and other intangibles and accrued liabilities.  Some of the more significant estimates include the allowance for sales returns, the reserve for inventory valuation estimates, medical and dental insurance reserve, the expected useful lives of leasehold improvements and equipment, asset retirement obligations and assumed future cash flows supporting long-lived assets.  Actual results could differ from those estimates.  The results of operations for the three and nine months ended October 31, 2009 are not necessarily indicative of the results that might be expected for fiscal 2009.  For further information, refer to the Company’s financial statements and notes included in the Company’s Form 10-K filed on March 23, 2009.

 

Nature of Business—The Company is a leading specialty retailer of action sports related apparel, footwear, equipment and accessories operating under the Zumiez brand name.  As of October 31, 2009, the Company operated 378 stores primarily located in shopping malls, giving the Company a presence in 35 states.  The Company’s stores cater to young men and women between the ages of 12 and 24 who seek brands representing a lifestyle centered on activities that include skateboarding, surfing, snowboarding, bicycle motocross (or “BMX”) and motocross.  The Company supports the action sports lifestyle and promotes its brand through a multi-faceted marketing approach that is designed to integrate its brand image with its customers’ activities and interests.  In addition, the Company operates a website that sells merchandise online and provides content and a community for its target customers.  The Company, based in Everett, Washington, was formed in August 1978 and operates within one reportable segment.

 

Fiscal Year—The Company uses a fiscal calendar widely used by the retail industry which results in a fiscal year consisting of a 52-week or 53-week period ending on the Saturday closest to January 31.  Each fiscal year consists of four 13-week quarters, with an extra week added to the fourth quarter every five or six years.  “Fiscal 2008” was the 52-week period ended January 31, 2009.  The first nine months of fiscal 2009 was the 39-week period ended October 31, 2009.  The first nine months of fiscal 2008 was the 39-week period ended November 1, 2008.  “Fiscal 2009” is the 52-week period ending January 30, 2010.

 

Reclassification of Previously Issued Financial Statements— The Company has reclassified certain current liabilities on the condensed consolidated balance sheet as of January 31, 2009 related to store equipment from current portion of deferred rent and tenant allowances to other accrued liabilities in the amount of $53,000.  The Company also revised the classification of the long-term portion of these certain liabilities from long-term deferred rent and tenant allowances to other long-term liabilities as of January 31, 2009 in the approximate of $177,000.  There was no impact on total current liabilities and total long-term liabilities as of January 31, 2009.  As a result of the reclassification, the statement of cash flows for the nine months ended November 1, 2008 was revised to

 

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reflect this reclassification.  The effect of the reclassification decreased the use of operating cash from other accrued liabilities and reduced the operating cash provided by deferred tenant allowances by approximately $211,000 for the nine months ended November 1, 2008 on the condensed consolidated statement of cash flows.  There was no impact on the net cash provided by operating activities for the nine months ended November 1, 2008 on the condensed consolidated statement of cash flows.

 

2. Summary of Significant Accounting Policies

 

Information regarding the Company’s significant accounting policies is contained in Note 2, “Summary of Significant Accounting Policies,” to the consolidated financial statements in the Company’s Form 10-K filed on March 23, 2009.  Presented below in this note and the following notes is supplemental information that should be read in conjunction with “Notes to Consolidated Financial Statements” in that annual report.  We follow accounting standards set by the Financial Accounting Standards Board, commonly referred to as the “FASB.”  The FASB sets generally accepted accounting principles (GAAP) that we follow to ensure we consistently report our financial condition, results of operations, and cash flows.  References to GAAP issued by the FASB in these footnotes are to the FASB Accounting Standards Codification, referred to as Codification or “ASC.”  The FASB finalized the Codification effective for periods ending on or after September 15, 2009.  For further discussion of the Codification see “Critical Accounting Policies and Estimates” in Management’s Discussion and Analysis of Financial Condition and Results of Operations elsewhere in this report.

 

Marketable Securities— The Company considers all liquid investments with original maturity of three months or less when purchased to be cash equivalents.

 

The following tables summarize the estimated fair value of our cash and marketable securities, the gross unrealized holding gains and losses, the other-than-temporarily impaired gross unrealized losses and the length of time available-for-sale securities were in a continuous unrealized loss positions as of October 31, 2009 and January 31, 2009 (in thousands):

 

		October 31, 2009
		Amortized Cost			Gross Unrealized Holding Gains			Gross Unrealized Holding Losses			Estimated Fair Value			Unrealized Loss Position Less Than Twelve Months			Continuous Unrealized Loss Position Greater Than Twelve Months
Cash and cash equivalents:
Cash		$	10,489		$	—		$	—		$	10,489		$	—		$	—
Total cash and cash equivalents		10,489			—			—			10,489			—			—
Short-term investments
State and local government securities		50,065			262			(6		)	50,321			(6		)	—
Total short-term investments		50,065			262			(6		)	50,321			(6		)	—
Long-term investments
State and local government securities		21,928			82			(184		)	21,826			(16		)	(168		)
Total long-term investments		21,928			82			(184		)	21,826			(16		)	(168		)
Total		$	82,482		$	344		$	(190	)	$	82,636		$	(22	)	$	(168	)

 

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		January 31, 2009
		Amortized Cost			Gross Unrealized Holding Gains			Gross Unrealized Holding Losses			Estimated Fair Value			Unrealized Loss Position Less Than Twelve Months			Continuous Unrealized Loss Position Greater Than Twelve Months
Cash and cash equivalents:
Cash		$	33,057		$	—		$	—		$	33,057		$	—		$	—
Total cash and cash equivalents		33,057			—			—			33,057			—			—
Short-term investments
Treasury and agency securities		8,329			61			—			8,390			—			—
State and local government securities		21,235			149			—			21,384			—			—
Total short-term investments		29,564			210			—			29,774			—			—
Long-term investments
State and local government securities		17,540			253			(275		)	17,518			(275		)	—
Total long-term investments		17,540			253			(275		)	17,518			(275		)	—
Total		$	80,161		$	463		$	(275	)	$	80,349		$	(275	)	$	—

 

The long-term gross unrealized holding losses on the state and local obligations primarily consist of an unrealized loss on the Company’s sole auction rate security.  The Company has the ability and intent to hold its available-for-sale securities until recovery of fair value, which may be at maturity, and thus does not currently consider any securities to be other-than-temporarily impaired.  All of our available-for-sale securities mature in two years or less.

 

The Company did not record a realized loss for other-than-temporary impairments during the three and nine months ended October 31, 2009 or for the fiscal year ended January 31, 2009.

 

At October 31, 2009, marketable securities, classified as available for sale, were $72.1 million and consisted primarily of state and local municipal instruments, U.S. treasury reserves and U.S. agency debt instruments with original maturities over 90 days.  As of January 31, 2009, we held two separate $1.0 million auction rate securities.  In May 2009, one of the auction rate securities sold at auction for par.  As of October 31, 2009, we had $0.8 million invested, net of temporary impairment charge of $0.2 million, in an auction rate security that is classified as long-term, available-for-sale marketable securities on our condensed consolidated balance sheet.

 

Auction rate securities are generally long-term debt instruments that provide liquidity through a Dutch auction process that resets the applicable interest rate at pre-determined calendar intervals.  This mechanism generally allows existing investors to rollover their holdings and continue to own their respective securities or liquidate their holdings by selling their securities at par value.  Prior to February 3, 2008, we invested in these securities for short periods of time as part of our cash management program.  However, the uncertainties in the credit markets, that began in early 2008,  have prevented us and other investors from liquidating holdings of auction rate securities in recent auctions for these securities because the amount of securities submitted for sale has exceeded the amount of purchase orders.  Should the auction continue to fail, we anticipate we have the ability to hold the security until the liquidity in the market improves.  The investment is fully collateralized by the United States government.  Although we are uncertain as to when the liquidity issues relating to this investment will improve, we consider the issue temporary.  It is possible that further declines in fair value may occur, and those declines, if any, would be recognized in our condensed consolidated balance sheet as “accumulated other comprehensive income (loss).”  We continue to monitor the market for auction rate securities and consider its impact, if any, on the fair market value of the investment.

 

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Receivables— At October 31, 2009 and January 31, 2009, receivables included the following (in thousands):

 

		October 31, 2009			January 31, 2009
Credit cards receivable		$	2,270		$	1,884
Refundable use tax		2,256			—
Tenant allowances receivable		1,348			901
Interest receivable		977			418
Vendor credits		474			410
Employee receivables		331			483
Other receivables		223			459
		$	7,879		$	4,555

 

The Company does not extend credit to its customers except through independent third-party credit cards, which are generally collected within several business days.  The refundable use tax amount in the table above of approximately $2.3 million represents an overpayment of use tax on construction costs to build and remodel stores that is expected to be collected or credited from State jurisdictions.

 

Merchandise Inventories—Merchandise inventories are valued at the lower of cost or market.  The cost of merchandise inventories are based upon an average cost methodology.  Merchandise inventories may include items that have been written down to the Company’s best estimate of their net realizable value.  The Company’s decisions to write-down its merchandise inventories are based on its current rate of sale, the age of the inventory and other factors.  Actual final sales prices to customers may be higher or lower than the Company’s estimated sales prices and could result in a fluctuation in gross profit.  Historically, any write-downs have not been significant to the Company.  We have reserved for inventory as of October 31, 2009 and January 31, 2009 in the amounts of approximately $1.5 million and $3.6 million.  The inventory reserve includes inventory whose estimated market value is below cost, and an estimate for inventory shrinkage.  These reserve amounts are evaluated quarterly.  The inventory related to these reserves is not marked up in subsequent periods.

 

Leasehold Improvements and Equipment—Leasehold improvements and equipment are stated at cost less accumulated depreciation utilizing the straight-line method over the assets’ estimated useful lives.  The useful lives of our major classes of assets are as follows:

 

Leasehold improvements		Lesser of 7 years or the term of the lease
Fixtures		3 — 7 years
Computer equipment, software, store equipment & other		3 — 5 years

 

The cost and related accumulated depreciation of assets sold or otherwise disposed of is removed from the accounts and the related gain or loss is reported in the condensed consolidated statement of operations.

 

Valuation of Long-Lived Assets—The Company reviews the carrying value of long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable.  Measurement of the impairment loss is based on the fair value of the asset or group of assets.  Generally, fair value will be determined using accepted valuation techniques, such as the present value of expected future cash flows.

 

Management performs a review of the carrying value of long-lived assets conducted in accordance with GAAP on a quarterly basis.  The third quarter 2009 review revealed that six stores were impaired, resulting in a non-cash impairment charge of approximately $0.4 million for the three months ended October 31, 2009.  For the nine month period ended October 31, 2009 a total of seven stores were determined to be impaired resulting in a non-cash impairment charge of approximately $0.7 million.  The non-cash impairment charge is included in selling, general and administrative expenses for the three and nine months ended October 31, 2009.

 

Fair Value of Financial Instruments—The Company discloses the estimated fair value of certain assets and liabilities as financial instruments.  Financial instruments are generally defined as cash, evidence of ownership interest in an entity, or a contractual obligation that both conveys to one entity a right to receive cash or other financial instruments from another entity and imposes on the other entity the obligation to deliver cash or other financial instruments to the first entity.  At October 31, 2009 and January 31, 2009, the carrying amounts of cash and cash equivalents, receivables, payables and other accrued liabilities approximated fair value because of the short maturity of these financial instruments.  The carrying value of marketable securities, excluding auction rate securities described below, approximate the fair value because these financial instruments have floating interest rates, which reflect current market conditions.

 

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Generally Accepted Accounting Principles defines fair value, establishes a framework for measuring fair value and requires disclosures about fair value measurements.  The FASB issued additional guidance that provides advice on determining whether a market for a financial asset is not active and eliminates the proposed presumption that all transactions are distressed (not orderly) unless proven otherwise.  Contractual maturities of investments underlying our available-for-sale securities at October 31, 2009 included $0.8 million in an auction rate security, net of $0.2 million temporary impairment.  Based on current market conditions, auctions related to this security may be unsuccessful at the scheduled auction.  An unsuccessful auction could result in our holding the security beyond the next scheduled auction reset date if a secondary market does not develop; therefore, limiting the short-term liquidity of the investment.

 

Other Accrued Liabilities—At October 31, 2009 and January 31, 2009 other accrued liabilities consisted of the following:

 

		October 31, 2009			January 31, 2009
Accrued payables		$	2,589		$	2,564
Unredeemed gift cards		1,970			3,061
Accrued sales tax		1,676			1,425
Accrued legal (see note 3)		1,424			—
Other current liabilities		656			603
		$	8,315		$	7,653

 

Cost of Goods Sold—Cost of goods sold consists of branded merchandise costs, and our private label merchandise including design, sourcing, importing and inbound freight costs.  Our cost of sales also includes shrinkage, certain promotional costs, buying, store occupancy and distribution and warehousing costs.  This may not be comparable to the way in which the Company’s competitors or other retailers compute their cost of goods sold.

 

With respect to the freight component of our ecommerce sales, we arrange and pay the freight for our customers and bill them for this service, unless our customers have their product shipped to one of our stores in which case we do not bill our customers.  Such amounts, if any, are billed and included in revenue and the related freight cost is charged to cost of goods sold.  For the three months ended October 31, 2009 and November 1, 2008, the Company incurred shipping costs related to ecommerce sales of approximately $0.2 million and $0.2 million.  For the nine months ended October 31, 2009 and November 1, 2008, the Company incurred shipping costs related to ecommerce sales of approximately $0.5 million and $0.4 million.

 

Stock Compensation—The Company maintains a 2005 Equity Incentive Plan under which non-qualified stock options and restricted stock have been granted to employees and non-employee directors.  The Company accounts for stock-based compensation by which the estimated fair value of share-based awards granted under the 2005 Equity Incentive Plan is recognized as compensation expense over the vesting period.

 

The fair value of stock option grants, excluding options granted under the exchange offer, discussed below, are estimated on the date of grant using the Black-Scholes option pricing method with the following weighted-average assumptions used for grants issued during the nine month periods ended October 31, 2009 and November 1, 2008.

 

		For the Nine Months Ended		For the Nine Months Ended
		October 31, 2009		November 1, 2008
Dividend yield		—	%	—	%
Volatility rate		66.78	%	55.35	%
Average expected life (in years):
Expected lives-Five years		6.50		6.50
Expected lives-Four years		6.25		6.25
Average risk-free interest rate:		1.67	%	2.77	%

 

Stock Option Exchange

 

On July 21, 2009, the Company completed an offer to exchange certain employee stock options issued under the 2005 Equity Incentive Plan (“Exchange Offer”).  Certain previously granted stock options were exchanged for new, lower-priced stock options granted on a one and one half-for-one basis (1.5:1).  An aggregate of 460,700 previously granted stock options were exchanged for an aggregate of 307,138 new stock options granted pursuant to the Exchange Offer with an exercise price of $8.64 per share.  The new

stock option grants will vest annually over a four-year period beginning on the first anniversary of the date granted.  The Exchange Offer resulted in a nominal increase in stock-based compensation expense.

 

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The following table summarizes the Company’s stock option activity for the nine months ended October 31, 2009 and November 1, 2008 (in thousands except weighted-average exercise price):

 

		Nine Months Ended
		October 31, 2009					November 1, 2008
		Stock Options		Weighted- Average Exercise Price			Stock Options		Weighted- Average Exercise Price
Outstanding at beginning of year		1,793		$	17.13		1,958		$	16.29
Granted year to date (1)		528		$	8.03		160		$	14.25
Exercised year to date		(250	)	$	1.64		(211	)	$	2.46
Forfeited and exchanged year to date (2)		(547	)	$	30.25		(96	)	$	27.36
Outstanding at the end of the period		1,524		$	11.83		1,811		$	17.28
Exercisable at end of the period		621		$	12.09		699		$	11.45

 

(1) Includes 307,138 stock options issued pursuant to the Exchange Offer.

(2) Includes 460,700 stock options exchanged in the Exchange Offer.

 

During the nine months ended October 31, 2009, the Company granted approximately 528,000 stock options of which approximately 307,000 were issued in conjunction with the stock option exchange that occurred on July 21, 2009.  There were approximately 221,000 stock options granted during the nine months ended October 31, 2009, not issued in conjunction with the stock option exchange, with a Black-Scholes weighted average fair value of $4.44.  There were 160,000 stock options with a Black-Scholes weighted average fair value of $7.89 issued during the nine months ended November 1, 2008.

 

The following table summarizes the Company’s restricted stock activity for the nine months ended October 31, 2009 and November 1, 2008 (in thousands except weighted-average fair value):

 

		Nine Months Ended
		October 31, 2009								November 1, 2008
		Restricted Stock		Grant Date Weighted Average Fair Value			Intrinsic Value			Restricted Stock		Grant Date Weighted Average Fair Value			Intrinsic Value
Outstanding at beginning of year		285		$	15.49		$	2,034		16		$	37.19		$	321
Granted year to date		445		$	7.10		—			333		$	14.52		—
Vested year to date		(80	)	$	15.96		—			(4	)	$	38.19		—
Forfeited year to date		(15	)	$	10.31		—			(15	)	$	14.22		—
Outstanding at end if period		635		$	9.67		$	8,553		330		$	15.34		$	3,221

 

The intrinsic value of restricted stock awards is the market value of the outstanding restricted stock on the last business day of the quarter.  The market value per share was $13.47 and $9.76 at October 31, 2009 and November 1, 2008.

 

The Company recorded approximately $1.2 million and $3.0 million of total stock-based compensation expense for the three and nine months ended October 31, 2009, of which approximately $0.1 million and $0.4 million, was attributable to the Board of Directors.  The Company recorded approximately $1.0 million and $3.3 million of stock-based compensation for the three and nine months ended November 1, 2008, of which approximately $0.1 million and $0.4 million was attributable to the Board of Directors.  The stock-based compensation expense is calculated on an accelerated method for stock options and a straight-line basis for restricted stock over the vesting periods of the related equity grant.  This charge had no impact on the Company’s reported cash flows.

 

At October 31, 2009 and January 31, 2009, there was approximately $8.2 million and $8.6 million, of total unrecognized compensation cost related to unvested stock options and restricted stock grants of which approximately $0.2 million and $0.2 million, was attributable to the Board of Directors.  This cost is expected to be recognized over a period of approximately three to eight years.

 

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Goodwill and Other Intangible Assets — The Company evaluates the recoverability of goodwill annually based on a two-step impairment test.  The first step compares the fair value of each reporting unit with its carrying amount, including goodwill.  If the carrying amount exceeds fair value, then the second step of the impairment test is performed to measure the amount of any impairment loss.  Additional impairment assessments may be performed on an interim basis if the Company encounters events or changes in circumstances that would indicate that, more likely than not, the book value of goodwill has been impaired.  The Company, in accordance with GAAP, does not amortize goodwill derived from purchase business combinations.  There was no impairment of goodwill for the nine months ended October 31, 2009 and November 1, 2008.

 

Asset Retirement Obligations — An asset retirement obligation (ARO) represents a legal obligation associated with the retirement of a tangible long-lived asset that is incurred upon the acquisition, construction, development, or normal operation of that long-lived asset.  The Company’s ARO’s are primarily associated with leasehold improvements, which, at the end of a lease, we are contractually obligated to remove in order to comply with certain lease agreements.  The ARO is recorded in leasehold improvements and equipment and other long-term liabilities in the condensed consolidated balance sheet as of October 31, 2009 and will be subsequently adjusted for changes in fair value.  The associated estimated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset and depreciated over its useful life.

 

Recent accounting pronouncements— Effective July 2009, the FASB codified accounting literature into a single source of authoritative accounting principles, except for certain authoritative rules and interpretive releases issued by the Securities and Exchange Commission.  Since the codification did not alter existing U.S. GAAP, it did not have an impact on our condensed consolidated financial statements.  All references to pre-codified U.S. GAAP have been removed from this Form 10-Q.

 

In December 2007,  the FASB issued guidance that continues to require the acquisition method of accounting to be applied to all business combinations but significantly changes the accounting for certain aspects of business combinations.  Acquisition costs will generally be expensed as incurred; non-controlling interests will be valued at fair value at the acquisition date; in-process research and development will be recorded at fair value as an indefinite-lived intangible asset at the acquisition date; restructuring costs associated with a business combination will generally be expensed subsequent to the acquisition date; and changes in deferred tax asset valuation allowances and income tax uncertainties after the acquisition date generally will affect income tax expense. This guidance is to be applied prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual period subsequent to December 15, 2008.  We expect this guidance to have an impact on our accounting for future business combinations, if any, but the effect is dependent upon the acquisitions that are made in the future.

 

In December 2007, the FASB established new accounting and reporting standards for the noncontrolling interest in a subsidiary and for deconsolidation of a subsidiary.  This guidance clarifies that a noncontrolling interest in a subsidiary (minority interest) is an ownership interest in the consolidated entity that should be reported as equity in the Consolidated Financial Statements and separate from the parent company’s equity.  Among other things, this guidance requires consolidated net income to be reported at amounts that include the amounts attributable to both the parent and the noncontrolling interest.  It also requires disclosure, on the face of the Consolidated Statements of Operations of the amounts of consolidated net income attributable to the parent and to the noncontrolling interest, if material.  This guidance was effective for us on February 1, 2009 and it did not have a material impact on our condensed consolidated financial statements.

 

In April 2008, the FASB issued guidance that amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset.  The intent of this guidance is to improve the consistency between the useful life of a recognized intangible asset and the period of expected cash flows used to measure the fair value of the asset.  This guidance was effective for us for consolidated financial statements issued for periods ending on or after January 31, 2009.  We do not expect this guidance to have a material impact on our accounting for future acquisitions or renewals of intangible assets, but the potential impact is dependent upon the acquisitions, if any, or renewals of intangible assets in the future.

 

In March 2009, the FASB issued guidance that provides additional advice on determining whether a market for a financial asset is not active and eliminates the proposed presumption that all transactions are distressed (not orderly) unless proven otherwise.  This guidance is effective for us for interim and annual condensed consolidated financial statements for periods ending on or after August 1, 2009.  The Company’s adoption of this guidance does not have a material impact on its condensed consolidated financial statements.

 

In March 2009, the FASB issued guidance that provides additional support for determining whether impairment is other-than-temporary to debt securities in the financial statements.  This guidance requires other-than-temporary impairments to be separated into the amount representing the decrease in cash flows expected to be collected from a security (referred to as credit losses) which is recognized in earnings and the amount related to other factors (referred to as noncredit losses) which is recognized in other comprehensive income.  This guidance is effective for us for interim and annual periods ending on or after August 1, 2009.  The Company does not meet the conditions necessary to recognize other-than-temporary or credit losses of its auction rate securities in earnings and as such, this guidance does not have a material impact on its condensed consolidated financial statements.

 

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In April 2009, the FASB issued guidance requiring us to provide disclosures about fair value of financial instruments in interim financial information and requires those disclosures in summarized financial information at interim reporting periods.  These disclosures are effective for us for interim periods ending on or after August 1, 2009.  The adoption of this guidance does not have a material impact on our condensed consolidated financial statements.

 

In May 2009, the FASB issued guidance on subsequent events that establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but prior to the issuance of the financial statements.  The guidance requires disclosure of the date through which subsequent events were evaluated and the basis for that date.  The guidance sets forth the following: (1) the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements; (2) the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements; and (3) the disclosures that an entity should make about events or transactions that occurred after the balance sheet date.  This guidance was effective for us for the period ending August 1, 2009 and required prospective application.  We have evaluated certain events and transactions occurring after October 31, 2009 and through December 7, 2009, the date of our Form10-Q filing.

 

3. Commitments and Contingencies

 

Leases—The Company is committed under operating leases for all of its retail store locations.  In addition to minimum future lease payments, all store leases provide for additional rental payments based on sales, as well as common area maintenance charges.  A majority of our leases provide for ongoing co-tenancy requirements that would further lower rental rates, or permit lease terminations, or both, in the event that co-tenants cease to operate for specific periods.  Total rent expense, base rent and contingent rent for the three and nine month periods ended October 31, 2009 and November 1, 2008 (in thousands) is as follows:

 

		For the Three Months Ended						For the Nine Months Ended
		October 31, 2009			November 1, 2008			October 31, 2009			November 1, 2008
Store base rent expense		$	9,014		$	8,437		$	25,606		$	22,532
Other base rent expense		243			243			727			729
Total base rent expense		9,257			8,680			26,333			23,261
Contingent and other rent expense		5,796			5,555			16,457			14,923
Total rent expense		$	15,053		$	14,235		$	42,790		$	38,184

 

Litigation— On December 10, 2007, a putative class action complaint was filed in the U.S. District Court for the Western District of Washington against the Company and certain of its current and former directors and officers.  The action was purported to be brought on behalf of a class of purchasers of the Company’s stock during the period March 14, 2007 to January 4, 2008 and alleged that the defendants violated the federal securities laws during this period of time by, among other things, having made materially false or misleading statements and that the defendants engaged in insider trading.  The defendants moved to dismiss all claims in October 2008.  On March 30, 2009, the U.S. District Court for the Western District of Washington issued its ruling without oral argument, dismissing the case with prejudice.

 

In addition, on December 20, 2007, a shareholder derivative action was filed in the Superior Court of the State of Washington (Snohomish County), allegedly on behalf of and for the benefit of the Company, against certain of the Company’s current directors and current and former officers.  Following the March 30, 2009 ruling by the U.S District Court on the putative class action complaint, the related shareholder derivative action was voluntarily dismissed.

 

On March 5, 2008, a former employee commenced an action against the Company in California state court (Evan Johnson v. Zumiez, Inc., et al., Case No. RG08374968, Alameda County Superior Court, filed March 5, 2008) alleging that the Company failed to pay all overtime wages owing to him and other employees in California, failed to provide meal breaks as required by California law, failed to provide employees with proper itemized wage statements (pay stubs) as required by California law, and failed to pay terminated employees waiting time penalties under California Labor Code section 203.  On July 16, 2009, the Company announced that it had reached an agreement to settle.  The claims made settlement agreement was submitted to the court for preliminary approval, but the court denied approval without prejudice and encouraged the parties to restructure and resubmit the agreement to the court for approval.  The Company is now discussing modifications to the settlement agreement with plaintiff’s counsel.  The Company does not believe the final settlement will be materially different than the previously disclosed amount of approximately $1.3 million including

 

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settlement awards to class members, an incentive payment to the plaintiff, attorney’s fees and costs, and claims administration costs.  This accrued charge was recorded in selling, general and administrative expenses in the condensed consolidated statement of operations for the three months ended August 1, 2009.

 

A putative class action, Chandra Berg v. Zumiez Inc., was filed against the Company in the Los Angeles Superior Court under case number BC408410 on February 25, 2009.  The action alleges causes of action for failure to pay overtime wages to present and former store managers in California, failure to provide meal periods and rest breaks to store managers, failure to reimburse retail employees for clothing required by the Company’s dress code, failure to reimburse retail employees for business expenses, failure to provide store managers with accurate itemized wage statements, failure to pay terminated store managers all wages due at the time of termination, unfair business practices and declaratory relief.  The Company has filed an answer to the Complaint and discovery is being conducted.  No motion requesting certification of the case as a class action has been filed.  At this early stage of the case, it is not possible to estimate the amount or range of potential loss with any degree of certainty.

 

Insurance Reserves— The Company is responsible for medical and dental insurance claims up to a specified aggregate amount.  The Company maintains a reserve for estimated medical and dental insurance claims based on historical claims experience and other estimated assumptions.

 

4. Fair Value Measurements— The Company defines fair value, establishes a framework for measuring fair value and expands disclosure about fair value measurements as follows:

 

·                  Level 1— Quoted prices in active markets for identical assets or liabilities;

 

·                  Level 2— Quoted prices for similar assets or liabilities in active markets or inputs that are observable;

 

·                  Level 3— Inputs that are unobservable.

 

The Company follows the guidelines for assessing fair value measurements consistent with GAAP that requires an assessment of whether certain factors exist to indicate that the market for an instrument is not active at the measurement date.  If, after evaluating those factors, the evidence indicates the market is not active, a company must determine whether recent quoted transaction prices are associated with distressed transactions.

 

The following table summarizes assets measured at fair value on a recurring basis at October 31, 2009 and January 31, 2009:

 

Marketable Securities		Level 1			Level 2			Level 3
		(in thousands)
At October 31, 2009		$	—		$	71,315		$	832
At January 31, 2009		$	—		$	45,525		$	1,767

 

The $0.8 million in Level 3 marketable securities represents a $1.0 million par value auction rate security net of temporary impairment charge of approximately $0.2 million.  This security failed to sell at its scheduled auction in March 2009.  The interest rate for this security reset to a rate of 1.16%.  The next scheduled auction for this security is in March 2010.  The Company’s valuation method is based on numerous assumptions including assessments of the underlying structure of the security, expected cash flows, credit ratings, liquidity and other relevant factors.  Accordingly, this security is classified as Level 3 within the valuation hierarchy.  The assumptions, assessments and the interpretations of relevant market data are subject to uncertainties and are difficult to predict and require significant judgment.  The use of different assumptions, applying different judgment to inherently subjective matters and changes in future market conditions could result in significantly different estimates of fair value.

 

As a result of the temporary declines in fair value for the Company’s auction rate security, which the Company attributes to recent liquidity issues rather than credit issues, it has recorded an unrealized loss of approximately $0.2 million to accumulated other comprehensive loss in the condensed consolidated balance sheet as of October 31, 2009.  The Company believes the current illiquid conditions are temporary in nature and that it has the ability to hold the auction rate security until liquidity returns to the market.  If it is later determined that the fair value of this security is other-than-temporarily impaired, the Company will record a loss in the consolidated statement of operations.  Due to the Company’s belief that the market for this investment may take in excess of twelve months to fully recover, the Company has classified it as a noncurrent asset on the accompanying condensed consolidated balance sheets as of October 31, 2009 and January 31, 2009.

 

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The Level 2 marketable securities includes high quality money market funds, US treasuries, US government sponsored enterprises, certificates of deposit, and municipal bonds traded in the over-the-counter market.  Fair values are based on quoted market prices for similar assets or liabilities or determined using inputs that use as their basis readily observable market data that are actively quoted and can be validated through external sources, including third-party pricing services, brokers, and market transactions.

 

The following table presents the changes in the Level 3 fair-value category for the nine months ended October 31, 2009.  The Company classifies financial instruments in Level 3 of the fair-value hierarchy when there is reliance on at least one significant unobservable input to the valuation model.  In addition to these unobservable inputs, the valuation models for Level 3 financial instruments may also rely on a number of inputs that are readily observable either directly or indirectly.

 

		January 31, 2009			Sale of Marketable Securities (Level 3)			Total Unrealized Income Included in Accumlated Other Comprehensive Income (Loss)			October 31, 2009
		(in thousands)
Marketable securities		$	1,767		$	(1,000	)	$	65		$	832

 

The following table represents the fair value hierarchy for assets measured at fair value on a nonrecurring basis as of October 31, 2009:

 

		Fair Value Measurements at October 31, 2009
		(in thousands)
		Nine Months Ended October 31, 2009			Fair Value Measurements Using Significant Unobservable Inputs (Level 3 Measurements)			Net Loss
Long-lived assets held and used		$	127		$	127		$	714

 

During the nine months ended October 31, 2009, certain long-lived store assets (primarily leasehold improvements and equipment) with a net carrying amount of $0.8 million were written down to their fair value of $0.1 million, resulting in a net impairment charge of $0.7 million which was included in earnings for the nine months ended October 31, 2009.  The fair value was determined using a discounted cash flow model at a store level. Store impairment expense was recorded net of the remaining tenant allowance.  The estimation of future cash flows from operating activities requires significant judgments of factors that include future sales, gross profit and operating expenses.  If the Company’s sales, gross profit or operating expenses are not achieved at or above the forecasted level, the carrying value of certain store assets may prove unrecoverable and the Company may incur additional impairment charges in the future.  There were no impairments charges recognized for the nine months ended November 1, 2008.

 

5. Net Income (Loss) Per Share, Basic and Diluted— Basic net income per share is computed based on the weighted average number of common shares outstanding during the period.  Diluted net income per share is applicable only in periods of net income and is computed by dividing net income by the weighted average number of common shares outstanding for the period and potentially dilutive common share equivalents outstanding for the period.

 

Common share equivalents included in the computation of diluted net income per share represent shares issuable upon assumed exercise of outstanding stock options, non-vested restricted stock and employee stock purchase plan share equivalents (“ESPP”).  Options to purchase approximately 452,000 and 832,000 shares of common stock in the three months ended October 31, 2009 and November 1, 2008 and 452,000 and 827,000 shares of common stock in the nine months ended October 31, 2009 and November 1, 2008, were not included in the computation of diluted earnings per share because either the option exercise price or the grant date fair value of the non-vested share is greater than the market price of the Company’s common stock.  There were approximately 617,000 and 410,000 shares of non-vested restricted shares included in the calculation of diluted earnings per share for the three and nine months ended October 31, 2009.  There were 270,000 and 193,000 shares of non-vested restricted shares included in the calculation of diluted earnings per share for the three and nine months ended November 1, 2008.

 

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