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WTSL > SEC Filings for WTSL > Form 10-K on 27-Mar-2014All Recent SEC Filings

Show all filings for WET SEAL INC

Form 10-K for WET SEAL INC


Annual Report

Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion should be read in conjunction with our audited consolidated financial statements and notes thereto included elsewhere in this Annual Report. The following discussion and analysis contains forward-looking statements which involve risks and uncertainties, and 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 the heading "Forward-Looking Statements" included elsewhere in this Annual Report. Executive Overview
We are a national multi-channel specialty retailer selling fashion apparel and accessory items designed for female customers aged 13 to 34 years old through our stores and e-commerce websites. We operate two nationwide, primarily mall-based, chains of retail stores under the names "Wet Seal" and "Arden B." As of February 1, 2014, we had 532 retail stores in 47 states and Puerto Rico. Of the 532 stores, there were 475 Wet Seal stores and 57 Arden B stores. We report our results of operations as two reportable segments representing our two retail divisions ("Wet Seal" and "Arden B"). E-commerce operations for Wet Seal and Arden B are included in their respective operating segments. Although the two operating segments have many similarities in their products, production processes, distribution methods and regulatory environments, there are differences in most of these areas and distinct differences in their economic characteristics.
Our fiscal year ends on the Saturday closest to the end of January. The reporting periods include 52 weeks of operations ended February 1, 2014 (fiscal 2013), 53 weeks of operations ended February 2, 2013 (fiscal 2012), and 52 weeks of operations ended January 28, 2012 (fiscal 2011).
We consider the following to be key performance indicators in evaluating our performance:
Comparable store sales-For purposes of measuring comparable store sales, sales include merchandise sales as well as membership fee revenues recognized under our Wet Seal division's frequent buyer program during the applicable period. Stores are deemed comparable stores on the first day of the month following the one-year anniversary of their opening or significant remodel/relocation, which we define to be a square footage increase or decrease of at least 20%. Stores that are remodeled or relocated with a resulting square footage change of less than 20% are maintained in the comparable store base with no interruption. However, stores that are closed for four or more days in a fiscal month, due to remodel, relocation or other reasons, are removed from the comparable store base for that fiscal month as well as for the comparable fiscal month in the following fiscal year. In addition, due to the 53rd week in fiscal 2012, comparable store sales for fiscal 2013 are compared to the 52 weeks ended February 2, 2013. Comparable store sales results are important in achieving operating leverage on expenses such as store payroll, occupancy, depreciation and amortization, general and administrative expenses, and other costs that are at least partially fixed. Positive comparable store sales results generate greater operating leverage on expenses while negative comparable store sales results negatively affect operating leverage. Comparable store sales results also have a direct impact on our total net sales, cash and working capital. Average transaction counts-We consider the trend in the average number of sales transactions occurring in our stores to be a key performance metric. To the extent we are able to increase transaction counts in our stores that more than offset the decrease, if any, in the average dollar sale per transaction, we will generate increases in our comparable store sales.
Gross margins-We analyze the components of gross margin, specifically cumulative mark-on, markups, markdowns, shrink, buying costs, distribution costs and store occupancy costs. Any inability to obtain acceptable levels of initial markups, a significant increase in our use of markdowns or in inventory shrink, or an inability to generate sufficient sales leverage on other components of cost of sales could have an adverse impact on our gross margin results and results of operations.
Operating (loss) income-We view operating (loss) income as a key indicator of our financial success. The key drivers of operating (loss) income are comparable store sales, gross margins and the changes we experience in operating costs.

Cash flow and liquidity (working capital)-We evaluate cash flow from operations, liquidity and working capital to determine our short-term operational financing needs.
Critical Accounting Policies and Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires the appropriate application of certain accounting policies, some of which require us to make estimates and assumptions about future events and their impact on amounts reported in our audited consolidated financial statements. Since future events and their impact cannot be determined with absolute certainty, the actual results will inevitably differ from our estimates.
We believe the application of our accounting policies, and the estimates inherently required therein, are reasonable. Our accounting policies and estimates are reevaluated on an ongoing basis, and adjustments are made when facts and circumstances dictate a change. Our accounting policies are more fully described in Note 1 - "Summary of Significant Accounting Policies," to our audited consolidated financial statements included elsewhere in this Annual Report.
The policies and estimates discussed below involve the selection or application of alternative accounting policies that are material to our audited consolidated financial statements. Management has discussed the development and selection of these critical accounting policies and estimates with the Audit Committee of our Board of Directors.
We have certain accounting policies that require more significant management judgment and estimates than others. These include our accounting policies with respect to revenue recognition, short-term investments, merchandise inventories, long-lived assets, stock-based compensation, accounting for income taxes, insurance reserves and legal loss contingencies. Revenue Recognition
Sales are recognized upon purchases by customers at our retail store locations. Taxes collected from our customers are recorded on a net basis. For e-commerce sales, revenue is recognized at the estimated time goods are received by customers. E-commerce customers typically receive goods within four days of being shipped. Shipping and handling fees billed to customers for e-commerce sales are included in net sales. For fiscal 2013, 2012, and 2011, shipping and handling fee revenues were $2.2 million, $2.3 million and $3.0 million, respectively, within net sales on the consolidated statements of operations. We have recorded accruals to estimate sales returns by customers based on historical sales return results. Our sales return policy allows customers to return merchandise within 30 days of original purchase. Both Wet Seal and Arden B retail store merchandise may be returned for refund of original method of payment within fourteen days of the original purchase date. Store returns made between fifteen and thirty days of purchase will be accepted for merchandise credit or exchange only. For e-commerce sales, merchandise may be returned within 30 days for a full refund. Actual return rates have historically been within management's estimates and the accruals established. As the accrual for merchandise returns is based on estimates, the actual returns could differ from the accrual, which could impact net sales. The accrual for merchandise returns is recorded in accrued liabilities on the consolidated balance sheets and was $0.1 million at February 1, 2014, and $0.2 million at February 2, 2013. We recognize the sales from gift cards, gift certificates and store credits as they are redeemed for merchandise. Prior to redemption, we maintain an unearned revenue liability for gift cards, gift certificates and store credits until we are released from such liability. Our gift cards, gift certificates and store credits do not have expiration dates; however, over time, a percentage of gift cards, gift certificates and store credits are not redeemed or recovered ("breakage"). Based upon historical redemption trend data, we determined that the likelihood of redemption of unredeemed gift cards, gift certificates and store credits two years after their issuance is remote and, accordingly, we adjust our unearned revenue liability quarterly to record breakage as additional sales for gift cards, gift certificates and store credits that remained unredeemed two years after their issuance. Our net sales for fiscal 2013, 2012, and 2011 included benefits of $1.2 million, $1.1 million and $1.1 million, respectively, to reduce our unearned revenue liability for estimated unredeemed amounts. The unearned revenue for gift cards, gift certificates and store credits is recorded in accrued liabilities in the consolidated balance sheets and was $4.7 million and $5.4 million at February 1, 2014 and February 2, 2013, respectively. If actual redemptions ultimately differ from the assumptions underlying our breakage adjustments, or our future experience indicates the likelihood of redemption of gift cards, gift certificates and store credits becomes remote at a different point in time after issuance, we may recognize further significant adjustments to our accruals for such unearned revenue, which could have a significant effect on our net sales and results of operations.

We maintain a frequent buyer program, the fashion insider card, through our Wet Seal division. Under the program, customers receive a 10% to 20% discount on all purchases made during a 12-month period and are provided $5-off coupons that may be used on purchases during such period. The annual membership fee of $20 is nonrefundable. Discounts received by customers on purchases using the fashion insider program are recognized at the time of such purchases.
We recognize membership fee revenue under the fashion insider program on a straight-line basis over the 12-month membership period. From time to time, we test alternative program structures, and promotions tied to the program, and may decide to further modify the program in ways that could affect customer usage patterns. As a result of this program testing and potential further modifications, we believe it is appropriate to maintain straight-line recognition of membership fee revenue. We may, in the future, determine that recognition of membership fee revenue on a different basis is appropriate, which would affect net sales. The unearned revenue for this program is recorded in accrued liabilities in the consolidated balance sheets and was $5.5 million and $5.7 million at February 1, 2014 and February 2, 2013, respectively. We maintain a customer loyalty program through our Arden B division. Under the program, customers accumulate points based on purchase activity. Once a loyalty program member achieves a certain point level, the member earns awards that may be redeemed for merchandise. Unredeemed awards and accumulated partial points are accrued as unearned revenue and awards redeemed by the member for merchandise are recorded as an increase to net sales.
We convert into fractional awards the points accumulated by customers who have not made purchases within the preceding 18 months. Similar to all other awards currently being granted under the program, such fractional awards expire if unredeemed after 60 days. The unearned revenue for this program is recorded in accrued liabilities on the consolidated balance sheets and was $0.8 million and $1.1 million at February 1, 2014 and February 2, 2013, respectively. If actual redemptions ultimately differ from accrued redemption levels, or if we further modify the terms of the program in a way that affects expected redemption value and levels, we could record adjustments to the unearned revenue accrual, which would affect net sales.
Short-term Investments
Our short-term investments consisted of interest-bearing bonds of various U.S. Government agencies and certificates of deposit, have maturities that are less than one year and are carried at amortized cost plus accrued income due to our intent to hold to maturity. Short-term investments on the consolidated balance sheets were $7.4 million at February 1, 2014, and $67.7 million at February 2, 2013.
Merchandise Inventories
Merchandise inventories are stated at the lower of cost or market. Market is determined based on the estimated net realizable value, which generally is the merchandise selling price. Cost is calculated using the retail inventory method. Under the retail inventory method, inventory is stated at its current retail selling value and then is converted to a cost basis by applying a cost-to-retail ratio based on beginning inventory and the fiscal year purchase activity. The retail inventory method inherently requires management judgments and estimates, such as the amount and timing of permanent markdowns to clear unproductive or slow-moving inventory, which may impact the ending inventory valuation as well as gross margins.
Markdowns are recorded when the sales value of the inventory has diminished. Factors considered in the determination of permanent markdowns include current and anticipated demand, customer preferences, age of the merchandise and fashion trends. When a decision is made to permanently mark down merchandise, the resulting gross margin reduction is recognized in the period the markdown is recorded. Total markdowns, including permanent and promotional markdowns, on a cost basis in fiscal 2013, 2012, and 2011, were $91.0 million, $108.2 million, and $86.4 million, respectively, and represented 17.2%, 18.6%, and 13.9% of net sales, respectively. We accrued $4.7 million and $3.9 million for planned but unexecuted markdowns, including markdowns related to slow moving merchandise, against the carrying value of merchandise inventories on our consolidated balance sheets as of February 1, 2014 and February 2, 2013, respectively. To the extent that management's estimates differ from actual results, additional markdowns may be required that could reduce our gross margin, operating income and the carrying value of inventories. Our success is largely dependent upon our ability to anticipate the changing fashion tastes of our customers and to respond to those changing tastes in a timely manner. If we fail to anticipate, identify or react appropriately to changing styles, trends or brand preferences of our customers, we may experience lower sales, excess inventories and more frequent and extensive markdowns, which would adversely affect our operating results.

Long-Lived Assets
We evaluate the carrying value of long-lived assets for impairment quarterly or whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Factors that are considered important that could result in the necessity to perform an impairment review include a current-period operating or cash flow loss combined with a history of operating or cash flow losses and a projection or forecast that indicates continuing losses or insufficient income associated with the realization of a long-lived asset or asset group. Other factors include a significant change in the manner of the use of the asset or a significant negative industry or economic trend. This evaluation is performed based on estimated undiscounted future cash flows from operating activities compared with the carrying value of the related assets. If the estimated undiscounted future cash flows are less than the carrying value, an impairment loss is recognized, measured by the difference between the carrying value and the estimated fair value of the assets, based on discounted estimated future cash flows using our weighted average cost of capital. With regard to store assets, which are comprised of leasehold improvements, fixtures and computer hardware and software, we consider the assets at each individual store to represent an asset group. In addition, we considered the relevant valuation techniques that could be applied without undue cost and effort and have determined that the discounted estimated future cash flow approach provides the most relevant and reliable means by which to determine fair value in this circumstance.
We conduct our quarterly impairment evaluation at the individual store level using the guidance under applicable accounting standards. The quarterly analysis includes our estimates of future cash flows using only the cash inflows and outflows that are directly related to each store over the remaining lease term. Key assumptions made by us and included within our cash flow estimates are future sales and gross margin projections. We determine the future sales and gross margin projections by considering each store's recent and historical performance, our overall performance trends and projections and the potential impact of strategic initiatives on future performance.
Our evaluation during fiscal 2013, 2012, and 2011 included impairment testing of 80, 157, and 20 stores and resulted in 67, 116, and 18 stores being impaired, respectively, as their projected future cash flows were not sufficient to cover the net carrying value of their assets. As such, we recorded the following non-cash charges related to our retail stores within asset impairment in the consolidated statements of operations, to write down the carrying values of these stores' long-lived assets to their estimated fair values (in thousands except for number of stores).

                                                              Fiscal Year
                                                2013               2012              2011
                                              (in thousands, expect for number of stores)
Aggregate carrying value of all
long-lived assets impaired                $        15,829     $      27,086     $      4,590
Less: Impairment charges                           14,873            27,000            4,503
Aggregate fair value of all long-lived
assets impaired                           $           956     $          86     $         87
Number of stores with asset impairment                 67               116               18

Of the 5 stores that were tested and not impaired during fiscal 2013, as of February 1, 2014, one could be deemed to be at risk of future impairment. When making this determination, we considered the potential impact that reasonably possible changes to sales and gross margin performance versus our current projections for these stores could have on their current estimated cash flows. In addition to recent and historical performance, we consider the positive impact expected from our strategic initiatives when determining the key assumptions to use within the projected cash flows for each store during our quarterly analysis. If we are not able to achieve our projected key financial metrics, and strategic initiatives being implemented do not result in significant improvements in our current financial performance trend, we may incur additional impairment charges in the future for those stores tested and not deemed to be impaired in our most recent quarterly analysis, as well as for additional stores not tested in our most recent quarterly analysis. Stock-Based Compensation
We measure and recognize compensation expense for all share-based payment awards to employees and directors based on estimated fair values.

We use the Black-Scholes option-pricing model to value stock options granted to employees. We use these values to recognize stock compensation expense for stock options. The Black-Scholes model is complex and requires significant exercise of judgment to estimate future common stock dividend yield, common stock expected volatility and the expected life of the stock options. These assumptions significantly affect our stock option valuations, and future changes in these assumptions could significantly change valuations of future stock option grants and, thus, affect future stock compensation expense. In addition, if circumstances were to change such that we determined stock option values were better represented by an alternative valuation method, such change could also significantly affect future stock compensation expense.
The vesting of performance share awards and performance stock units is based on corporate performance objectives. Performance share awards and performance stock units are expensed based on our quarterly assessment of likelihood of vesting based on the stated corporate performance objectives. During fiscal year 2013, the Company recognized compensation expense associated with the performance share awards and performance stock units in the first and second quarters and then reversed the compensation expense in the third quarter due to the decline in business performance.
The following table summarizes stock-based compensation recorded in the consolidated statements of operations:

                                                         Fiscal Year
                                                  2013       2012       2011
                                                        (in thousands)
Cost of sales                                   $   300    $   300    $   271
Selling, general, and administrative expenses     1,344      2,649      4,376
Stock-based compensation                        $ 1,644    $ 2,949    $ 4,647

Accounting for Income Taxes
Our provision for income taxes, deferred tax assets and reserves for unrecognized tax benefits reflect management's best assessment of estimated future taxes to be paid and tax benefits to be realized. We are subject to income taxes in the United States federal jurisdiction as well as various state jurisdictions within the United States. Significant judgments and estimates are required in determining the consolidated provision for income taxes. Deferred income taxes arise from temporary differences between the tax and financial statement recognition of revenue and expense and net operating loss ("NOLs"), pursuant to applicable accounting standards. In evaluating our ability to recover our deferred tax assets within the jurisdictions from which they arise, we consider whether it is more likely than not that some portion or all of the deferred tax assets will be realized using all available positive and negative evidence, including our 3-year cumulative operating results, projected future taxable income and tax planning strategies. In projecting future taxable income, we begin with historical results adjusted for the results of changes in accounting policies and incorporate assumptions including the amount of future state and federal pretax operating income, the reversal of temporary differences, and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income and are consistent with the plans and estimates we use to manage the business. These estimates are based on our best judgment at the time made based on current and projected circumstances and conditions. In accordance with the applicable accounting standards, we maintain a valuation allowance for a deferred tax asset when it is deemed it to be more likely than not that some or all of the deferred tax asset will not be realized. As a result of our evaluation of all evidence as of February 2, 2013, we concluded that it was more likely than not that we would not realize our net deferred tax assets and we recorded a $71.1 million increase to provision for income taxes in order to establish a valuation allowance against our deferred tax assets. As a result, we have discontinued recognizing income tax benefits related to our NOLs until it is determined that it is more likely than not that we will generate sufficient taxable income to realize the benefits from our deferred tax assets. For further information, see Note 4 - "Income Taxes," to the Notes to Consolidated Financial Statements in this Annual Report.
Our effective income tax rate for fiscal 2013 was approximately negative 1.0% due in part to the maintenance of the valuation allowance against our net deferred tax assets. We also incurred cash payable for income taxes for the fiscal year of approximately 0.7% of pre-tax loss, representing certain state income taxes.
Our effective income tax rate for fiscal 2012 was approximately negative 61.0% due to the establishment of the valuation allowance against our net deferred tax assets. We also incurred cash payable for income taxes for the fiscal year of approximately 0.2% of pre-tax loss, representing certain state income taxes.

Section 382 of the Internal Revenue Code ("Section 382") contains provisions that may limit the availability of federal NOLs to be used to offset taxable income in any given year upon the occurrence of certain events, including significant changes in ownership interests of our common stock. Under
Section 382, an ownership change that triggers potential limitations on NOLs occurs when there has been a greater than 50% change in ownership interest by shareholders owning 5% or more of a company over a period of three years or less. Based on our analysis, we had ownership changes in April 2005 and December 2006, which resulted in Section 382 limitations applying to federal NOLs generated prior to those dates, which were approximately $150.6 million. Despite these ownership changes, we may utilize all of our $165.0 million of NOLs as of February 1, 2014, to offset future taxable income. We may experience additional ownership changes in the future, which could further limit the amount of federal NOLs annually available. As of February 1, 2014, there have been no ownership changes since 2006.
In addition, we may determine that varying state laws with respect to NOL utilization may result in lower limits, or an inability to utilize NOLs in some states altogether, which could result in us incurring additional state income taxes. Through a series of legislative actions, the State of California suspended our ability to utilize NOLs to offset taxable income in fiscal years 2008 through 2011. As a result, we incurred additional cash state income taxes in California. The Company may also generate income in future periods on a federal alternative minimum tax basis, which would result in alternative minimum taxes payable on a portion of such income.
The calculation of our tax assets involves assessing uncertainties in the application of complex tax laws and regulations in a multitude of jurisdictions across our operations. At February 1, 2014, we had no significant unrecognized tax benefits or expenses that, if recognized, would affect our effective income tax rate in future periods. We are currently unaware of any issues under review that could result in significant payments, accruals or material deviations from our recognized tax positions. However, if we later identify other income tax issues that result in significant additional payments or necessary accruals, this could have a material adverse effect on our reported results. Insurance Reserves
We are partially self-insured for our workers' compensation and employee group health plans. Under the workers' compensation insurance program, we are liable for a deductible of $0.25 million for each individual claim and an aggregate annual liability of $1.4 million. Under our employee group health plan, we are liable for a deductible of $0.175 million for each claim and an aggregate monthly liability of $0.5 million. The monthly aggregate liability is subject to adjustment based on the number of participants in the plan each month. For both of these insurance plans, we record a liability for the costs associated with . . .

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