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ITEM 2.
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
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General
This discussion and analysis is based on, should be read with, and is qualified in its entirety by, the accompanying unaudited condensed consolidated financial statements and related notes, as well as our consolidated financial statements and the related Management’s Discussion and Analysis of Financial Condition and Results of Operations as contained in our Annual Report on Form 10-K for the year ended January 28, 2011. It also should be read in conjunction with the disclosure under “Cautionary Disclosure Regarding Forward-Looking Statements” in this report.
Executive Overview
We are the largest discount retailer in the United States by number of stores, with 9,496 stores located in 35 states as of April 29, 2011, primarily in the southern, southwestern, midwestern and eastern United States. We offer a broad selection of merchandise, including consumable products such as food, paper and cleaning products, health and beauty products and pet supplies, and non-consumable products such as seasonal merchandise, home decor and domestics, and apparel. Our merchandise includes high quality national brands from leading manufacturers, as well as comparable quality private brand selections with prices at substantial discounts to national brands. We offer our customers these national brand and private brand products at everyday low prices (typically $10 or less) in our convenient small-box (small store) locations.
The customers we serve are value-conscious, and Dollar General has always been intensely focused on helping our customers make the most of their spending dollars. We believe our convenient store format and broad selection of high quality products at compelling values have driven our substantial growth and financial success over the years. Like other companies, over the past three years we have been operating in an environment with heightened economic challenges and uncertainties. Consumers are facing very high rates of unemployment, fluctuating food, gasoline and energy costs, rising medical costs, and a continued weakness in housing and credit markets, and the timetable for economic recovery remains uncertain. Similarly, we continue to face significant uncertainty with respect to commodity and diesel fuel prices. Nonetheless, as a result of our long-term mission of serving the value-conscious customer, coupled with a vigorous focus on improving our operating and financial performance, we remain optimistic with regard to executing our operating priorities in 2011.
At the beginning of 2008, we defined the following four operating priorities on which we remain keenly focused:
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drive productive sales growth,
·
increase our gross profit rate,
·
leverage process improvements and information technology to reduce costs, and
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·
strengthen and expand our culture of serving others.
Our first priority is driving productive sales growth by increasing shopper frequency and transaction amount and maximizing sales per square foot. We have enhanced our category management processes, allowing us to continue expanding our product offerings while also improving profitability, by adding more productive items and eliminating unproductive items. We are utilizing the space in our stores more productively by implementing more consistent space planning; and in the 2011 first quarter, we completed the final phase of our three year initiative to raise the shelf height in our stores, increasing the linear feet available to expand our merchandise offerings. In addition, we are making significant progress in defining and improving our store standards with a goal of maintaining a consistent look and feel across all stores. We evaluate our store hours on an ongoing basis and opportunistically adjust our hours for our customers’ convenience. We are targeting both new and existing customers with our improved advertising circulars as well as through our website and social media. Finally, we believe we have significant potential to grow sales through new store growth in both existing and new markets. We plan to open approximately 625 new stores in fiscal 2011, including 139 stores opened in the first quarter, and to enter three additional states: Connecticut, New Hampshire and Nevada. We are currently in the process of developing our strategy and locating store sites for our planned entrance into California in 2012. Our criteria for opening new stores are based on numerous factors including, among other things, availability of appropriate sites, expected sales, lease terms, population demographics, competition, and the employment environment.
Our second priority is to increase gross profit through category management, distribution efficiencies, shrink reduction, an improved pricing model, and expansion of private brand offerings and increased foreign sourcing. Over the period from 2008 through 2010, our gross profit rate improved significantly, and we believe we have additional opportunities to improve, although at a more moderate pace. Our merchandising team has been successful in efforts to upgrade our merchandise selection to better serve our customers while managing our everyday low price strategy. We constantly review our pricing and markdown strategies and work diligently to minimize product cost increases and to remain competitive. We believe we have the potential to directly source a larger portion of our products at significant savings to current costs. We are focused on sales of private brands, which generally have higher gross profit rates than national brands, while we continue to offer a wide variety of national brands to ensure an optimal mix of product offerings. Our operations group continues to be highly focused on inventory shrink reduction initiatives, while our supply chain team continues its efforts to increase efficiencies, with the goal of leveraging transportation and distribution expenses.
Our third priority is leveraging process improvements and information technology to reduce costs. We are committed as an organization to extract costs that do not affect the customer experience. Examples of our cost reduction initiatives include the implementation of workforce management standards, a keen focus on safety to minimize workers’ compensation expense, health awareness initiatives to control healthcare costs, the installation of energy management systems in our stores as well as increased preventive maintenance, and the reduction of waste management costs through recycling of cardboard. In addition, our real estate team has had success in negotiating lease renewals which we anticipate will benefit us going forward.
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Our fourth priority is to strengthen and expand Dollar General’s culture of serving others. For customers this means helping them “Save time. Save money. Every day!” by providing clean, well-stocked stores with quality products at low prices. For employees, this means creating an environment that attracts and retains key employees throughout the organization. For the public, this means giving back to our store communities. For shareholders, this means meeting their expectations of an efficiently and profitably run organization that operates with compassion and integrity.
Focus on these priorities has resulted in improved performance in the first quarter of 2011 over the comparable 2010 period in many of our key financial metrics. Basis points amounts referred to below are equal to 0.01% as a percentage of sales.
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Total sales increased 10.9% to $3.45 billion. Sales in same-stores increased 5.4% driven by increases in customer traffic and average transaction amount. Average sales per square foot for all stores over the 52-week period ended April 29, 2011 were approximately $203, up from $197 for the comparable prior 52-week period.
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Gross profit, as a percentage of sales, was 31.5% compared to 32.1% in the 2010 period. In the quarter, we took higher markdowns and refrained from making significant price increases in order to build customer loyalty and drive sales in a challenging macroeconomic environment. The gross profit rate was also impacted by a change in sales mix resulting from sales of consumables, which generally have a lower gross profit rate, increasing at a higher rate than non-consumables. In addition, increased fuel prices contributed to higher transportation costs, and we recorded a LIFO charge in the 2011 quarter only. Inventory shrink reduction and distribution efficiencies had a favorable impact on gross profit in the quarter.
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Selling, general and administrative expenses, or SG&A, as a percentage of sales, was 22.2% compared to 22.8% in the 2010 quarter, a decrease of 60 basis points. The improvement was primarily driven by retail labor, and to a lesser degree advertising and repairs and maintenance. The 2011 quarter included accruals for the expected settlement of two legal matters while the 2010 quarter included certain expenses resulting from a secondary offering of our common stock, and the difference between these items accounted for 10 of the 60 basis points reduction.
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Interest expense decreased by $6.4 million to $65.6 million in the 2011 first quarter. In the quarter, we repurchased an additional $25 million of our 10.625% senior notes due 2015, resulting in a pretax loss of $2.2 million. Total long-term obligations as of April 29, 2011 were $3.26 billion.
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Net income was $157.0 million, or $0.45 per diluted share, compared to net income of $136.0 million, or $0.39 per diluted share, in the 2010 quarter.
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Cash generated from operating activities was $223.6 million. At April 29, 2011, we had a cash balance of $602.5 million.
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Inventory turnover was 5.2 times on a rolling four-quarter basis. Inventories increased 4% on a per store basis over the 2010 first quarter. Improving our in-stock levels, while improving our inventory turns, remains a high priority.
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During the 2011 first quarter, we opened 139 new stores, remodeled or relocated 184 stores, and closed 15 stores, resulting in a store count of 9,496 as of April 29, 2011.
During the quarter, we were very cautious with regard to raising prices to the consumer. In this period of extended macroeconomic uncertainties, we believe that adhering to our strategy of everyday low prices has helped us to build loyalty with our customers as evidenced by our strong same-store sales. We expect to continue to experience uncertainty with regard to product costs, and we expect transportation costs to remain high or to increase for the remainder of the year due to diesel fuel rates. We also do not expect that the percentage of non-consumables sales in our total sales mix will grow significantly this year as we do not believe that our customers will be able to increase their discretionary spending due to the economic uncertainty they continue to face.
As discussed in more detail below, in recent years we have generated significant cash flows from operating activities. We have used a portion of these cash flows to pay down debt and to invest in new store growth through our traditional leased stores. We currently estimate that in 2011, the average cost per traditional leased store including improvements, equipment and fixtures will be as follows: $185,000 for new stores, $175,000 for relocated stores, and $90,000 for remodeled stores. These costs include strategic merchandising sales initiatives related to an increased number of in-store coolers, additional fixtures and equipment, and higher leasehold improvement costs for stores in metropolitan areas. Initial inventory, net of payables, increases the investment in new leased stores by approximately $75,000. In addition, during 2010 we made a strategic decision to purchase certain of our leased stores. This program has continued into 2011. We believe that the current environment in the real estate markets provides an opportunity to make these investments at levels which are expected to result in favorable returns and positively impact our operating results.
The above discussion is a summary only. Readers should refer to the detailed discussion of our operating results below for the full analysis of our financial performance in the current year period as compared with the prior year period.
Results of Operations
Accounting Periods
. We follow the concept of a 52-53 week fiscal year that ends on the Friday nearest to January 31. The following text contains references to years 2011 and 2010, which represent the 53-week fiscal year ending February 3, 2012, and the 52-week fiscal year ended January 28, 2011. References to the first quarter accounting periods for 2011 and 2010 contained herein refer to the 13-week accounting periods ended April 29, 2011 and April 30, 2010, respectively.
Seasonality.
The nature of our business is seasonal to a certain extent. Primarily because of sales of holiday-related merchandise, our sales and gross profit rate in the fourth quarter have historically been higher than those achieved in each of the first three quarters of the fiscal year.
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Expenses and, to a greater extent, operating income, vary by quarter. Results of a period shorter than a full year may not be indicative of results expected for the entire year. Furthermore, the seasonal nature of our business may affect comparisons between periods.
The following table contains results of operations data for the first 13 weeks of each of 2011 and 2010, and the dollar and percentage variances among those periods:
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13 Weeks Ended
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2011 vs. 2010
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(dollars in millions, except per share amounts)
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April 29,
2011
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April 30,
2010
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Amount
change
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%
change
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Net sales by category:
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Consumables
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$
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2,529.1
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$
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2,231.5
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$
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297.6
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13.3
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%
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% of net sales
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73.27
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%
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71.72
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%
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|
|
|
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Seasonal
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457.1
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430.1
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27.0
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6.3
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% of net sales
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13.24
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%
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13.82
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%
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|
|
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Home products
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234.2
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224.9
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9.3
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4.2
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% of net sales
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6.79
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%
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7.23
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%
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|
|
|
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Apparel
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231.4
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224.9
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6.5
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2.9
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% of net sales
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6.70
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%
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7.23
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%
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|
|
|
|
|
Net sales
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|
3,451.7
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3,111.3
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340.4
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10.9
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|
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Cost of goods sold
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2,364.3
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2,111.6
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|
252.7
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12.0
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|
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% of net sales
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68.50
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%
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67.87
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%
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|
|
|
|
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Gross profit
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1,087.4
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999.8
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87.6
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8.8
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% of net sales
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31.50
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%
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32.13
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%
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|
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|
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Selling, general and administrative expenses
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765.8
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709.0
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56.7
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8.0
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% of net sales
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22.19
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%
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22.79
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%
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|
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Operating profit
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321.6
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290.7
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30.9
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10.6
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% of net sales
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9.32
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%
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9.34
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%
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|
|
|
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Interest income
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(0.0
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)
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(0.0
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)
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(0.0
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)
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216.7
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|
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% of net sales
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(0.00
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)%
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(0.00
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)%
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|
|
|
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Interest expense
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65.6
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72.0
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(6.4
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)
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(8.9
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)
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% of net sales
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1.90
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%
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2.31
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%
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|
|
|
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Other (income) expense
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2.3
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0.1
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2.1
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—
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% of net sales
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0.07
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%
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0.00
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%
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|
|
|
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Income before income taxes
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253.8
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218.6
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35.2
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16.1
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% of net sales
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7.35
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%
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7.02
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%
|
|
|
|
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Income tax expense
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96.8
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|
82.6
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14.2
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17.2
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% of net sales
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2.80
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%
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2.65
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%
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|
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Net income
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$
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157.0
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$
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136.0
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$
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21.0
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15.4
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%
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% of net sales
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4.55
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%
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4.37
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%
|
|
|
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Diluted earnings per share
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$
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0.45
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$
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0.39
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$
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0.06
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15.4
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%
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13 WEEKS ENDED APRIL 29, 2011 AND APRIL 30, 2010
Net Sales
. The net sales increase in the 2011 first quarter reflects a same-store sales increase of 5.4% compared to the 2010 quarter. Same-stores include stores that have been open for 13 months and remain open at the end of the reporting period. For the 2011 quarter, there were 8,815 same-stores which accounted for sales of $3.24 billion. Increases in customer traffic and average transaction amount contributed to the increase in same-store sales. The remainder of the sales increase was attributable to new stores, partially offset by sales from closed stores.
We believe that the increase in sales reflects the impact of various operating and merchandising initiatives discussed in the Executive Overview, including the impact of improved
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store standards, the expansion of our merchandise offerings, improved utilization of store square footage and enhanced marketing efforts.
Gross Profit.
The gross profit rate as a percentage of sales was 31.5% in the 2011 first quarter compared to 32.1% in the 2010 first quarter. The decrease in the 2011 gross profit rate resulted primarily from utilizing higher markdowns to sell through winter apparel and home products, in addition to the impact of the change in sales mix resulting from sales of consumables, which generally have a lower gross profit rate, increasing at a higher rate than sales of non-consumables. Increased transportation costs, resulting from higher rates for diesel fuel, also contributed to the gross profit rate decrease. We recorded a $3.6 million LIFO charge in the 2011 quarter compared to zero in the 2010 quarter. Inventory shrinkage and distribution costs were favorable in the quarter. We believe that maintaining our commitment to everyday low prices is important to maintaining the loyalty of our customers, and so, from time to time, we may experience associated decreases in our gross profit rate.
Selling, General and Administrative (“SG&A”) Expense.
SG&A expense was 22.2% as a percentage of sales in the 2011 period compared to 22.8% in the 2010 period, a decrease of 60 basis points. SG&A in the 2011 period included expenses totaling $13.1 million, or 38 basis points, for accruals related to the expected settlement of legal matters related to an employment case and a terminated derivatives contract. SG&A in the 2010 period included expenses totaling $15.0 million, or 48 basis points, relating to a secondary offering of our common stock, consisting of $0.7 million of legal and other transaction expenses and $14.3 million relating to the acceleration of certain equity appreciation rights. Retail salaries and store repairs and maintenance increased at a rate lower than our 10.9% increase in sales. In addition, decreases in total advertising costs contributed to the overall decrease in SG&A as a percentage of sales, as did other cost reduction and productivity initiatives. SG&A, as a percentage of sales, was also favorably impacted by the increase in sales. These improvements were partially offset by depreciation and amortization expenses, which increased at a higher rate than the increase in sales, primarily due to increased investment in store fixtures and equipment resulting from recent merchandising initiatives such as raising the height of our store shelves, as well as the purchase of stores.
Interest Expense
. The decrease in interest expense in the 2011 period from the 2010 period is due to lower outstanding borrowings, resulting from our repurchases of indebtedness in 2010 and lower all-in interest rates on our Term Loan Facility which is described below.
Other (Income) Expense.
In
the 2011 period, we recorded pretax losses of $2.2 million resulting from the repurchase in the open market of $25.0 million aggregate principal amount of our Senior Notes (as described below) plus accrued and unpaid interest.
Income Taxes.
The effective income tax rate for the 2011 period was 38.1% compared to a rate of 37.8% for the 2010 period which represents a net increase of 0.3%.
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Liquidity and Capital Resources
Credit Facilities
We have two senior secured credit facilities (the “Credit Facilities”) which provide financing of up to $2.995 billion as of April 29, 2011. The Credit Facilities consist of a $1.964 billion senior secured term loan facility (“Term Loan Facility”) and a senior secured asset-based revolving credit facility (“ABL Facility”). Total commitments under the ABL Facility are equal to $1.031 billion (of which up to $350.0 million is available for letters of credit), subject to borrowing base availability. The ABL Facility includes borrowing capacity available for letters of credit and for short-term borrowings referred to as swingline loans.
The amount available under the ABL Facility (including letters of credit) is subject to certain borrowing base limitations. The ABL Facility includes a “last out” tranche in respect of which we may borrow up to a maximum amount of $101.0 million.
Borrowings under the Credit Facilities bear interest at a rate equal to an applicable margin plus, at our option, either (a) LIBOR or (b) a base rate (which is usually equal to the prime rate). The applicable margin for borrowings is (i) under the Term Loan Facility, 2.75% for LIBOR borrowings and 1.75% for base-rate borrowings (ii) as of April 29, 2011, under the ABL Facility (except in the last out tranche described above), 1.25% for LIBOR borrowings and 0.25% for base-rate borrowings; and for any last out borrowings, 2.25% for LIBOR borrowings and 1.25% for base-rate borrowings. The applicable margins for borrowings under the ABL Facility (except in the case of last out borrowings) are subject to adjustment each quarter based on average daily excess availability under the ABL Facility. We are also required to pay a commitment fee to the lenders under the ABL Facility for any unutilized commitments at a rate of 0.375% per annum. We also must pay customary letter of credit fees.
Under the Term Loan Facility we are required to prepay outstanding term loans, subject to certain exceptions, with: up to 50% of our annual excess cash flow (as defined in the credit agreement) which will be reduced to 25% and 0% if we achieve and maintain a total net leverage ratio of 6.0 to 1.0 and 5.0 to 1.0, respectively; the net cash proceeds of certain non-ordinary course asset sales or other dispositions of property; and the net cash proceeds of any incurrence of debt other than proceeds from debt permitted under the senior secured credit agreement. Through April 29, 2011, no prepayments have been required under the prepayment provisions listed above. The Term Loan Facility can be prepaid in whole or in part at any time.
We voluntarily prepaid $325.0 million of the Term Loan Facility in January 2010 and, as a result, no further principal payments will be required prior to its maturity on July 6, 2014, assuming no mandatory prepayment provisions are triggered before such date. There is no amortization under the ABL Facility. The entire principal amounts (if any) outstanding under the ABL Facility are due and payable in full at maturity on July 6, 2013.
In addition, we are required to prepay the ABL Facility, subject to certain exceptions, with the net cash proceeds of all non-ordinary course asset sales or other dispositions of revolving facility collateral (as defined in the senior secured credit agreement); and to the extent
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such extensions of credit exceed the then current borrowing base. Through April 29, 2011, no prepayments have been required under any prepayment provisions.
We may voluntarily repay outstanding loans under the Term Loan Facility or the ABL Facility at any time without premium or penalty, other than customary “breakage” costs with respect to LIBOR loans.
All obligations under the Credit Facilities are unconditionally guaranteed by substantially all of our existing and future domestic subsidiaries (excluding certain immaterial subsidiaries and certain subsidiaries designated by us under our senior secured credit agreements as “unrestricted subsidiaries”), referred to, collectively, as U.S. Guarantors.
All obligations and related guarantees under the Term Loan Facility are secured by:
·
a second-priority security interest in all existing and after-acquired inventory, accounts receivable, and other assets arising from such inventory and accounts receivable, of our company and each U.S. Guarantor (the “Revolving Facility Collateral”), subject to certain exceptions;
·
a first-priority security interest in, and mortgages on, substantially all of our and each U.S. Guarantor’s tangible and intangible assets (other than the Revolving Facility Collateral); and
·
a first-priority pledge of 100% of the capital stock held by us, or any of our domestic subsidiaries that are directly owned by us or one of the U.S. Guarantors and 65% of the voting capital stock of each of our existing and future foreign subsidiaries that are directly owned by us or one of the U.S. Guarantors.
All obligations and related guarantees under the ABL Facility are secured by the Revolving Facility Collateral, subject to certain exceptions.
The senior secured credit agreements contain a number of covenants that, among other things, restrict, subject to certain exceptions, our ability to: incur additional indebtedness; sell assets; pay dividends and distributions or repurchase our capital stock; make investments or acquisitions; repay or repurchase subordinated indebtedness (including the Senior Subordinated Notes discussed below) and the Senior Notes discussed below; amend material agreements governing our subordinated indebtedness (including the Senior Subordinated Notes discussed below) or our Senior Notes discussed below; or change our lines of business. The senior secured credit agreements also contain certain customary affirmative covenants and events of default.
At April 29, 2011, we had no borrowings, $11.9 million of commercial letters of credit, and $52.0 million of standby letters of credit outstanding under our ABL Facility.
Senior Notes due 2015 and Senior Subordinated Toggle Notes due 2017
As of April 29, 2011, we have $839.3 million aggregate principal amount of 10.625% senior notes due 2015 (the “Senior Notes”) outstanding (reflected in our consolidated balance sheet net of a $10.4 million discount), which mature on July 15, 2015, pursuant to an indenture
29
dated as of July 6, 2007 (the “senior indenture”), and $450.7 million aggregate principal amount of 11.875%/12.625% senior subordinated toggle notes due 2017 (the “Senior Subordinated Notes”) outstanding, which mature on July 15, 2017, pursuant to an indenture dated as of July 6, 2007 (the “senior subordinated indenture”). The Senior Notes and the Senior Subordinated Notes are collectively referred to herein as the “Notes.” The senior indenture and the senior subordinated indenture are collectively referred to herein as the “indentures.”
Interest on the Notes is payable on January 15 and July 15 of each year. Interest on the Senior Notes is payable in cash. Cash interest on the Senior Subordinated Notes accrues at a rate of 11.875% per annum. For the Senior Subordinated Notes, we previously had the ability to elect to pay interest by increasing the principal amount of the Senior Subordinated Notes or issuing new Senior Subordinated Notes (“PIK interest”) instead of paying cash interest. Due to the expiration of the notification period for such option, all interest on the Notes has been paid or will be payable in cash.
We intend to redeem all of the Senior Notes on or following the first scheduled call date in July 2011 at the redemption price set forth in the senior indenture. We also may redeem some or all of the Senior Subordinated Notes at any time at the redemption prices set forth in the senior subordinated indenture. We also may seek, from time to time, to retire some or all of the Notes through cash purchases on the open market, in privately negotiated transactions or otherwise. Such redemptions and repurchases, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors. The amounts involved may be material. On April 29, 2011, we repurchased in the open market $25.0 million aggregate principal amount of Senior Notes at a price of 107.0% plus accrued and unpaid interest. The pretax loss on this transaction of approximately $2.2 million was reflected in our consolidated financial statements in the first quarter of 2011.
Upon the occurrence of a change of control, which is defined in the indentures, each holder of the Notes has the right to require us to repurchase some or all of such holder’s Notes at a purchase price in cash equal to 101% of the principal amount thereof, plus accrued and unpaid interest, if any, to the repurchase date.
The indentures contain covenants limiting, among other things, our ability and the ability of our restricted subsidiaries to (subject to certain exceptions):
i
ncur additional debt, issue disqualified stock or issue certain preferred stock; pay dividends on or make certain distributions and other restricted payments; create certain liens or encumbrances; sell assets; enter into transactions with affiliates; make payments to us; consolidate, merge, sell or otherwise dispose of all or substantially all of our assets; or designate our subsidiaries as unrestricted subsidiaries.
The indentures also provide for events of default which, if any of them occurs, would permit or require the principal of and accrued interest on the Notes to become or to be declared due and payable.
Adjusted EBITDA
Under the agreements governing the Credit Facilities and the indentures, certain limitations and restrictions could arise if we are not able to satisfy and remain in compliance with
30
specified financial ratios. Management believes the most significant of such ratios is the senior secured incurrence test under the Credit Facilities. This test measures the ratio of the senior secured debt to Adjusted EBITDA. This ratio would need to be no greater than 4.25 to 1 to avoid such limitations and restrictions. As of April 29, 2011, this ratio was 0.9 to 1. Senior secured debt is defined as our total debt secured by liens or similar encumbrances less cash and cash equivalents. EBITDA is defined as income (loss) from continuing operations before cumulative effect of change in accounting principle plus interest and other financing costs, net, provision for income taxes, and depreciation and amortization. Adjusted EBITDA is defined as EBITDA, further adjusted to give effect to adjustments required in calculating this covenant ratio under our Credit Facilities. EBITDA and Adjusted EBITDA are not presentations made in accordance with generally accepted accounting principles in the United States (“U.S. GAAP”), are not measures of financial performance or condition, liquidity or profitability, and should not be considered as an alternative to (i) net income, operating income or any other performance measures determined in accordance with U.S. GAAP or (ii) operating cash flows determined in accordance with U.S. GAAP. Additionally, EBITDA and Adjusted EBITDA are not intended to be measures of free cash flow for management’s discretionary use, as they do not consider certain cash requirements such as interest payments, tax payments and debt service requirements and replacements of fixed assets.
Our presentation of EBITDA and Adjusted EBITDA has limitations as an analytical tool, and should not be considered in isolation or as a substitute for analysis of our results as reported under U.S. GAAP. Because not all companies use identical calculations, these presentations of EBITDA and Adjusted EBITDA may not be comparable to other similarly titled measures of other companies. We believe that the presentation of EBITDA and Adjusted EBITDA is appropriate to provide additional information about the calculation of this financial ratio in the Credit Facilities. Adjusted EBITDA is a material component of this ratio. Specifically, non-compliance with the senior secured indebtedness ratio contained in our Credit Facilities could prohibit us, subject to specified exceptions, from making investments, incurring liens, making certain restricted payments and incurring additional secured indebtedness (other than the additional funding provided for under the senior secured credit agreement).
31
The calculation of Adjusted EBITDA under the Credit Facilities is as follows:
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|
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13-weeks ended
|
|
52-weeks ended
|
|
|
(in millions)
|
|
April 29,
2011
|
|
April 30,
2010
|
|
April 29,
2011
|
|
January 28,
2011
|
|
|
Net income
|
|
$
|
157.0
|
|
$
|
136.0
|
|
$
|
648.9
|
|
$
|
627.9
|
|
|
Add (subtract):
|
|
|
|
|
|
|
|
|
|
|
Interest income
|
|
(0.0
|
)
|
(0.0
|
)
|
(0.2
|
)
|
(0.2
|
)
|
|
Interest expense
|
|
65.6
|
|
72.0
|
|
267.7
|
|
274.1
|
|
|
Depreciation and amortization
|
|
64.3
|
|
60.1
|
|
246.5
|
|
242.3
|
|
|
Income taxes
|
|
96.8
|
|
82.6
|
|
371.3
|
|
357.1
|
|
|
EBITDA
|
|
383.7
|
|
350.7
|
|
1,534.2
|
|
1,501.2
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Adjustments:
|
|
|
|
|
|
|
|
|
|
|
Loss on debt retirements
|
|
2.2
|
|
—
|
|
16.8
|
|
14.6
|
|
|
Loss on hedging instruments
|
|
0.1
|
|
0.1
|
|
0.4
|
|
0.4
|
|
|
Advisory and consulting fees to affiliates
|
|
—
|
|
0.1
|
|
—
|
|
0.1
|
|
|
Non-cash expense for share-based awards
|
|
3.5
|
|
6.1
|
|
13.4
|
|
16.0
|
|
|
Litigation settlement and related costs, net
|
|
13.1
|
|
—
|
|
13.1
|
|
—
|
|
|
Indirect costs related to merger and stock offering
|
|
—
|
|
0.8
|
|
0.5
|
|
1.3
|
|
|
Other non-cash charges (including LIFO)
|
|
5.5
|
|
1.8
|
|
15.2
|
|
11.5
|
|
|
Total Adjustments
|
|
24.4
|
|
8.9
|
|
59.4
|
|
43.9
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Adjusted EBITDA
|
|
$
|
408.1
|
|
$
|
359.6
|
|
$
|
1,593.6
|
|
$
|
1,545.1
|
|
Current Financial Condition / Recent Developments
At April 29, 2011, we had total outstanding debt (including the current portion of long-term obligations) of approximately $3.26 billion. We had $967.1 million available for borrowing under our ABL Facility at that date. Our liquidity needs are significant, primarily due to our debt service and other obligations. However, we believe our cash flow from operations and existing cash balances, combined with availability under the Credit Facilities, will provide sufficient liquidity to fund our current obligations, projected working capital requirements and capital spending for a period that includes the next twelve months as well as the next several years.
Our inventory balance represented approximately 43% of our total assets exclusive of goodwill and other intangible assets as of April 29, 2011. Our proficiency in managing our inventory balances can have a significant impact on our cash flows from operations during a given fiscal year. Inventory purchases are often somewhat seasonal in nature, such as the purchase of warm-weather or Christmas-related merchandise. Efficient management of our inventory has been and continues to be an area of focus for us.
As described in Note 8 to the condensed consolidated financial statements, we are involved in a number of legal actions and claims, some of which could potentially result in material cash payments. Adverse developments in those actions could materially and adversely affect our liquidity. We also have certain income tax-related contingencies as more fully described below under “Critical Accounting Policies and Estimates” and in Note 4 to the
32
condensed consolidated financial statements. Future negative developments could have a material adverse effect on our liquidity.
In March 2011, Standard & Poor’s, which currently has a rating of BB on our long-term debt, upgraded our outlook from stable to positive. Our Moody’s long-term debt rating remains at Ba3 with a positive outlook. These current ratings are considered non-investment grade. Our current credit ratings, as well as future rating agency actions, could (i) impact our ability to obtain financings to finance our operations on satisfactory terms; (ii) affect our financing costs; and (iii) affect our insurance premiums and collateral requirements necessary for our self-insured programs.
Cash flows from operating activities
. Cash flows from operating activities were $223.6 million in the 2011 period, an increase of $132.4 million over the 2010 period. The most significant components of the increase in cash flows from operating activities in the 2011 period as compared to the 2010 period were related to working capital in general and Merchandise inventories and Accrued expenses and other in particular. We continue to closely monitor and manage our inventory balances, and they may fluctuate from year to year based on new store openings, the timing of purchases, and other factors. Merchandise inventories were virtually unchanged during the first quarter of 2011 compared to a 6% overall increase during the first quarter of 2010. Inventory levels in our four inventory categories in the 2011 period compared to the respective 2010 period were as follows: the consumables category increased 4% compared to a 7% increase; the seasonal category declined by 6% compared to a 7% increase; the home products category declined by 12% compared to virtually unchanged; and apparel increased by 2% in both periods. The primary items affecting Accrued expenses and other include increased accruals for legal settlements, changes in tax reserves, and lower incentive compensation payments in the 2011 period compared to the 2010 period. Cash flows from operating activities in the 2011 period compared to the 2010 period were positively impacted by our strong operating performance due to greater sales and increased net income, as described in more detail above under “Results of Operations.”
Cash flows from investing activities
. Significant components of property and equipment purchases in the 2011 period included the following approximate amounts: $40 million for improvements, upgrades, remodels and relocations of existing stores; $22 million related to new leased stores, primarily for leasehold improvements, fixtures and equipment; $17 million for stores purchased or built by us; $7 million for distribution and transportation-related capital expenditures; and $6 million for information systems upgrades and technology-related projects. The timing of new, remodeled and relocated store openings along with other factors may affect the relationship between such openings and the related property and equipment purchases in any given period. During the 2011 period, we opened 139 new stores and remodeled or relocated 184 stores.
Significant components of property and equipment purchases in the 2010 period included the following approximate amounts: $38 million for improvements and upgrades to existing stores; $28 million for new leased stores; $14 million for remodels and relocations of existing stores; and $7 million for distribution and transportation related purchases. During the 2010 period, we opened 155 new stores and remodeled or relocated 128 stores.
33
Capital expenditures for the 2011 fiscal year are projected to be approximately $550 to $600 million. We anticipate funding our 2011 capital requirements with existing cash balances, cash flows from operations, and if necessary, we also have significant availability under our ABL Facility.
Cash flows from financing activities
. During the 2011 period, we repurchased $25.0 million outstanding principal amount of our outstanding Senior Notes at a total cost of $26.8 million including associated premiums. We had no borrowings or repayments under the ABL Facility in the 2011 or 2010 periods.
Critical Accounting Policies and Estimates
The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect reported amounts and related disclosures. In addition to the estimates presented below, there are other items within our financial statements that require estimation, but are not deemed critical as defined below. We believe these estimates are reasonable and appropriate. However, if actual experience differs from the assumptions and other considerations used, the resulting changes could have a material effect on the financial statements taken as a whole.
Management believes the following policies and estimates are critical because they involve significant judgments, assumptions, and estimates. Management has discussed the development and selection of the critical accounting estimates with the Audit Committee of our Board of Directors, and the Audit Committee has reviewed the disclosures presented below relating to those policies and estimates.
Merchandise Inventories
.
Merchandise inventories are stated at the lower of cost or market with cost determined using the retail last-in, first-out (“LIFO”) method. Under our retail inventory method (“RIM”), the calculation of gross profit and the resulting valuation of inventories at cost are computed by applying a calculated cost-to-retail inventory ratio to the retail value of sales at a department level. The RIM is an averaging method that has been widely used in the retail industry due to its practicality. Also, it is recognized that the use of the RIM will result in valuing inventories at the lower of cost or market (“LCM”) if markdowns are currently taken as a reduction of the retail value of inventories.
Inherent in the RIM calculation are certain significant management judgments and estimates including, among others, initial markups, markdowns, and shrinkage, which significantly impact the gross profit calculation as well as the ending inventory valuation at cost. These significant estimates, coupled with the fact that the RIM is an averaging process, can, under certain circumstances, produce distorted cost figures. Factors that can lead to distortion in the calculation of the inventory balance include:
·
applying the RIM to a group of products that is not fairly uniform in terms of its cost and selling price relationship and turnover;
·
applying the RIM to transactions over a period of time that include different rates of gross profit, such as those relating to seasonal merchandise;
34
·
inaccurate estimates of inventory shrinkage between the date of the last physical inventory at a store and the financial statement date; and
·
inaccurate estimates of LCM and/or LIFO reserves.
Factors that reduce potential distortion include the use of historical experience in estimating the shrink provision (see discussion below) and an annual LIFO analysis whereby all SKUs are considered in the index formulation. An actual valuation of inventory under the LIFO method is made at the end of each year based on the inventory levels and costs at that time. Accordingly, interim LIFO calculations are based on management’s estimates of expected year-end inventory levels, sales for the year and the expected rate of inflation/deflation for the year and are thus subject to adjustment in the final year-end LIFO inventory valuation. We also perform interim inventory analysis for determining obsolete inventory. Our policy is to write down inventory to an LCM value based on various management assumptions including estimated markdowns and sales required to liquidate such inventory in future periods. Inventory is reviewed on a quarterly basis and adjusted as appropriate to reflect write-downs determined to be necessary.
Factors such as slower inventory turnover due to changes in competitors’ practices, consumer preferences, consumer spending and unseasonable weather patterns, among other factors, could cause excess inventory requiring greater than estimated markdowns to entice consumer purchases, resulting in an unfavorable impact on our consolidated financial statements. Sales shortfalls due to the above factors could cause reduced purchases from vendors and associated vendor allowances that would also result in an unfavorable impact on our consolidated financial statements.
We calculate our shrink provision based on actual physical inventory results during the fiscal period and an accrual for estimated shrink occurring subsequent to a physical inventory through the end of the fiscal reporting period. This accrual is calculated as a percentage of sales at each retail store, at a department level, and is determined by dividing the book-to-physical inventory adjustments recorded during the previous twelve months by the related sales for the same period for each store. To the extent that subsequent physical inventories yield different results than this estimated accrual, our effective shrink rate for a given reporting period will include the impact of adjusting the estimated results to the actual results. Although we perform physical inventories in virtually all of our stores on an annual basis, the same stores do not necessarily get counted in the same reporting periods from year to year, which could impact comparability in a given reporting period.
We believe our estimates and assumptions related to merchandise inventories have generally been accurate in recent years and we do not currently anticipate material changes in these estimates and assumptions.
Goodwill and Other Intangible Assets.
We amortize intangible assets over their estimated useful lives unless such lives are deemed indefinite. If impairment indicators are noted, amortizable intangible assets are tested for impairment based on projected undiscounted cash flows, and, if impaired, written down to fair value based on either discounted projected cash
35
flows or appraised values. Future cash flow projections are based on management’s projections. Significant judgments required in this testing process may include projecting future cash flows, determining appropriate discount rates and other assumptions. Projections are based on management’s best estimates given recent financial performance, market trends, strategic plans and other available information which in recent years have been materially accurate. Although not currently anticipated, changes in these estimates and assumptions could materially affect the determination of fair value or impairment. Future indicators of impairment could result in an asset impairment charge.
Under accounting standards for goodwill and other intangible assets, we are required to test such assets with indefinite lives for impairment annually, or more frequently if impairment indicators occur. The goodwill impairment test is a two-step process that requires management to make judgments in determining what assumptions to use in the calculation. The first step of the process consists of estimating the fair value of our reporting unit based on valuation techniques (including a discounted cash flow model using revenue and profit forecasts) and comparing that estimated fair value with the recorded carrying value, which includes goodwill. If the estimated fair value is less than the carrying value, a second step is performed to compute the amount of the impairment by determining an “implied fair value” of goodwill. The determination of the implied fair value of goodwill would require us to allocate the estimated fair value of our reporting unit to its assets and liabilities. Any unallocated fair value represents the implied fair value of goodwill, which would be compared to its corresponding carrying value.
The impairment test for indefinite-lived intangible assets consists of a comparison of the fair value of the intangible asset with its carrying amount. If the carrying amount of an indefinite-lived intangible asset exceeds its fair value, an impairment loss is recognized in an amount equal to that excess.
Our most recent annual impairment tests of goodwill and indefinite-lived intangible assets was performed during the third quarter of 2010 based on conditions as of the end of the second quarter of 2010. The tests indicated that no impairment charge was necessary. We are not currently projecting a decline in cash flows that could be expected to have an adverse effect such as a violation of debt covenants or future impairment charges.
Property and Equipment
.
Property and equipment are recorded at cost. We group our assets into relatively homogeneous classes and generally provide for depreciation on a straight-line basis over the estimated average useful life of each asset class, except for leasehold improvements, which are amortized over the lesser of the applicable lease term or the estimated useful life of the asset. Certain store and warehouse fixtures, when fully depreciated, are removed from the cost and related accumulated depreciation and amortization accounts. The valuation and classification of these assets and the assignment of depreciable lives involves significant judgments and the use of estimates, which we believe have been materially accurate in recent years.
Impairment of Long-lived Assets.
We review the carrying value of all long-lived assets for impairment at least annually, and whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. In accordance with accounting standards for impairment or disposal of long-lived assets, we review for impairment stores open for
36
approximately two years or more for which recent cash flows from operations are negative. Impairment results when the carrying value of the assets exceeds the estimated undiscounted future cash flows over the life of the lease. Our estimate of undiscounted future cash flows over the lease term is based upon historical operations of the stores and estimates of future store profitability which encompasses many factors that are subject to variability and are difficult to predict. If a long-lived asset is found to be impaired, the amount recognized for impairment is equal to the difference between the carrying value and the asset’s estimated fair value. The fair value is estimated based primarily upon projected future cash flows (discounted at our credit adjusted risk-free rate) or other reasonable estimates of fair market value in accordance with U.S. GAAP.
Insurance Liabilities
.
We retain a significant portion of the risk for our workers’ compensation, employee health, property loss, automobile and general liability. These represent significant costs primarily due to the large employee base and number of stores. Provisions are made to these liabilities on an undiscounted basis based on actual claim data and estimates of incurred but not reported claims developed using actuarial methodologies based on historical claim trends, which have been and are anticipated to continue to be materially accurate. If future claim trends deviate from recent historical patterns, we may be required to record additional expenses or expense reductions, which could be material to our future financial results.
Contingent Liabilities — Income Taxes.
Income tax reserves are determined using the methodology established by accounting standards relating to uncertainty in income taxes. These standards require companies to assess each income tax position taken using a two step process. A determination is first made as to whether it is more likely than not that the position will be sustained, based upon the technical merits, upon examination by the taxing authorities. If the tax position is expected to meet the more likely than not criteria, the benefit recorded for the tax position equals the largest amount that is greater than 50% likely to be realized upon ultimate settlement of the respective tax position. Uncertain tax positions require determinations and estimated liabilities to be made based on provisions of the tax law which may be subject to change or varying interpretation. If our determinations and estimates prove to be inaccurate, the resulting adjustments could be material to our future financial results.
Contingent Liabilities - Legal Matters
.
We are subject to legal, regulatory and other proceedings and claims. We establish liabilities as appropriate for these claims and proceedings based upon the probability and estimability of losses and to fairly present, in conjunction with the disclosures of these matters in our financial statements and SEC filings, management’s view of our exposure. We review outstanding claims and proceedings with external counsel to assess probability and estimates of loss. We re-evaluate these assessments on a quarterly basis or as new and significant information becomes available to determine whether a liability should be established or if any existing liability should be adjusted. The actual cost of resolving a claim or proceeding ultimately may be substantially different than the amount of the recorded liability. In addition, because it is not permissible under U.S. GAAP to establish a litigation liability until the loss is both probable and estimable, in some cases there may be insufficient time to establish a liability prior to the actual incurrence of the loss (upon verdict and judgment at trial, for example, or in the case of a quickly negotiated settlement).
37
Lease Accounting and Excess Facilities
.
Many of our stores are subject to build-to-suit arrangements with landlords, which typically carry a primary lease term of 10-15 years with multiple renewal options. We also have stores subject to shorter-term leases (usually with initial or current terms of 3 to 5 years), and many of these leases have multiple renewal options. As of January 28, 2011, approximately 35% of our stores had provisions for contingent rentals based upon a percentage of defined sales volume. We recognize contingent rental expense when the achievement of specified sales targets is considered probable. We recognize rent expense over the term of the lease. We record minimum rental expense on a straight-line basis over the base, non-cancelable lease term commencing on the date that we take physical possession of the property from the landlord, which normally includes a period prior to store opening to make necessary leasehold improvements and install store fixtures. When a lease contains a predetermined fixed escalation of the minimum rent, we recognize the related rent expense on a straight-line basis and record the difference between the recognized rental expense and the amounts payable under the lease as deferred rent. Tenant allowances, to the extent received, are recorded as deferred incentive rent and amortized as a reduction to rent expense over the term of the lease. We reflect as a liability any difference between the calculated expense and the amounts actually paid. Improvements of leased properties are amortized over the shorter of the life of the applicable lease term or the estimated useful life of the asset.
For store closures where a lease obligation still exists, we record the estimated future liability associated with the rental obligation on the date the store is closed in accordance with accounting standards for costs associated with exit or disposal activities. Based on an overall analysis of store performance and expected trends, management periodically evaluates the need to close underperforming stores. Liabilities are established at the point of closure for the present value of any remaining operating lease obligations, net of estimated sublease income, and at the communication date for severance and other exit costs. Key assumptions in calculating the liability include the timeframe expected to terminate lease agreements, estimates related to the sublease potential of closed locations, and estimation of other related exit costs. Historically, these estimates have not been materially inaccurate; however, if actual timing and potential termination costs or realization of sublease income differ from our estimates, the resulting liabilities could vary from recorded amounts. These liabilities are reviewed periodically and adjusted when necessary.
Share-Based Payments
.
Our share-based stock option awards are valued on an individual grant basis using the Black-Scholes-Merton closed form option pricing model. We believe that this model fairly estimates the value of our share-based awards. The application of this valuation model involves assumptions that are judgmental and highly sensitive in the valuation of stock options, which affects compensation expense related to these options. These assumptions include an estimate of the fair value of our common stock, the term that the options are expected to be outstanding, an estimate of the volatility of our stock price (which is based on a peer group of publicly traded companies), applicable interest rates and the dividend yield of our stock. Our volatility estimates are based on a peer group due to the fact that our stock has been publicly traded for a relatively short period of time in relation to the expected term of outstanding options. Other factors involving judgments that affect the expensing of share-based payments include estimated forfeiture rates of share-based awards. Historically, these estimates have not been materially inaccurate; however, if our estimates differ materially from actual experience, we may
38
be required to record additional expense or reductions of expense, which could be material to our future financial results.
Fair Value Measurements.
We measure fair value of assets and liabilities in accordance with applicable accounting standards, which require that fair values be determined based on the assumptions that market participants would use in pricing the asset or liability. These standards establish a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy). Therefore, Level 3 inputs are typically based on an entity’s own assumptions, as there is little, if any, related market activity, and thus require the use of significant judgment and estimates. Currently, we have no assets or liabilities that are valued based solely on Level 3 inputs.
Our fair value measurements are primarily associated with our derivative financial instruments, intangible assets, property and equipment, and to a lesser degree our investments. The values of our derivative financial instruments are determined using widely accepted valuation techniques, including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves. The fair values of interest rate swaps are determined using the market standard methodology of netting the discounted future fixed cash payments (or receipts) and the discounted expected variable cash receipts (or payments). The variable cash receipts (or payments) are based on an expectation of future interest rates (forward curves) derived from observable market interest rate curves. In recent years, these methodologies have produced materially accurate valuations.
Derivative Financial Instruments.
We account for our derivative instruments in accordance with accounting standards for derivative instruments (including certain derivative instruments embedded in other contracts) and hedging activities, as amended and interpreted, which establish accounting and reporting requirements for such instruments and activities. These standards require that every derivative instrument be recorded in the balance sheet as either an asset or liability measured at its fair value, and that changes in the derivative’s fair value be recognized currently in earnings unless specific hedge accounting criteria are met. See “Fair Value Measurements” above for a discussion of derivative valuations. Special accounting for qualifying hedges allows a derivative’s gains and losses to either offset related results on the hedged item in the statement of operations or be accumulated in other comprehensive income, and requires that a company formally document, designate, and assess the effectiveness of transactions that receive hedge accounting. We use derivative instruments to manage our exposure to changing interest rates, primarily with interest rate swaps.
In addition to making valuation estimates, we also bear the risk that certain derivative instruments that have been designated as hedges and currently meet the strict hedge accounting requirements may not qualify in the future as “highly effective,” as defined, as well as the risk that hedged transactions in cash flow hedging relationships may no longer be considered probable to occur. Further, new interpretations and guidance related to these instruments may be
39
issued in the future, and we cannot predict the possible impact that such guidance may have on our use of derivative instruments going forward.
ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
There have been no material changes to the disclosures relating to this item from those set forth in our Annual Report on Form 10-K for the fiscal year ended January 28, 2011.
ITEM 4.
CONTROLS AND PROCEDURES.
(a) Disclosure Controls and Procedures
. Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) or 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based on this evaluation, our principal executive officer and our principal financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report.
(b) Changes in Internal Control Over Financial Reporting
. There have been no changes in our internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f)) during the quarter ended April 29, 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
40
