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1. Interim Financial Statements
The accompanying Consolidated Financial Statements of American Eagle Outfitters, Inc. (the “Company”) at July 30, 2011 and July 31, 2010 and for the 13 and 26 week periods ended July 30, 2011 and July 31, 2010 have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. Certain notes and other information have been condensed or omitted from the interim Consolidated Financial Statements presented in this Quarterly Report on Form 10-Q. Therefore, these Consolidated Financial Statements should be read in conjunction with the Company’s Fiscal 2010 Annual Report. In the opinion of the Company’s management, all adjustments (consisting of normal recurring adjustments and those described in the footnotes that follow) considered necessary for a fair presentation have been included. The existence of subsequent events has been evaluated through the filing date of this Quarterly Report on Form 10-Q.
As used in this report, all references to “we,” “our” and the “Company” refer to American Eagle Outfitters, Inc. and its wholly owned subsidiaries. “American Eagle Outfitters,” “American Eagle,” “AE” and the “AE Brand” refer to our U.S. and Canadian American Eagle Outfitters stores. “aerie” refers to our U.S. and Canadian aerie® by American Eagle® stores. “77kids” refers to our 77kids by american eagle® stores. “AEO Direct” refers to our e-commerce operations, ae.com, aerie.com and 77kids.com. “MARTIN+OSA” or “M+O” refers to the MARTIN+OSA stores and e-commerce operation which we operated until its closure during the second quarter of Fiscal 2010.
The Company’s business is affected by the pattern of seasonality common to most retail apparel businesses. The results for the current and prior periods are not necessarily indicative of future financial results.
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2. Summary of Significant Accounting Policies
Principles of Consolidation
The Consolidated Financial Statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany transactions and balances have been eliminated in consolidation. At July 30, 2011, the Company operated in one reportable segment.
On March 5, 2010, the Company’s Board of Directors (the “Board”) approved management’s recommendation to proceed with the closure of the M+O brand. The Company completed the closure of the M+O stores and e-commerce operation during the second quarter of Fiscal 2010. These Consolidated Financial Statements reflect the results of M+O as a discontinued operation for all periods presented.
Fiscal Year
The Company’s financial year is a 52/53 week year that ends on the Saturday nearest to January 31. As used herein, “Fiscal 2011” refers to the 52 week period ending January 28, 2012. “Fiscal 2010” and “Fiscal 2009” refer to the 52 week periods ended January 29, 2011 and January 30, 2010, respectively.
Estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of our contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. On an ongoing basis, our management reviews its estimates based on currently available information. Changes in facts and circumstances may result in revised estimates.
Recent Accounting Pronouncements
In June 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2011-05, Presentation of Comprehensive Income (“ASU 2011-05”). ASU 2011-05 requires that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In the two-statement approach, the first statement should present total net income and its components followed consecutively by a second statement that should present total other comprehensive income, the components of other comprehensive income and the total of comprehensive income. For public entities, the amendments in ASU 2011-05 are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011, and are to be applied retrospectively, with early adoption permitted. The Company is currently evaluating the impact of ASU 2011-05 on its financial statement presentation of comprehensive income.
Foreign Currency Translation
The Canadian dollar is the functional currency for the Canadian business. In accordance with Accounting Standards Codification (“ASC”) 830, Foreign Currency Matters, assets and liabilities denominated in foreign currencies were translated into U.S. dollars (the reporting currency) at the exchange rate prevailing at the balance sheet date. Revenues and expenses denominated in foreign currencies were translated into U.S. dollars at the monthly average exchange rate for the period. Gains or losses resulting from foreign currency transactions are included in the results of operations, whereas, related translation adjustments are reported as an element of other comprehensive income in accordance with ASC 220, Comprehensive Income (refer to Note 9 to the Consolidated Financial Statements).
Revenue Recognition
Revenue is recorded for store sales upon the purchase of merchandise by customers. The Company’s e-commerce operation records revenue upon the estimated customer receipt date of the merchandise. Shipping and handling revenues are included in net sales. Sales tax collected from customers is excluded from revenue and is included as part of accrued income and other taxes on the Company’s Consolidated Balance Sheets.
Revenue is recorded net of estimated and actual sales returns and deductions for coupon redemptions and other promotions. The Company records the impact of adjustments to its sales return reserve quarterly within net sales and cost of sales. The sales return reserve reflects an estimate of sales returns based on projected merchandise returns determined through the use of historical average return percentages.
Revenue is not recorded on the purchase of gift cards. A current liability is recorded upon purchase, and revenue is recognized when the gift card is redeemed for merchandise. Additionally, the Company recognizes revenue on unredeemed gift cards based on an estimate of the amounts that will not be redeemed (“gift card breakage”), determined through historical redemption trends. Gift card breakage revenue is recognized in proportion to actual gift card redemptions as a component of net sales. For further information on the Company’s gift card program, refer to the Gift Cards caption below.
The Company recognizes revenue generated from its franchise agreements based upon a percentage of merchandise sales by the franchisee. This revenue is recorded as a component of net sales when earned.
The Company sells off end-of-season, overstock and irregular merchandise to a third-party. The proceeds from these sales are presented on a gross basis, with proceeds and cost of sell-offs recorded in net sales and cost of sales, respectively.
Cost of Sales, Including Certain Buying, Occupancy and Warehousing Expenses
Cost of sales consists of merchandise costs, including design, sourcing, importing and inbound freight costs, as well as markdowns, shrinkage and certain promotional costs (collectively “merchandise costs”) and buying, occupancy, and warehousing costs. Buying, occupancy and warehousing costs consist of compensation, employee benefit expenses and travel for our buyers and certain senior merchandising executives; rent and utilities related to our stores, corporate headquarters, distribution centers and other office space; freight from our distribution centers to the stores; compensation and supplies for our distribution centers, including purchasing, receiving and inspection costs; and shipping and handling costs related to our e-commerce operation. Merchandise margin is the difference between net sales and merchandise costs. Gross profit is the difference between net sales and cost of sales.
Selling, General and Administrative Expenses
Selling, general and administrative expenses consist of compensation and employee benefit expenses, including salaries, incentives and related benefits associated with our stores and corporate headquarters. Selling, general and administrative expenses also include advertising costs, supplies for our stores and home office, communication costs, travel and entertainment, leasing costs and services purchased. Selling, general and administrative expenses do not include compensation, employee benefit expenses and travel for our design, sourcing and importing teams, our buyers and our distribution centers as these amounts are recorded in cost of sales.
Other Income (Expense), Net
Other income (expense), net consists primarily of interest income/expense, foreign currency transaction gain/loss and realized investment gain/loss.
Other-than-Temporary Impairment
The Company evaluates its investments for impairment in accordance with ASC 320, Investments – Debt and Equity Securities (“ASC 320”). ASC 320 provides guidance for determining when an investment is considered impaired, whether impairment is other-than-temporary, and measurement of an impairment loss. An investment is considered impaired if the fair value of the investment is less than its cost. If, after consideration of all available evidence to evaluate the realizable value of its investment, impairment is determined to be other-than-temporary, then an impairment loss is recognized in the Consolidated Statement of Operations equal to the difference between the investment’s cost and its fair value. Additionally, ASC 320 requires additional disclosures relating to debt and equity securities both in the interim and annual periods as well as requires the Company to present total other-than-temporary impairment (“OTTI”) with an offsetting reduction for any non-credit loss impairment amount recognized in other comprehensive income (“OCI”).
There was no net impairment loss recognized in earnings during the 13 and 26 weeks ended July 30, 2011. The following table presents the components of net impairment loss recognized in earnings within other income (expense), net on the Consolidated Statement of Operations for the 13 and 26 weeks ended July 31, 2010:
13 Weeks Ended | 26 Weeks Ended | |||||||
(In thousands) | July 31, 2010 | July 31, 2010 | ||||||
Total other-than-temporary impairment losses |
($ | 4,575 | ) | ($ | 5,089 | ) | ||
Portion of loss recognized in other comprehensive income, before tax |
3,327 | 3,841 | ||||||
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Net impairment loss recognized in earnings |
($ | 1,248 | ) | ($ | 1,248 | ) | ||
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Refer to Notes 4 to the Consolidated Financial Statements for additional information regarding net impairment losses recognized in earnings.
Cash and Cash Equivalents, Short-term Investments and Long-term Investments
Cash includes cash equivalents. The Company considers all highly liquid investments purchased with a maturity of three months or less to be cash equivalents.
As of July 30, 2011, short-term investments included commercial paper, corporate bonds, treasury bills and term deposits purchased with a maturity of greater than three months, but less than one year. It also includes auction rate securities (“ARS”) classified as available for sale that the Company expects to be redeemed at par within 12 months.
As of July 30, 2011, long-term investments include the Company’s ARS Call Option related to investment sales during Fiscal 2010. The ARS Call Option expires on October 29, 2013.
Unrealized gains and losses on the Company’s available-for-sale securities are excluded from earnings and are reported as a separate component of stockholders’ equity, within accumulated other comprehensive income, until realized. The components of OTTI losses related to credit losses, as defined by ASC 320, are considered by the Company to be realized and are recorded in earnings. When available-for-sale securities are sold, the cost of the securities is specifically identified and is used to determine any realized gain or loss.
Refer to Note 3 to the Consolidated Financial Statements for information regarding cash and cash equivalents, short-term investments and long-term investments.
Merchandise Inventory
Merchandise inventory is valued at the lower of average cost or market, utilizing the retail method. Average cost includes merchandise design and sourcing costs and related expenses. The Company records merchandise receipts at the time merchandise is delivered to the foreign shipping port by the manufacturer (FOB port). This is the point at which title and risk of loss transfer to the Company.
The Company reviews its inventory levels to identify slow-moving merchandise and generally uses markdowns to clear merchandise. Additionally, the Company estimates a markdown reserve for future planned permanent markdowns related to current inventory. Markdowns may occur when inventory exceeds customer demand for reasons of style, seasonal adaptation, changes in customer preference, lack of consumer acceptance of fashion items, competition, or if it is determined that the inventory in stock will not sell at its currently ticketed price. Such markdowns may have a material adverse impact on earnings, depending on the extent and amount of inventory affected. The Company also estimates a shrinkage reserve for the period between the last physical count and the balance sheet date. The estimate for the shrinkage reserve, based on historical results, can be affected by changes in merchandise mix and changes in actual shrinkage trends.
Income Taxes
The Company calculates income taxes in accordance with ASC 740, Income Taxes (“ASC 740”), which requires the use of the asset and liability method. Under this method, deferred tax assets and liabilities are recognized based on the difference between the Consolidated Financial Statement carrying amounts of existing assets and liabilities and their respective tax bases as computed pursuant to ASC 740. Deferred tax assets and liabilities are measured using the tax rates, based on certain judgments regarding enacted tax laws and published guidance, in effect in the years when those temporary differences are expected to reverse. A valuation allowance is established against the deferred tax assets when it is more likely than not that some portion or all of the deferred taxes may not be realized. Changes in the Company’s level and composition of earnings, tax laws or the deferred tax valuation allowance, as well as the results of tax audits may materially impact our effective income tax rate.
The Company evaluates its income tax positions in accordance with ASC 740, which prescribes a comprehensive model for recognizing, measuring, presenting and disclosing in the financial statements tax positions taken or expected to be taken on a tax return, including a decision whether to file or not to file in a particular jurisdiction. Under ASC 740, a tax benefit from an uncertain position may be recognized only if it is “more likely than not” that the position is sustainable based on its technical merits.
The calculation of the deferred tax assets and liabilities, as well as the decision to recognize a tax benefit from an uncertain position and to establish a valuation allowance require management to make estimates and assumptions. The Company believes that its assumptions and estimates are reasonable, although actual results may have a positive or negative material impact on the balances of deferred tax assets and liabilities, valuation allowances or net income.
Property and Equipment
Property and equipment is recorded on the basis of cost with depreciation computed utilizing the straight-line method over the assets’ estimated useful lives. The useful lives of our major classes of assets are as follows:
Buildings | 25 years | |
Leasehold improvements | Lesser of 10 years or the term of the lease | |
Fixtures and equipment | 5 years |
In accordance with ASC 360, Property, Plant, and Equipment (“ASC 360”), the Company’s management evaluates the value of leasehold improvements and store fixtures associated with retail stores, which have been open for a period of time sufficient to reach maturity. The Company evaluates long-lived assets for impairment at the individual store level, which is the lowest level at which individual cash flows can be identified. Impairment losses are recorded on long-lived assets used in operations when events and circumstances indicate that the assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amounts of the assets. When events such as these occur, the impaired assets are adjusted to their estimated fair value and an impairment loss is recognized within selling, general and administrative expenses on the Consolidated Statements of Operations.
No asset impairment charges were recorded during the 26 weeks ended July 30, 2011. During the 26 weeks ended July 31, 2010, the Company recorded asset impairment charges of $18.0 million related to the impairment of M+O stores. Based on the Company’s decision to close all M+O stores in Fiscal 2010, the Company determined that the stores not previously impaired would not be able to generate sufficient cash flow over the life of the related leases to recover the Company’s initial investment in them. The asset impairment charges for the 26 weeks ended July 31, 2010 are recorded within Loss from Discontinued Operations on the Consolidated Statements of Operations.
Refer to Note 13 to the Consolidated Financial Statements for additional information regarding the discontinued operations of M+O.
Goodwill
As of July 30, 2011, the Company had approximately $11.7 million of goodwill compared to $11.5 million as of January 29, 2011. The Company’s goodwill is primarily related to the acquisition of its importing operations and Canadian business. The increase in goodwill is due to the fluctuation in the foreign exchange spot rate at which the Canadian goodwill is translated. In accordance with ASC 350, the Company evaluates goodwill for possible impairment on at least an annual basis and last performed an annual impairment test as of January 29, 2011. As a result of the Company’s annual goodwill impairment test, the Company concluded that its goodwill was not impaired.
Intangible Assets
Intangible assets are recorded on the basis of cost with amortization computed utilizing the straight-line method over the assets’ estimated useful lives. The Company’s intangible assets, which primarily include trademark assets, are amortized over 15 to 25 years.
The Company evaluates intangible assets for impairment in accordance with ASC 350 when events or circumstances indicate that the carrying value of the asset may not be recoverable. Such an evaluation includes the estimation of undiscounted future cash flows to be generated by those assets. If the sum of the estimated future undiscounted cash flows are less than the carrying amounts of the assets, then the assets are impaired and are adjusted to their estimated fair value. No intangible asset impairment charges were recorded in both the 13 and 26 weeks ended July 30, 2011 and July 31, 2010.
Refer to Note 7 to the Consolidated Financial Statements for additional information regarding intangible assets.
Gift Cards
The value of a gift card is recorded as a current liability upon purchase, and revenue is recognized when the gift card is redeemed for merchandise. The Company estimates gift card breakage and recognizes revenue in proportion to actual gift card redemptions as a component of net sales. The Company determines an estimated gift card breakage rate by continuously evaluating historical redemption data and the time when there is a remote likelihood that a gift card will be redeemed. During the 13 weeks ended July 30, 2011 and July 31, 2010, the Company recorded $0.9 million and $0.7 million, respectively, of revenue related to gift card breakage. During the 26 weeks ended July 30, 2011 and July 31, 2010, the Company recorded $2.0 million and $1.7 million, respectively, of revenue related to gift card breakage.
Deferred Lease Credits
Deferred lease credits represent the unamortized portion of construction allowances received from landlords related to the Company’s retail stores. Construction allowances are generally comprised of cash amounts received by the Company from its landlords as part of the negotiated lease terms. The Company records a receivable and a deferred lease credit liability at the lease commencement date (date of initial possession of the store). The deferred lease credit is amortized on a straight-line basis as a reduction of rent expense over the term of the original lease (including the pre-opening build-out period) and any subsequent renewal terms. The receivable is reduced as amounts are received from the landlord.
Co-branded Credit Card and Customer Loyalty Program
The Company offers a co-branded credit card (the “AEO Visa Card”) and a private label credit card (the “AEO Credit Card”) under the American Eagle, aerie and 77kids brands. These credit cards are issued by a third-party bank (the “Bank”), and the Company has no liability to the Bank for bad debt expense, provided that purchases are made in accordance with the Bank’s procedures. Once a customer is approved to receive the AEO Visa Card or the AEO Credit Card and the card is activated, the customer is eligible to participate in the credit card rewards program. Customers who make purchases at AE, aerie and 77kids earn discounts in the form of savings certificates when certain purchase levels are reached. Also, AEO Visa Card customers who make purchases at other retailers where the card is accepted earn additional discounts. Savings certificates are valid for 90 days from issuance.
Points earned under the credit card rewards program on purchases at AE, aerie and 77kids are accounted for by analogy to ASC 605-25, Revenue Recognition, Multiple Element Arrangements (“ASC 605-25”). The Company believes that points earned under its point and loyalty programs represent deliverables in a multiple element arrangement rather than a rebate or refund of cash. Accordingly, the portion of the sales revenue attributed to the award points is deferred and recognized when the award is redeemed or when the points expire. Additionally, credit card reward points earned on non-AE, aerie or 77kids purchases are accounted for in accordance with ASC 605-25. As the points are earned, a current liability is recorded for the estimated cost of the award, and the impact of adjustments is recorded in cost of sales.
The Company offers its customers the AEREWARD$sm loyalty program (the “Program”). Under the Program, customers accumulate points based on purchase activity and earn rewards by reaching certain point thresholds during three-month earning periods. Rewards earned during these periods are valid through the stated expiration date, which is approximately one month from the mailing date of the reward. These rewards can be redeemed for a discount on a purchase of merchandise. Rewards not redeemed during the one-month redemption period are forfeited. The Company determined that rewards earned using the Program should be accounted for in accordance with ASC 605-25. Accordingly, the portion of the sales revenue attributed to the award credits is deferred and recognized when the awards are redeemed or expire.
Segment Information
In accordance with ASC 280, Segment Reporting (“ASC 280”), the Company has identified four operating segments (American Eagle Brand US and Canadian stores, aerie retail stores, 77kids retail stores and AEO Direct) that reflect the basis used internally to review performance and allocate resources. All of the operating segments have been aggregated and are presented as one reportable segment, as permitted by ASC 280.
Reclassification
Certain reclassifications have been made to the Consolidated Financial Statements for prior periods in order to conform to the current period presentation.
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3. Cash and Cash Equivalents, Short-term Investments and Long-term Investments
The following table summarizes the fair market values for the Company’s cash and marketable securities, which are recorded as cash and cash equivalents, short-term investments and long-term investments on the Consolidated Balance Sheets:
(In thousands) | July 30, 2011 |
January 29, 2011 |
July 31, 2010 |
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Cash and cash equivalents: |
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Cash |
$ | 287,753 | $ | 122,578 | $ | 186,888 | ||||||
Money-market |
74,387 | 397,440 | 88,411 | |||||||||
Commercial paper |
23,996 | 40,884 | 31,499 | |||||||||
Treasury bills |
3,163 | 102,996 | 118,725 | |||||||||
Corporate bonds |
— | 3,695 | — | |||||||||
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Total cash and cash equivalents |
$ | 389,299 | $ | 667,593 | $ | 425,523 | ||||||
Short-term investments: |
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Treasury bills |
$ | 76,262 | $ | — | $ | — | ||||||
Corporate bonds |
16,111 | — | — | |||||||||
Term-deposits |
15,427 | 63,402 | — | |||||||||
Commercial paper |
9,997 | — | — | |||||||||
State and local government ARS |
6,900 | 3,700 | 5,800 | |||||||||
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Total short-term investments |
$ | 124,697 | $ | 67,102 | $ | 5,800 | ||||||
Long-term investments: |
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ARS Call Option |
$ | 648 | $ | 415 | $ | — | ||||||
State and local government ARS |
— | 5,500 | 22,200 | |||||||||
Student-loan backed ARS |
— | — | 131,163 | |||||||||
Auction rate preferred securities |
— | — | 13,354 | |||||||||
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Total long-term investments |
$ | 648 | $ | 5,915 | $ | 166,717 | ||||||
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Total |
$ | 514,644 | $ | 740,610 | $ | 598,040 | ||||||
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Proceeds from the sale of investments were $115.2 million and $27.9 million for the 26 weeks ended July 30, 2011 and July 31, 2010, respectively. The purchase of investments for the 26 weeks ended July 30, 2011 was $166.4 million. There were no purchases of investments during the 26 weeks ended July 31, 2010.
The following table presents the length of time available-for-sale securities were in continuous unrealized loss positions but were not deemed to be other-than-temporarily impaired. As of July 30, 2011, the fair value of all ARS investments approximated par, with no gross unrealized holding losses.
Less Than 12 Months | Greater Than
or Equal to 12 Months |
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Gross Unrealized Holding Losses |
Fair Value | Gross Unrealized Holding Losses |
Fair Value | |||||||||||||
(In thousands) | ||||||||||||||||
July 31, 2010 |
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Student-loan backed ARS |
$ | (805 | ) | $ | 54,959 | $ | (9,384 | ) | $ | 47,453 | ||||||
Auction rate preferred securities |
— | — | (706 | ) | 14,294 | |||||||||||
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Total (1) |
$ | (805 | ) | $ | 54,959 | $ | (10,090 | ) | $ | 61,747 | ||||||
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(1) | Fair value excludes $58.0 million as of July 31, 2010 of securities whose fair value approximated par. Additionally, as of July 31, 2010, fair value shown above excludes ($2.2) million of OTTI that has been previously recognized in earnings. |
During Fiscal 2010, the Company liquidated $191.4 million carrying value of ARS investments for proceeds of $177.5 million and a realized loss of $24.4 million (of which $10.9 million was previously included in OCI on the Company’s Consolidated Balance Sheets). The ARS securities sold during Fiscal 2010 included $119.7 million of par value ARS securities whereby the Company entered into a settlement agreement under which a financial institution (the “purchaser”) purchased the ARS at a discount to par, plus accrued interest. Additionally, under this agreement, the Company retained a right (the “ARS Call Option”), for a period ending October 29, 2013 to: (a) repurchase any or all of the ARS securities sold at the agreed upon purchase prices received from the purchaser plus accrued interest; and/or (b) receive additional proceeds from the purchaser upon certain redemptions of the ARS securities sold. The ARS Call Option is cancelable by the purchaser for additional cash consideration.
The Company is required to assess the value of the ARS Call Option at the end of each reporting period, with any changes in fair value recorded within the Consolidated Statement of Operations. Upon origination, the Company determined that the fair value was $0.4 million. The fair value of the ARS Call Option was included as an offsetting amount within the net loss on liquidation of $24.4 million referenced above. As of July 30, 2011, the Company determined that the remaining value of the ARS Call Option, which is classified as a long-term investment on the Consolidated Balance Sheets, was $0.6 million.
The Company continues to monitor the market for ARS and consider the impact, if any, on the fair value of its investments. If current market conditions deteriorate further, or the anticipated recovery in market values does not occur, the Company may be required to record impairment charges on its remaining ARS investments.
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4. Fair Value Measurements
ASC 820, Fair Value Measurement Disclosures (“ASC 820”), defines fair value, establishes a framework for measuring fair value in accordance with GAAP, and expands disclosures about fair value measurements. Fair value is defined under ASC 820 as the exit price associated with the sale of an asset or transfer of a liability in an orderly transaction between market participants at the measurement date.
Financial Instruments
Valuation techniques used to measure fair value under ASC 820 must maximize the use of observable inputs and minimize the use of unobservable inputs. In addition, ASC 820 establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. These tiers include:
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Level 1 — Quoted prices in active markets for identical assets or liabilities. |
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Level 2 — Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. |
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Level 3 — Unobservable inputs (i.e., projections, estimates, interpretations, etc.) that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. |
As of July 30, 2011 and July 31, 2010, the Company held certain assets that are required to be measured at fair value on a recurring basis. These include cash equivalents and short and long-term investments, including ARS and auction rate preferred securities.
In accordance with ASC 820, the following table represents the Company’s fair value hierarchy for its financial assets (cash equivalents and investments) measured at fair value on a recurring basis as of July 30, 2011 and July 31, 2010:
Fair Value Measurements at July 30, 2011 | ||||||||||||||||
(In thousands) | Carrying Amount | Quoted Market Prices in Active Markets for Identical Assets (Level 1) |
Significant Other Observable Inputs (Level 2) |
Significant Unobservable Inputs (Level 3) |
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Cash and cash equivalents: |
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Cash |
$ | 287,753 | $ | 287,753 | $ | — | $ | — | ||||||||
Money-market |
74,387 | 74,387 | — | — | ||||||||||||
Commercial paper |
23,996 | 23,996 | — | — | ||||||||||||
Treasury bills |
3,163 | 3,163 | — | — | ||||||||||||
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Total cash and cash equivalents |
$ | 389,299 | $ | 389,299 | $ | — | $ | — | ||||||||
Short-term investments: |
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Treasury bills |
$ | 76,262 | $ | 76,262 | $ | — | $ | — | ||||||||
Corporate bonds |
16,111 | 16,111 | — | — | ||||||||||||
Term-deposits |
15,427 | 15,427 | — | — | ||||||||||||
Commercial paper |
9,997 | 9,997 | — | — | ||||||||||||
State and local government ARS |
6,900 | — | — | 6,900 | ||||||||||||
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Total short-term investments |
$ | 124,697 | $ | 117,797 | $ | — | $ | 6,900 | ||||||||
Long-term investments: |
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ARS Call Option |
$ | 648 | $ | — | $ | — | $ | 648 | ||||||||
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Total long-term investments |
$ | 648 | $ | — | $ | — | $ | 648 | ||||||||
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Total |
$ | 514,644 | $ | 507,096 | $ | — | $ | 7,548 | ||||||||
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Fair Value Measurements at July 31, 2010 | ||||||||||||||||
(In thousands) | Carrying Amount | Quoted Market Prices in Active Markets for Identical Assets (Level 1) |
Significant Other Observable Inputs (Level 2) |
Significant Unobservable Inputs (Level 3) |
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Cash and cash equivalents: |
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Cash |
$ | 186,888 | $ | 186,888 | $ | — | $ | — | ||||||||
Treasury bills |
118,725 | 118,725 | — | — | ||||||||||||
Money-market |
88,411 | 88,411 | — | — | ||||||||||||
Commercial paper |
31,499 | 31,499 | — | — | ||||||||||||
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Total cash and cash equivalents |
$ | 425,523 | $ | 425,523 | $ | — | $ | — | ||||||||
Short-term investments: |
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State and local government ARS |
$ | 5,800 | $ | — | $ | — | $ | 5,800 | ||||||||
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Total short-term investments |
$ | 5,800 | $ | — | $ | — | $ | 5,800 | ||||||||
Long-term investments: |
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Student-loan backed ARS |
$ | 131,163 | $ | — | $ | — | $ | 131,163 | ||||||||
State and local government ARS |
22,200 | — | — | 22,200 | ||||||||||||
Auction rate preferred securities |
13,354 | — | — | 13,354 | ||||||||||||
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Total long-term investments |
$ | 166,717 | $ | — | $ | — | $ | 166,717 | ||||||||
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Total |
$ | 598,040 | $ | 425,523 | $ | — | $ | 172,517 | ||||||||
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The Company uses a discounted cash flow model to value its Level 3 investments. For July 30, 2011, the assumptions in the Company’s model for Level 3 investments, excluding the ARS Call Option, included different recovery periods, ranging from two to 11 months depending on the type of security, a discount factor for yield of 0.16% and illiquidity of 0.50%. For July 31, 2010, the assumptions in the Company’s model included different recovery periods, ranging from 11 months to 11 years depending on the type of security, varying discount factors for yield, ranging from 0.1% to 4.4%, and illiquidity, ranging from 0.3% to 4.0%. These assumptions are subjective. They are based on the Company’s current judgment and its view of current market conditions. The use of different assumptions would result in a different valuation and related charge.
As a result of the discounted cash flow analysis, no net impairment loss was recorded for the 13 or 26 weeks ended July 30, 2011. For the 26 weeks ended July 31, 2010, the Company recognized a net impairment of $0.6 million ($0.4 million, net of tax), which increased the total cumulative impairment recognized in OCI as of July 31, 2010 to $10.9 million ($6.8 million, net of tax) from $10.3 million ($6.4 million, net of tax) at the end of Fiscal 2009. The increase in temporary impairment was primarily driven by unfavorable changes in the discount rate. These amounts were recorded in OCI and resulted in a decrease in the investments’ estimated fair values. As a result of a credit rating downgrade on a student-loan backed ARS, the Company also recorded an impairment loss in earnings of $1.2 million during the 13 weeks ended July 31, 2010.
The reconciliation of the Company’s assets measured at fair value on a recurring basis using unobservable inputs (Level 3) is as follows:
Level 3 (Unobservable inputs) | ||||||||||||||||
(In thousands) | Total | State and Local Government ARS |
Student Loan- Backed Auction-Rate Securities |
Auction-Rate Preferred Securities |
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Carrying value at January 30, 2010 |
$ | 202,448 | $ | 40,244 | $ | 149,431 | $ | 12,773 | ||||||||
Settlements |
(28,100 | ) | (12,700 | ) | (15,400 | ) | — | |||||||||
Gains and (losses): |
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Reported in earnings |
(1,248 | ) | — | (1,248 | ) | — | ||||||||||
Reported in OCI |
(583 | ) | 456 | (1,620 | ) | 581 | ||||||||||
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Balance at July 31, 2010 |
$ | 172,517 | $ | 28,000 | $ | 131,163 | $ | 13,354 | ||||||||
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As of July 30, 2011, the Company’s Level 3 (unobservable inputs) included $6.9 million and $0.6 million in state and local government ARS and the ARS Call Option, respectively. The $6.9 million of state and local government ARS are presented net of $2.3 million of settlements during the 26 weeks ended July 30, 2011. Additionally, there was a $0.2 million increase in the carrying value of ARS Call Option reported in earnings during the 26 weeks ended July 30, 2011.
Non-Financial Assets
The Company’s non-financial assets, which include goodwill, intangible assets and property and equipment, are not required to be measured at fair value on a recurring basis. However, if certain triggering events occur, or if an annual impairment test is required and the Company is required to evaluate the non-financial instrument for impairment, a resulting asset impairment would require that the non-financial asset be recorded at the estimated fair value. As a result of the Company’s annual goodwill impairment test performed as of January 29, 2011, the Company concluded that its goodwill was not impaired. During the 13 and 26 weeks ended July 30, 2011, there were no triggering events that prompted an asset impairment test of the Company’s goodwill.
Certain long-lived assets were measured at fair value on a nonrecurring basis using Level 3 inputs as defined in ASC 820. Based on the decision to close all M+O stores in Fiscal 2010, the Company determined that the M+O stores not previously impaired would not be able to generate sufficient cash flow over the life of the related leases to recover the Company’s initial investment in them. Therefore, during the 26 weeks ended July 31, 2010, the M+O stores not previously impaired were written down to their fair value, resulting in a loss on impairment of assets of $18.0 million. The fair value of those stores were determined by estimating the amount and timing of net future cash flows and discounting them using a risk-adjusted rate of interest. The Company estimates future cash flows based on its experience and knowledge of the market in which the store is located.
Refer to Note 13 to the Consolidated Financial Statements for additional information regarding the discontinued operations of M+O.
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6. Property and Equipment
Property and equipment consists of the following:
(In thousands) | July 30, 2011 |
January 29, 2011 |
July 31, 2010 |
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Property and equipment, at cost |
$ | 1,478,208 | $ | 1,432,802 | $ | 1,393,899 | ||||||
Less: Accumulated depreciation |
(842,668 | ) | (789,682 | ) | (736,768 | ) | ||||||
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Property and equipment, net |
$ | 635,540 | $ | 643,120 | $ | 657,131 | ||||||
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7. Intangible Assets
Intangible assets include costs to acquire and register the Company’s trademark assets. During the 26 weeks ended July 30, 2011, the Company purchased $33.5 million of trademark assets primarily to support its international expansion strategy. The following table represents intangible assets as of July 30, 2011, January 29, 2011 and July 31, 2010.
(In thousands) | July 30, 2011 |
January 29, 2011 |
July 31, 2010 |
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Trademarks, at cost |
$ | 43,506 | $ | 9,967 | $ | 8,676 | ||||||
Less: Accumulated amortization |
(3,211 | ) | (2,482 | ) | (2,156 | ) | ||||||
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Intangible assets, net |
$ | 40,295 | $ | 7,485 | $ | 6,520 | ||||||
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Intangible assets are recorded on the basis of cost with amortization computed utilizing the straight-line method over the assets estimated useful life of 15 to 25 years. Amortization expense was $0.7 million and $1.0 million for the 13 and 26 weeks ended July 30, 2011, respectively, and $0.3 million and $0.6 million for the 13 and 26 weeks ended July 31, 2010, respectively.
The table below summarizes the estimated future amortization expense for the next five fiscal years:
(In thousands) | Future Amortization |
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Remainder of 2011 |
$ | 976 | ||
2012 |
1,912 | |||
2013 |
1,912 | |||
2014 |
1,912 | |||
2015 |
1,909 |
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8. Other Credit Arrangements
The Company has borrowing agreements with four separate financial institutions under which it may borrow an aggregate of $295.0 million United States Dollars (“USD”) and $25.0 million Canadian Dollars (“CAD”). Of this amount, $185.0 million USD can be used for demand letter of credit issuances, $50.0 million USD and $25.0 million CAD can be used for demand line borrowings and the remaining $60.0 million USD can be used for either letters of credit or demand line borrowings at the Company’s discretion.
The letter of credit facilities of $150.0 million USD and $35.0 million USD expire November 1, 2011 and May 31, 2012, respectively. The $50.0 million USD and $25.0 million CAD demand lines expire on April 19, 2012 and December 13, 2011, respectively. The remaining $60.0 million USD facility expires on May 22, 2012.
As of July 30, 2011, the Company had outstanding demand letters of credit of $56.0 million USD and no demand line borrowings. The availability of any future borrowings is subject to acceptance by the respective financial institutions.
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9. Comprehensive Income
Comprehensive income is comprised of the following:
(In thousands) | 13 Weeks Ended | 26 Weeks Ended | ||||||||||||||
July 30, 2011 |
July 31, 2010 |
July 30, 2011 |
July 31, 2010 |
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Net income |
$ | 19,669 | $ | 9,663 | $ | 47,994 | $ | 20,585 | ||||||||
Other comprehensive (loss) income: |
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Temporary impairment reversal related to ARS, net of tax (1) |
— | (1,057 | ) | — | (361 | ) | ||||||||||
Foreign currency translation adjustment |
(881 | ) | (749 | ) | 4,620 | 2,773 | ||||||||||
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Other comprehensive (loss) income: |
(881 | ) | (1,806 | ) | 4,620 | 2,412 | ||||||||||
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Total comprehensive income |
$ | 18,788 | $ | 7,857 | $ | 52,614 | $ | 22,997 | ||||||||
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(1) | Amounts are shown net of tax of $1.4 million and $1.0 million for the 13 and 26 weeks ended July 31, 2010, respectively. |
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11. Income Taxes
The provision for income taxes from continuing operations is based on the current estimate of the annual effective income tax rate and is adjusted as necessary for quarterly events. The effective income tax rate from continuing operations based on actual operating results for the 13 weeks ended July 30, 2011 was 36.0% compared to 30.3% for the 13 weeks ended July 31, 2010. The effective income tax rate from continuing operations based on actual operating results for the 26 weeks ended July 30, 2011 was 34.8% compared to 32.0% for the 26 weeks ended July 31, 2010. The lower effective income tax rate for the 13 and 26 weeks ended July 31, 2010 was primarily due to a release of the valuation allowance associated with state income tax credit carryforwards. This valuation allowance was released as a result of a favorable incentive program agreed to with the Kansas Department of Commerce during the 13 weeks ended July 31, 2010 related to the Company’s distribution center in Ottawa, Kansas.
The Company records accrued interest and penalties related to unrecognized tax benefits in income tax expense.
The Company recognizes income tax liabilities related to unrecognized tax benefits in accordance with ASC 740 and adjusts these liabilities when its judgment changes as the result of the evaluation of new information not previously available. Unrecognized tax benefits decreased by $1.5 million and $2.6 million during the 13 weeks ended July 30, 2011 and July 31, 2010, respectively. The decreases were primarily due to federal and state income tax settlements and other changes in income tax reserves. The Company does not anticipate any significant changes to the unrecognized tax benefits recorded at the balance sheet date within the next 12 months.
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12. Legal Proceedings
The Company is subject to certain legal proceedings and claims arising out of the conduct of its business. In accordance with ASC 450, Contingencies (“ASC 450”), management records a reserve for estimated losses when the loss is probable and the amount can be reasonably estimated. If a range of possible loss exists and no anticipated loss within the range is more likely than any other anticipated loss, the Company records the accrual at the low end of the range, in accordance with ASC 450. As the Company believes that it has provided adequate reserves, it anticipates that the ultimate outcome of any matter currently pending against the Company will not materially affect the consolidated financial position or results of operations of the Company.
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13. Discontinued Operations
On March 5, 2010, the Company’s Board approved management’s recommendation to proceed with the closure of the M+O brand. The Company completed the closure of the M+O stores and e-commerce operation during the second quarter of Fiscal 2010. These Consolidated Financial Statements reflect the results of M+O as a discontinued operation for all periods presented.
Costs associated with exit or disposal activities are recorded when incurred. A summary of the exit and disposal costs recognized within Loss from Discontinued Operations on the Consolidated Income Statement for the 13 and 26 weeks ended July 31, 2010 are as follows:
13 Weeks Ended | 26 Weeks Ended | |||||||
(In thousands) | July 31, 2010 | July 31, 2010 | ||||||
Non-cash charges: |
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Asset impairments |
$ | — | $ | 17,980 | ||||
Cash charges: |
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Lease-related charges (1) |
15,481 | 15,481 | ||||||
Inventory charges |
— | 2,422 | ||||||
Severence charges |
2,429 | 7,790 | ||||||
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Total Charges |
$ | 17,910 | $ | 43,673 | ||||
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(1) | Presented net of the reversal of non-cash lease credits. |
The table below presents the significant components of M+O’s results included in Loss from Discontinued Operations on the Consolidated Statement of Operations for the 13 and 26 weeks ended July 31, 2010.
13 Weeks Ended July 31, 2010 |
26 Weeks Ended July 31, 2010 |
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(In thousands) | ||||||||
Net sales |
$ | 10,890 | $ | 21,881 | ||||
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Loss from discontinued operations, before income taxes |
$ | (26,223 | ) | $ | (66,688 | ) | ||
Income tax benefit |
10,043 | 25,568 | ||||||
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Loss from discontinued operations, net of tax |
$ | (16,180 | ) | $ | (41,120 | ) | ||
Loss per common share from discontinued operations: |
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Basic |
$ | (0.08 | ) | $ | (0.20 | ) | ||
Diluted |
$ | (0.08 | ) | $ | (0.20 | ) |
There were no assets or liabilities included in the Consolidated Balance Sheets for M+O as of July 30, 2011 or January 29, 2011. The major classes of assets and liabilities included in the Consolidated Balance Sheets for M+O as of July 31, 2010 are as follows:
(In thousands) | July 31, 2010 | |||
Current assets |
$ | 2,357 | ||
Non-current assets |
— | |||
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Total assets |
$ | 2,357 | ||
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Total current liabilities |
$ | 21,767 | ||
Total non-current liabilities |
— | |||
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Total liabilities |
$ | 21,767 | ||
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Principles of Consolidation
The Consolidated Financial Statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany transactions and balances have been eliminated in consolidation. At July 30, 2011, the Company operated in one reportable segment.
On March 5, 2010, the Company’s Board of Directors (the “Board”) approved management’s recommendation to proceed with the closure of the M+O brand. The Company completed the closure of the M+O stores and e-commerce operation during the second quarter of Fiscal 2010. These Consolidated Financial Statements reflect the results of M+O as a discontinued operation for all periods presented.
Fiscal Year
The Company’s financial year is a 52/53 week year that ends on the Saturday nearest to January 31. As used herein, “Fiscal 2011” refers to the 52 week period ending January 28, 2012. “Fiscal 2010” and “Fiscal 2009” refer to the 52 week periods ended January 29, 2011 and January 30, 2010, respectively.
Estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of our contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. On an ongoing basis, our management reviews its estimates based on currently available information. Changes in facts and circumstances may result in revised estimates.
Recent Accounting Pronouncements
In June 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2011-05, Presentation of Comprehensive Income (“ASU 2011-05”). ASU 2011-05 requires that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In the two-statement approach, the first statement should present total net income and its components followed consecutively by a second statement that should present total other comprehensive income, the components of other comprehensive income and the total of comprehensive income. For public entities, the amendments in ASU 2011-05 are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011, and are to be applied retrospectively, with early adoption permitted. The Company is currently evaluating the impact of ASU 2011-05 on its financial statement presentation of comprehensive income.
Foreign Currency Translation
The Canadian dollar is the functional currency for the Canadian business. In accordance with Accounting Standards Codification (“ASC”) 830, Foreign Currency Matters, assets and liabilities denominated in foreign currencies were translated into U.S. dollars (the reporting currency) at the exchange rate prevailing at the balance sheet date. Revenues and expenses denominated in foreign currencies were translated into U.S. dollars at the monthly average exchange rate for the period. Gains or losses resulting from foreign currency transactions are included in the results of operations, whereas, related translation adjustments are reported as an element of other comprehensive income in accordance with ASC 220, Comprehensive Income (refer to Note 9 to the Consolidated Financial Statements).
Revenue Recognition
Revenue is recorded for store sales upon the purchase of merchandise by customers. The Company’s e-commerce operation records revenue upon the estimated customer receipt date of the merchandise. Shipping and handling revenues are included in net sales. Sales tax collected from customers is excluded from revenue and is included as part of accrued income and other taxes on the Company’s Consolidated Balance Sheets.
Revenue is recorded net of estimated and actual sales returns and deductions for coupon redemptions and other promotions. The Company records the impact of adjustments to its sales return reserve quarterly within net sales and cost of sales. The sales return reserve reflects an estimate of sales returns based on projected merchandise returns determined through the use of historical average return percentages.
Revenue is not recorded on the purchase of gift cards. A current liability is recorded upon purchase, and revenue is recognized when the gift card is redeemed for merchandise. Additionally, the Company recognizes revenue on unredeemed gift cards based on an estimate of the amounts that will not be redeemed (“gift card breakage”), determined through historical redemption trends. Gift card breakage revenue is recognized in proportion to actual gift card redemptions as a component of net sales. For further information on the Company’s gift card program, refer to the Gift Cards caption below.
The Company recognizes revenue generated from its franchise agreements based upon a percentage of merchandise sales by the franchisee. This revenue is recorded as a component of net sales when earned.
The Company sells off end-of-season, overstock and irregular merchandise to a third-party. The proceeds from these sales are presented on a gross basis, with proceeds and cost of sell-offs recorded in net sales and cost of sales, respectively.
Cost of Sales, Including Certain Buying, Occupancy and Warehousing Expenses
Cost of sales consists of merchandise costs, including design, sourcing, importing and inbound freight costs, as well as markdowns, shrinkage and certain promotional costs (collectively “merchandise costs”) and buying, occupancy, and warehousing costs. Buying, occupancy and warehousing costs consist of compensation, employee benefit expenses and travel for our buyers and certain senior merchandising executives; rent and utilities related to our stores, corporate headquarters, distribution centers and other office space; freight from our distribution centers to the stores; compensation and supplies for our distribution centers, including purchasing, receiving and inspection costs; and shipping and handling costs related to our e-commerce operation. Merchandise margin is the difference between net sales and merchandise costs. Gross profit is the difference between net sales and cost of sales.
Selling, General and Administrative Expenses
Selling, general and administrative expenses consist of compensation and employee benefit expenses, including salaries, incentives and related benefits associated with our stores and corporate headquarters. Selling, general and administrative expenses also include advertising costs, supplies for our stores and home office, communication costs, travel and entertainment, leasing costs and services purchased. Selling, general and administrative expenses do not include compensation, employee benefit expenses and travel for our design, sourcing and importing teams, our buyers and our distribution centers as these amounts are recorded in cost of sales.
Other Income (Expense), Net
Other income (expense), net consists primarily of interest income/expense, foreign currency transaction gain/loss and realized investment gain/loss.
Other-than-Temporary Impairment
The Company evaluates its investments for impairment in accordance with ASC 320, Investments – Debt and Equity Securities (“ASC 320”). ASC 320 provides guidance for determining when an investment is considered impaired, whether impairment is other-than-temporary, and measurement of an impairment loss. An investment is considered impaired if the fair value of the investment is less than its cost. If, after consideration of all available evidence to evaluate the realizable value of its investment, impairment is determined to be other-than-temporary, then an impairment loss is recognized in the Consolidated Statement of Operations equal to the difference between the investment’s cost and its fair value. Additionally, ASC 320 requires additional disclosures relating to debt and equity securities both in the interim and annual periods as well as requires the Company to present total other-than-temporary impairment (“OTTI”) with an offsetting reduction for any non-credit loss impairment amount recognized in other comprehensive income (“OCI”).
There was no net impairment loss recognized in earnings during the 13 and 26 weeks ended July 30, 2011.
Cash and Cash Equivalents, Short-term Investments and Long-term Investments
Cash includes cash equivalents. The Company considers all highly liquid investments purchased with a maturity of three months or less to be cash equivalents.
As of July 30, 2011, short-term investments included commercial paper, corporate bonds, treasury bills and term deposits purchased with a maturity of greater than three months, but less than one year. It also includes auction rate securities (“ARS”) classified as available for sale that the Company expects to be redeemed at par within 12 months.
As of July 30, 2011, long-term investments include the Company’s ARS Call Option related to investment sales during Fiscal 2010. The ARS Call Option expires on October 29, 2013.
Unrealized gains and losses on the Company’s available-for-sale securities are excluded from earnings and are reported as a separate component of stockholders’ equity, within accumulated other comprehensive income, until realized. The components of OTTI losses related to credit losses, as defined by ASC 320, are considered by the Company to be realized and are recorded in earnings. When available-for-sale securities are sold, the cost of the securities is specifically identified and is used to determine any realized gain or loss.
Refer to Note 3 to the Consolidated Financial Statements for information regarding cash and cash equivalents, short-term investments and long-term investments.
Merchandise Inventory
Merchandise inventory is valued at the lower of average cost or market, utilizing the retail method. Average cost includes merchandise design and sourcing costs and related expenses. The Company records merchandise receipts at the time merchandise is delivered to the foreign shipping port by the manufacturer (FOB port). This is the point at which title and risk of loss transfer to the Company.
The Company reviews its inventory levels to identify slow-moving merchandise and generally uses markdowns to clear merchandise. Additionally, the Company estimates a markdown reserve for future planned permanent markdowns related to current inventory. Markdowns may occur when inventory exceeds customer demand for reasons of style, seasonal adaptation, changes in customer preference, lack of consumer acceptance of fashion items, competition, or if it is determined that the inventory in stock will not sell at its currently ticketed price. Such markdowns may have a material adverse impact on earnings, depending on the extent and amount of inventory affected. The Company also estimates a shrinkage reserve for the period between the last physical count and the balance sheet date. The estimate for the shrinkage reserve, based on historical results, can be affected by changes in merchandise mix and changes in actual shrinkage trends.
Income Taxes
The Company calculates income taxes in accordance with ASC 740, Income Taxes (“ASC 740”), which requires the use of the asset and liability method. Under this method, deferred tax assets and liabilities are recognized based on the difference between the Consolidated Financial Statement carrying amounts of existing assets and liabilities and their respective tax bases as computed pursuant to ASC 740. Deferred tax assets and liabilities are measured using the tax rates, based on certain judgments regarding enacted tax laws and published guidance, in effect in the years when those temporary differences are expected to reverse. A valuation allowance is established against the deferred tax assets when it is more likely than not that some portion or all of the deferred taxes may not be realized. Changes in the Company’s level and composition of earnings, tax laws or the deferred tax valuation allowance, as well as the results of tax audits may materially impact our effective income tax rate.
The Company evaluates its income tax positions in accordance with ASC 740, which prescribes a comprehensive model for recognizing, measuring, presenting and disclosing in the financial statements tax positions taken or expected to be taken on a tax return, including a decision whether to file or not to file in a particular jurisdiction. Under ASC 740, a tax benefit from an uncertain position may be recognized only if it is “more likely than not” that the position is sustainable based on its technical merits.
The calculation of the deferred tax assets and liabilities, as well as the decision to recognize a tax benefit from an uncertain position and to establish a valuation allowance require management to make estimates and assumptions. The Company believes that its assumptions and estimates are reasonable, although actual results may have a positive or negative material impact on the balances of deferred tax assets and liabilities, valuation allowances or net income.
Property and Equipment
Property and equipment is recorded on the basis of cost with depreciation computed utilizing the straight-line method over the assets’ estimated useful lives. The useful lives of our major classes of assets are as follows:
Buildings | 25 years | |
Leasehold improvements | Lesser of 10 years or the term of the lease | |
Fixtures and equipment | 5 years |
In accordance with ASC 360, Property, Plant, and Equipment (“ASC 360”), the Company’s management evaluates the value of leasehold improvements and store fixtures associated with retail stores, which have been open for a period of time sufficient to reach maturity. The Company evaluates long-lived assets for impairment at the individual store level, which is the lowest level at which individual cash flows can be identified. Impairment losses are recorded on long-lived assets used in operations when events and circumstances indicate that the assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amounts of the assets. When events such as these occur, the impaired assets are adjusted to their estimated fair value and an impairment loss is recognized within selling, general and administrative expenses on the Consolidated Statements of Operations.
No asset impairment charges were recorded during the 26 weeks ended July 30, 2011. During the 26 weeks ended July 31, 2010, the Company recorded asset impairment charges of $18.0 million related to the impairment of M+O stores. Based on the Company’s decision to close all M+O stores in Fiscal 2010, the Company determined that the stores not previously impaired would not be able to generate sufficient cash flow over the life of the related leases to recover the Company’s initial investment in them. The asset impairment charges for the 26 weeks ended July 31, 2010 are recorded within Loss from Discontinued Operations on the Consolidated Statements of Operations.
Refer to Note 13 to the Consolidated Financial Statements for additional information regarding the discontinued operations of M+O.
Goodwill
As of July 30, 2011, the Company had approximately $11.7 million of goodwill compared to $11.5 million as of January 29, 2011. The Company’s goodwill is primarily related to the acquisition of its importing operations and Canadian business. The increase in goodwill is due to the fluctuation in the foreign exchange spot rate at which the Canadian goodwill is translated. In accordance with ASC 350, the Company evaluates goodwill for possible impairment on at least an annual basis and last performed an annual impairment test as of January 29, 2011. As a result of the Company’s annual goodwill impairment test, the Company concluded that its goodwill was not impaired.
Intangible Assets
Intangible assets are recorded on the basis of cost with amortization computed utilizing the straight-line method over the assets’ estimated useful lives. The Company’s intangible assets, which primarily include trademark assets, are amortized over 15 to 25 years.
The Company evaluates intangible assets for impairment in accordance with ASC 350 when events or circumstances indicate that the carrying value of the asset may not be recoverable. Such an evaluation includes the estimation of undiscounted future cash flows to be generated by those assets. If the sum of the estimated future undiscounted cash flows are less than the carrying amounts of the assets, then the assets are impaired and are adjusted to their estimated fair value. No intangible asset impairment charges were recorded in both the 13 and 26 weeks ended July 30, 2011 and July 31, 2010.
Refer to Note 7 to the Consolidated Financial Statements for additional information regarding intangible assets.
Gift Cards
The value of a gift card is recorded as a current liability upon purchase, and revenue is recognized when the gift card is redeemed for merchandise. The Company estimates gift card breakage and recognizes revenue in proportion to actual gift card redemptions as a component of net sales. The Company determines an estimated gift card breakage rate by continuously evaluating historical redemption data and the time when there is a remote likelihood that a gift card will be redeemed. During the 13 weeks ended July 30, 2011 and July 31, 2010, the Company recorded $0.9 million and $0.7 million, respectively, of revenue related to gift card breakage. During the 26 weeks ended July 30, 2011 and July 31, 2010, the Company recorded $2.0 million and $1.7 million, respectively, of revenue related to gift card breakage.
Deferred Lease Credits
Deferred lease credits represent the unamortized portion of construction allowances received from landlords related to the Company’s retail stores. Construction allowances are generally comprised of cash amounts received by the Company from its landlords as part of the negotiated lease terms. The Company records a receivable and a deferred lease credit liability at the lease commencement date (date of initial possession of the store). The deferred lease credit is amortized on a straight-line basis as a reduction of rent expense over the term of the original lease (including the pre-opening build-out period) and any subsequent renewal terms. The receivable is reduced as amounts are received from the landlord.
Co-branded Credit Card and Customer Loyalty Program
The Company offers a co-branded credit card (the “AEO Visa Card”) and a private label credit card (the “AEO Credit Card”) under the American Eagle, aerie and 77kids brands. These credit cards are issued by a third-party bank (the “Bank”), and the Company has no liability to the Bank for bad debt expense, provided that purchases are made in accordance with the Bank’s procedures. Once a customer is approved to receive the AEO Visa Card or the AEO Credit Card and the card is activated, the customer is eligible to participate in the credit card rewards program. Customers who make purchases at AE, aerie and 77kids earn discounts in the form of savings certificates when certain purchase levels are reached. Also, AEO Visa Card customers who make purchases at other retailers where the card is accepted earn additional discounts. Savings certificates are valid for 90 days from issuance.
Points earned under the credit card rewards program on purchases at AE, aerie and 77kids are accounted for by analogy to ASC 605-25, Revenue Recognition, Multiple Element Arrangements (“ASC 605-25”). The Company believes that points earned under its point and loyalty programs represent deliverables in a multiple element arrangement rather than a rebate or refund of cash. Accordingly, the portion of the sales revenue attributed to the award points is deferred and recognized when the award is redeemed or when the points expire. Additionally, credit card reward points earned on non-AE, aerie or 77kids purchases are accounted for in accordance with ASC 605-25. As the points are earned, a current liability is recorded for the estimated cost of the award, and the impact of adjustments is recorded in cost of sales.
The Company offers its customers the AEREWARD$sm loyalty program (the “Program”). Under the Program, customers accumulate points based on purchase activity and earn rewards by reaching certain point thresholds during three-month earning periods. Rewards earned during these periods are valid through the stated expiration date, which is approximately one month from the mailing date of the reward. These rewards can be redeemed for a discount on a purchase of merchandise. Rewards not redeemed during the one-month redemption period are forfeited. The Company determined that rewards earned using the Program should be accounted for in accordance with ASC 605-25. Accordingly, the portion of the sales revenue attributed to the award credits is deferred and recognized when the awards are redeemed or expire.
Segment Information
In accordance with ASC 280, Segment Reporting (“ASC 280”), the Company has identified four operating segments (American Eagle Brand US and Canadian stores, aerie retail stores, 77kids retail stores and AEO Direct) that reflect the basis used internally to review performance and allocate resources. All of the operating segments have been aggregated and are presented as one reportable segment, as permitted by ASC 280.
Reclassification
Certain reclassifications have been made to the Consolidated Financial Statements for prior periods in order to conform to the current period presentation.
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The following table presents the components of net impairment loss recognized in earnings within other income (expense), net on the Consolidated Statement of Operations for the 13 and 26 weeks ended July 31, 2010:
(In thousands) | 13 Weeks Ended July 31, 2010 |
26 Weeks Ended July 31, 2010 |
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Total other-than-temporary impairment losses |
($ | 4,575 | ) | ($ | 5,089 | ) | ||
Portion of loss recognized in other comprehensive income, before tax |
3,327 | 3,841 | ||||||
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Net impairment loss recognized in earnings |
($ | 1,248 | ) | ($ | 1,248 | ) | ||
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The useful lives of our major classes of assets are as follows:
Buildings | 25 years | |
Leasehold improvements | Lesser of 10 years or the term of the lease | |
Fixtures and equipment | 5 years |
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The following table summarizes the fair market values for the Company’s cash and marketable securities, which are recorded as cash and cash equivalents, short-term investments and long-term investments on the Consolidated Balance Sheets:
(In thousands) | July 30, 2011 |
January 29, 2011 |
July 31, 2010 |
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Cash and cash equivalents: |
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Cash |
$ | 287,753 | $ | 122,578 | $ | 186,888 | ||||||
Money-market |
74,387 | 397,440 | 88,411 | |||||||||
Commercial paper |
23,996 | 40,884 | 31,499 | |||||||||
Treasury bills |
3,163 | 102,996 | 118,725 | |||||||||
Corporate bonds |
— | 3,695 | — | |||||||||
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Total cash and cash equivalents |
$ | 389,299 | $ | 667,593 | $ | 425,523 | ||||||
Short-term investments: |
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Treasury bills |
$ | 76,262 | $ | — | $ | — | ||||||
Corporate bonds |
16,111 | — | — | |||||||||
Term-deposits |
15,427 | 63,402 | — | |||||||||
Commercial paper |
9,997 | — | — | |||||||||
State and local government ARS |
6,900 | 3,700 | 5,800 | |||||||||
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Total short-term investments |
$ | 124,697 | $ | 67,102 | $ | 5,800 | ||||||
Long-term investments: |
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ARS Call Option |
$ | 648 | $ | 415 | $ | — | ||||||
State and local government ARS |
— | 5,500 | 22,200 | |||||||||
Student-loan backed ARS |
— | — | 131,163 | |||||||||
Auction rate preferred securities |
— | — | 13,354 | |||||||||
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Total long-term investments |
$ | 648 | $ | 5,915 | $ | 166,717 | ||||||
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Total |
$ | 514,644 | $ | 740,610 | $ | 598,040 | ||||||
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The following table presents the length of time available-for-sale securities were in continuous unrealized loss positions but were not deemed to be other-than-temporarily impaired. As of July 30, 2011, the fair value of all ARS investments approximated par, with no gross unrealized holding losses.
Less Than 12 Months | Greater Than
or Equal to 12 Months |
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Gross Unrealized Holding Losses |
Fair Value | Gross Unrealized Holding Losses |
Fair Value | |||||||||||||
(In thousands) | ||||||||||||||||
July 31, 2010 |
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Student-loan backed ARS |
$ | (805 | ) | $ | 54,959 | $ | (9,384 | ) | $ | 47,453 | ||||||
Auction rate preferred securities |
— | — | (706 | ) | 14,294 | |||||||||||
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Total (1) |
$ | (805 | ) | $ | 54,959 | $ | (10,090 | ) | $ | 61,747 | ||||||
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(1) | Fair value excludes $58.0 million as of July 31, 2010 of securities whose fair value approximated par. Additionally, as of July 31, 2010, fair value shown above excludes ($2.2) million of OTTI that has been previously recognized in earnings. |
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In accordance with ASC 820, the following table represents the Company’s fair value hierarchy for its financial assets (cash equivalents and investments) measured at fair value on a recurring basis as of July 30, 2011 and July 31, 2010:
Fair Value Measurements at July 30, 2011 | ||||||||||||||||
(In thousands) | Carrying Amount | Quoted Market Prices in Active Markets for Identical Assets (Level 1) |
Significant Other Observable Inputs (Level 2) |
Significant Unobservable Inputs (Level 3) |
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Cash and cash equivalents: |
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Cash |
$ | 287,753 | $ | 287,753 | $ | — | $ | — | ||||||||
Money-market |
74,387 | 74,387 | — | — | ||||||||||||
Commercial paper |
23,996 | 23,996 | — | — | ||||||||||||
Treasury bills |
3,163 | 3,163 | — | — | ||||||||||||
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Total cash and cash equivalents |
$ | 389,299 | $ | 389,299 | $ | — | $ | — | ||||||||
Short-term investments: |
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Treasury bills |
$ | 76,262 | $ | 76,262 | $ | — | $ | — | ||||||||
Corporate bonds |
16,111 | 16,111 | — | — | ||||||||||||
Term-deposits |
15,427 | 15,427 | — | — | ||||||||||||
Commercial paper |
9,997 | 9,997 | — | — | ||||||||||||
State and local government ARS |
6,900 | — | — | 6,900 | ||||||||||||
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Total short-term investments |
$ | 124,697 | $ | 117,797 | $ | — | $ | 6,900 | ||||||||
Long-term investments: |
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ARS Call Option |
$ | 648 | $ | — | $ | — | $ | 648 | ||||||||
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Total long-term investments |
$ | 648 | $ | — | $ | — | $ | 648 | ||||||||
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Total |
$ | 514,644 | $ | 507,096 | $ | — | $ | 7,548 | ||||||||
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Fair Value Measurements at July 31, 2010 | ||||||||||||||||
(In thousands) | Carrying Amount | Quoted Market Prices in Active Markets for Identical Assets (Level 1) |
Significant Other Observable Inputs (Level 2) |
Significant Unobservable Inputs (Level 3) |
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Cash and cash equivalents: |
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Cash |
$ | 186,888 | $ | 186,888 | $ | — | $ | — | ||||||||
Treasury bills |
118,725 | 118,725 | — | — | ||||||||||||
Money-market |
88,411 | 88,411 | — | — | ||||||||||||
Commercial paper |
31,499 | 31,499 | — | — | ||||||||||||
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Total cash and cash equivalents |
$ | 425,523 | $ | 425,523 | $ | — | $ | — | ||||||||
Short-term investments: |
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State and local government ARS |
$ | 5,800 | $ | — | $ | — | $ | 5,800 | ||||||||
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Total short-term investments |
$ | 5,800 | $ | — | $ | — | $ | 5,800 | ||||||||
Long-term investments: |
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Student-loan backed ARS |
$ | 131,163 | $ | — | $ | — | $ | 131,163 | ||||||||
State and local government ARS |
22,200 | — | — | 22,200 | ||||||||||||
Auction rate preferred securities |
13,354 | — | — | 13,354 | ||||||||||||
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Total long-term investments |
$ | 166,717 | $ | — | $ | — | $ | 166,717 | ||||||||
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Total |
$ | 598,040 | $ | 425,523 | $ | — | $ | 172,517 | ||||||||
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The reconciliation of the Company’s assets measured at fair value on a recurring basis using unobservable inputs (Level 3) is as follows:
Level 3 (Unobservable inputs) | ||||||||||||||||
(In thousands) | Total | State and Local Government ARS |
Student Loan- Backed Auction-Rate Securities |
Auction-Rate Preferred Securities |
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Carrying value at January 30, 2010 |
$ | 202,448 | $ | 40,244 | $ | 149,431 | $ | 12,773 | ||||||||
Settlements |
(28,100 | ) | (12,700 | ) | (15,400 | ) | — | |||||||||
Gains and (losses): |
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Reported in earnings |
(1,248 | ) | — | (1,248 | ) | — | ||||||||||
Reported in OCI |
(583 | ) | 456 | (1,620 | ) | 581 | ||||||||||
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Balance at July 31, 2010 |
$ | 172,517 | $ | 28,000 | $ | 131,163 | $ | 13,354 | ||||||||
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Property and equipment consists of the following:
(In thousands) | July 30, 2011 |
January 29, 2011 |
July 31, 2010 |
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Property and equipment, at cost |
$ | 1,478,208 | $ | 1,432,802 | $ | 1,393,899 | ||||||
Less: Accumulated depreciation |
(842,668 | ) | (789,682 | ) | (736,768 | ) | ||||||
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Property and equipment, net |
$ | 635,540 | $ | 643,120 | $ | 657,131 | ||||||
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The following table represents intangible assets as of July 30, 2011, January 29, 2011 and July 31, 2010.
(In thousands) | July 30, 2011 |
January 29, 2011 |
July 31, 2010 |
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Trademarks, at cost |
$ | 43,506 | $ | 9,967 | $ | 8,676 | ||||||
Less: Accumulated amortization |
(3,211 | ) | (2,482 | ) | (2,156 | ) | ||||||
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Intangible assets, net |
$ | 40,295 | $ | 7,485 | $ | 6,520 | ||||||
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The table below summarizes the estimated future amortization expense for the next five fiscal years:
(In thousands) | Future Amortization |
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Remainder of 2011 |
$ | 976 | ||
2012 |
1,912 | |||
2013 |
1,912 | |||
2014 |
1,912 | |||
2015 |
1,909 |
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Comprehensive income is comprised of the following:
(In thousands) | 13 Weeks Ended | 26 Weeks Ended | ||||||||||||||
July 30, 2011 |
July 31, 2010 |
July 30, 2011 |
July 31, 2010 |
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Net income |
$ | 19,669 | $ | 9,663 | $ | 47,994 | $ | 20,585 | ||||||||
Other comprehensive (loss) income: |
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Temporary impairment reversal related to ARS, net of tax (1) |
— | (1,057 | ) | — | (361 | ) | ||||||||||
Foreign currency translation adjustment |
(881 | ) | (749 | ) | 4,620 | 2,773 | ||||||||||
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Other comprehensive (loss) income: |
(881 | ) | (1,806 | ) | 4,620 | 2,412 | ||||||||||
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Total comprehensive income |
$ | 18,788 | $ | 7,857 | $ | 52,614 | $ | 22,997 | ||||||||
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(1) | Amounts are shown net of tax of $1.4 million and $1.0 million for the 13 and 26 weeks ended July 31, 2010, respectively. |
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A summary of the exit and disposal costs recognized within Loss from Discontinued Operations on the Consolidated Income Statement for the 13 and 26 weeks ended July 31, 2010 are as follows:
13 Weeks Ended | 26 Weeks Ended | |||||||
(In thousands) | July 31, 2010 | July 31, 2010 | ||||||
Non-cash charges: |
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Asset impairments |
$ | — | $ | 17,980 | ||||
Cash charges: |
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Lease-related charges (1) |
15,481 | 15,481 | ||||||
Inventory charges |
— | 2,422 | ||||||
Severence charges |
2,429 | 7,790 | ||||||
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Total Charges |
$ | 17,910 | $ | 43,673 | ||||
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(1) | Presented net of the reversal of non-cash lease credits. |
The table below presents the significant components of M+O’s results included in Loss from Discontinued Operations on the Consolidated Statement of Operations for the 13 and 26 weeks ended July 31, 2010.
13 Weeks Ended July 31, 2010 |
26 Weeks Ended July 31, 2010 |
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(In thousands) | ||||||||
Net sales |
$ | 10,890 | $ | 21,881 | ||||
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Loss from discontinued operations, before income taxes |
$ | (26,223 | ) | $ | (66,688 | ) | ||
Income tax benefit |
10,043 | 25,568 | ||||||
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Loss from discontinued operations, net of tax |
$ | (16,180 | ) | $ | (41,120 | ) | ||
Loss per common share from discontinued operations: |
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Basic |
$ | (0.08 | ) | $ | (0.20 | ) | ||
Diluted |
$ | (0.08 | ) | $ | (0.20 | ) |
The major classes of assets and liabilities included in the Consolidated Balance Sheets for M+O as of July 31, 2010 are as follows:
(In thousands) | July 31, 2010 | |||
Current assets |
$ | 2,357 | ||
Non-current assets |
— | |||
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Total assets |
$ | 2,357 | ||
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Total current liabilities |
$ | 21,767 | ||
Total non-current liabilities |
— | |||
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Total liabilities |
$ | 21,767 | ||
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