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BEBE STORES, INC. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Consolidated Financial Statements and related Notes included elsewhere in this report. The following Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward looking statements, which involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth under "Risks Factors" under Item 1A of this report. Overview We design, develop and produce a distinctive line of contemporary women's apparel and accessories under the bebe, BEBE SPORT and bbsp brand names. We operate stores in the United States, Puerto Rico, Virgin Islands and Canada. In addition, we have an on-line store at www.bebe.com that ships to customers in the United States, Canada, Puerto Rico, the U.S. Protectorates and internationally via our third-party provider, International Checkout. We also have international stores operated by licensees in South East Asia, United Arab Emirates, Israel, Russia, South America, South Africa and Turkey. Our distinctive product offering includes a full range of separates, tops, dresses, active wear and accessories to satisfy her every day wardrobe needs across all occasions. We design and develop the majority of our merchandise in-house, which is manufactured to our specifications. The remainder is sourced directly from third-party manufacturers. 18 --------------------------------------------------------------------------------Fiscal 2014 financial highlights include the following: • Net sales from continuing operations for fiscal 2014 were $425.1 million, down 8.2% from $463.2 million for fiscal 2013. Comparable store sales for fiscal 2014 decreased 3.2% compared to a decrease of 9.6% in the previous fiscal year. The inclusion of the on-line store increased the comparable store percentage by 3.0% for the fiscal year ended July 5, 2014. • Gross margin from continuing operations for fiscal 2014 was 32.5% compared to 33.3% for fiscal 2013. • Selling, general and administrative expenses from continuing operations for the 2014 fiscal year were $197.8 million, an increase of 0.3% from $197.2 million for fiscal 2013. • Net loss from continuing operations for the fiscal year ended July 5, 2014 was $59.2 million, or $0.75 per share on a diluted basis, compared to net loss of $69.1 million, or $0.84 per share on a diluted basis, in the prior year. • In fiscal 2014, cash and equivalents increased by $7.4 million compared to a decrease of $18.0 million for fiscal 2013, as 2013 was impacted by share repurchases. Our strategic focus for fiscal 2015 is on re-building the bebe brand, enhancing our product offering and merchandising the stores by lifestyle occasion, while maintaining a compelling fashion and value equation for our customers. In addition to driving sales and improving margin, our focus will also continue to be on pragmatically preserving cash. Critical Accounting Policies Management's Discussion and Analysis of Financial Condition and Results of Operations are based upon our consolidated financial statements, which have been prepared in conformity with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the appropriate application of certain accounting policies, many of which require us to make estimates and assumptions about future events and their impact on amounts reported in our financial statements and related notes. Since future events and their impact cannot be determined with certainty, the actual results will inevitably differ from our estimates. Such differences could be material to the financial statements. We believe our application of accounting policies, and the estimates inherently required therein, are reasonable. These accounting policies and estimates are constantly reevaluated, and adjustments are made when facts and circumstances dictate a change. Our accounting policies are more fully described in Note 1 to our consolidated financial statements included in this report. We have identified certain critical accounting policies, which are described below. Revenue recognition. We recognize revenue at the time the products are received by the customers. We recognize revenue for store sales at the point at which the customer receives and pays for the merchandise at the register. For on-line sales, we recognize revenue at the time we estimate the customer receives the product. We estimate and defer revenue and the related product costs for shipments that are in transit to the customer. Customers typically receive goods within one week of shipment. We reflect amounts related to shipping billed to customers in net sales and the related costs in cost of goods sold. We record retail sales net of sales tax collected from customers at the time of the transaction. We record a reserve for estimated product returns based on historical return trends. If actual returns are greater than those projected, we may record additional sales returns in the future. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our sales return reserve. However, if the actual rate of sales returns increases significantly, our operating results could be adversely affected. Discounts offered to customers consist primarily of point of sale markdowns and are recorded at the time of the related sale as a reduction of revenue. We include the value of points and rewards earned by our loyalty program members as a liability and a reduction of revenue at the time the points and rewards are earned based on historical conversion and redemption rates. We recognize the associated revenue when the rewards are redeemed or expire. We record gift certificates sold as a liability, and we recognize sales revenue when the gift certificate is redeemed. Similarly, customers may receive a store credit in exchange for returned goods. We carry store credits as a liability until redeemed. We recognize unredeemed store credits and gift certificates as other income three and four years, respectively, after issuance, which is when management deems redemptions to be remote. In addition, we sell gift cards with no expiration dates to customers in our retail store locations, through our on-line stores and through third parties. We recognize sales revenue from gift cards when they are redeemed by the customer. In addition, we recognize income on unredeemed gift cards when we can determine that the likelihood of the gift card being redeemed is 19 -------------------------------------------------------------------------------- remote and there is no legal obligation to remit the unredeemed gift cards to relevant jurisdictions (gift card breakage), which we estimate is four years. Gift card breakage is included within selling, general and administrative expenses. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our breakage income. However, if the actual rate of redemption for gift certificates, store credits, and gift cards increases significantly, our operating results could be adversely affected. We record royalty revenue from product licensees as the greater of the minimum amount guaranteed in the contract or amount sold. We recognize wholesale licensee revenue from sale of product to international licensee operated bebe stores at the time we estimate the licensee receives shipment. We exclude these stores from comparable store sales. Stock Based Compensation. We have stock-based awards to employees that have service-based vesting conditions, and we also have awards to employees that have market-based performance conditions. For awards to employees that have service-based vesting conditions, we recognize compensation expense, based on the calculated fair value on the date of grant. We determine the fair value using the Black-Scholes option pricing model. This model requires subjective assumptions, which are affected by our stock price as well as assumptions regarding a number of complex and subjective variables. These variables include our expected stock price volatility over the term of the awards, actual and projected employee exercise behaviors, risk-free interest rate and expected dividends. As the stock-based compensation expense recognized in the consolidated statements of operations and comprehensive income (loss) for fiscal 2014, 2013 and 2012 is based on awards ultimately expected to vest, such amount has been reduced for estimated forfeitures. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. We estimate forfeitures based on our historical experience. In fiscal 2014, we accelerated the vesting on certain awards granted to our former CEO at the time of his resignation. A modification of an award that accelerates vesting is accounted for as a cancellation of the original award and an issuance of a new award. The compensation expense associated with the original award is reversed while compensation expense for the new award is recorded at fair value determined at the time the modification occurs. Compensation expense for the new award is recorded over the period the employee is required to provide service (if any). During fiscal year 2014, as part of the total long term executive incentive plan our Board of Directors granted a target performance award of 132,138 restricted stock units ("RSU") to certain members of its senior executive team that contained a market-based performance condition in addition to a service component. These RSUs vest after three years from the date of grant and the grants ultimately awarded will be based upon the performance percentage, which can range from 0-200% of the target performance award grant. The RSUs ultimately awarded upon vesting are based on our performance relative to peer group companies' two year compound annual growth rate of total shareholder return. Total shareholder return is measured based on a comparison of the closing price on June 30, 2013, the day prior to the performance period beginning, and the closing price on June 30, 2015, the last day of the performance period. Total shareholder return will include the effect of dividends paid during the performance period. The fair value of these RSUs at their grant date was $6.83 and was estimated on the date of grant using a Monte Carlo simulation model that included valuation inputs for expected volatility 41%, risk free interest rate 0.38%, dividend yield 1.8% and correlation to peer group companies of 22%. Inventories. We state inventories at the lower of weighted average cost or market. We generally determine market based on the merchandise selling price. To ensure that our raw material is properly valued, we age the fabric inventory and record a reserve in accordance with our established policy, which is based on historical experience. To ensure our finished goods inventory is properly valued, we review the age and turnover of our inventory and record an adjustment if the selling price is estimated to be marked down below cost. These assumptions can have an impact on current and future operating results and financial position. We estimate and record shrinkage for the period between the last physical count and balance sheet date based on historic shrinkage trends. We also record losses on non-cancellable purchase orders when estimated selling price is below cost. Investments. We hold a variety of interest bearing auction rate securities ("ARS") consisting of federally insured student loan backed securities and insured municipal authority bonds. As of July 5, 2014, our ARS portfolio totaled approximately $11.9 million, net of a temporary impairment charge of $3.6 million, classified as available for sale securities. These ARS investments are intended to provide liquidity via an auction process that resets the applicable interest rate at predetermined calendar intervals, allowing investors to either roll over their holdings or gain immediate liquidity by selling such interests at par. The uncertainties in the credit markets that began in February 2008 have affected our holdings in ARS investments and auctions for our investments in these securities have failed to settle on their respective settlement dates. Historically the fair value of ARS investments had approximated par value due to the frequent resets through the auction process. While we continue to earn interest on our ARS investments at the maximum contractual rate, the majority of these investments are not 20 -------------------------------------------------------------------------------- currently trading and therefore do not currently have a readily determinable market value. Accordingly, the estimated fair value of ARS no longer approximates par value. Consequently, the investments are not currently liquid, and we will not be able to access these funds until a future auction of these investments is successful, the issuer redeems the securities or at maturity. Maturity dates for these ARS range from 2031 to 2033 with principal distributions occurring on certain securities prior to maturity. We also hold short-term available for sale securities totaling $18.7 million at July 5, 2014 that consist of certificates of deposit. We review our investments for impairment in accordance with guidance issued by the FASB and SEC in order to determine the classification of the impairment as "temporary" or "other-than-temporary". A temporary impairment charge results in an unrealized loss being recorded in the other comprehensive income component of shareholders' equity. Such an unrealized loss does not affect net income for the applicable accounting period. An other-than-temporary impairment charge is recorded as a loss in the consolidated statements of operations and comprehensive income (loss) and reduces net income for the applicable accounting period. When evaluating the investments for other-than-temporary impairment, we estimate the expected cash flows of the underlying collateral by reviewing factors such as the length of time and extent to which the fair value has been below cost basis, the financial condition of the issuer and any changes thereto, and our intent to sell, or whether it is more likely than not it will be required to sell, the investment before recovery of the investment's unamortized cost basis. The valuation of our investment portfolio is subject to uncertainties that are difficult to predict. Factors that may impact our valuation include changes to credit ratings of the issuers of the securities as well as to the underlying assets supporting those securities, rates of default of the underlying assets, underlying collateral value, discount rates and ongoing strength and quality of market credit and liquidity. Impairment of long-lived assets. We review long-lived assets for impairment whenever events or changes in circumstances, such as planned store closures or poor performing stores, indicate that the carrying value of an asset may not be recoverable. Assets are grouped and evaluated for impairment at the lowest level of which there are identifiable cash flows, which is generally at a store level. Store assets are reviewed using factors including, but not limited to our future operating plans and projected cash flows. The determination of whether impairment has occurred is based on an estimate of undiscounted future cash flows directly related to that store, compared to the carrying value of the assets. If the sum of the undiscounted future cash flows of a store does not exceed the carrying value of the assets, full or partial impairment may exist. For impaired assets, we recognize a loss equal to the difference between the net book value of the asset and its estimated fair value. Fair value is based upon discounted future cash flows of the asset using a discount rate commensurate with the risk. In addition, at the time a decision is made to close a store, we record an impairment charge, if appropriate, or accelerate depreciation over the revised useful life of the asset. During fiscal 2014, 2013 and 2012, we recorded charges of $7.0 million, $3.8 million and $0.5 million, respectively for the impairment of store assets. We believe at this time that the long-lived assets' carrying values and useful lives continue to be appropriate; however significant changes from our current forecasts could result in additional impairment charges. Income Taxes. We account for income taxes using an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements or tax returns. We are subject to periodic audits by the Internal Revenue Service and other foreign, state and local taxing authorities. These audits may challenge certain of our tax positions such as the timing and amount of income and deductions and the allocation of taxable income to various tax jurisdictions. We evaluate our tax positions and establish liabilities in accordance with applicable accounting guidance on uncertainty in income taxes. To the extent that our estimates change or the final tax outcome of these matters is different than the amounts recorded, such differences will impact the income tax provision in the period in which such determinations are made. We regularly asses the need for a valuation allowance against our deferred tax assets. In evaluating whether it is more likely than not that some or all of our deferred tax assets will not be realized, we consider all available positive and negative evidence, including recent year's operational results which is objectively verifiable evidence. As a result of this evaluation, in fiscal 2013, we concluded that it is more likely than not that the majority of our deferred tax assets will not be realized and therefore we increased our valuation allowance by approximately $44.8 million. As of July 5, 2014, we continue to conclude that it is more likely than not that the majority of our deferred tax assets will not be realized, and as such we maintained a valuation allowance. Our effective tax rate in a given financial statement period may be materially impacted by changes in the mix and level of earnings, changes in the expected outcome of audits or changes in the deferred tax valuation allowance. Lease accounting. We lease retail stores and office space under operating leases. Costs associated with securing new store leases are capitalized in other assets and amortized over the lease term. Many of our operating leases contain predetermined fixed increases of the minimum rental rate during the initial lease term. For these leases, we recognize the related rental expense on a straight-line basis over the lease term, commencing when possession of the property is taken from the landlord, 21 -------------------------------------------------------------------------------- which normally includes a construction period prior to the store opening. We record the difference between the recognized rent expense and the amounts paid as deferred rent. We receive construction allowances from landlords, which are deferred and amortized on a straight-line basis over the lease term, including the construction period, as a reduction of rent expense. Construction allowances are recorded under deferred rent and other lease incentives on the balance sheet. When we discontinued our 2b division, we closed stores prior to the expiration of the related lease. Certain of those leases contain a contractual cap on the amount we owe and we have accrued a liability pursuant to the terms of the contract. For leases with no contractual maximum we recorded an expense for the difference between the present value of our future lease payments and related costs (e.g. common area maintenance and real estate taxes) from the date of closure through the end of the remaining lease term, reduced by assumed sublease rental income. Our estimate of future cash flows is based on an analysis of the specific real estate market and included input from an independent real estate broker. Cash flows are discounted using a credit-adjusted risk free interest rate. The liability for these leases contains uncertainties because management is required to make assumptions including the duration and amount of sublease income. Furthermore, we intend to pursue a negotiated settlement with the respective landlords, and actual negotiated settlements could result in amounts that could be materially different. Recent Accounting Pronouncements Other Comprehensive Income In February 2013, the FASB issued an ASU that requires enhanced disclosures around the amounts reclassified out of accumulated other comprehensive income. The amendments do not change the requirements for reporting net income or other comprehensive income. The ASU requires an entity to present information about significant reclassifications out of accumulated other comprehensive income and their corresponding effects on the respective line items in net income. The ASU was effective for annual and interim reporting periods beginning after December 15, 2012 and as such we adopted the disclosure provisions in the first quarter of fiscal 2014, and it did not have a material impact on our consolidated financial statements. Presentation of Financial Statements In April 2014, the FASB issued ASU No. 2014-08, "Presentation of Financial Statements (Topic 205) and Property, Plant, and Equipment (Topic 360): Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity", or ASU 2014-08. Under ASU 2014-08, only disposals representing a strategic shift in operations should be presented as discontinued operations. Those strategic shifts should have a major effect on the organization's operations and financial results. Additionally, ASU 2014-08 required expanded disclosures about discontinued operations that will provide financial statement users with more information about the assets, liabilities, income, and expenses of discontinued operations. ASU 2014-08 is effective for fiscal and interim periods beginning on or after December 15, 2014, with early adoption permitted. We have not early-adopted this ASU. Revenue Recognition In May 2014, the FASB issued ASU No. 2014-09, "Revenue from Contracts with Customers", or ASU 2014-09, which states that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To achieve this, an entity will need to identify the contract with a customer; identify the separate performance obligations in the contract; determine the transaction price; allocate the transaction price to the separate performance obligation in the contract; and recognized revenue when (or as) the entity satisfies each performance obligation. ASU No. 2014-09 will be effective beginning January 1, 2017 and can be adopted on a full retrospective basis or on a modified retrospective basis. We are currently assessing its approach to the adoption of this standard and the impact on our results of operations and financial position. 22 -------------------------------------------------------------------------------- Results of Operations Our fiscal year ends on the first Saturday on or after June 30. Fiscal year 2014 had 52 weeks, fiscal year 2013 had 53 weeks and fiscal year 2012 had 52 weeks. The following table sets forth certain financial data as a percentage of net sales for the periods indicated: Fiscal Year Ended July 5, July 6, June 30, 2014 2013 2012 Summary of Operating Data: Net sales 100.0 % 100.0 % 100.0 % Cost of sales, including production and occupancy(1) 67.5 66.7 59.8 Gross margin 32.5 33.3 40.2 Selling, general and administrative expenses(2) 46.5 42.6 36.0 Operating income (loss) (14.0 ) (9.3 ) 4.2 Interest and other income, net 0.1 0.2 0.2 Income (loss) from continuing operations before income taxes (13.9 ) (9.1 ) 4.4 Income tax provision - 5.8 1.8 Income (loss) from continuing operations, net of tax (13.9 ) (14.9 ) 2.6 Loss from discontinued operations, net of tax (3.3 ) (1.8 ) (0.3 ) Net income (loss) (17.2 )% (16.7 )% 2.3 % (1) Cost of sales includes the cost of merchandise, occupancy costs and production costs. (2) Selling, general and administrative expenses primarily consist of non-occupancy store costs, corporate overhead and advertising costs. Fiscal Years Ended July 5, 2014 and July 6, 2013 Net Sales. Net sales from continuing operations decreased to $425.1 million during the fiscal year ended July 5, 2014 from $463.2 million in fiscal 2013, a decrease of $38.1 million, or 8.2%. The decrease in net sales was primarily attributable to a 3.2% decrease in comparable store sales due to a decrease in comparable store traffic as well as a decrease in wholesale sales of $2.2 million, or 5.8%. On-line store sales increased 15.3% during the year. A significant contributor to our increase in e-commerce sales in 2014 was the continued movement towards more seamless multi-channel capabilities, including increasing our on-line assortment and improving on-line ordering capabilities in stores. Gross Margin. Gross margin from continuing operations decreased to $138.1 million for the fiscal year ended July 5, 2014 from $154.2 million in fiscal 2013, a decrease of $16.1 million, or 10.4%. As a percentage of net sales, gross margin of 32.5% was lower than the prior year at 33.3% primarily due to higher promotional activity partially offset by occupancy leverage. Gross margin in fiscal 2013 also included $2.9 million in markdowns for inventory and fabric. Selling, General and Administrative Expenses. Selling, general and administrative expenses from continuing operations, which primarily consist of non-occupancy store costs, corporate overhead and advertising costs, increased to $197.8 million during fiscal 2014 from $197.2 million in fiscal 2013, an increase of $0.6 million, or 0.3%. The increase was due primarily to increases in advertising costs and store impairment charges ($4.2 million and $3.2 million, respectively) compared to the prior year. These increases were offset by reductions in professional fees of $3.1 million and a reduction in depreciation of $1.5 million compared with the prior year. Interest and Other Income, Net. We generated $0.3 million of interest and other income, net of other expenses, during fiscal 2014 as compared to $0.8 million in fiscal 2013. The year over year decrease reflected the sales of auction rate securities and our continued investment in lower-yielding tax-exempt investments and money market funds. 23 -------------------------------------------------------------------------------- Provision for Income Taxes. Our effective tax rate was (0.3)% for fiscal 2014 as compared to 64.0% for fiscal 2013. The rate for fiscal 2014 reflected the continuing impact of maintaining a valuation allowance against most of our deferred tax assets. Fiscal 2013 was impacted by a valuation allowance that we recorded for the majority of our deferred tax assets that was recorded in the third quarter of fiscal 2013. In future years, we expect the continuing impact of maintaining a valuation allowance against deferred tax assets to result in a near 0% effective tax rate. Discontinued Operations. In the fourth quarter of fiscal 2014, we discontinued operations of the 2b division, allowing us to focus our efforts on the core bebe brand's retail and outlet stores, e-commerce and international licensing business. We closed 18 2b mall-based stores, including the e-commerce business, in the fourth fiscal quarter of 2014. The results of the 2b stores closed to date, net of income tax benefit, which consists of 18 and 20 stores for the fiscal years ended July 5, 2014 and July 6, 2013, respectively, have been presented as a discontinued operation in the accompanying consolidated statements of operations and comprehensive income (loss) for all periods presented and are as follows: Fiscal Year Ended Fiscal Year Ended July 5, 2014 July 6, 2013 (In thousands) Net sales $ 21,418 $ 21,516 Cost of sales, including production and occupancy 18,692 17,414 Gross margin 2,726 4,102 Selling, general and administrative expenses 16,857 12,375 Loss from discontinued operations, before income tax provision (14,131 ) (8,273 ) Add: tax provision 2 2 Loss from discontinued operations, net of tax provision $ (14,133 ) $ (8,275 ) Loss from discontinued operations, net of tax provision increased $5.9 million, or 71%, in fiscal year 2014 compared with fiscal year 2013 primarily as a result of increased selling, general and administrative expenses. The increase in selling, general and administrative expenses of $4.5, or 36%, in fiscal 2014 reflects the effect million of $6.4 million in lease obligation costs related to 2b store leases, primarily offset by the impact of $3.3 million in store impairment charges incurred in fiscal 2013. Fiscal Years Ended July 6, 2013 and June 30, 2012 Net Sales. Net sales from continuing operations decreased to $463.2 million during the fiscal year ended July 6, 2013 from $519.8 million in fiscal 2012, a decrease of $56.6 million, or 10.9%. The decrease in net sales was primarily attributable to a 9.6% decrease in comparable store sales as well as a decrease in wholesale sales of $3.9 million, or 9.3%. On-line store sales increased 4.2% during the year. The increase in e-commerce sales was driven by increased sales of both bebe and 2b brand merchandise. A significant contributor to our increase in e-commerce sales in 2013 was the continued movement towards more seamless multi-channel capabilities, including increasing our on-line assortment and improving on-line ordering capabilities in stores. We believe that bringing website administration in house in the first quarter of 2013 has enabled us and will continue to enable us to continue to grow on-line sales, although not necessarily at the same rate as in the past given progress we have already made in this area. Gross Margin. Gross margin from continuing operations decreased to $154.2 million for the fiscal year ended July 6, 2013 from $208.8 million in fiscal 2012, a decrease of $54.6 million, or 26.1%. As a percentage of net sales, gross margin of 33.3% was lower than the prior year at 40.2% primarily due to an increase in markdowns coupled with unfavorable occupancy leverage. Gross margin in fiscal 2013 also included $2.9 million in markdowns for inventory and fabric. Selling, General and Administrative Expenses. Selling, general and administrative expenses from continuing operations, which primarily consist of non-occupancy store costs, corporate overhead and advertising costs, increased to $197.2 million during fiscal 2013 from $186.9 million in fiscal 2012, an increase of $10.3 million, or 5.5%. This increase was primarily a result of a $3.2 million increase in store impairment costs, a $1.4 million increase in rebranding agency costs, settlement related expenses of $3.3 million and costs related to executive transitions of $4.9 million. The comparable period of the prior year included $4.7 million in incentive compensation costs as well as $0.2 million in store impairment and closure costs. Interest and Other Income, Net. We generated $0.8 million of interest and other income, net of other expenses, during fiscal 2013 as compared to $0.9 million in fiscal 2012. The year over year consistency reflected our continued investment in lower-yielding tax-exempt investments and money market funds. 24 -------------------------------------------------------------------------------- Provision for Income Taxes. Our effective tax rate from continuing operations was 64.0% for fiscal 2013 as compared to 42.0% for fiscal 2012. During the third quarter of fiscal 2013 we recorded a valuation allowance for the majority of our deferred tax assets. As a result, our effective tax rate for fiscal 2013 is not comparable to the comparable period of the prior year. Discontinued Operations. The results of the 2b stores closed in fiscal 2014, net of income tax provision (benefit), which consists of 20 and 14 stores for the fiscal years ended July 6, 2013 and June 30, 2012, respectively, have been presented as a discontinued operation in the accompanying consolidated statements of operations and comprehensive income (loss) for all periods presented and are as follows: Fiscal Year Ended Fiscal Year Ended July 6, 2013 June 30, 2012 (In thousands) Net sales $ 21,516 $ 10,986 Cost of sales, including production and occupancy 17,414 8,664 Gross margin 4,102 2,322 Selling, general and administrative expenses 12,375 4,746 Loss from discontinued operations, before income tax (benefit) provision (8,273 ) (2,424 ) Add: tax provision (benefit) 2 (944 ) Loss from discontinued operations, net of tax (benefit) provision $ (8,275 ) $ (1,480 ) Net sales increased $10.5 million or 96% in fiscal 2013 compared with the prior year due to new store openings in fiscal 2013. Selling, general and administrative expenses increased $7.6 million in fiscal 2013, primarily reflecting the effects of a $1.5 million and $2.5 million increase in compensation and store occupancy costs, respectively, and $3.3 million in store impairment charges. Seasonality of Business and Quarterly Results Our business varies with general seasonal trends that are characteristic of the retail and apparel industries. As a result, our typical store generates a higher percentage of its annual net sales and profitability in the second quarter of our fiscal year, which includes the holiday selling season, compared to other quarters of our fiscal year. If for any reason our sales were below seasonal norms during the second quarter of our fiscal year, our annual operating results would be negatively impacted. Because of the seasonality of our business, results for any quarter are not necessarily indicative of results that may be achieved for a full fiscal year. Liquidity and Capital Resources Our working capital requirements vary widely throughout the year and generally peak during the first and second fiscal quarters. At July 5, 2014, we had approximately $125.0 million of cash, cash equivalents and investments on hand of which $94.3 million were cash and equivalents, approximately $11.9 million, net of impairment charges of $3.6 million, were auction rate securities ("ARS") and approximately $18.7 million were certificates of deposit. We do not anticipate the lack of liquidity in the ARS to impact our ability to fund our operations in the foreseeable future and believe we have sufficient cash and equivalents to fund ongoing operations. In addition, we have a stand-by letter of credit agreement which provides for issuance of one or more stand-by letters of credit. As of July 5, 2014, there was $3.8 million outstanding, related to two stand-by letters of credit. To date, no beneficiary has drawn upon the stand-by letter of credit. At July 5, 2014, we had cash and cash equivalents of $94.3 million held in accounts managed by third-party financial institutions consisting of invested cash and cash in our operating accounts. The invested cash is invested in interest bearing funds managed by third-party financial institutions. These funds invest in direct obligations of the government of the United States. To date, we have experienced no loss or lack of access to our invested cash or equivalents; however, we can provide no assurances that access to our invested cash and equivalents will not be impacted by adverse conditions in the financial markets. We hold our operating and invested cash in accounts that are with third-party financial institutions. The balances in these accounts exceed the Federal Deposit Insurance Corporation insurance limits. While we monitor daily the cash balances in our operating accounts and adjust the cash balances as appropriate, these cash balances could be impacted if the underlying 25 -------------------------------------------------------------------------------- financial institutions fail or could be subject to other adverse conditions in the financial markets. To date, we have experienced no loss or lack of access to invested cash or cash in our operating accounts. Net cash (used by) provided by operating activities in fiscal 2014, 2013 and 2012 was $(30.3) million, $(8.4) million and $32.7 million, respectively. The decrease in cash provided by operating activities of $21.9 million from 2013 to 2014 was primarily due to lower net income (excluding the deferred tax valuation allowance) and a change in working capital. The changes in working capital of $31.0 million are primarily related to increased accrued expenses related to lease obligation costs for our 2b discontinued operations and corporate restructuring. The change from fiscal 2012 to 2013 was a result of lower overall net income (excluding the deferred tax valuation allowance) and a change in working capital of $9.6 million related to lower prepaid income tax related to our reported operating loss, lower construction allowances receivable related to timing of store construction as well as increased accounts payable as a result of the timing of our inventory orders. Net cash provided by investing activities was $44.8 million versus net cash provided by investing activities of $19.6 million and net cash used by investing activities of $(15.2) million in fiscal 2014, 2013 and 2012, respectively. The increase in net cash provided by investing activities in fiscal 2014 from fiscal 2013 was a result of increased net proceeds from sales and maturities of investments related to the increased settlement of our ARS investments at par. The change from fiscal 2012 to 2013 was also primarily a result of increased net proceeds from sales and maturities of investments related to the increased settlement of our ARS investments at par offset by lower capital expenditures. Capital expenditures of $19.8 million in fiscal 2014 primarily included $1.9 million related to the opening of new stores, $7.9 million related to the relocation and expansion of existing stores, $6.7 million related to investments in management information systems and $2.2 million related to visual and pre-production initiatives. Capital expenditures of $24.6 million in fiscal 2013 primarily included $6.8 million related to the opening of new stores, $9.2 million related to the relocation and expansion of existing stores, $3.1 million related to investments in management information systems and $1.2 million related to visual and pre-production initiatives. We opened 2, 10 and 13 new stores in fiscal 2014, 2013 and 2012, respectively, and we expect to open 6 stores in fiscal 2015. In fiscal 2015, we expect capital expenditures of approximately $16.0 million, which will include capital expenditures for new stores, remodels, store expansions, information technology systems and office improvements. During fiscal 2014, the average of new store construction costs before tenant allowances was $478,000 and the average gross inventory investment per store was $126,000. Net cash used by financing activities was $6.8 million in fiscal 2014 compared to net cash used by financing activities of $28.8 million in fiscal 2013. The decrease in cash used by financing activities of $22.0 million was primarily a result of the stock repurchases of $21.2 million in fiscal 2013. Net cash used by financing activities was $28.8 million in fiscal 2013 compared to net cash used by financing activities of $7.0 million in fiscal 2012. The increase in cash used by financing activities of $21.8 million was primarily a result of stock repurchases of $21.2 million in fiscal 2013. We hold a variety of interest bearing ARS consisting of federally insured student loan backed securities and insured municipal authority bonds. As of July 5, 2014, our ARS portfolio totaled approximately $11.9 million, net of a temporary impairment charge of $3.6 million, classified as available for sale securities. These ARS investments are intended to provide liquidity via an auction process that resets the applicable interest rate at predetermined calendar intervals, allowing investors to either roll over their holdings or gain immediate liquidity by selling such interests at par. The uncertainties in the credit markets that began in February 2008 have affected our holdings in ARS investments and auctions for our investments in these securities have failed to settle on their respective settlement dates. Historically the fair value of ARS investments had approximated par value due to the frequent resets through the auction process. While we continue to earn interest on our ARS investments at the maximum contractual rate, the majority of these investments are not currently trading and therefore do not currently have a readily determinable market value. Accordingly, the estimated fair value of ARS no longer approximates par value. Consequently, the investments are not currently liquid, and we will not be able to access these funds until a future auction of these investments is successful, the issuer redeems the securities, or at maturity. Maturity dates for these ARS investments range from 2031 to 2033 with principal distributions occurring on certain securities prior to maturity. We do not intend to sell our remaining ARS until we can recover the full principal amount through one of the means described above. In addition, we do not believe it is more likely than not we would be required to sell our remaining ARS until we can recover the full principal amount based on our other sources of liquidity. We also hold short-term available for sale securities totaling $18.7 million at July 5, 2014 that consist of certificates of deposit. In November 2012, our board of directors authorized a program to repurchase up to $30 million of our common stock. We intend, from time to time, as business conditions warrant, to purchase stock in the open market or through private 26 -------------------------------------------------------------------------------- transactions. Purchases may be increased, decreased or discontinued at any time without prior notice. The plan does not obligate us to purchase any specific number of shares and may be suspended at any time at management's discretion. In fiscal 2013, we repurchased approximately 5.5 million shares at a weighted average price per share of $3.88. No shares were repurchased during the 2014 fiscal year. We believe that our cash on hand, together with our cash flows from operations, will be sufficient to meet our capital and operating requirements for at least the next twelve months. Our future capital requirements, however, will depend on numerous factors, including without limitation, liquidity of our auction rate securities, the size and number of new and expanded stores and/or store concepts, investment costs for management information systems, potential acquisitions and/or joint ventures, repurchase of stock and future results of operations. Summary Disclosures about Contractual Obligations and Commitments: Other than operating leases, we do not have any off-balance-sheet financing. The following tables summarize our significant contractual obligations and commercial commitments as of July 5, 2014 (in thousands): Amount of commitment expiration period Less than After Total 1 year 1 - 3 years 4 - 5 years 5 years Operating leases(3) $ 253,930 $ 51,978 $ 82,266 $ 55,037 $ 64,649 Unconditional purchase obligations(1) 69,363 67,186 2,177 - - Total contractual obligations and commitments(2) $ 323,293 $ 119,164 $ 84,443 $ 55,037 $ 64,649 (1) Unconditional purchase obligations are defined as agreements to purchase goods or services that are enforceable and legally binding on us and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Included in the purchase obligations category above are commitments for inventory purchases, capital expenditures, information technology and professional services. Most arrangements are cancellable without a significant penalty and with short notice, usually 30 to 90 days. We excluded amounts reflected on the consolidated balance sheet as accounts payable and accrued liabilities from the table above. (2) The table above does not include liabilities related to unrecognized tax benefits. As we are unable to reasonably predict the timing of settlement of such liabilities, the table does not include $0.1 million of income tax, interest and penalties relating to unrecognized tax benefits that are recorded as noncurrent liabilities within our consolidated balance sheet as of July 5, 2014. (3) Includes amounts for operating leases related to closed 2b stores classified as discontinued operations for the following fiscal years (in thousands): 2015: $2,015; 2016: $2,074; 2017: $2,128; 2018: $2,175; 2019: $2,224; and thereafter: $5,449. Inflation We do not believe that inflation has had a material effect on the results of operations in the recent past. However, we cannot assure that our business will not be affected by inflation in the future. For example, cotton prices rose substantially in fiscal 2011 and 2012. Should this rise continue in fiscal 2015, there will be pressure on our average unit costs and our gross margins will continue to be impacted. |