Description
Filed with the SEC from Sep 13 to Sep 19:
Wet Seal (WTSLA)
On Sept. 13, hedge fund Clinton Group sent a letter to the board reiterating its goal of voting out four of five directors and replacing them with a slate of candidates proposed by Clinton.
BUSINESS OVERVIEW
Forward-Looking Statements
Certain sections of this Annual Report on Form 10-K (the “Annual Report”), including “Item 1. Business” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contain various forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended (the “Exchange Act”), which represent our expectations or beliefs concerning future events.
Forward-looking statements include statements that are predictive in nature, which depend upon or refer to future events or conditions, and/or which include words such as “believes,” “plans,” “intends,” “anticipates,” “estimates,” “expects,” “may,” “will” or similar expressions. In addition, any statements concerning future financial performance, ongoing strategies or prospects, and possible future actions, which may be provided by our management, are also forward-looking statements. Forward-looking statements are based on current expectations and projections about future events and are subject to risks, uncertainties, and assumptions about our company, economic and market factors, and the industry in which we do business, among other things. These statements are not guarantees of future performance, and we undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events, or otherwise.
Actual events and results may differ materially from those expressed or forecasted in forward-looking statements due to a number of factors. Factors that could cause our actual performance, future results and actions to differ materially from any forward-looking statements include, but are not limited to, those discussed in “Item 1A. Risk Factors” below and elsewhere in this Annual Report.
All references to “we,” “our,” “us” and “our company” in this Annual Report mean The Wet Seal, Inc. and its wholly owned subsidiaries. All references in this Annual Report to “fiscal 2012,” “fiscal 2011,” “fiscal 2010,” “fiscal 2009,” “fiscal 2008,” “fiscal 2007” and “fiscal 2006” mean the fiscal year ending February 2, 2013, and the fiscal years ended January 28, 2012, January 29, 2011, January 30, 2010, February 31, 2009, February 2, 2008 and February 3, 2007, respectively.
Available Information
Our Annual Report, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to those reports and the proxy statement for our annual meeting of stockholders are made available, free of charge, on our corporate web site, www.wetsealinc.com , as soon as reasonably practicable after such reports have been electronically filed with or furnished to the Securities and Exchange Commission, or the “SEC.” Our Code of Business Ethics and Conduct and our Code of Ethics Policy for our Chief Executive Officer and Chief Financial Officer are also located within the Corporate Information section of our corporate web site. These documents are also available in print to any stockholder who requests a copy from our Investor Relations department. The public may also read and copy any materials that we have filed with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. Members of the general public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330 . In addition, these materials may be obtained at the web site maintained by the SEC at www.sec.gov . The content of our web sites ( www.wetsealinc.com , www.wetseal.com , and www.ardenb.com ) is not intended to be incorporated by reference in this Annual Report.
General
Incorporated in the State of Delaware in 1990, we are a national specialty retailer operating stores selling fashionable and contemporary apparel and accessory items designed for female customers aged 15 to 39 years old. As of January 28, 2012, we operated 558 retail stores in 47 states and Puerto Rico. Our products can also be purchased through our e-commerce web sites.
The names “Wet Seal” and “Arden B” (which are registered in the retail store services and other classes) are trademarks and service marks of our company. Each trademark, trade name, or service mark of any other company appearing in this Annual Report belongs to its respective owner.
Business Segments
We operate two nationwide, primarily mall-based, chains of retail stores under the names “Wet Seal” and “Arden B.” Although the two operating segments have many similarities in their products, production processes, distribution methods, and regulatory environment, there are differences in most of these areas and distinct differences in their economic characteristics. As a result, we consider these segments to be two distinct reportable segments.
Wet Seal. Wet Seal is a junior apparel brand for girls who seek fashionable clothing at a value, with a target customer age range of 15 to 23 years old. Wet Seal seeks to provide its customer base with a balance of trend right and fashion basic apparel and accessories that are affordably priced.
Arden B. Arden B is a fashion brand at value price points for the contemporary woman. Arden B targets customers aged 25 to 39 years old and seeks to deliver differentiated contemporary fashion, dresses, sportswear separates and accessories for any occasion of the customers’ lifestyles.
We maintain a Web-based store located at www.wetseal.com , offering Wet Seal merchandise comparable to that carried in our stores, to customers over the Internet. We also maintain a Web-based store located at www.ardenb.com , offering Arden B merchandise comparable to that carried in our stores, to customers over the Internet. Our e-commerce stores are designed to serve as an extension of the in-store experience and offer an expanded selection of merchandise, with the goal of growing both e-commerce and in-store sales. We continue to develop our Wet Seal and Arden B websites to increase their effectiveness in marketing our brands. We do not consider our Web-based business to be a distinct reportable segment. The Wet Seal and Arden B reportable segments include, in addition to data from their respective stores, data from their respective e-commerce operations.
See Note 13 to the consolidated financial statements included in this Annual Report for financial information regarding segment reporting, which information is incorporated herein by reference.
Our Stores
Wet Seal stores average approximately 4,000 square feet in size and in fiscal 2011 had average sales per square foot of $271. As of January 28, 2012, we operated 472 Wet Seal stores. Arden B stores average approximately 3,100 square feet in size and in fiscal 2011 had average sales per square foot of $327. As of January 28, 2012, we operated 86 Arden B stores.
During fiscal 2011, we opened 28 and closed six Wet Seal stores and opened four and closed one Arden B stores.
We currently plan to open approximately 25 to 30 mall-based Wet Seal stores, net of store closings, in fiscal 2012. We currently intend to maintain our existing Arden B store count in 2012 as we focus efforts on improving merchandising and marketing strategies in that business. We believe future closures for at least the next 12 months following the date of this Annual Report will primarily result from lease expirations where we decide not to extend, or are unable to extend, store leases. We may, however, accelerate the closure of underperforming stores prior to their lease expirations in cases where we can obtain favorable early lease terminations with the landlords or exercise certain rights contained in the leases. We have approximately 139 existing store leases scheduled to expire in fiscal 2012. We plan to remodel or relocate approximately 28 of these Wet Seal and Arden B stores during fiscal 2012 upon lease renewals. Additionally, approximately 60 of these leases expire in the last few days of fiscal 2012, and we expect to remodel or relocate a portion of these stores during fiscal 2013. For the remaining expiring leases, we expect to negotiate new leases that will allow us to remain in all but a small number of these locations.
Our ability to increase the number of Wet Seal and Arden B stores in the future will depend, in part, on satisfactory cash flows from existing operations, the demand for our merchandise, and our ability to find suitable mall or other locations with acceptable sites, and satisfactory terms and general business conditions. Our management does not believe there are significant geographic constraints within the U.S. on the locations of future stores.
Competitive Strengths
Experienced Management Team. We have had significant changes among our senior management team in the past two fiscal years. Our management team has extensive experience and knowledge in the retail apparel industry, which will be instrumental in managing our company through the current difficult economic environment and driving our company in the next phase of its growth cycle. Ms. Susan P. McGalla, our chief executive officer who joined our company in January 2011, held various leadership roles with American Eagle Outfitters, Inc. from 1994 to 2009, most recently serving as the president and chief merchandising officer of that company. Mr. Ken Seipel, our president and chief operating officer who joined our company in March 2011, most recently served as the president and chief merchandise/marketing officer of Pamida Discount Stores LLC since 2009. Previous to this, Mr. Seipel served as executive vice president of stores, operations and store design for the Old Navy division of Gap, Inc. from 2003 through 2008 and also held various merchandising and operations management roles earlier in his career with Target Corporation, Shopko Stores, Inc. and J. C. Penney Company, Inc. Our chief financial officer, Mr. Steven H. Benrubi, served as our corporate controller for over two years prior to his appointment as chief financial officer in September 2007.
Ms. Harriet Bailiss-Sustarsic was appointed executive vice president and chief merchandise officer, Wet Seal division, in November 2011. Prior to joining our company, Ms. Sustarsic most recently served as the senior vice president and general merchandise manager for the North American Guess Retail Division (“Guess”) from 2006 to 2010. Ms. Sustarsic served as the vice president and general merchandise manager for Guess from 2004 to 2006. Prior to joining Guess, Ms. Sustarsic held various management positions at Charlotte Russe Holdings, Inc. (“Charlotte Russe”) from 1996 to 2003. In 2001, Ms. Sustarsic was named president and chief merchandising officer of Charlotte Russe. Ms. Sustarsic also held various merchandising and management positions in the specialty and department store retail sectors from 1980 to 1996. Ms. Sharon Hughes, our president and chief merchandise officer for the Arden B division, served as a consultant to our Arden B merchandising team from February 2008 to November 2009, at which time she became an employee of our company in her current role. Ms. Hughes previously was an employee of our company from 1990 through 2002, during which period she was involved in the formation of the Arden B division and held several different merchant roles, including senior vice president of merchandising.
Ms. Barbara Cook was appointed senior vice president of store operations of The Wet Seal, Inc. in November 2011. Prior to joining our company, Ms. Cook served as the senior vice president of Gap Stores and Operations, North America, from 2007 to 2011. Ms. Cook also served as the managing director of Europe Gap, Outlet & Banana Republic for Gap Inc. (“Gap”) from 2005 to 2007. Prior to joining Gap, Ms. Cook served as the managing director for the United Kingdom (“UK”) Retail Division of T-Mobile, a mobile communications retailer and wireless carrier, from 2002 to 2005. Ms. Cook also served as the regional general manager of UK for Starbucks Coffee Company, an international coffee company and coffeehouse chain with over 17,000 stores worldwide. Ms. Cook held various management positions in the apparel and grocer retail sectors from 1976 to 1999.
Merchandising Models at Wet Seal and Arden B are Focused on Fashion at Affordable Prices, Speed and Flexibility. At Wet Seal, we have developed considerable expertise in identifying, sourcing and selling a broad assortment of fresh and fashionable apparel and accessories at competitive prices for our customers. At Arden B we continue to focus on offering unique and fashionable apparel and accessories for our young contemporary customers and have shifted the merchandising model over recent years to be quicker and more flexible. Additionally, Arden B has been established as a preferred destination for dresses and other social occasion fashion needs for our customers. Our buyers work closely with senior management to evaluate the optimal merchandise assortments and promotion and pricing strategies. A significant portion of our merchandise is sourced domestically or from domestic importers. This sourcing strategy is intended to enable us to ship new merchandise to stores with a high frequency and to react quickly to changing fashion trends. We also take regular markdowns with the objective of ensuring the rapid sale of slow-moving inventory.
Strong Financial Position. In recent years, we have increased our cash, cash equivalents and investments position, extinguished our debt and repurchased a significant number of shares of our Class A common stock. Through fiscal 2010, $56 million in principal amount of our convertible notes and $24.6 million in face amount of our convertible preferred stock had been converted into shares of our Class A common stock. Also, in fiscal 2011, 2010, 2009, and 2007, we repurchased 12.3 million, 2.3 million, 2.0 million, and 3.6 million shares of our Class A common stock for $54.5 million, $8.2 million, $7.3 million, and $20.1 million, respectively under our share repurchase program and for tendering employee shares upon restricted share vesting for tax obligations. We repurchased no common stock during fiscal 2008. As of January 28, 2012, our cash, cash equivalents and investments were $157.2 million, with no debt, and our stockholders’ equity was $241.1 million.
Strategy
As part of a strategic review of business operations, we have identified what we believe are significant opportunities to improve our business trends and drive sales productivity. We are creatively positioning ourselves for growth in existing store sales productivity and in our store base. The key elements of our opportunities are to:
Develop a Culture of Customer Obsession. In fiscal 2011, we began to develop a culture of customer obsession throughout our company, with a goal to make our customer the first and foremost priority in everything we do within our organization. To better understand our target customers for both our Wet Seal and Arden B brands, in the first half of fiscal 2011 we conducted a qualitative and quantitative customer research project, with assistance from an outside research agency. This project focused on determining our target customers wants and aspirations, her likes and dislikes, why she did or did not shop our stores, what she liked and did not like about us, and competitively where she shopped and why. Through this research, we learned that Wet Seal is known by its customer for fashion, consistent newness in merchandise and value pricing, while Arden B is best known by its customers for fashionable dresses and other social occasion wear. We also learned of key opportunities for improvement that we believe will allow us to enhance our customers’ shopping experience and better serve the needs of our target customers, including those that do not currently shop our stores. We will continue to obtain customer feedback and act upon it to support our customer obsession.
Understand and Redefine our Brands. Through our customer research, we gained an understanding of how our target customers perceive our existing brands and set the groundwork for refining the “brand DNA” for both of our divisions. We conducted brand definition work in late fiscal 2011 through early fiscal 2012, through which we believe that we have developed clear and concise brand positions for both Wet Seal and Arden B. During fiscal 2012, we intend to articulate these brand positions within our company and improve how we communicate with our Wet Seal and Arden B customers, both in our stores and e-commerce, as well as with the broader marketplace. We believe our refined brand definitions and messaging will support our buying teams in their efforts to present more cohesive merchandise edits in our stores, will provide our store associates with a common voice with which to interact with our customers, and will clarify the point of view of our two business concepts.
Continue to Manage Business Conservatively in the Near Term Through the Difficult and Competitive Retail and Economic Environment. We have taken many actions intended to increase our financial strength through a difficult economic environment over the near term and to position ourselves to capitalize on our company’s growth and operating leverage opportunities when such environment improves. In anticipation of a continuing difficult retail environment, our near term goals include preserving a strong balance sheet and our existing sales, continuing moderate growth of our Wet Seal division store base, pursuing capital expenditure investments that are accretive or provide efficiencies to the business and maintaining clean inventory levels, although we cannot assure we will be successful in achieving our goals. We plan to open 25 to 30 mall-based Wet Seal stores, net of store closings, during fiscal 2012. Additionally, we intend to continue to identify opportunities to further leverage our planning and allocation, merchandising and inventory management systems, and our distribution center sorter system; and plan to continue to closely monitor inventory positions during fiscal 2012, while seeking to have the appropriate inventory mix and levels to obtain new trend opportunities.
Improve Merchandise Margin. In our Wet Seal division, we enacted numerous strategies during fiscal 2011 in an effort to improve merchandise margins. These efforts included consolidation of price points, clarification and reduction of promotional messages, enhanced inventory planning and allocation processes, and modification of markdown cadences. This led to merchandise margin improvement for the year despite increased commodity cost pressure, primarily from cotton, and a continuing highly promotional competitive environment. We intend to continue executing these merchandising strategies, as well as optimizing size offerings, further refining the use of our markdown optimization system, improving merchandise sourcing, including leveraging our recently implemented vendor scorecard program that allows us to better measure vendor performance, partner with vendors on plans for continued improvement and to ensure we conduct business with our best vendors, and better exploiting key merchandise categories, as informed by our customer research and brand definition work, in order to build upon our fiscal 2011 improvement. In our Arden B division, we intend to maintain our strong dress business while also expanding our sportswear business, in order to build market share and provide a merchandise assortment better aligned with our target customer’s wants. We plan to continue to enhance our promotional planning and strategies, and further improve inventory management, in order to maintain the significant merchandise margin improvement generated in this division in recent years. We also intend to continue making improvements to our sourcing processes and expand and strengthen our sourcing base, including leveraging our recently implemented vendor scorecard program, as noted above, and to improve our price messaging to gain more recognition from our customers of our value proposition.
Improve Store Operations and Develop a Selling Culture. We are improving customer service, to support our company customer obsession objectives, through the development of more precise labor scheduling tools to allow our store associates to focus more on our customers, increase store productivity and comparable store sales growth. We intend to increase store productivity and efficiency through streamlined operational tasks and/or eliminated non-selling activities and by providing our store associates with the key performance metrics needed to manage and build their business, and perform more detailed analysis and monitoring to identify improvement opportunities for underperforming stores. In addition, we intend to improve our employee selling skills through stronger partnerships with the merchandising organization in addition to new e-learning training and development programs.
Moderately Grow Store Base and Position for Future Growth. We expect fiscal 2012 openings of approximately 25 to 30 new Wet Seal stores, net of store closings, and we expect to maintain the existing Arden B store base as we focus 2012 efforts on improving merchandising and marketing strategies. Additionally, we plan to remodel or relocate approximately 28 Wet Seal and Arden B stores during fiscal 2012 upon lease renewals. As we open new Wet Seal stores, or remodel our existing Wet Seal stores, in fiscal 2012, we intend to continue to utilize a refreshed store design that was developed in fiscal 2011, and to develop a new store design for use in 2013 and beyond. We also intend to continue to utilize an Arden B new store prototype developed in 2010 as we remodel Arden B stores prospectively. As part of a strategic planning process in fiscal 2012, we intend to develop market-by-market growth targets, identify target malls within those markets, clarify ideal co-tenancies to support location priorities within target malls, and utilize elements of our customer research, brand definitions and new Wet Seal store design to develop marketing strategies to use with our major mall landlords. We believe these efforts should position Wet Seal and Arden B for store base growth beyond fiscal 2012.
Improve Marketing. We believe we have an opportunity to improve our marketing strategies and execution. We intend to make modest incremental marketing investments at both Wet Seal and Arden B and intend to develop and implement specific plans in fiscal 2012 that will incorporate the refined “brand DNA” for each division in the second half of the year. We intend to develop a strategic marketing plan to reach our existing and potential customers and communicate regularly, messaging around our product and our brands. We also intend to build upon progress made in fiscal 2011 with in-store marketing, primarily through improved storefront window displays and store interior product images. We also intend to continue to enhance our e-commerce sites as marketing vehicles for our stores, including social networking, and to focus on direct marketing programs and in-store visual merchandising.
CEO BACKGROUND
Jonathan Duskin
Age: 44
Mr. Jonathan Duskin has been a director of our Company since March 6, 2006, and he serves as a member of our Audit and Compensation Committees. Mr. Duskin has served as Chief Executive Officer of Macellum Capital Management LLC, a Delaware limited liability company which operates a New York-based pooled investment fund, since September 2008. From 2005 to April 2008, Mr. Duskin served as a Managing Director and Partner at Prentice Capital Management, LP, an investment management firm. From 2002 to 2005, Mr. Duskin was a Managing Director at S.A.C. Capital Associates LLC, a New York-based hedge fund. From 1998 to 2002, Mr. Duskin was a Managing Director at Lehman Brothers Inc., and served as Head of Product Management and Chairman of the Investment Policy Committee within the Research Department. Mr. Duskin previously served on each of the boards of directors of Whitehall Jewelers Inc., a former specialty retailer of jewelry, Plvtz, Inc., the holding company of Levitz Furniture Inc., and KB Toys, a former mall-based retail toy store chain. Our Board of Directors believes that Mr. Duskin’s extensive experience in the financial services industry, retail investment expertise and familiarity with our Company qualify him for his continued service on the Board of Directors.
Sidney M. Horn
Age: 61
Mr. Sidney M. Horn has been a director of our Company since January 27, 2005. Mr. Horn is the Chairman of our Nominating and Governance Committee and also serves as a member of our Audit and Compensation Committees. Mr. Horn has been a partner at the law firm of Stikeman Elliot LLP since May 2000. From 1984 to May 2000, Mr. Horn was a partner at the law firm of Phillips & Vineberg LLP. Mr. Horn currently serves on the boards of directors of Astral Media Inc., a Canadian specialty television and radio broadcaster and outdoor advertising company, Genworth MI Canada Inc., a Canadian residential mortgage insurance company, where he serves as Chairman of the Compensation Committee and as Lead Director, and Landauer Metropolitan Inc., a distributor of medical equipment. Since February 2010, Mr. Horn has also served as Corporate Secretary to Richmont Mines Inc., a Canadian gold mining company. Mr. Horn previously served on each of the boards of directors of Prime Restaurants, Inc., a restaurant franchisor, Le Chateau, Inc., a chain of specialty women’s and men’s apparel retail stores, and Algo Group, Inc., a diversified wholesaler of ladies’ apparel. Our Board of Directors believes that Mr. Horn’s experience as a director on several company boards, his extensive experience in a large variety of corporate and business transactions and his experience as legal and strategic advisor to several retail and wholesale apparel companies qualify him for his continued service on the Board of Directors.
Harold D. Kahn
Age: 66
Mr. Harold D. Kahn served as a director of our Company from January 27, 2005 to October 23, 2008, when he resigned as director and became Chief Executive Officer of Steve & Barry’s, a former retail clothing chain. After his relationship with Steve & Barry’s terminated, Mr. Kahn was re-appointed as a director of our Company on November 19, 2008. Mr. Kahn was appointed Chairman of our Board of Directors on December 13, 2009. Mr. Kahn also serves as a member of our Compensation Committee and our Nominating and Governance Committee. Since February 2004, Mr. Kahn has served as President of HDK Associates, a consulting company that advises financial and investment groups. From January 1994 to February 2004, Mr. Kahn served as Chairman and Chief Executive Officer of Macy’s East, a division of Macy’s. Mr. Kahn previously served on each of the boards of directors and Audit Committees of Ronco Corporation, a company that engages in the development, marketing and distribution of kitchen and other household products in the United States, and Steven Madden, Ltd., a designer and marketer of fashion footwear and accessories for women, men and children. Our Board of Directors believes Mr. Kahn’s multi-decade experience in the retail industry, including his role as president and chief executive officer of various divisions of a leading retailer and his leadership ability qualify him for his continued service on the Board of Directors.
Susan P. McGalla
Age: 47
Ms. Susan P. McGalla was appointed a director of our Company on January 18, 2011, in conjunction with her appointment as Chief Executive Officer of our Company. Prior to joining our Company, Ms. McGalla was the President and Chief Merchandising Officer of American Eagle Outfitters, Inc., or AE O, from 2007 to 2009, and was the President and Chief Merchandising Officer of its AE Brand from 2003 to 2007. From 1994 to 2003, Ms. McGalla held various management positions with AEO. Ms. McGalla also held various merchandising and management positions in the department store retail sector from 1986 to 1994. Ms. McGalla currently serves on the Board of Directors of HFF, Inc., a commercial real estate capital intermediary, the Board of Trustees for the University of Pittsburgh and the council for the University of Pittsburgh Cancer Institute. Ms. McGalla formerly served on the Executive Committee and Board of Directors for the Allegheny Conference on Community Development. Our Board of Directors believes that Ms. McGalla’s extensive experience in the retail industry, and particularly in senior management roles, and her leadership ability qualify her for her continued service on the Board of Directors.
Kenneth M. Reiss
Age: 69
Mr. Kenneth M. Reiss has been a director of our Company since January 27, 2005. Mr. Reiss is Chairman of our Audit Committee and also serves as a member of our Nominating and Governance Committee. Prior to his retirement in June 2003, Mr. Reiss was a partner at the accounting firm of Ernst & Young L.L.P., where he served as the lead auditor for several publicly traded companies, including Toys “R” Us, Inc., Staples, Inc., Phillips-Van Heusen, Inc. and Kenneth Cole Productions, Inc. Mr. Reiss serves on the Board of Directors of Harman International Industries, Inc., a manufacturer of audio and electronic products for automotive, consumer and professional use and serves as the Chairman of its Audit Committee and as a member of its Governance and Nominating Committee. Additionally, Mr. Reiss previously served on the boards of directors of each of Eddie Bauer Holdings, Inc., a holding company that operates a specialty retailer of men’s and women’s apparel, and Guitar Center, Inc., a musical instrument retail chain. Our Board of Directors believes that Mr. Reiss’ extensive audit, accounting and financial experience and expertise and his knowledge and experience with retail and apparel companies qualify him for his continued service on the Board of Directors.
Henry D. Winterstern
Age: 54
Mr. Henry D. Winterstern has been a director of our Company since August 18, 2004. Mr. Winterstern is the Chairman of our Compensation Committee and also serves as a member of our Audit Committee. Since April 2008, Mr. Winterstern has served as a Managing Director at Fortress Investment Group LLC, a leading, highly diversified global investment management firm, most recently serving as the Managing Director of the Hybrid Funds. From July 2005 to March 2007, Mr. Winterstern served as Co-Chairman of the Board of Directors and Chief Executive Officer of First Look Studios, Inc., an independent film studio specializing in home video releases of films and television series. Between 1999 and 2004, Mr. Winterstern served as Chief Executive Officer of CDP Capital Entertainment, an investment management and advisory services company for the entertainment industry. Between June 1998 and April 2002, Mr. Winterstern served on the Board of Directors of Algo Group, Inc., which operated in the fashion apparel industry in the United States and Canada and for which Mr. Winterstern also served as Vice Chairman from September 2000 to April 2002. He also served as director and as Vice Chairman for Consoltex Inc., a Canadian manufacturer of technical textiles, from May 1996 to October 1999 and from May 1997 to October 1999, respectively. Our Board of Directors believes that Mr. Winterstern’s experience in the retail sector and his role as a strategic advisor for acquisitions and financings in several industries qualify him for his continued service on the Board of Directors.
MANAGEMENT DISCUSSION FROM LATEST 10K
Executive Overview
We are a national specialty retailer operating stores selling fashionable and contemporary apparel and accessory items designed for female customers aged 15 to 39 years old. We operate two nationwide, primarily mall-based, chains of retail stores under the names “Wet Seal” and “Arden B”. At January 28, 2012, we had 558 retail stores in 47 states and Puerto Rico. Of the 558 stores, there were 472 Wet Seal stores and 86 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. Fiscal 2011, fiscal 2010, and fiscal 2009 each include 52 weeks of operations.
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. 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 income —We view operating income as a key indicator of our financial success. The key drivers of operating 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 of America 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 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 to our 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 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 and insurance reserves.
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 2011, 2010 and 2009, shipping and handling fee revenues were $3.0 million, $3.2 million and $2.9 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 21 days of original purchase. Wet Seal retail store merchandise may be returned for store credit only and Arden B retail store merchandise may be returned for cash refund or store credit within seven days of the original purchase date, and for store credit only thereafter. For Wet Seal and Arden B e-commerce sales, merchandise may be returned within 21 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 $0.2 million and $0.3 million at January 28, 2012, and January 29, 2011, respectively.
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 previously determined that the likelihood of redemption of unredeemed gift cards, gift certificates and store credits three years after their issuance is remote and adjusted our unearned revenue liability quarterly to record breakage as additional sales for gift cards, gift certificates and store credits that remained unredeemed three years after their issuance. Based upon an analysis completed by us during the second fiscal quarter of 2009, historical redemption patterns indicated that the likelihood of redemption of unredeemed gift cards, gift certificates and store credits greater than two years after their issuance is remote. As a result, beginning in the second quarter of fiscal 2009, we adjusted our unearned revenue liability to recognize the change in estimated timing of when breakage of gift cards, gift certificates and store credits is recognized from greater than three years after their issuance dates to greater than two years after their issuance dates. Our net sales in the second quarter of fiscal 2009 included a benefit of $1.2 million due to this change in estimate to reduce our unearned revenue liability for estimated unredeemed amounts. Our net sales for fiscal 2011, fiscal 2010 and fiscal 2009 included a benefit of $1.1 million, $1.4 million and $2.2 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 $5.5 million and $5.1 million at January 28, 2012 and January 29, 2011, 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 frequent buyer program are recognized at the time of such purchases.
We recognize membership fee revenue under the frequent buyer 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 $5.3 million and $3.8 million at January 28, 2012, and January 29, 2011, 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 $1.3 million and $1.3 million at January 28, 2012, and January 29, 2011, 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 corporate bonds that were guaranteed by the U.S. Government under the Temporary Liquidity Guarantee Program, had maturities that were less than one year and were carried at amortized cost plus accrued income. Short-term investments were carried at amortized cost due to our intent to hold to maturity. Short-term investments on the consolidated balance sheets were $50.7 million at January 29, 2011. During fiscal 2011, our short-term investments matured and we recovered the entire amortized cost basis of the securities.
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 2011, 2010 and 2009 were $86.4 million, $84.2 million and $78.6 million, respectively, and represented 13.9%, 14.5% and 14.0% of net sales, respectively. We accrued $4.3 million and $2.7 million for planned but unexecuted markdowns, including markdowns related to slow moving merchandise, as of January 28, 2012, and January 29, 2011, 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 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 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 cash flows using our weighted average cost of capital. We have considered all relevant valuation techniques that could be obtained without undue cost and effort and have determined that the discounted cash flow approach continues to provide the most relevant and reliable means by which to determine fair value in this circumstance.
Quarterly, we assess whether events or changes in circumstances have occurred that potentially indicate the carrying value of long-lived assets may not be recoverable. During fiscal 2011, 2010 and 2009, we determined such events or changes in circumstances had occurred with respect to certain of our retail stores, and that operating losses or insufficient operating income would likely continue. As such, we recorded noncash charges of $4.5 million, $4.2 million and $2.3 million, respectively, in our consolidated statements of operations for fiscal 2011, 2010 and 2009 to write down the carrying value of these stores’ long-lived assets to their estimated fair values.
The estimation of future cash flows from operating activities requires significant estimates of factors that include future sales growth and gross margin performance. If our sales growth, gross margin performance or other estimated operating results are not achieved at or above our forecasted level, or inflation exceeds our forecast and we are unable to recover such costs through price increases, the carrying value of certain of our retail stores may prove to be unrecoverable and we may incur additional impairment charges in the future.
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 currently 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.
We also apply the Black-Scholes and Monte-Carlo simulation models to value performance shares granted to employees. Use of the Black-Scholes model for this purpose requires the same exercise of judgment noted above. The Monte-Carlo simulation model is also complex and requires significant exercise of judgment to estimate expected returns on our common stock, expected common stock volatility and our maximum expected share value during applicable vesting periods.
We currently believe Monte-Carlo simulation provides the most relevant value of performance share grants as the simulation allows for vesting throughout the vesting period and includes an assumption for equity returns over time, while the Black-Scholes method does not. As the Monte-Carlo simulation provides a more precise estimate of fair value, we have used that approach to value our performance shares for accounting purposes.
The assumptions we use to value our performance shares significantly affect the resulting values used for accounting purposes. Accordingly, changes in these assumptions could significantly change valuations and, thus, affect future stock compensation expense. In addition, if circumstances were to change such that we determined performance share values were better represented by the Black-Scholes model or an alternative valuation method, and such changes resulted in a significant change in the value of performance shares, such changes could also significantly affect future stock compensation.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
Executive Overview
We are a national specialty retailer operating stores selling fashionable and contemporary apparel and accessory items designed for female customers from their early teens to 39 years old. We operate two nationwide, primarily mall-based, chains of retail stores under the names “Wet Seal” and “Arden B.” At July 28, 2012, we had 550 retail stores in 47 states and Puerto Rico. Of the 550 stores, there were 468 Wet Seal stores and 82 Arden B stores. Our merchandise can also be purchased online through the respective websites of each of our operating segments.
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. 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 income —We view operating income as a key indicator of our financial success. The key drivers of operating 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.
Business Segments
We report our results 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 reporting segments. Although the two operating segments have many similarities in their products, production processes, distribution methods, and regulatory environment, there are differences in most of these areas and distinct differences in their economic characteristics. As a result, we consider these segments to be two distinct reportable segments.
Wet Seal. Wet Seal is a junior apparel brand for girls and young women who seek fashionable clothing at a value, with a target customer age range of teens to early twenties. Wet Seal seeks to provide its customer base with a balance of trend right and fashion basic apparel and accessories that are affordably priced.
Arden B. Arden B is a fashion brand at value price points for the contemporary woman. Arden B targets customers aged 25 to 39 years old and seeks to deliver differentiated contemporary fashion, dresses, sportswear separates and accessories for any occasion of the customers’ lifestyles.
We maintain a Web-based store located at www.wetseal.com , offering Wet Seal merchandise comparable to that carried in our stores, to customers over the Internet. We also maintain a Web-based store located at www.ardenb.com , offering Arden B merchandise comparable to that carried in our stores, to customers over the Internet. Our e-commerce stores are designed to serve as an extension of the in-store experience and offer an expanded selection of merchandise, with the goal of growing both e-commerce and in-store sales. We continue to develop our Wet Seal and Arden B websites to increase their effectiveness in marketing our brands. We do not consider our Web-based business to be a distinct reportable segment. The Wet Seal and Arden B reportable segments include, in addition to data from their respective stores, data from their respective e-commerce operations.
See Note 7 of the notes to condensed consolidated financial statements for financial information regarding segment reporting, which information is incorporated herein by reference.
Current Trends and Outlook
The retail environment in the U.S. has shown slight improvement in the first half of 2012. However, only modest growth in the retail industry is expected for 2012 due to continued uncertainty regarding the global economy and the lack of significant improvement in the U.S. housing market and unemployment rates throughout the U.S. In addition, U.S. gross domestic product growth remains slow, further contributing to a volatile, and generally weak, retail environment. During the first half of fiscal 2012, we ran aggressive promotions and incurred high levels of clearance markdowns at both Wet Seal and Arden B to address product that was performing below expectations, primarily in the tops category. As a result, we experienced significant declines in our merchandise margin and comparable store sales. We expect continued weak performance in our merchandise margins in the near term as we aggressively promote our existing product in an effort to expeditiously re-merchandise our stores with product that will appeal to a broader demographic.
Our performance is subject to general economic conditions and their impact on levels of consumer confidence and consumer spending. Consumer purchases of discretionary items, including our merchandise, generally decline during periods when disposable income is adversely affected or there is economic uncertainty. As a result of the continued difficult economic conditions, we may face risks that will impact many facets of our operations, including, among other things, the ability of one or more of our vendors to deliver their merchandise in a timely manner or otherwise meet their obligations to us. Although we believe we are sufficiently prepared and financially strong enough to endure poor economic conditions in the U.S. and world economic markets, if such conditions continue, or if they deteriorate further, our business, financial condition, and results of operations may be further materially adversely affected.
Our comparable store sales decreased 11.1% during the 13 weeks ended July 28, 2012, driven by an 11.0% comparable store sales decrease in our Wet Seal division and an 11.6% comparable store sales decrease in our Arden B division. The Wet Seal division’s comparable store sales decrease was primarily driven by a decrease in transaction volume, partially offset by an increase in average dollar sales per transaction, which was driven by an increase in units purchased per customer, offset by a decrease in average unit selling price. At Wet Seal, we underperformed, we believe, as a result of shifting away from our core expertise of fast fashion merchandising which resulted in an assortment geared toward higher-priced product that was not well received by our target customers and a lack of compelling merchandise for the young teen customer during the beginning of the important back-to-school season. Our knit tops business declined significantly, while woven tops, denim bottoms, shoes, and outerwear sales increased. The Arden B division comparable store sales decrease was primarily driven by a decline in transaction volume and a decrease in average dollar sales per transaction, which was driven by a decrease in average unit selling price, partially offset by an increase in units purchased per customer. At Arden B, we under performed, we believe, as a result of too narrow of an assortment, leading to sales declines in all categories except bottoms. Our combined e-commerce sales declined 5% during the 13 weeks ended July 28, 2012, as compared to the prior year quarter, as a result of too narrow of an assortment and higher levels of promotional and clearance selling in an effort to sell product that was not well received by our target customers, consistent with the reception of product within our stores.
The end of the second quarter was the beginning of an important transition period for our Company as we made the decision to return to our core expertise of fast fashion merchandising. We began taking aggressive action to refocus our strategy in a way that we believe will address the issues that resulted in our disappointing fiscal 2012 second quarter, including, returning to merchandising to a broader demographic, including the young teen customer at Wet Seal, sourcing a broader variety of product more directly from fast fashion vendors, committing to merchandise purchases closer to time of need, and focusing our price points on our core customer, which long supported success for our Company. We expect it will take several months to begin to realize the impact of the transition in our merchandise and in-store marketing. Although we expect continued weak performance through the fiscal 2012 third quarter, we believe that this trend will bottom out in the coming months and that we will begin to see clear signs of improvement in the fiscal 2012 fourth quarter and will ultimately return to a level of sales and earnings that this strategy has driven for many years. As a result, we believe our Company will be positioned to stabilize the business during the holiday season of fiscal 2012 and fiscal 2013.
Employee Retention Plan
To retain the talent critical to executing upon our strategy and enhancing shareholder value, we have implemented an Employee Retention Plan for our senior leadership and certain other key team members. We believe it is critical to retain this talent base, and this Employee Retention Plan is designed to help provide stability and continuity for us during this important transition period. The Employee Retention Plan was approved by our Board of Directors effective August 19, 2012, and provides for a cash payment to each of the eligible employees, payable August 19, 2013, provided the employee is still employed by us, subject to acceleration upon certain terminations following a change in control. The total cost of the Employee Retention Plan is approximately $1.2 million and will be expensed over the one-year retention period.
In addition, effective August 19, 2012, our Board of Directors approved an amendment to our fiscal 2012 Management Bonus Plan to provide for a 25% payout of the annual bonus for fiscal 2012 for all eligible employees if we attain certain performance metrics in the fiscal 2012 fourth quarter. If achieved, the total cost of the fourth quarter bonus would be approximately $0.9 million and is payable in April 2013, contingent upon continued employment at that time.
Also effective August 19, 2012, our Board of Directors made grants of restricted stock to our senior leadership and certain other key team members in lieu of stock option grants typically made at this time each year. The aggregate grant was 196,300 shares with vesting to occur in equal amounts on the first and second anniversary dates of the grant. The grants are also subject to acceleration substantially as provided in the Company’s standard agreements, including upon a change in control.
As of the date of this report, no award under the Employee Retention Plan or grant of restricted stock, described above, has been made to Kenneth D. Seipel, our President and Chief Operating Officer, or Steven H. Benrubi, our Executive Vice President and Chief Financial Officer. Barbara Cook, our Senior Vice President of Store Operations, received an award under the Employee Retention Plan of $75,000 and a grant of 10,000 shares of restricted stock. Harriet Bailiss-Sustartic, our Chief Merchandise Officer, Wet Seal Division, received an award under the Employee Retention Plan of $75,000 and a grant of 10,000 shares of restricted stock.
Supplemental Director Compensation
In recognition of the significant additional duties being assumed by Hal Kahn, Chairman of the Board, and the three directors assigned to the Strategic Oversight Committee, established by the Board, the compensation of these directors has been increased for a six month period. The compensation will solely be in shares of restricted stock and was determined in consultation with an independent compensation consultant.
Under this program, Mr. Kahn has received a grant of restricted stock with a value of $500,000 to vest 70% on the three month anniversary of grant and 30% on the six month anniversary of grant. For this six month period, this stock grant to Mr. Kahn is in lieu of the cash stipend historically paid to him for service as Chairman of the Board ($75,000 per year). The members of the Strategic Oversight Committee each received a grant of restricted stock having a value of $90,000 to vest 50% on the three month anniversary and 50% on the six month anniversary of the date of grant. The grants are also subject to acceleration substantially as provided in the Company’s standard director stock award agreements, including upon a change in control.
Store Openings and Closures
As we focus on restoring our fast fashion merchandising strategy, we have deferred making additional new store opening commitments in our Wet Seal division through the remainder of fiscal 2012. Our real estate plan is now expected to total from two to four net store closings at Wet Seal for fiscal 2012, which is a decrease from our prior plan of 20 to 22 net store openings. At Arden B, our real estate plan remains unchanged from our prior plan, with 15 to 20 net store closings for fiscal 2012. As a result, we estimate we will end fiscal 2012 with 468 to 470 Wet Seal stores and 66 to 71 Arden B stores.
At Wet Seal, we opened three new stores and closed four stores during the 13 weeks ended July 28, 2012. At Arden B, we closed two stores during the 13 weeks ended July 28, 2012.
Critical Accounting Policies and Estimates
Our condensed consolidated financial statements were prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements.
The preparation of financial statements in conformity with GAAP requires the appropriate application of accounting policies, some of which require us to make estimates and assumptions about future events and their impact on amounts reported in our condensed 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 of Notes to Consolidated Financial Statements and in Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the fiscal year ended January 28, 2012.
The policies and estimates discussed below involve the selection or application of alternative accounting policies that are material to our condensed 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, merchandise inventories, long-lived assets, stock-based compensation, accounting for income taxes and insurance reserves. There have been no significant additions to or modifications of the application of the critical accounting policies described in our Annual Report on Form 10-K for the fiscal year ended January 28, 2012, except for the following updates for our critical accounting policies for long-lived assets and accounting for income taxes.
Long-Lived Assets
We evaluate the carrying value of long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. 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 will be recognized, measured as 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. Forecasted earnings, growth rates and other assumptions used to estimate carrying value recoverability rely heavily upon estimates made by management, including continued declines in comparable store sales in the short term and modest growth in future periods, and the expected outcomes of strategic initiatives being implemented. If we are not able to achieve our projected growth rates and cash flows, and strategic initiatives currently being implemented do not result in significant improvements in our current financial performance trend, we would incur additional impairment of assets in the future. We have considered all relevant valuation techniques that could be applied without undue cost and effort and have determined that the discounted estimated future cash flow approach continues to provide the most relevant and reliable means by which to determine fair value in this circumstance.
Quarterly, we assess whether events or changes in circumstances have occurred that potentially indicate the carrying value of long-lived assets may not be recoverable. During the 13 and 26 weeks ended July 28, 2012, and July 30, 2011, we determined such events or changes in circumstances had occurred with respect to certain of our retail stores, and that operating losses or insufficient operating income would likely continue. As such, we recorded noncash charges of $9.0 million, $12.6 million, $1.1 million and $1.3 million, in our condensed consolidated statements of operations for the 13 and 26 weeks ended July 28, 2012, and July 30, 2011, respectively, to write down the carrying value of these stores’ long-lived assets to their estimated fair values.
CONF CALL
Edmond Thomas
Good afternoon everyone. Thank you for joining us today to discuss our second quarter fiscal 2009 results. With me are Steve Benrubi, our Chief Financial Officer and Jennifer McEntee, our Vice President of Financial Planning & Analysis. Before we begin Jen will provide our Safe Harbor statement. Jen.
Jennifer McEntee - Vice President of Financial Planning & Analysis
Certain statements during this call may contain forward-looking information. Forward-looking statements are based on current expectations and projections about future events and are subject to risks, uncertainties and assumptions about our company, economic conditions and market sectors and the industry in which we do business among other things.
These statements are not guarantees of future performance and we undertake no obligation to publicly update any forward-looking statements whether as a result of new information, future events or otherwise.
Actual events and results may differ from those expressed in any forward-looking statements due to a number of factors. Factors that could cause our actual performance, future results and actions to differ materially from any forward-looking statements include, but are not limited to those discussed in risk factors within our Form 10-K for the fiscal year ended January 31, 2009 and our Form 10-Q for the fiscal quarter ended May 2, 2009, as filed with the Securities and Exchange Commission.
On today’s call we will make references to net income and earnings per diluted share for the second quarter of 2009 and 2008 before certain charges. These non-GAAP financial measures are provided to facilitate meaningful year-over-year comparisons. An explanation of why these non-GAAP financial measures are useful and how they are used by management can be obtained from the company’s website at www.wetsealinc.com. Ed.
Ed Thomas - President & Chief Executive Officer
During the second quarter, we continue to manage conservatively through a difficult retail environment. Although we are not pleased with our second quarter results overall, we have seen times of progress in both of our division especially at Arden B and we began the second half of 2009 with the cautious optimism that we can improve upon our results from the first half of the year.
At Wet Seal, we tightly controlled inventories during the quarter as we progress towards correcting mistakes in our assortment and positioning the business for the back to school season. As we previously said at the beginning of the second quarter, we were in the process of addressing inventory mix issues at Wet Seal that required corrections and indeed we made significant progress on this front.
Nonetheless, sales in merchandise margin performance were challenged along the way. Regarding Arden B, the second quarter marked continued improvement in the profitability of this business with operating income that exceeded both the prior year second quarter and the current year first quarter results.
While our conservative inventory investment in our lower price merchandizing model likely constrained comparable store sales results, this has also led to segment operating income of nearly 12% of sales in the first half signaling a return to profitability for this division after several years of significant losses.
We have gained according with the new Arden B strategy, and now have confidence to invest in higher inventory levels in an effort to facilitate consistent comparable store sales growth. Also during the quarter, we continue to generate decreases in our corporate G&A expenses.
As you may know, we begin focusing on cost reductions in G&A and other areas of our business almost two years ago, resulting in several million dollars of savings in fiscal 2008. Through additional staff reductions in January 2009, and continued cost discipline, we further reduced G&A in the second quarter of this year versus the prior year quarter.
In addition, our balance sheet remains very healthy. Our cash balance was $144 million at the end of the quarter with minimal long-term debt. We continue to view cash preservation as a leading priority, and inventory levels declined 14.6% to $38 million in the second quarter with both divisions conservatively positioned at quarter end.
Now turning to our division results. At Wet Seal, we experienced 11.9% decline in comparable store sales in the second quarter. The retail environment remained challenging and highly promotional. Nonetheless we believe much of this decline resulted from our own assortment weaknesses, primarily excess levels of basic tops in certain accessories in light positions and fashion tops and dresses.
During the course of the second quarter we rebalanced our tops assortment between fashion and basics and began to generate significantly improved results in that category as July progressed. We also worked with core performing accessory categories primarily scarves and jewelry which negatively affected gross margin in the second quarter.
We have very little overhang in these categories heading into the second half. This progress better positions Wet Seal going into the third quarter, but there are still further opportunities for improvement that we are addressing.
We will continue to build inventories in key ready-to-wear categories including fall dresses and outerwear, and in accessories such as jewelry that should help these categories complement sales improvements we’ve recently in tops and denim bottoms.
As we announced during July, we recently brought two new and very experienced divisional merchandise managers to the Wet Seal leadership team, Kim Bajrech and Debbie Shinn. Kim and Debbie are replacing two former merchandize managers who recently left the company.
Kim returns to Wet Seal after having served in a similar role thought my prior tenure with the company in the ‘90s and Debbie come to us with nearly 30 years of general merchandizing leadership experience. I’m confident that they will provide tremendous support to Maria as we work to improve consistency in the division’s merchandize assortments, and sales as margin resolves.
Regarding systems initiatives, we remain on track with the rollout of markdown optimization at Wet Seal, which should enable us to further improve markdown. We now have about one-third of our Wet Seal business supported by this system and expect to rollout completion by the end of September. We also plan to have our size optimization software implemented before the holiday season which will enable us to better align our size offerings to our Wet Seal customer’s need.
We are also currently pivoting updated point of sale systems which should improve transaction processing efficiency in our stores, a key opportunity in our high transaction volumes business. Looking further out, we will deploy an updated retail merchandizing system sometime in 2010 which will improve our merchandizing decision to support an inventory management.
These system enhancements are all merchandizing, and operationally focused with each supporting our efforts to improve sales and operating margins, and we are managing these systems improvements carefully to ensure no significant disruptions in our business.
In terms of the Wet Seal real estate portfolio, we opened six Wet Seal stores and remodeled 10 Wet Seal stores in the second quarter of which all now have redesigned fixture packages, in-store firms with our new store prototype. We now expect 32 Wet Seal store remodels with the new store prototype design, and fixture package will be completed during fiscal 2009.
This is down from our prior estimate of 40 stores this year, due to timing, shifts and lease renewal negotiation. On year-end, approximately 18% of the Wet Seal fleet will be in the new format. This new prototype allows a more efficient and [shoppable] presentation of the higher number of units we merchandise in our Wet Seal stores and earlier on has demonstrated an opportunity to drive sales improvements.
We have acted decisively to rebound from our disappointing second quarter results of Wet Seal. We believe these merchandise and corrections and software implementations combined with our ongoing transition to a new store prototype fixture package will improve store level productivity at Wet Seal in the second half of 2009 and beyond. That said we will continue to manage the business and inventory positions conservatively through the ongoing economic challenges.
Turning to our Arden B business, we continue to be very pleased with the progress we have made in the turnaround at Arden B. We have instituted many changes at this division over the last 18 months. We significantly cut the size and cost structure of the Arden B merchandising organization. We reduced the in-house design activities and we have evolved product development and sourcing to include greater collaboration with our merchandised suppliers making us much faster to market in the process.
During the first half of 2009, these changes have paid off. For the second quarter we significantly increased Arden B division’s operating income which rose to $3.3 million or 13.1% of net sales versus operating income of $1 million or 3.6% of net sales in the second quarter of last year.
This represented our second consecutive quarter with a strong operating income rate. This also add to our first half operating margin of $5.8 million, or 11.9% of sales, a vast improvement over our proximate breakeven results in last year’s first half.
Since converting to a lower price merchandising strategy at the beginning of this year, we have generated a year-over-year increase in transactions of nearly 30%. We continued to believe that much of this increase is coming from new customers to Arden B demonstrating we are regaining our image as a differentiated young contemporary retailer that offers excellent fashion at the right price.
Our customers want fashionable trend looks, but not at a premier price tag and Arden B aligns perfectly with this trend. We have cautiously built inventory levels at Arden B with units per square foot up approximately 20% of the prior year, at most times during the first half. All along we had monitored transaction volume improvement and AUR trends to evaluate the proficiency of this increase.
Our measured approach led to major improvements and regular price selling in merchandised margins at Arden B which are the biggest contributing factors in the division’s return to profitability. By earning on the side of caution, we also know that we have challenged comparable store sales results at Arden B.
While we generated positive comps in April and May due to much higher than anticipated swelters and dresses, fashion tops and other key categories. These strong sales results combined with our considerable inventory management led to right inventory positions in volume driving categories in the subsequent tier months. With experience came under our strategy we are now confident that we should increase the inventory unit volumes further at Arden B.
We believe this will provide opportunity for more consistent comparable store sales growth without sacrificing the benefits we have achieved from significantly improving regular price volume and merchandized margins. Given our continued improvement in Arden B, we also have modified plans to close stores of most Arden B lease explorations; instead we now intend to renew lease business we can obtain attractive lease terms.
We are not however at a point where we plan to open new Arden B stores although we did reopen one recently closed store during the quarter after negotiating more favorable restructures. With respect to both of our operating divisions we will continue to monitor the overall real estate and leasing environment to guide further growth plans.
We remain conservative in our real estate strategy looking to open Wet Sales stores only in situations where we are confident we can generate strong return on investment even in a tough market. As I have mentioned before there are approximately 100 Arden B malls in which we previously had Wet Seal stores and which have been among our highest performing locations.
Many of our 2009 store openings have been in these models and we have seen encouraging sales results today. We look forward to reopening Wet Seal stores in more of these malls at some point. At this movement we expect to open 17 new Wet Seal stores this year. We now plan to close our 16 Wet Seal stores and our Arden B stores which will result in nominal store count change if any in fiscal 2009.
We had not yet established to our growth plans beyond 2009, but we remain convinced that long-term opportunity exists or between 700 to 750 domestic Wet Seal stores and assuming we sustained recent improvements between 200 and 250 domestic Arden B stores.
In conclusion, we will continue to move forward with initiatives to increase store productivity and improve profitability at both divisions through systems implementation, operational improvements and enhanced marketing program. At the same time, we will maintain a healthy balance sheet through careful cost controls and conservative capital spending to position the company for further growth when we decide the time as well.
With that I will turn the call over to Steve who will discuss our second quarter result and introduce our third quarter 2009 outlook in greater detail. Steve.
Steve Benrubi - Chief Financial Officer
Thanks Ed. Consolidated sales for the second quarter ended August 1, 2009, were $136.4 million, compared to net sales of $149.1 million for the second quarter ended August 2, 2008. Sales included a $1.2 million breakage benefit related to unredeemed gift cards and sales credits. The effect of the breakage benefit is not included in comparable store sales results.
Comparable store sales for the current year quarter decreased 10.6%. The company reported a 4.4% comp store sales decrease in the prior year quarter. On a comp store basis, our second quarter combined transaction count per store decreased 2.2%. Average unit retail in the second quarter decreased 15.4% to $8.89 while our average number of units per transaction increased 9.4%.
During the second quarter internet sales increased by 12.7% as compared to the same period last year. Net sales in the Wet Seal division were $111.5 million as compared to $121.7 million in the prior year second quarter. Comp store sales decreased 11.9%. Comparable store sales in last year’s second quarter decreased 1.8%. The Wet Seal division net sales in this year’s second quarter included breakage benefit of $800,000.
Net sales in the Arden B division totaled $24.8 million as compared to $27.4 million in the second quarter last year. Comp store sales decreased 4.1% for Arden B. Comparable stores sales in last year’s second quarter decreased 13.8%. The Arden B division net sales in this year’s second quarter included breakage benefit of $400,000.
For the quarter, excluding the impact of the $1.2 million breakage benefit, gross profit was $38 million, a rate of 28.1% as compared to $52 million or 34.9% rate in last year’s second quarter. The 680 basis point decrease in gross margin reflected a 490 basis point decrease in merchandise margins with a significant decline in Wet Seal merchandise margins partially offset by an improvement in Arden B.
In addition, we had 230 basis points of deleveraging of occupancy costs due to the comparable store sales decline. This was partially offset by a reduction in buying and distribution costs primarily associated with the eliminative positions from the restructuring of the Arden B buying and design organization and operational efficiencies in our distribution function.
Selling, general, and administrative expense for the quarter was $34.3 million, or 25.4% of net sales adjusted for the breakage benefit, as compared to $39.9 million or 26.8% of net sales in the same period last year.
Selling expenses, one of two components of SG&A $28.2 million in the quarter or 20.9% of adjusted net sales as compared to $32 million or 21.5% of net sales in last year’s second quarter, the 11.8% decrease in selling expense was primarily due to a decrease in store payroll and benefits, a reduction in advertising and marketing expenditures and lower merchandise delivery costs.
General and administrative cost totaled $6.1 million or 4.5% of adjusted net sales as compared to $7.9 million or 5.3% of net sales in last year’s second quarter. The decline in G&A was primarily due to reduced corporate wages and stock compensation expense as well as the $400,000 credit in the current year quarter to reverse previously accrued incentive compensation due to performance below bonus targets.
We recorded a $1.6 million non-cash asset impairment charge in the second quarter related to assets for certain Wet Seal stores where we do not fully future cash flows will be sufficient to realize the carrying value. Operating income for the second quarter adjusted for the breakage benefit and the asset impairment charge was $3.6 million or 2.7% of adjusted net sales compared to operating income adjusted for a $300,000 asset impairment charge of $12.1 million or 8.1% of net sales for the same period last year.
Operating income in the Wet Seal division adjusted for the items noted about was $6.8 million in the second quarter compared to adjusted operating income of $18.4 million for the same period last year. Adjusted operating margin was 6.1% in the second quarter as compared to 15.1% in the same quarter last year for Wet Seal.
Operating income in the Arden B division adjusted for the breakage benefit was $2.9 million or 11.8% of adjusted net sales in the second quarter, compared to operating income of $1 million, or 3.6% of net sales for the same period last year. Interest expense in the quarter was $114,000 as compared to $1.5 million in the same period last year.
Interest expense in the second quarter of last year included a $1.9 million charge related to the conversion of our secured convertible notes. The effective tax rate was 2.5% for the quarter as compared to 1.7% in last year second quarter. We now estimate our annual effective tax rate will be 3%, down slightly from our estimate of 3.3% in the first quarter.
As we previously reported in 2004, we established a 100% tax valuation allowance in accordance with FAS 109 accounting for income taxes which requires the differed tax assets be reduced by evaluation allowance if it is more likely than not, that some or all differed tax assets will not be realized in the foreseeable future.
We continue to maintain the valuation allowance. Our differed tax assets consist principally of net operating loss carry forward to NOLs. These NOLs do not begin to expire until the year 2023. We begin fiscal 2009 with approximately $118 million of federal NOL carry forward available to offset taxable income in 2009 and thereafter, subject to certain annual limits based on the provisions of Section 382 of the Internal Revenue Code.
Subject to potential further adjustment, we believe NOL carry forwards available will be sufficient to offset all reasonably foreseeable federal, regular taxable income if any in fiscal 2009.
Accordingly, if we were to generate taxable income in 2009, we forecast an effective income tax rate of 3% related to a limited portion of federal alternative minimum taxes that cannot be offset by NOL carry forwards as well as income taxes in the State of California, which cannot be offset by NOLs and certain other state income taxes.
In addition, if we generate taxable income in 2009 we may determine that our tax valuation allowance is no longer necessary and if so will record a significant credit to our provision for income taxes to a limiting evaluation allowance. If this were to occur respectively we would anticipate an effective income tax rate approximating statutory rates for about 38% to 39%.
In such case though we would still expect our cash payments for income taxes to be substantially less than our effective income tax rate as we would continue to utilize available NOLs.
Net income in the second quarter was $3.1 million, or $0.03 per diluted share. Excluding the impact of the previously discussed breakage benefit and asset impairment, net income for the quarter would remain $0.03 per diluted share. This compares to net income of $10.1 million or $0.10 per diluted share in the second quarter of 2008.
Excluding the effect of the prior year $1.9 million, non-cash interest charge net income for the second quarter of fiscal 2008 was $12 million or $0.12 per diluted share. We ended the quarter with a strong balance sheet.
At quarter end, we had cash and cash equivalents of $144 million. We generated $11 million of cash from operations in the second quarter and incurred $6.6 million in capital expenditures, which includes $6 million on new stores and remodel construction cost.
At August 1, 2009, inventory totaled $38.1 million representing a decrease of 14.6% as compared to August 2, 2008 levels. Average inventory per square foot decreased 14.9% as compared to the prior year second quarter.
Turning to our third quarter 2009 guidance, we estimate earnings per diluted share in the range of $0.02 to $0.05. This guidance is based on the following major assumptions. Total net sales between $138 million and $142 million, versus $146.6 million in the prior year third quarter. Comparable store sales between negative 6% and negative 9% versus a 7.6% consolidated decrease in the prior year third quarter.
Gross margin rose between 27.9% and 29.7%, of net sales versus 31.3% in the prior year, a decrease driven mainly by a deleveraging effect on occupancy costs from the forecasted comparable store sales decrease and a reduction in merchandise margin.
We also estimate current year SG&A expense between 26.0% and 26.4% of net sales versus 26.1% in the prior year quarter. Operating income in the third quarter is estimated to be between $2.1 million and $5.2 million, versus $7.1 million in the prior year third quarter. Operating income for the third quarter of 2008 included an asset impairment charge of approximately $500,000.
Interest expense in the current year quarter is estimated to be $135,000. Net interest income in the third quarter of 2008 was $378,000. We expect third quarter income tax expense of between $100,000 and $200,000. We estimate gross capital expenditures for all of 2009, of between $25 million and $26 million with offsetting improvement allowances of approximately $2 million for a net cash impact of $23 million to $24 million.
This includes approximately $18 million for cost associated with opening 17 new Wet Seal stores, as well as four remodeling approximately 32 existing stores upon lease renewals and/or store relocations.
We anticipate closing 16 stores when their leases expire, so we estimate nominal store count change if any in 2009. Our capital spending plan in those areas may change depending on the economic environment.
That concludes our prepared remarks. With that I will turn the call over to the operator to start a question-and-answer session.
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