Zumiez Inc - Quarter Report: 2009 August (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 August 28, 2009 was 30,154,284 shares.

 

 

Table of Contents

 

ZUMIEZ INC.

FORM 10-Q

TABLE OF CONTENTS

 

Part I.	Financial Information
	Item 1.	Condensed Consolidated Financial Statements
		Condensed Consolidated Balance Sheets at August 1, 2009 (unaudited) and January 31, 2009	3
		Condensed Consolidated Statements of Operations for the three and six months ended August 1, 2009 and August 2, 2008 (unaudited)	4
		Condensed Consolidated Statement of Changes in Shareholders’ Equity for the six months ended August 1, 2009 (unaudited)	5
		Condensed Consolidated Statements of Cash Flows for the six months ended August 1, 2009 and August 2, 2008 (unaudited)	6
		Notes to Condensed Consolidated Financial Statements	7
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	18
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	35
	Item 4.	Controls and Procedures	35
Part II.	Other Information		36
	Item 1.	Legal Proceedings	36
	Item 1A.	Risk Factors	36
	Item 2.	Changes in Securities; Use of Proceeds and Issuer Purchases of Equity Securities	36
	Item 3.	Defaults Upon Senior Securities	36
	Item 4.	Submission of Matters to a Vote of Security Holders	36
	Item 5.	Other Information	37
	Item 6.	Exhibits	37
Signatures			38
Exhibit 31.1
Exhibit 31.2
Exhibit 32.1

 

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ZUMIEZ INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share amounts)

 

		August 1, 2009			January 31, 2009
		(Unaudited)
Assets
Current assets
Cash and cash equivalents		$	21,304		$	33,057
Marketable securities		60,748			45,525
Receivables		7,486			4,555
Income tax receivable		1,399			—
Inventory		69,569			51,974
Prepaid expenses and other		6,381			5,614
Deferred tax assets		4,048			2,588
Total current assets		170,935			143,313
Leasehold improvements and equipment, net		74,367			73,932
Goodwill and other intangibles		13,211			13,236
Marketable securities - long-term		799			1,767
Deferred tax assets		2,291			1,101
Total long-term assets		90,668			90,036
Total assets		$	261,603		$	233,349
Liabilities and Shareholders’ Equity
Current liabilities
Trade accounts payable		$	43,352		$	15,909
Accrued payroll and payroll taxes		3,540			4,739
Income taxes payable		—			238
Current portion of deferred rent and tenant allowances		3,227			2,735
Other accrued liabilities		8,642			7,600
Total current liabilities		58,761			31,221
Long-term deferred rent and tenant allowances, less current portion		27,192			24,177
Total liabilities		85,953			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; 30,155,034 shares issued and outstanding at August 1, 2009, 29,533,067 shares issued and outstanding at January 31, 2009		78,259			75,789
Accumulated other comprehensive income		90			117
Retained earnings		97,301			102,045
Total shareholders’ equity		175,650			177,951
Total liabilities and shareholders’ equity		$	261,603		$	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						Six Months Ended
		August 1,			August 2,			August 1,			August 2,
		2009			2008			2009			2008
Net sales		$	85,170		$	92,258		$	161,977		$	170,960
Cost of goods sold		60,526			62,155			115,434			116,297
Gross profit		24,644			30,103			46,543			54,663
Selling, general and administrative expenses		29,870			26,191			55,208			49,125
Operating (loss) profit		(5,226		)	3,912			(8,665		)	5,538
Interest income, net		307			495			664			1,084
(Loss) earnings before income taxes		(4,919		)	4,407			(8,001		)	6,622
(Benefit) provision for income taxes		(1,834		)	1,680			(3,257		)	2,533
Net (loss) income		$	(3,085	)	$	2,727		$	(4,744	)	$	4,089
Basic net (loss) income per share		$	(0.10	)	$	0.09		$	(0.16	)	$	0.14
Diluted net (loss) income per share		$	(0.10	)	$	0.09		$	(0.16	)	$	0.14
Weighted average shares used in computation of (loss) earnings per share:
Basic		29,496,039			29,072,536			29,252,545			29,042,861
Diluted		29,496,039			29,378,589			29,252,545			29,374,015

 

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
		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 including tax benefit of $298		622		686			—			—			686
Stock-based compensation expense		—		1,784									1,784
Unrealized losses, net of tax benefit of $17		—		—			(27		)	—			(27		)
Net loss										(4,744		)	(4,744		)
Balance at August 1, 2009		30,155		$	78,259		$	90		$	97,301		$	175,650

 

See accompanying notes to condensed consolidated financial statements

 

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ZUMIEZ INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

 

		Six Months Ended
		August 1, 2009			August 2, 2008
Cash flows from operating activities:
Net (loss) income		$	(4,744	)	$	4,089
Adjustments to reconcile net (loss) income to net cash provided by operating activities:
Depreciation and amortization		10,755			9,170
Deferred tax expense		(2,633		)	(2,424		)
Stock-based compensation expense		1,784			2,129
Loss on disposal of assets		116			138
Excess tax benefit from stock options		(298		)	(509		)
Impairment of long-lived asets		294			—
Changes in operating assets and liabilities:
Receivables		(2,931		)	(3,501		)
Inventory		(17,595		)	(23,359		)
Prepaid expenses and other		(767		)	(1,215		)
Trade accounts payable		27,443			24,922
Accrued payroll and payroll taxes		(1,199		)	(1,602		)
Income taxes payable/receivable		(1,339		)	3,192
Other accrued liabilities		1,042			(387		)
Deferred rent and tenant allowances		3,507			5,055
Net cash provided by operating activities		13,435			15,698
Cash flows from investing activities:
Additions to leasehold improvements and equipment		(10,957		)	(19,006		)
Purchases of marketable securities		(36,871		)	(51,722		)
Sales and maturities of marketable securities		21,954			55,225
Net cash used in investing activities		(25,874		)	(15,503		)
Cash flows from financing activities:
Change in book overdraft		—			(5,183		)
Proceeds from exercise of stock options		388			609
Excess tax benefit from stock options		298			509
Net cash provided by (used in) financing activities		686			(4,065		)
Net decrease in cash and cash equivalents		(11,753		)	(3,870		)
Cash and cash equivalents, beginning of period		33,057			11,945
Cash and cash equivalents, end of period		$	21,304		$	8,075
Supplemental disclosure on cash flow information:
Cash paid during the period for interest		$	—		$	9
Cash paid during the period for income taxes		716			1,768

 

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 August 1, 2009, the condensed consolidated statements of operations for the three and six months ended August 1, 2009 and August 2, 2008, the condensed consolidated statement of changes in shareholders’ equity for the six months ended August 1, 2009 and the condensed consolidated statements of cash flows for the six months ended August 1, 2009 and August 2, 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, fixed assets, 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 fixed assets and assumed future cash flows supporting long-lived assets.  Actual results could differ from those estimates.  The results of operations for the three and six months ended August 1, 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 August 1, 2009, the Company operated 369 stores primarily located in shopping malls, giving the Company a presence in 34 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 six months of fiscal 2009 was the 26-week period ended August 1, 2009.  The first six months of fiscal 2008 was the 26-week period ended August 2, 2008.  “Fiscal 2009” is the 52-week period ending January 30, 2010.

 

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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.

 

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 August 1, 2009 and January 31, 2009 (in thousands):

 

		August 1, 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		$	21,304		$	—		$	—		$	21,304		$	—		$	—
Total cash and cash equivalents		21,304			—			—			21,304			—			—
Short-term investments
Treasury and agency securities		2,998			2			—			3,000			—			—
State and local government securities		43,551			258			(10		)	43,799			(8		)	(2		)
Total short-term investments		46,549			260			(10		)	46,799			(8		)	(2		)
Long-term investments
State and local government securities		14,852			97			(201		)	14,748			—			(201		)
Total long-term investments		14,852			97			(201		)	14,748			—			(201		)
Total		$	82,705		$	357		$	(211	)	$	82,851		$	(8	)	$	(203	)

 

		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	)	$	—

 

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The long-term gross unrealized holding losses on the state and local obligations consist of an unrealized loss on the Company’s 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 six months ended August 1, 2009.

 

At August 1, 2009, marketable securities, classified as available for sale, were $61.5 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 August 1, 2009, we had $0.8 million invested, net of impairment charge of $0.2 million, in an auction rate security which 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 and insured against loss of principal and interest by a bond insurer whose current credit rating is Ba3 by Moody’s Investors Services.  If the credit ratings of the issuer, the bond insurers or the collateral deteriorate, we may adjust the carrying value of this investment.  Although we are uncertain as to when the liquidity issues relating to this investment will improve, we consider the issue to be only 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 August 1, 2009 and January 31, 2009, receivables included the following (in thousands):

 

		August 1, 2009			January 31, 2009
Credit cards receivable		$	3,326		$	1,884
Tenant allowances receivable		2,169			901
Vendor credits		682			410
Interest receivable		673			418
Employee receivables		355			483
Other receivables		281			459
		$	7,486		$	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.

 

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 August 1, 2009 and January 31, 2009 in the amounts of approximately $2.7 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.

 

During the second quarter, management performed a review of the carrying value of long-lived assets conducted in accordance with SFAS No. 144 “Accounting for the Impairment or Disposal of long-Lived Assets.”  The review revealed that three stores were impaired as of August 1, 2009.  Accordingly, a non-cash impairment charge of approximately $0.3 million was included in selling, general and administrative expenses for the three and six months ended August 1, 2009.

 

Fair Value of Financial Instruments—Statement of Financial Accounting Standards No. 107 “Disclosures about Fair Value of Financial Instruments” (“SFAS No. 107”), requires management to disclose the estimated fair value of certain assets and liabilities as financial instruments.  Financial instruments are generally defined by SFAS No. 107 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 August 1, 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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Statement of Financial Accounting Standards No. 157 “Fair Value Measurements” defines fair value, establishes framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value measurements.  In October 2008, the Financial Accounting Standards Board (“FASB”), issued Financial Accounting Standards Board Staff Position (“FSP”) No. SFAS 157-3 (“FSP 157-3”), “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active.  FSP 157-3 clarifies the application of SFAS No. 157 “Fair Value Measurements,” in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active.  Contractual maturities of investments underlying our available-for-sale securities at August 1, 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 August 1, 2009 and January 31, 2009 other accrued liabilities consisted of the following:

 

		Fiscal Year Ended
		August 1, 2009			January 31, 2009
Accrued payables		$	2,381		$	2,564
Accrued sales tax		2,092			1,425
Gift cards unredeemed		2,078			3,061
Accrued legal		1,398			—
Other current liabilities		693			550
		$	8,642		$	7,600

 

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 markdowns, shrinkage, certain promotional costs, buying, occupancy 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 August 1, 2009 and August 2, 2008, the Company incurred shipping costs related to ecommerce sales of approximately $0.1 million.  For the six months ended August 1, 2009 and August 2, 2008, the Company incurred shipping costs related to ecommerce sales of approximately $0.3 million.

 

Stock Compensation—The Company maintains a 2005 Equity Incentive Plan under which non-qualified stock options, incentive stock options and restricted stock have been granted to employees and non-employee directors.  The Company accounts for stock-based compensation in accordance with FASB Statement No. 123(R), Share-Based Payment (“SFAS No. 123(R)”).  Under the provisions of SFAS No. 123(R), 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 six month periods ended August 1, 2009 and August 2, 2008.

 

		For the Six Months Ended
		August 1, 2009		August 2, 2008
Dividend yield		—	%	—	%
Volatility rate		66.71	%	55.20	%
Average expected life (in years):
Expected lives-Five years		—		6.50
Expected lives-Four years		6.25		6.25
Average risk-free interest rate:		1.65	%	2.78	%

 

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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.

 

The following table summarizes the Company’s stock option activity for the six months ended August 1, 2009 and August 2, 2008 (in thousands except weighted-average exercise price):

 

		Six Months Ended
		August 1, 2009					August 2, 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)		520		$	7.92		155		$	14.17
Exercised year to date		(168	)	$	1.33		(79	)	$	3.45
Forfeited and exchanged year to date (2)		(543	)	$	30.24		(54	)	$	32.73
Outstanding at the end of the period		1,602		$	11.35		1,980		$	18.26
Exercisable at end of the period		618		$	12.01		684		$	10.33

 

(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 six months ended August 1, 2009 and August 2, 2008, the Company granted, excluding stock options granted under the Exchange Offer, approximately 213,000 and 155,000 stock options with a Black-Scholes weighted average fair value of $4.24 and $7.83.

 

The following table summarizes the Company’s restricted stock activity for the six months ended August 1, 2009 and August 2, 2008 (in thousands except weighted-average fair value):

 

		Six Months Ended
		August 1, 2009								August 2, 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		442		$	7.06		—			285		$	14.33		—
Vested year to date		(68	)	$	15.75		—			(3	)	$	38.19		—
Forfeited year to date		(10	)	$	10.63		—			(3	)	$	14.00		—
Outstanding at end if period		649		$	9.80		$	6,194		295		$	16.37		$	4,402

 

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 $9.55 and $14.90 at August 1, 2009 and August 2, 2008.

 

During the six months ended August 1, 2009 and August 2, 2008, the Company granted approximately 442,000 and 285,000 shares of restricted stock with a weighted average fair market value on the date of grant of $7.06 and $14.33 per share. The Company recorded approximately $1.2 million and $1.8 million of total stock-based compensation expense for the three and six months ended August 1, 2009, of which approximately $0.1 million and $0.2 million, was attributable to the Board of Directors.  The Company recorded approximately $1.2 million and $2.1 million of stock-based compensation for the three and six months ended August 2, 2008, of which approximately $0.1 million and $0.3 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.

 

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At August 1, 2009 and January 31, 2009, there was approximately $9.2 million and $8.6 million, of total unrecognized compensation cost related to unvested stock options and restricted stock grants of which approximately $0.3 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.

 

Goodwill and Other Intangible Assets — In accordance with Statement of Financial Accounting Standards No. 142, “Accounting for Goodwill and Other Intangible Assets” (“SFAS No. 142”), the Company does not amortize goodwill derived from purchase business combinations.  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.  There was no impairment of goodwill for the six months ended August 1, 2009 and August 2, 2008.

 

Recent accounting pronouncements—

 

In December 2007, FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (“SFAS 141No. (R),”) which replaces SFAS No. 141, “Business Combinations” (“SFAS No. 141”).  SFAS No. 141(R) retains the underlying concepts of SFAS 141 in that all business combinations are still required to be accounted for at fair value under the acquisition method of accounting but SFAS No. 141(R) changed the method of applying the acquisition method in a number of significant aspects.  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. SFAS No. 141(R) is effective on a prospective basis for all business combinations for which the acquisition date is on or after the beginning of the first annual period subsequent to December 15, 2008, with the exception of the accounting for valuation allowances on deferred taxes and acquired tax contingencies.  SFAS No. 141(R) amends SFAS No. 109, “Accounting for Income Taxes,” such that adjustments made to valuation allowances on deferred taxes and acquired tax contingencies associated with acquisitions that closed prior to the effective date of SFAS No. 141(R) would also apply the provisions of SFAS No. 141(R).  The Company’s adoption of SFAS No. 141(R) does not have a material impact on its condensed consolidated financial statements.

 

In December 2007, the FASB issued SFAS No. 160, “Non-controlling Interests in Consolidated Financial Statements.”  (“SFAS No. 160”) amends Accounting Research Bulletin No. 51, “Consolidated Financial Statements” and requires (i) classification of non-controlling interests, commonly referred to as minority interests, within stockholders’ equity, (ii) net income to include the net income attributable to the non-controlling interest and (iii) enhanced disclosure of activity related to non-controlling interests.  SFAS No. 160 is effective for fiscal years beginning after December 15, 2008.  The Company’s adoption of SFAS No. 160 does not have a material impact on its condensed consolidated financial statements.

 

In February 2008, the FASB issued FSP No. FAS 157-2, (“FSP 157-2”), which delays the effective date of SFAS No.157, “Fair Value Measurements,” for nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually).  Nonfinancial assets and nonfinancial liabilities would include all assets and liabilities other than those meeting the definition of a financial asset or financial liability as defined in paragraph 6 of SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.”  This FASB Staff Position defers the effective date of SFAS No. 157 to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years for items within the scope of FSP 157-2.  During the current fiscal year, the Company adopted the provisions of FSP 157-2 and determined that it does not have a material impact on the condensed consolidated financial statements.

 

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In April 2008, the FASB issued FSP No. FAS 142-3, Determination of the Useful Lives of Intangible Assets (“FSP 142-3”), which amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, Goodwill and Other Intangible Assets.  The intent of FSP 142-3 is to improve the consistency between the useful life of a recognized intangible asset under SFAS No. 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS No. 141(R) and other U.S. generally accepted accounting principles.  FSP 142-3 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years.  The Company’s adoption of FSP 142-3 does not have a material impact on its condensed consolidated financial statements.

 

In March 2009, the FASB issued FSP No. FAS 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly”  (“FSP 157-4”),  which provides additional guidance 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  under the fair value measurements of SFAS No. 157, “Fair Value Measurements.”  FSP 157-4 is effective for interim periods ending after June 15, 2009.  The Company’s adoption of FSP 157-4 does not have a material impact on its condensed consolidated financial statements.

 

In March 2009, the FASB issued FSP No. FAS 115-2, “Recognition  and Presentation of Other-Than-Temporary Impairments” (“ FSP 115-2”) and FAS 124-2 “Recognition of Other-Than-Temporary Impairments,” which provides additional guidance for determining whether an impairment is other-than-temporary to debt securities in the financial statements.  FSP 115-2 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.  FSP 115-2 and FAS 124-2 is effective for interim periods and annual periods ending after June 15, 2009.  The Company does not meet the conditions necessary to recognize other-than-temporary losses, or credit losses, of its auction rate securities in earnings.  The Company’s adoption of FSP 115-2 and FAS 124-2 does not have a material impact on its condensed consolidated financial statements.

 

In April 2009, the FASB issued FSP No. FAS 107-1, “Interim Disclosures about Fair Value of Financial Instruments,” (“FSP 107-1”), that require an entity to provide disclosures about fair value of financial instruments in interim financial information and Accounting Principles Board Opinion No. 28 (“APB 28-1”) “Interim Financial Disclosures, that requires those disclosures in summarized financial information at interim reporting periods.  FSP 107-1 and APB 28-1 are effective for interim periods ending after June 15, 2009.  The Company’s adoption of FAS 107-1 and APB 28-1 does not have a material impact on its condensed consolidated financial statements.

 

In May 2009, the FASB issued SFAS No. FAS 165, “Subsequent Events,” (“FAS 165”), which provides guidance on management’s assessment of subsequent events and disclosure of the date of the subsequent event.  FAS 165 is effective for interim and annual periods ending after June 15, 2009.  The Company’s adoption of FAS 165 does not have a material impact on its condensed consolidated financial statements.

 

In June 2009, the FASB issued SFAS No. 168, “The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles — a replacement of FASB Statement No. 162” (“FAS 168”).  The new statement modifies the U.S. generally accepted accounting principles (“GAAP”) hierarchy created by SFAS No. 162 “The Hierarchy of Generally Accepted Accounting Principles” by establishing only two levels of GAAP: authoritative and nonauthoritative.  This is accomplished by authorizing the FASB Accounting Standards Codification (“Codification”) to become the single source of authoritative U.S. accounting and reporting standards, except for rules and interpretive releases of the SEC under authority of the federal securities laws, which are sources of authoritative GAAP for SEC registrants.  FAS 168 is effective for financial statements for interim and annual periods ending after September 15, 2009.  All existing accounting standard documents are superseded and all other accounting literature not included in the Codification is considered nonauthoritative.  The Company does not anticipate the adoption of FAS 168 will have a material effect on the Company’s condensed consolidated financial statements.

 

3. Commitments and Contingencies

 

Leases—The Company is committed under operating leases for its entire 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 which would further lower rental rates, or permit lease terminations, or both, in the event that co-tenants cease to operate for specific periods of time.

 

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Total rent expense, base rent and contingent rent for the three and six month periods ended August 1, 2009 and August 2, 2008 (in thousands) is as follows:

 

		For the Three Months Ended						For the Six Months Ended
		August 1, 2009			August 2, 2008			August 1, 2009			August 2, 2008
Store base rent expense		$	8,700		$	7,308		$	16,592		$	14,095
Other base rent expense		242			243			485			486
Total base rent expense		8,942			7,551			17,077			14,581
Contingent and other rent expense		5,434			4,915			10,658			9,368
Total rent expense		$	14,376		$	12,466		$	27,735		$	23,949

 

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 settlement agreement, which is subject to documentation and court approval, provides for a claims made settlement expected to cost the Company approximately $1.3 million which includes 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— On February 3, 2008, the Company adopted SFAS No. 157, “Fair Value Measurements” (“FAS 157”).  FAS 157 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;

 

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·                  Level 3— Inputs that are unobservable.

 

The Company adopted FSP FAS No. 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active” (“FSP 157-3”), which was issued in October 2008 and became effective immediately for any unissued financial statements.  FSP 157-3 clarifies the application of FAS 157 to financial assets for which an active market does not exist.  FSP 157-3 applies to financial assets within the scope of accounting pronouncements that require or permit fair value measurement in accordance with FAS 157.

 

The Company adopted FSP No. FAS 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly” (“FSP 157-4”), effective June 15, 2009.  The FSP provides guidelines for making fair value measurements consistent with the principles presented in FAS 157 and 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 August 1, 2009 and January 31, 2009, as required by SFAS 157:

 

Marketable securities		Level 1			Level 2			Level 3
					(in thousands)
At August 1, 2009		$	—		$	60,748		$	799
At January 31, 2009		$	—		$	45,525		$	1,767

 

The $0.8 million in Level 3 marketable securities represents a $1.0 million 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 SFAS 157’s valuation hierarchy since the Company’s initial adoption of SFAS 157 at February 3, 2008.  These assumptions, assessments and the interpretations of relevant market data are subject to uncertainties 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 current 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 August 1, 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 balances sheet as of August 1, 2009 and January 31, 2009.

 

The Level 2 marketable securities includes high credit money market accounts, US treasuries, US government agency securities, 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 six months ended August 1, 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.

 

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		January 31, 2009			Transfers in and/or (out) of level 3			Total unrealized income included in Accumlated Comprehensive Income (Loss)			August 1, 2009
		(in thousands)
Marketable securities		$	1,767		$	(1,000	)	$	32		$	799

 

The following table represents the fair value hierarchy for assets measured at fair value on a nonrecurring basis as of August 1, 2009:

 

		Fair Value Measurements at August 1, 2009
		(in thousands)
					Ouoted Prices in Active Markets for Indentical Assets			Significant Other Observable Inputs			Significant Unobservable Inputs
		Total			Level (1)			Level (2)			(Level 3)
Long-lived assets held and used		$	74,367		$	—		$	—		$	74,367

 

In accordance with the provisions of SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” long-lived store assets (primarily leasehold improvements and equipment) with a carrying amount of $74.7 million were written down to their fair value of $74.4 million, resulting in an impairment charge of approximately $0.3 million, which was included in the operating results for the period ended August 1, 2009.  Fair value is determined using a undiscounted cash flow model.  The estimation of future cash flows from operating activities requires significant estimates of factors that include future sales and gross margin performance.  If the Company’s sales or gross margin performance or other estimated operating results 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.

 

5. Net Income (Loss) Per Share, Basic and Diluted— Basic net income per share is computed pursuant to SFAS No. 128 “Earnings per Share” 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.  For purposes of calculating diluted earnings per share, incremental shares were excluded for the three and six months ended August 1, 2009, as the Company is in a net loss position and any effect of common share equivalents would be considered anti-dilutive.

 

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 447,000 and 862,000 shares of common stock in the three months ended August 1, 2009 and August 2, 2008 and 446,000 and 862,000 shares of common stock in the six months ended August 1, 2009 and August 2, 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 251,000 and 208,000 shares of non-vested restricted shares included in the calculation of diluted earnings per share for the three and six months ended August 2, 2008.

 

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The following table sets forth the computation of basic and diluted net (loss) per share (in thousands, except share and per share amounts):

 

		For the Three Months Ended						For the Six Months Ended
		August 1, 2009			August 2, 2008			August 1, 2009			August 2, 2008
Net (loss) income		$	(3,085	)	$	2,727		$	(4,744	)	$	4,089
Weighted average common shares for basic net (loss) income per share		29,496,039			29,072,536			29,252,545			29,042,861
Dilutive effect of stock options, restricted stock and ESPP		—			306,053			—			331,154
Weighted average common shares for diluted net (loss) income per share		29,496,039			29,378,589			29,252,545			29,374,015
Basic net (loss) income per share		$	(0.10	)	$	0.09		$	(0.16	)	$	0.14
Diluted net (loss) income per share		$	(0.10	)	$	0.09		$	(0.16	)	$	0.14

 

6.  Subsequent Events— The Company has evaluated subsequent events through the filing date of this Form 10-Q and has determined that there were no subsequent events to recognize or disclose in these financial statements.

 

Item 2:  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes included elsewhere in this quarterly report.  This discussion contains forward-looking statements that involve risks and uncertainties.  Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed in the section entitled “Risk Factors” in our Form 10-K filed with the SEC on March 23, 2009 and in this Form 10-Q.

 

Forward-looking statements are based on our expectations regarding net sales, selling, general and administrative expenses, profitability, financial position, business strategy, new store openings, and plans and objectives of management.  The words “believe,” “may,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “expect” and similar expressions, as they relate to us and our business, industry, markets and consumers, are intended to identify forward-looking statements.  We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy and financial needs.  These forward-looking statements are subject to a number of risks, uncertainties and assumptions, including, among others, those described in “Risk Factors” and elsewhere in this quarterly report and in the Form 10-K referred to in the preceding paragraph.  New risk factors emerge from time to time and it is not possible for our management to predict all risk factors, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.  We assume no obligation to update any forward-looking statements as a result of new information, future events or developments.  References in the following discussion to “we,” “us,” “our,” “the Company” and similar references mean Zumiez Inc. and its consolidated subsidiary, unless otherwise expressly stated or the context otherwise requires.

 

Overview

 

We are a mall based specialty retailer of action sports related apparel, footwear, equipment and accessories operating under the Zumiez brand name.  As of August 1, 2009, we operated 369 stores primarily located in shopping malls, giving us a presence in 34 states.  Our 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, BMX, and motocross.  We support the action sports lifestyle and promote our brand through a multi-faceted marketing approach that is designed to integrate our brand image with our customers’ activities and interests.  This approach, combined with our differentiated merchandising strategy, store design, comprehensive training programs and passionate employees, allows us to provide an experience for our customers that we believe is consistent with their attitudes, fashion tastes and identities and is otherwise unavailable in most malls.

 

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General

 

Net sales constitute gross sales net of estimated returns.  Net sales include our in-store sales and our ecommerce sales, which includes ecommerce shipping revenue.  Information in this report with respect to comparable store sales includes ecommerce sales.  Ecommerce sales were 1.6% and 1.2% of total sales for the six month periods ended August 1, 2009 and August 2, 2008.  Sales with respect to gift cards are deferred and recognized when gift cards are redeemed.  The amount of the gift card liability is determined taking into account our estimate of the portion of gift cards that will not be redeemed or recovered (“gift card breakage”).  Gift card breakage is recognized as revenue after 24 months, at which time the likelihood of redemption is considered remote based on our historical redemption data.

 

We report “comparable store sales” based on net sales, and stores including ecommerce, are included in our comparable store sales beginning on the first anniversary of their first day of operation.  Changes in our comparable store sales between two periods are based on net sales of stores which were in operation during both of the two periods being compared and, if a store is included in the calculation of comparable store sales for only a portion of one of the two periods being compared, then that store is included in the calculation for only the comparable portion of the corresponding period.  When additional square footage is added to a store that is included in comparable store sales, the store remains in comparable store sales.  There may be variations in the way in which some of our competitors and other apparel retailers calculate comparable or same store sales.  As a result, data regarding our comparable store sales may not be comparable to similar data made available by our competitors or other retailers.

 

Cost of goods sold consists of the cost of merchandise sold to customers, inbound shipping costs, ecommerce shipping costs, distribution costs, depreciation on leasehold improvements at our distribution center, buying and merchandising costs and store occupancy costs.  This may not be comparable to the way in which our competitors or other retailers compute their cost of goods sold.

 

Selling, general and administrative expenses consist primarily of store personnel wages and benefits, administrative staff and infrastructure expenses, store supplies, depreciation on leasehold improvements at our home office and stores, facility expenses, training, advertising and marketing costs.  Credit card fees, insurance, public company expenses, legal expenses and other miscellaneous operating costs are also included in selling, general and administrative expenses.  This may not be comparable to the way in which our competitors or other retailers compute their selling, general and administrative expenses.  We expect that our selling, general and administrative expenses will, as described below, increase in future periods due in part to increased expenses associated with opening new stores.

 

Our success is largely dependent upon our ability to anticipate, identify and respond to the fashion tastes of our customers and to provide merchandise that satisfies customer demands.  Any inability to provide appropriate merchandise in sufficient  quantities in a timely manner could have a material adverse effect on our business, operating results and financial condition.

 

Key Performance Indicators

 

Our management evaluates the following items, which we consider key performance indicators, in assessing our performance:

 

Comparable store sales.  Comparable store sales provide a measure of sales growth for stores open at least one year over the comparable prior year period.

 

Our management considers comparable store sales to be an important indicator of our current performance.  Comparable store sales results are important to achieve leveraging of our costs, including store payroll, store supplies and rent.  Comparable store sales also have a direct impact on our total net sales, cash and working capital.

 

Gross profit.  Gross profit measures whether we are optimizing the price and inventory levels of our merchandise.  Gross profit is the difference between net sales and cost of sales.  Cost of sales consists of branded merchandise costs, and our private label merchandise including design, sourcing, importing and inbound freight costs.  Our cost of sales also includes markdowns, shrinkage, certain promotional costs and buying, store occupancy and warehousing costs.  Any inability to obtain acceptable levels of initial markups or any significant increase in our use of markdowns could have an adverse effect on our gross profit and results of operations.

 

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