MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
The following discussion of our financial condition and results of operations should be read together with our consolidated financial statements and notes to those statements included in PART II, ITEM 8 of this report.
Overview
Shoe Carnival, Inc. is one of the nation’s largest family footwear retailers. As of February 3, 2007, we operated 271 stores in 24 states primarily in the Midwest, South and Southeast regions of the United States. We offer a distinctive shopping experience, a broad merchandise assortment and value to our customers while maintaining an efficient store level cost structure.
Our stores combine competitive pricing with a highly promotional, in-store marketing effort that encourages customer participation and creates a fun and exciting shopping experience. We believe this highly promotional atmosphere results in various competitive advantages, including increased multiple unit sales; the building of a loyal, repeat customer base; the creation of word-of-mouth advertising; and enhanced sell through of in-season goods. Our objective is to be the destination store-of-choice for a wide range of consumers seeking moderately priced, current season name brand and private label footwear. Our product assortment includes dress and casual shoes, sandals, boots and a wide assortment of athletic shoes for the entire family. We believe that by offering a wide selection of both athletic and non-athletic footwear, we are able to reduce our exposure to shifts in fashion preferences between those categories. Our ability to identify and react to
fashion changes is a key factor in our sales and earnings performance.
Our marketing effort targets middle income, value-conscious consumers seeking name brand footwear for all age groups. We believe that by offering a wide selection of popular styles of name brand merchandise at competitive prices, we generate broad customer appeal. Our cost-efficient store operations and real estate strategy enable us to price products competitively and earn attractive store level returns. Low labor costs are achieved by housing merchandise directly on the selling floor in an open-stock format, enabling customers who choose to serve themselves. This reduces the staffing required to assist customers and reduces store level labor costs as a percentage of sales. We locate stores predominantly in strip shopping centers in order to take advantage of lower occupancy costs and maximize our exposure to value-oriented shoppers.
Our fiscal year is a 52/53 week year ending on the Saturday closest to January 31. Unless otherwise stated, references to years 2006, 2005, 2004, 2003, and 2002 relate respectively to the fiscal years ended February 3, 2007, January 28, 2006, January 29, 2005, January 31, 2004, and February 1, 2003. Fiscal year 2006 consisted of 53 weeks and the other fiscal years consisted of 52 weeks.
Critical Accounting Policies
It is necessary for us to include certain judgements in our reported financial results. These judgements involve estimates that are inherently uncertain and actual results could differ materially from these estimates. The accounting policies that require the more significant judgements are:
Merchandise Inventories
- Merchandise inventories are stated at the lower of cost or market using the first-in, first-out (FIFO) method. In determining market value, we estimate the future sales price of items of merchandise contained in the inventory as of the balance sheet date. Factors considered in this determination include, among others, current and recently recorded sales prices, the length of time product has been held in inventory and quantities of various product styles contained in inventory. The ultimate amount realized from the sale of certain product could differ materially from our estimates. We also estimate a shrinkage reserve for the period between the last physical count and the balance sheet date. The estimate for the shrinkage reserve can be affected by changes in merchandise mix and changes in actual shrinkage trends.
Valuation of Long-Lived Assets
- We review long-lived assets whenever events or circumstances indicate the carrying value of an asset may not be recoverable and annually when no such event has occurred. We evaluate the ongoing value of assets associated with retail stores that have been open longer than one year. When events such as these occur, the assets subject to impairment are adjusted to estimated fair value and, if applicable, an impairment loss is recorded in selling, general and administrative expenses. Our assumptions and estimates used in the evaluation of impairment, including current and future economic trends for stores, are subject to a high degree of judgement and if actual results or market conditions differ from those anticipated, additional losses may be recorded.
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Income Taxes
- We calculate income taxes in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes”, 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 basis. Deferred tax assets and liabilities are measured using the tax rates in effect in the years when those temporary differences are expected to reverse. Inherent in the measurement of these deferred balances are certain judgements and interpretations of existing tax law and other published guidance as applied to our operations. Tax reserves have been established, which we believe to be adequate in relation to the potential for additional assessments. Once established, reserves are adjusted only when
more information becomes available or when an event occurs necessitating a change to the reserves. Our effective tax rate considers our judgement of expected tax liabilities in the various taxing jurisdictions within which we are subject to tax. We have also been involved in tax audits. At any given time, multiple tax years are subject to audit by various taxing authorities.
2007 Outlook
We anticipate opening between 23 and 25 new stores and closing three stores during fiscal 2007. These new stores will be located in large and small markets primarily within our existing geographic areas. Our intention is to back fill under-penetrated larger markets with additional stores, thereby increasing the performance of the overall market. We believe the following key infrastructure enhancements initiated in fiscal 2006 will support our accelerated growth strategy in fiscal 2007 and beyond.
New Distribution Center
- During the fourth quarter of fiscal 2006, we opened a new 410,000 square foot distribution center. We are leasing the land, building and improvements for an initial period of 15 years. The conversion to this new facility was completed in the first quarter of fiscal 2007. The new distribution center, utilizing state-of-the-art processing and product movement equipment, can support the processing and distribution needs of approximately 465 stores. The facility was designed to be expanded and will ultimately provide us with the processing and storage capacity to support a total of approximately 650 stores.
New Corporate Headquarters
– Construction on our new corporate headquarters is expected to be completed in the second quarter of fiscal 2007. The 60,000 square foot leased facility is designed to meet our specific business needs and has capacity to accommodate additional administrative personnel as we grow our store base. The new corporate headquarters marks an important milestone in our history and serves as a visible sign of our commitment to the ongoing growth and development of the company. During 2007, our projected investment in furniture and fixtures for the new facility will be approximately $2 million.
Information Technology
- In fiscal 2006, we substantially completed the chain-wide implementation of a wide area network (the "WAN"). The WAN has enabled us to achieve immediate operational enhancements and cost savings in a number of areas by providing improved connectivity between our corporate headquarters, new distribution center and store locations. The immediate benefits of the WAN included a reduction in the amount of time required to authorize settlement transactions and a reduction in debit and credit card fees. We expect the WAN to continue to provide improvements in connectivity and enhanced support of new applications in fiscal 2007 and beyond. These new applications include a time and attendance payroll system that was substantially complete in fiscal 2006 and an inventory locator system we expect to implement in fiscal 2007.
Markdown Optimization Software -
In late Spring of 2006, we completed our implementation of Oracle’s Retail Price Optimization solution ("Price Optimization"). Price Optimization is a sophisticated analytical software program that helps our buyers manage in-season pricing and markdowns, taking into account the historical lifecycle of the various product categories and the effect of the various promotions we run. Through enhanced management of product markdowns, we expect to improve inventory turnover, keep our seasonal product fresh and ultimately improve our gross profit margin. Price Optimization also provides a platform for zone pricing which allows us to price an item differently in each zone based on the item’s sell through. Although we believe that the benefit of Price Optimization was minimal to the results for 2006, we expect to see improvements to our profit margin in fiscal 2007 as the software becomes
more integrated with our merchandise processes.
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Results of Operations
The following table sets forth our results of operations expressed as a percentage of net sales for the following fiscal years:
2006
2005
2004
Net sales
100.0
%
100.0
%
100.0
%
Cost of sales (including buying,
distribution and occupancy costs)
70.8
71.1
71.7
Gross profit
29.2
28.9
28.3
Selling, general and
administrative expenses
23.7
24.2
24.8
Operating income
5.5
4.7
3.5
Interest income
(0.2
)
(0.0
)
(0.0
)
Interest expense
0.0
0.1
0.1
Income before income taxes
5.7
4.6
3.4
Income tax expense
2.2
1.7
1.3
Net income
3.5
%
2.9
%
2.1
%
2006 Compared to 2005
Net Sales
In the regular course of business, we offer our customers sales incentives including coupons, discounts, and free merchandise. Sales are recorded net of such incentives and returns and allowances. If an incentive involves free merchandise, that merchandise is recorded as a zero sale and the cost is included in cost of sales. Comparable store sales for the periods indicated include stores that have been open for 13 full months prior to the beginning of the period, including those stores that have been relocated or remodeled. Therefore, stores opened or closed during the periods indicated are not included in comparable store sales.
Net sales increased $26.1 million to $681.7 million in fiscal 2006, a 4.0% increase over net sales of $655.6 million in fiscal 2005. Fiscal 2006 consisted of 53 weeks compared to 52 weeks in fiscal 2005. Sales of approximately $11.5 million were recorded in the extra week of fiscal 2006. Comparable store sales for the 52-week period ended January 27, 2007 increased 1.5%, or approximately $9.5 million. The remaining increase was primarily related to sales generated by our new stores partially offset by the sales decrease resulting from store closings.
Comparable store sales for the 52-week period ended January 27, 2007 increased 4.9% for non-athletic merchandise and decreased 1.1% for athletic product. We attribute the sales decline in athletic product to the current fashion trends favoring dress and casual styles over that of traditional athletic. We made significant progress in fiscal 2006 towards our goal of increasing women’s casual and dress product as a percent of total sales. Historically, women’s non-athletic product has achieved the highest gross profit margin of any of our footwear categories. Our long-term goal is to achieve total sales of 28 to 30 percent in women’s dress and casual merchandise. For fiscal 2006, our women’s non-athletic product rose to 27% of total sales compared to 25% in fiscal 2005.
As we look forward to fiscal 2007, our focus will remain on increasing our brand recognition, as well as focusing on the fashion aspect of our business to drive comparable store sales gains through a combination of increased unit sales and growth in average selling prices.
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Gross Profit
Gross profit increased $9.1 million to $198.8 million in fiscal 2006, a 4.8% increase from gross profit of $189.7 million in fiscal 2005. The gross profit margin for fiscal 2006 increased to 29.2% from 28.9% in fiscal 2005. As a percentage of sales, the merchandise margin increased 0.5% and buying, distribution and occupancy costs increased 0.2%. The increase in merchandise margin, as a percentage of sales, was primarily driven by our continued improvements in inventory management and product assortment which resulted in an increase in average selling price. The increase in buying, distribution and occupancy costs, as a percentage of sales, was due primarily to incremental expenses of approximately $900,000 associated with the opening of a new distribution center during the fourth quarter of fiscal 2006.
Selling, General and Administrative Expenses
Selling, general and administrative expenses increased $2.2 million to $161.1 million in fiscal 2006 from $158.9 million in fiscal 2005. Selling, general and administrative expenses during fiscal 2006, as a percentage of sales, decreased to 23.7% from 24.2% in fiscal 2005. Significant changes in expenses included a $964,000 increase in stock-based compensation and a $826,000 decrease in health care costs. Disclosure regarding our stock-based compensation plans and the effect of the adoption of SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”), is contained in the Notes to the Consolidated Financial Statements contained in PART II, ITEM 8 of this report. Health care costs incurred during fiscal 2005 were unusually high and we believe we experienced a return to a more normal usage of benefits in fiscal 2006. Additionally, at the beginning of our third quarter of fiscal 2006, we entered into an agreement with a new provider
to manage our self-insured health benefits plan. This resulted in year-over-year savings on claim management fees and preferred provider discounts.
The portion of store closing costs included in selling, general and administrative expenses for fiscal 2006 was $621,000, or 0.1% as a percentage of sales. These costs related to six fiscal 2006 store closings and an impairment charge for one store expected to be closed in fiscal 2007. In fiscal 2005, we incurred $1.5 million, or 0.2% as a percentage of sales, in store closing costs related to seven fiscal 2005 store closings and impairment charges for three of the stores that closed in fiscal 2006. The year-over-year decrease was primarily attributable to the impairment charges we recorded in fiscal 2005 for the three stores we closed in fiscal 2006. The timing and actual amount of expense recorded in closing a store can vary significantly on a store-by-store basis depending, in part, on the period in which management commits to a closing plan, the remaining basis in the fixed assets at the store and any amounts required to be paid as part of the lease
termination.
Pre-opening expenses for the 14 new stores in fiscal 2006 and the 15 new stores in fiscal 2005 were approximately $494,000 and $753,000, respectively. Pre-opening expenses represented 0.1% of sales for both years. Pre-opening costs, such as advertising, payroll and supplies, incurred prior to the opening of a new store are charged to expense in the period they are incurred. Our average pre-opening costs per store dropped by nearly 30% in fiscal 2006 to $35,000 from $50,000 in fiscal 2005. This decrease was primarily due to changes in the mix of advertising media selected to advertise our openings and an increase in vendor cooperative advertising funds.
Interest Income and Expense
Interest income increased to $1.2 million in fiscal 2006 from $170,000 in fiscal 2005. The increase was attributable to higher average cash and cash equivalents balances available for investment purposes throughout fiscal 2006. Interest expense decreased to $152,000 in fiscal 2006 from $524,000 in fiscal 2005. The decrease was attributable to the effect of no direct borrowings being incurred during fiscal 2006.
Income Taxes
The effective income tax rate was 38.6% for fiscal 2006 and 38.4% in fiscal 2005. The effective income tax rate for both years differed from the statutory rate due primarily to state and local income taxes, net of the federal tax benefit.
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2005 Compared to 2004
Net Sales
Net sales increased $65.4 million to $655.6 million in fiscal 2005, an 11.1% increase over net sales of $590.2 million in fiscal 2004. Of the increase, $27.8 million was attributable to the sales generated by the 15 stores opened in fiscal 2005 and the effect of a full year’s worth of sales for the 22 stores opened in fiscal 2004, but was partially offset by seven store closings. The balance of the increase was attributable to a comparable store sales increase of 6.9%.
In the last half of fiscal 2004, we undertook two initiatives. The first was to enhance the fashion content of our men’s and women’s non-athletic product and the second was to improve the way in which we advertise to our customers. The record 6.9% comparable store sales gain for fiscal 2005 was due to the results achieved in both our women’s and men’s non-athletic business. Our men’s non-athletic product had a comparable store sales increase of 11.0%. Our women’s non-athletic product had an even greater comparable store sales increase of 14.7%.
Gross Profit
Our gross profit increased $22.5 million to $189.7 million in fiscal 2005, a 13.4% increase from a gross profit of $167.2 million in fiscal 2004. Our gross profit margin, as a percentage of sales, rose to 28.9% for fiscal 2005 as compared to 28.3% for fiscal 2004. As a percentage of sales, the merchandise margin increased 0.2% and buying, distribution and occupancy costs decreased 0.4%. The decrease in buying, distribution and occupancy costs, as a percentage of sales, was due primarily to leveraging occupancy costs against a higher sales base.
Selling, General and Administrative Expenses
Selling, general and administrative expenses increased $12.5 million to $158.9 million in fiscal 2005 from $146.4 million in fiscal 2004. Approximately $5.3 million of this increase was directly attributable to operating the 37 new stores opened in fiscal 2004 and fiscal 2005 (net of seven store closings in fiscal 2005). We also incurred an increase of $1.9 million in health care costs and an increase of $2.2 million for incentive compensation in fiscal 2005 as compared to fiscal 2004. The increase in incentive compensation was primarily a result of higher operating earnings, which is the major component of our performance-based incentive plans.
As a percentage of sales, selling, general and administrative expenses decreased to 24.2% in fiscal 2005 from the prior year at 24.8%. This percentage decrease was primarily due to leveraging expenses against a larger sales base. However, this leveraging was partially offset by a 0.2% increase in employee healthcare and a 0.3% increase in incentive compensation, both as a percentage of sales. The increase in incentive compensation as a percentage of sales was primarily a result of higher operating earnings, which is the major component of our performance-based incentive plans currently in place.
During fiscal 2005, we incurred $1.5 million in store closing costs related to seven fiscal 2005 store closings and impairment charges for three stores that were closed in fiscal 2006. In fiscal 2004, we incurred $565,000 in store closing costs for six stores that were closed in fiscal 2004 and fiscal 2005. The year-over-year increase was primarily attributable to impairment charges for three stores that were closed in fiscal 2006.
The aggregate of pre-opening expenses for the 15 new stores in fiscal 2005 was approximately $753,000, or 0.1% of sales, and was $1.7 million, or 0.3% of sales, for the 22 new stores in fiscal 2004. Our average pre-opening costs per store dropped by nearly 35% in fiscal 2005 to $50,000 from $77,000 in fiscal 2004. Approximately 65% of this decrease was due to an increase in cooperative advertising dollars received from our vendors and differences in advertising costs in markets where we have opened new stores.
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Interest Income and Expense
Interest income increased to $170,000 in fiscal 2005 from $73,000 in fiscal 2004. The increase was attributable to a higher average cash and cash equivalent balance available for investment purposes throughout fiscal 2005. Interest expense decreased to $524,000 in fiscal 2005 from $731,000 in fiscal 2004. The decrease was attributable to the effect of lower average borrowings incurred during fiscal 2005.
Income Taxes
The effective income tax rate was 38.4% for fiscal 2005 and 38.0% in fiscal 2004. The effective income tax rate for both years differed from the statutory rate due primarily to state and local income taxes, net of the federal tax benefit.
Liquidity and Capital Resources
Our sources and uses of cash are summarized as follows:
(000’s)
Fiscal years
2006
2005
2004
Net income plus depreciation and amortization
$
38,232
$
33,556
$
26,957
Deferred income taxes
(2,383
)
(3,824
)
304
Lease incentives
953
874
719
Changes in operating assets and liabilities
(8,676
)
827
(54
)
Other operating activities
1,141
2,252
1,206
Net cash provided by operating activities
29,267
33,685
29,132
Net cash used in investing activities
(17,748
)
(14,524
)
(14,154
)
Net cash provided by (used in ) financing activities
3,016
(3,746
)
(14,160
)
Net increase in cash and cash equivalents
$
14,535
$
15,415
$
818
Our primary sources of funds are cash flows from operations and borrowings under our revolving credit facility. For fiscal 2006, net cash provided by operating activities was $29.3 million compared to net cash provided by operating activities of $33.7 million for fiscal 2005. These amounts reflect the income from operations adjusted for non-cash items and working capital changes. The $4.4 million decrease in cash provided by operating activities between the two respective periods related primarily to higher merchandise inventories at February 3, 2007, partially offset by the increase in net income and stock-based compensation between years. This increase in inventories was mainly due to an increase in store openings and the timing of receipts for the Easter selling season compared to last year.
Working capital increased to $152.2 million at February 3, 2007 from $131.8 million at January 28, 2006, primarily from a $14.5 million increase in cash and cash equivalents and a $12.7 million increase in merchandise inventories. This increase was partially offset by the increases in accounts payable and accrued and other liabilities. The current ratio at February 3, 2007 was 2.8 as compared to 2.7 at January 28, 2006. We had no outstanding long-term debt at February 3, 2007 or January 28, 2006.
Capital expenditures were $25.0 million in fiscal 2006, $14.7 million in fiscal 2005 and $14.2 million in fiscal 2004. No capital lease obligations were incurred during this three year period. Of the fiscal 2006 capital expenditures, approximately $13.1 million was incurred to equip the new distribution center, $5.8 million for new stores, $1.9 million for store remodeling and relocations, and $2.1 million for software and information technology. Lease incentives received from landlords were $953,000, $874,000 and $719,000 for fiscal years 2006, 2005 and 2004, respectively.
Capital expenditures are expected to be $21 million to $22 million in fiscal 2007. Of this amount, approximately $4.6 million represents equipment for the new distribution center and $2 million represents our projected investment in furniture and fixtures for our new corporate headquarters. We intend to open 23 to 25 stores at an expected aggregate cost of between $7.1 million and $7.8 million in fiscal 2007. The remaining capital expenditures are expected to be incurred for store remodels, visual presentation enhancements and various other store improvements, along with continued investments in technology and normal asset replacement activities. The actual amount of cash required for capital expenditures for store operations depends in part on the number of new stores opened, the amount of lease incentives, if any, received from landlords and the number of stores remodeled. The opening of new stores will be dependent upon, among other things, the availability
of desirable locations, the negotiation of acceptable lease terms and general economic and business conditions affecting consumer spending in areas we target for expansion.
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Our current store prototype uses between 6,500 and 12,000 square feet depending upon, among other factors, the location of the store and the population base the store is expected to service. Capital expenditures for a new store in fiscal 2007 are expected to average approximately $310,000. The average inventory investment in a new store is expected to range from $350,000 to $750,000 depending on the size and sales expectation of the store and the timing of the new store opening. Pre-opening expenses, such as advertising, salaries and supplies, are expected to average approximately $48,000 per store in fiscal 2007 as compared to $35,000 in fiscal 2006. On a per-store basis, for the 14 stores opened during fiscal 2006, the initial inventory investment averaged $512,000, capital expenditures averaged $378,000 and lease incentives received from landlords averaged $50,000.
Significant contractual obligations as of February 3, 2007 and the periods in which payments are due include:
(000’s)
Payments Due By Period
Less Than
1-3
4-5
After 5
Contractual Obligations
Total
1 Year
Years
Years
Years
Letters of credit
$
8,697
$
8,697
$
0
$
0
$
0
Operating leases
255,699
41,343
76,085
56,541
81,730
Purchase commitments
176,230
176,230
0
0
0
Deferred compensation
3,149
61
71
134
2,883
Total Contractual Obligations
$
443,775
$
226,331
$
76,156
$
56,675
$
84,613
Our unsecured credit facility provides for up to $70 million in cash advances on a revolving basis and commercial letters of credit. Borrowings under the revolving credit line are based on eligible inventory. The agreement governing the credit facility stipulates a minimum threshold for net worth, a maximum ratio of funded debt plus rent to EBITDA plus rent, and a maximum of total distributions for stock repurchases and cash dividends. We were in compliance with these requirements as of February 3, 2007. Should a default condition be reported, the lenders may preclude additional borrowings and call all loans and accrued interest at their discretion. The credit agreement and amendments thereto are filed as exhibits to (or incorporated by reference in) this Annual Report on Form 10-K. There were no borrowings outstanding under the credit facility and letters of credit outstanding were $8.7 million at February 3, 2007. Estimated interest payments on our line of
credit are not included in the above table as our line of credit is subject to frequent borrowing and/or repayment activities which does not lend itself to reliable forecasting for disclosure purposes. As of February 3, 2007, $61.3 million was available to us for additional borrowings under the credit facility. On December 15, 2006 the credit agreement was amended to extend the maturity date to April 30, 2010 and to allow us to acquire a maximum of $50.0 million of our outstanding shares of common stock. This amendment follows the Board of Director’s December 2006 authorization of a $50.0 million stock buy-back program which will terminate on the earlier of the repurchase of the maximum amount or December 31, 2008. No common stock was repurchased under this plan during fiscal 2006.
We anticipate that our existing cash and cash flow from operations, supplemented by borrowings under our revolving credit line, will be sufficient to fund our planned store expansion, the capital investment required for the new corporate headquarters and distribution center, the repurchase of our common stock under our current repurchase plan and other operating cash requirements for at least the next 12 months.
See Note 5 - “Long Term Debt” and Note 6 - “Leases” to our Notes to Consolidated Financial Statements contained in PART II, ITEM 8 of this report for a discussion of long-term debt and leases, respectively.
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Off-Balance Sheet Arrangements
During fiscal 2006, we completed negotiations to assign two store operating leases to separate third parties. We also remain secondarily liable on one other assignment of an operating lease covering a former store location. We believe that the likelihood of material liability being triggered under these leases is remote, and no liability has been accrued for these contingent lease obligations in our consolidated financial statements as of February 3, 2007. See Note 6 - “Leases” to our Notes to Consolidated Financial Statements contained in PART II, ITEM 8 of this report for further discussion.
Except for the assignment of certain store operating leases and operating leases entered into in the normal course of business, we have not entered into any off-balance sheet arrangements during fiscal 2006 or fiscal 2005, nor did we have any off-balance sheet arrangements outstanding at February 3, 2007 or January 28, 2006.
Seasonality
Our quarterly results of operations have fluctuated, and are expected to continue to fluctuate in the future, primarily as a result of seasonal variances and the timing of sales and costs associated with opening new stores. Non-capital expenditures, such as advertising and payroll, incurred prior to the opening of a new store are charged to expense as incurred. Therefore, our results of operations may be adversely affected in any quarter in which we incur pre-opening expenses related to the opening of new stores.
We have three distinct peak selling periods: Easter, back-to-school and Christmas.
New Accounting Pronouncements
Recent accounting pronouncements applicable to our operations are contained in Note 2 – “Summary of Significant Accounting Policies,” contained in the Notes to Consolidated Financial Statements included in PART II, ITEM 8 of this report.
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