8-K/A

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C. 20549

 

 

FORM 8-K/A

(Amendment No. 1)

 

 

CURRENT REPORT

Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

Date of Report (date of earliest event reported): October 23, 2019

 

 

FRANCHISE GROUP, INC.

(Exact name of registrant as specified in charter)

 

 

 

Delaware   001-35588   27-3561876

(State or other jurisdiction

of incorporation)

 

(Commission

File Number)

 

(I.R.S. Employer

Identification Number)

1716 Corporate Landing Parkway, Virginia Beach, Virginia 23454

(Address of Principal Executive Offices) (Zip Code)

(757) 493-8855

(Registrant’s telephone number, including area code)

Not Applicable

(Former name or former address, if changed since last report)

 

 

Check the appropriate box below if the Form 8-K filing is intended to simultaneously satisfy the filing obligation of the registrant under any of the following provisions (see General Instruction A.2. below):

 

Written communications pursuant to Rule 425 under the Securities Act (17 CFR 230.425)

 

Soliciting material pursuant to Rule 14a-12 under the Exchange Act (17 CFR 240.14a-12)

 

Pre-commencement communications pursuant to Rule 14d-2(b) under the Exchange Act (17 CFR 240.14d-2(b))

 

Pre-commencement communications pursuant to Rule 13e-4(c) under the Exchange Act (17 CFR 240.13e-4(c))

Securities registered pursuant to Section 12(b) of the Exchange Act:

 

Title of each class

 

Trading

Symbol(s)

 

Name of each exchange

on which registered

Common Stock, $0.01 par value   FRG   NASDAQ Global Market

Indicate by check mark whether the registrant is an emerging growth company as defined in Rule 405 of the Securities Act of 1933 (§230.405 of this chapter) or Rule 12b-2 of the Securities Exchange Act of 1934 (§240.12b-2 of this chapter).

Emerging growth company  ☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ☐

 

 

 


Explanatory Note

This Current Report on Form 8-K/A amends each of (i) the Form 8-K previously filed by Franchise Group, Inc. (the “Company”) on October 23, 2019 and (ii) the Form 8-K previously filed by the Company on December 17, 2019. This report includes the financial statements that had been omitted from each of the previously filed Current Reports on Form 8-K as permitted by Item 9.01(a)(4) of Form 8-K.

On October 23, 2019, the Company completed its acquisition (which was previously announced in the Company’s Current Report on Form 8-K filed by the Company with the Securities and Exchange Commission on August 28, 2019) of the Sears Outlet segment and Buddy’s Home Furnishing Stores businesses of Sears Hometown and Outlet Stores, Inc., a Delaware corporation (“SHOS”), each as described in SHOS’s annual report on Form 10-K for the fiscal year ended February 2, 2019 (collectively, the “Business”) of SHOS, pursuant to the terms of the Equity and Asset Purchase Agreement (the “Purchase Agreement”), dated as of August 27, 2019, by and among SHOS, Franchise Group Newco S, LLC (“Newco S”) and the Company (solely for the purposes of Section 10.17 thereto, pursuant to which the Company guaranteed, among other things, the performance of Newco S’s obligations and the payment of amounts due to SHOS under the Purchase Agreement up to and including the closing of the Acquisition (the “Closing”), in addition to agreeing to fund a certain equity contribution to Newco S in order to consummate the Acquisition). At the Closing, pursuant to the Purchase Agreement, Newco S acquired the Business from SHOS (the “Acquisition”) through the purchase of certain assets and the assumption of certain liabilities, as well as the acquisition of the equity interests of certain subsidiaries of SHOS, in each case primarily used in or related to the Business, and the Company’s guarantee obligations under the Purchase Agreement terminated.

On December 16, 2019, pursuant to the terms of the Agreement and Plan of Merger, dated August 7, 2019 (as amended from time to time, the “Merger Agreement”), by and among Vitamin Shoppe, Inc., a Delaware corporation (“Vitamin Shoppe”), the Company, and Valor Acquisition, LLC, a Delaware limited liability company and an indirect subsidiary of the Company (“Merger Sub”), the Company and Vitamin Shoppe completed the merger of Vitamin Shoppe and Merger Sub, with Merger Sub surviving the merger as an indirect subsidiary of the Company (the “Merger”).

The Company is filing this Current Report on Form 8-K/A to provide certain financial statements of Sears Outlet Stores (a carve-out business of SHOS) (“Sears Outlet Stores”) and Vitamin Shoppe and unaudited pro forma financial information of Sears Outlet Stores, Vitamin Shoppe and the Company required by Item 9.01 of Form 8-K and should be read in conjunction with the Company’s Current Reports on Form 8-K previously filed on October 23, 2019 and December 17, 2019.

Item 9.01. Financial Statements and Exhibits

 

(a)

Financial Statements of Business Acquired

The audited combined financial statements of Sears Outlet Stores as of and for the years ended February 2, 2019 and February 3, 2018, including the notes to such financial statements and the report of BDO USA, LLP are filed with this Current Report on Form 8-K/A as Exhibit 99.1 and are incorporated by reference herein.

The unaudited combined financial statements of Sears Outlet Stores as of and for the six months ended August 3, 2019 and August 4, 2018, are filed with this Current Report on Form 8-K/A as Exhibit 99.2 and are incorporated by reference herein.

The audited consolidated financial statements of Vitamin Shoppe as of and for the years ended December 29, 2018, December 30, 2017 and December 31, 2016, including the notes to such financial statements and the report of Deloitte & Touche LLP are filed with this Current Report on Form 8-K/A as Exhibit 99.3 and are incorporated by reference herein.

The unaudited consolidated financial statements of Vitamin Shoppe as of and for the nine months ended September 28, 2019 and September 29, 2018, are filed with this Current Report on Form 8-K/A as Exhibit 99.4 and are incorporated by reference herein.


(b)

Pro forma Financial Information

The unaudited pro forma financial information included with this Current Report on Form 8-K/A has been prepared to illustrate the pro forma effects of the Acquisition, the Merger, the Company’s previously announced merger with Buddy’s Newco, LLC and the Company’s previously announced tender offer to purchase certain of its outstanding shares of common stock and the related debt and equity financings (collectively, the “Transactions”). The unaudited pro forma combined balance sheet as of October 31, 2019 and the unaudited pro forma combined statement of operations for the six months ended October 31, 2019 and year ended April 30, 2019 are filed with this Current Report on Form 8-K/A as Exhibit 99.5 and are incorporated by reference herein. The unaudited pro forma combined balance sheet as of October 31, 2019 gives effect to the Transactions as if they had occurred as of October 31, 2019. The unaudited pro forma combined statements of operations for the six months ended October 31, 2019 and year ended April 30, 2019 gives effect to the Transactions as if they had occurred as of May 1, 2018. All pro forma information in this Current Report on Form 8-K/A has been prepared for informational purposes only and is not necessarily indicative of the past or future results of operations or financial position of Sears Outlet Stores, Vitamin Shoppe or the Company.

 

(d)

Exhibits

The following exhibits are filed herewith:

 

Exhibit No.   

Description of Exhibits

23.1    Consent of BDO USA, LLP
23.2    Consent of Deloitte & Touche LLP
99.1    Combined Financial Statements for Sears Outlet Stores as of and for the years ended February 2, 2019 and February 3, 2018
99.2    Combined Financial Statements for Sears Outlet Stores as of and for the six months ended August 3, 2019 and August 4, 2018
99.3    Consolidated Financial Statements for Vitamin Shoppe as of and for the years ended December 29, 2018, December 30, 2017 and December 31, 2016
99.4    Consolidated Financial Statements for Vitamin Shoppe as of and for the nine months ended September 28, 2019 and September 29, 2018
99.5    Unaudited pro forma combined balance sheet as of October 31, 2019 and the unaudited pro forma combined statement of operations for the six months ended October 31, 2019 and year ended April 30, 2019


EXHIBIT INDEX

 

Exhibit No.   

Description of Exhibits

23.1    Consent of BDO USA, LLP
23.2    Consent of Deloitte & Touche LLP
99.1    Combined Financial Statements for Sears Outlet Stores as of and for the years ended February 2, 2019 and February 3, 2018
99.2    Combined Financial Statements for Sears Outlet Stores as of and for the six months ended August 3, 2019 and August 4, 2018
99.3    Consolidated Financial Statements for Vitamin Shoppe as of and for the years ended December 29, 2018, December 30, 2017 and December 31, 2016
99.4    Consolidated Financial Statements for Vitamin Shoppe as of and for the nine months ended September 28, 2019 and September 29, 2018
99.5    Unaudited pro forma combined balance sheet as of October 31, 2019 and the unaudited pro forma combined statement of operations for the six months ended October 31, 2019 and year ended April  30, 2019


SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.

 

    FRANCHISE GROUP, INC.
Date: January 8, 2020     By:  

/s/ Eric Seeton

      Eric Seeton
      Chief Financial Officer
EX-23.1

Exhibit 23.1

Consent of Independent Auditor

Franchise Group, Inc.

Virginia Beach, Virginia

We hereby consent to the incorporation by reference in the Registration Statement on Form S-8 (No. 333-182585) of Franchise Group, Inc. of our report dated January 7, 2020, relating to the combined financial statements of Sears Outlet Stores (a carve-out business of Sears Hometown and Outlet Stores, Inc.), which appears in this Form 8-K/A.

/s/ BDO USA, LLP

Chicago, Illinois

January 8, 2020

 

EX-23.2

Exhibit 23.2

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

We consent to the incorporation by reference in Registration Statement No. 333-182585 on Form S-8 of Franchise Group, Inc. of our report dated February 26, 2019, relating to the financial statements of Vitamin Shoppe, Inc. appearing in this Current Report on Form 8-K/A dated January 8, 2020.

 

/s/ Deloitte & Touche LLP
Richmond, Virginia
January 8, 2020
EX-99.1

Exhibit 99.1

 

LOGO

SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

Combined Financial Statements

For the Fiscal Years Ended

February 2, 2019 and February 3, 2018

 

   LOGO   

LOGO

 

 

1


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

TABLE OF CONTENTS

 

     Page  

Independent Auditor’s Report

     3  

Combined Statements of Operations for the Fiscal Years Ended February 2, 2019 and February 3, 2018

     4  

Combined Balance Sheets as of February 2, 2019 and February 3, 2018

     5  

Combined Statements of Changes in Equity for the Fiscal Years Ended February 2, 2019 and February 3, 2018

     6  

Combined Statements of Cash Flows for the Fiscal Years Ended February 2, 2019 and February 3, 2018

     7  

Notes to Combined Financial Statements

     8  

 

2


LOGO

  

Tel: 312-856-9100

Fax: 312-856-1379

www.bdo.com

  

330 N. Wabash Avenue, Suite 3200

Chicago, IL 60611

Independent Auditor’s Report

To the Stockholders of Sears Outlet Stores, L.L.C., Leasing Operations, LLC and Outlet Merchandise, LLC

Sears Outlet Stores (a carve-out business of Sears Hometown and Outlet Stores, Inc.)

Hoffman Estates, Illinois

We have audited the accompanying combined financial statements of Sears Outlet Stores (a carve-out business of Sears Hometown and Outlet Stores, Inc.), which comprise the combined balance sheets as of February 2, 2019 and February 3, 2018, and the related combined statements of operations, changes in equity, and cash flows for the fiscal years then ended, and the related notes to the combined financial statements.

Management’s Responsibility for the Combined Financial Statements

Management is responsible for the preparation and fair presentation of these combined financial statements in accordance with accounting principles generally accepted in the United States of America; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of combined financial statements that are free from material misstatement, whether due to fraud or error.

Auditor’s Responsibility

Our responsibility is to express an opinion on these combined financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the combined financial statements are free from material misstatement.

An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the combined financial statements. The procedures selected depend on the auditor’s judgment, including the assessment of the risks of material misstatement of the combined financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity’s preparation and fair presentation of the combined financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the combined financial statements.

We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion.

Opinion

In our opinion, the combined financial statements referred to above present fairly, in all material respects, the financial position of Sears Outlet Stores (a carve-out business of Sears Hometown and Outlet, Inc.) as of February 2, 2019 and February 3, 2018, and the results of its operations and its cash flows for the fiscal years then ended in accordance with accounting principles generally accepted in the United States of America.

Emphasis of Matter

As described in Note 1, on October 23, 2019, Sears Hometown and Outlet Stores, Inc. completed the sale of Sears Outlet Stores (a carve-out business of Sears Hometown and Outlet, Inc.) including substantially all of the assets and liabilities to Franchise Group Newco S, LLC, an indirect subsidiary of Franchise Group, LLC. Our opinion is not modified with respect to this matter.

 

LOGO

Chicago, Illinois

January 7, 2020

 

3


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

COMBINED STATEMENTS OF OPERATIONS

 

In thousands    Year ended
February 2, 2019
    Year ended
February 3, 2018
 

NET SALES

   $ 495,274     $ 543,856  

COSTS AND EXPENSES

    

Cost of sales and occupancy

     361,413       440,876  

Selling and administrative

     124,876       143,859  

Impairment of property and equipment

     1,082       —    

Depreciation and amortization

     6,171       7,661  

Gain on sale of assets

     (1,358     —    
  

 

 

   

 

 

 

Total costs and expenses

     492,184       592,396  
  

 

 

   

 

 

 

Operating income (loss)

     3,090       (48,540

Interest expense

     (6,054     (2,508

Other income

     163       704  
  

 

 

   

 

 

 

Loss before income taxes

     (2,801     (50,344

Income tax expense (benefit)

     263       (108
  

 

 

   

 

 

 

NET LOSS

   $ (3,064   $ (50,236
  

 

 

   

 

 

 

See Notes to Combined Financial Statements.

 

4


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

COMBINED BALANCE SHEETS

 

In thousands    February 2, 2019      February 3, 2018  

ASSETS

     

CURRENT ASSETS

     

Cash and cash equivalents

   $ 445      $ 470  

Accounts and franchisee receivables, net

     2,026        1,282  

Merchandise inventories

     98,237        99,749  

Due from Parent

     2,318        2,533  

Prepaid expenses and other current assets

     7,983        5,773  
  

 

 

    

 

 

 

Total current assets

     111,009        109,807  
  

 

 

    

 

 

 

PROPERTY AND EQUIPMENT, net

     16,902        22,409  

OTHER ASSETS, net

     458        3,647  
  

 

 

    

 

 

 

TOTAL ASSETS

   $ 128,369      $ 135,863  
  

 

 

    

 

 

 

LIABILITIES

     

CURRENT LIABILITIES

     

Payable to related party

   $ 2,843      $ 4,217  

Accounts payable

     16,437        11,507  

Other current liabilities

     24,417        18,350  
  

 

 

    

 

 

 

Total current liabilities

     43,697        34,074  

OTHER LONG-TERM LIABILITIES

     1,600        1,680  
  

 

 

    

 

 

 

TOTAL LIABILITIES

     45,297        35,754  

COMMITMENTS AND CONTINGENCIES

     

EQUITY

     

Net Parent investment

     83,072        100,109  
  

 

 

    

 

 

 

TOTAL LIABILITIES AND EQUITY

   $ 128,369      $ 135,863  
  

 

 

    

 

 

 

See Notes to Combined Financial Statements.

 

5


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

COMBINED STATEMENTS OF CHANGES IN EQUITY

 

In thousands    Net Parent
Investment
 

Balance at January 28, 2017

   $ 113,173  

Net loss

     (50,236

Transfers from Parent

     37,172  
  

 

 

 

Balance at February 3, 2018

     100,109  

Net loss

     (3,064

Transfers to Parent

     (13,469

Cumulative effect adjustment from adoption of new revenue recognition standard

     (504
  

 

 

 

Balance at February 2, 2019

   $ 83,072  
  

 

 

 

See Notes to Combined Financial Statements.

 

6


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

COMBINED STATEMENTS OF CASH FLOWS

 

In thousands    Year ended
February 2, 2019
    Year ended
February 3, 2018
 

CASH FLOWS FROM OPERATING ACTIVITIES

    

Net loss

   $ (3,064   $ (50,236

Adjustments to reconcile net loss to net cash provided by (used in) operating activities:

    

Depreciation and amortization

     6,171       7,661  

Gain on the sale of assets

     (1,358     —    

Impairment of property and equipment

     1,082       —    

Provision for losses on franchisee receivables

     2,839       7,561  

Changes in operating assets and liabilities:

    

Accounts and franchisee receivables

     (3,583     (4,665

Merchandise inventories

     1,512       23,395  

Payable to related party

     (1,374     (11,285

Accounts payable

     4,930       (3,076

Store closing accrual

     (2,967     2,546  

Customer deposits

     971       799  

Due from Parent

     215       1,316  

Other operating assets and liabilities, net

     6,383       (6,186
  

 

 

   

 

 

 

Net cash provided by (used in) operating activities

     11,757       (32,170
  

 

 

   

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES

    

Proceeds from sale of property

     2,837       —    

Purchases of property and equipment

     (1,482     (4,750
  

 

 

   

 

 

 

Net cash provided by (used in) investing activities

     1,355       (4,750
  

 

 

   

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES

    

(Distributions to) contributions from Parent, net

     (13,469     37,172  

Net borrowings from capital lease obligations

     332       —    
  

 

 

   

 

 

 

Net cash (used in) provided by financing activities

     (13,137     37,172  
  

 

 

   

 

 

 

NET CHANGE IN CASH AND CASH EQUIVALENTS

     (25     252  

CASH AND CASH EQUIVALENTS - Beginning of period

     470       218  
  

 

 

   

 

 

 

CASH AND CASH EQUIVALENTS - End of period

   $ 445     $ 470  
  

 

 

   

 

 

 

See Notes to Combined Financial Statements.

 

7


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

NOTES TO COMBINED FINANCIAL STATEMENTS

(Amounts in thousands)

NOTE 1—BACKGROUND, BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Background

Sears Outlet Stores, (“SOS,” the “Company,” “we,” “our,” or “us”) is a carve-out business of Sears Hometown and Outlet Stores, Inc. (“SHO” or “Parent”) which combines the accounts of Sears Outlet Stores, L.L.C., Leasing Operations, LLC, and Outlet Merchandise, LLC. On April 23, 2012, SHO was formed as a wholly owned subsidiary of Sears Holdings, and on October 11, 2012, Sears Holdings completed the separation of SHO. On October 23, 2019, SHO completed the sale of the Company, including substantially all of the assets and liabilities to Franchise Group Newco S, LLC (the “Purchaser”), an indirect subsidiary of Franchise Group, LLC (formerly known as Liberty Tax, Inc.), pursuant to the Equity and Asset Purchase Agreement, dated as of August 27, 2019.

The Company is a national retailer primarily focused on providing customers with in-store and online access to purchase, at prices that are significantly lower than list prices, new, one-of-a-kind, out-of-carton, discontinued, obsolete, used, reconditioned, overstocked, and scratched and dented products across a broad assortment of merchandise categories, including home appliances, apparel, mattresses, lawn and garden equipment, sporting goods and tools.    

As of February 2, 2019, we operated 14 distribution centers and 123 Sears Outlet retail stores in the United States including one distribution center and store in Puerto Rico. Our independent franchisees operated five of our Sears Outlet retail stores. The business model and economic structure of the franchisee operated stores, which are independently owned, are substantially similar to Company-operated stores in many respects. The Company requires all of the stores to operate under specified circumstances according to the Company’s standards. Stores must display the required merchandise, offer all required products and services, and use the Company’s point of sale system. Also, the Company has the right to approve advertising and promotional and marketing materials and imposes specified advertising requirements on the owners. The Company owns the merchandise, establishes all selling prices for the merchandise, and bears general inventory risk (with specific exceptions) until sale of the merchandise and if the customer returns the merchandise. In addition, because each transaction is recorded in the Company’s point of sale system, the Company bears customer credit risk. The Company establishes a commission structure for stores operated by our franchisees and pays commissions when our franchisees sell the merchandise and services. Several of the primary differences between Company-operated stores and franchisee-operated stores are that (1) the Company is responsible for occupancy and payroll costs associated with Company-operated stores while our franchisees are responsible for these costs for their stores, (2) the Company is responsible for all terms and conditions of employment for the employees in the Company-operated stores and our franchisees are responsible for all terms and conditions of employment for the employees in their stores, and (3) we pay commissions to our franchisees.

We also operated eight Buddy’s Home Furnishings stores where we are a franchisee, enabling us to benefit from Buddy’s expertise and system infrastructure in the rent-to-own business which we own the inventory that we rent to our customers.    

Basis of Presentation

Stand-alone financial statements have not been historically prepared for the Company. The accompanying Combined Financial Statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”). These Combined Financial Statements are presented as carve-out financial statements and reflect the combined historical results of operations, balance sheets and cash flows of the Company. All intercompany balances and transactions within the Company have been eliminated in these Combined Financial Statements. As described in Note 7 Related Party Agreements and Transactions, certain transactions between the Company and our Parent have been included in these Combined Financial Statements.

The Combined Balance Sheets reflect, among other things, all the assets and liabilities of the Company that are specifically identifiable as being directly attributable to the Company, including net Parent investment as a component of equity. Net Parent Investment represents our Parent’s historical investment in the Company and includes accumulated net earnings (loss) attributable to our Parent, the net effect of certain transactions with our Parent and our Parent’s subsidiaries, and cost allocations from our Parent that were not historically allocated to the Company.

SHO uses a centralized approach to cash management and financing of its operations. These arrangements are not reflective of the manner in which the Company would have financed its operations had it been a stand-alone business separate from SHO during the periods presented. Cash pooling arrangements are excluded from the asset and liability balances in the Combined Balance Sheets. These amounts have instead been reported as Net Parent Investment.

 

8


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

NOTES TO COMBINED FINANCIAL STATEMENTS

(Amounts in thousands)

 

SHO and its subsidiaries provide a variety of services to the Company. The Combined Statements of Operations includes expense allocations for services and certain support functions that are provided on a centralized basis within SHO such as legal, information technology, human resources, corporate audit, treasury and various other SHO corporate functions that are allocated to the Company and reflected in the Combined Statements of Operations within total costs and expenses. Where allocations of amounts were necessary, the Company believes the allocation of these amounts were determined on a reasonable basis, reflecting all of the costs of the Company, and consistently applied in the periods presented. These allocated amounts, however, are not necessarily indicative of the actual amounts that might have been incurred or realized had the Company operated as a separate stand-alone entity during the periods presented. Consequently, these Combined Financial Statements do not necessarily represent the results the Company would have achieved if the Company had operated as a separate stand-alone entity from SHO during the periods presented.

As noted above, the Company depends on SHO to provide all key products and services to the Company and SHO depends on Transform Holdco (Sears Holdings prior to Transform Holdco acquiring most of the operating assets and assuming the related operative agreements and obligations of Sears Holdings from bankruptcy in mid-February 2019) for most of its key products and services. Consequently, if Transform Holdco is unwilling, unable, or otherwise fails to provide these key products and services or if Transform Holdco’s brands are impaired, the Company could be materially and adversely affected. These key products and services include:

 

 

inventory procurement, including KCD (KENMORE®, CRAFTSMAN®, and DIEHARD®) products and other products, which collectively account for a majority of SHO’s revenue. For the fiscal year ended February 2, 2019, products which SHO acquired through Transform Holdco (Sears Holdings prior to mid-February 2019) accounted for approximately 78% of SHO’s merchandise purchases,

 

 

logistical, supply chain, and inventory support services,

 

 

online, computer and information technology infrastructure (including the point-of-sale system used by the Company and dealers and franchisees), and support,

 

 

use of the Sears brand name and other intellectual property owned by Transform Holdco.

The Company has evaluated for subsequent events through to the date the Combined Financial Statements were available to be issued as at January 7, 2020.

Variable Interest Entities

On an ongoing basis the Company evaluates its business relationships, such as those with its franchisees, to identify potential variable interest entities. Generally, these businesses qualify for a scope exception under the consolidation guidance, or, where a variable interest exists, the Company does not possess the power to direct the activities that most significantly impact the economic performance of these businesses. The Company has not consolidated any of such entities in the periods presented.

SIGNIFICANT ACCOUNTING POLICIES

Fiscal Year

Our fiscal years end on the Saturday closest to January 31. Unless otherwise stated, references to specific years in these notes are to fiscal years. The following fiscal periods are presented herein.

 

Fiscal Year

   Ended      Weeks  

2018

     February 2, 2019        52  

2017

     February 3, 2018        53  

 

9


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

NOTES TO COMBINED FINANCIAL STATEMENTS

(Amounts in thousands)

 

Use of Estimates

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions about future events. The estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as reported amounts of revenues and expenses during the reporting period. We evaluate our estimates and assumptions on an ongoing basis using historical experience and other factors that management believes to be reasonable under the circumstances. Adjustments to estimates and assumptions are made when facts and circumstances dictate. As future events and their effects cannot be determined with absolute certainty, actual results may differ from the estimates used in preparing the accompanying financial statements. Significant estimates and assumptions are required as part of determining inventory and accounts and franchisee receivables valuation, estimating depreciation and recoverability of long-lived assets, establishing insurance, warranty, legal and other reserves, performing long-lived asset impairment analysis, and establishing valuation allowances on deferred income tax assets and reserves for tax examination exposures.

Cash and Cash Equivalents

Cash equivalents include deposits in-transit from banks for payments related to third-party credit card and debit card transactions.

Under SHO’s cash management system, the Company utilizes available borrowings from the Parent, on an as-needed basis, to fund the clearing of checks as they are presented for payment. As of February 2, 2019 and February 3, 2018, outstanding deposits totaling $2.3 million and $2.5 million, respectively, were included in Due from Parent in the Combined Balance Sheets.

Allowance for Doubtful Accounts

We provide an allowance for doubtful accounts based on both historical experience and a specific identification basis. Allowances for doubtful accounts on accounts and franchisee receivable balances were $1.3 million and $3.1 million at February 2, 2019 and February 3, 2018, respectively. Our accounts receivable balance is comprised of various vendor-related and customer-related accounts receivable. Our franchisee receivable balance is comprised of promissory notes that relate primarily to the sale of assets for our franchised locations.

The Company provides an allowance for losses on franchisee receivables (which consist primarily of franchisee promissory notes) in an amount equal to estimated probable losses net of recoveries. The allowance is based on an analysis of expected future write-offs, existing economic conditions, and an assessment of specific identifiable franchisee promissory notes and other franchisee receivables considered at risk or uncollectible. The expense associated with the allowance for losses on franchisee receivables is recognized as selling and administrative expense. As of February 2, 2019, all franchisee receivables have been fully reserved.

Merchandise Inventories

Merchandise inventories are valued at the lower of cost or market. Merchandise inventories are valued under the retail inventory method, or “RIM,” using primarily a last-in, first-out, or “LIFO,” cost-flow assumption.

Inherent in RIM calculations are certain significant management judgments and estimates including, among others, merchandise markons, markups, markdowns, and shrinkage, which significantly impact the ending inventory valuation at cost and resulting gross margins. The methodologies utilized by us in our application of RIM are consistent for all periods presented. Such methodologies include the development of the cost-to-retail ratios, the groupings of homogeneous classes of merchandise, the development of shrinkage and obsolescence reserves, the accounting for price changes, and the computations inherent in the LIFO adjustment (where applicable). Management believes that RIM provides an inventory valuation that reasonably approximates cost and results in carrying inventory at the lower of cost or market.

In connection with our LIFO calculation, we estimate the effects of inflation on inventories by utilizing external price indices determined by the U.S. Bureau of Labor Statistics. If we had used the first-in, first-out, or “FIFO” method of inventory valuation instead of the LIFO method, merchandise inventories would have been insignificantly higher at February 2, 2019 and February 3, 2018.

 

10


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

NOTES TO COMBINED FINANCIAL STATEMENTS

(Amounts in thousands)

 

Vendor Rebates and Allowances

We receive rebates and allowances from vendors through a variety of programs and arrangements intended to offset the costs of promoting and selling the vendors’ products. In addition, Transform Holdco (Sears Holdings prior to February 11, 2019) allocates a portion of the rebates and allowances it receives from vendors based on shipments to or sales of the related products to the Company. Vendor payments are recognized and recorded as a reduction to the cost of merchandise inventories when earned and, thereafter, as a reduction of cost of sales and occupancy as the merchandise is sold. Up-front consideration received from vendors linked to purchases or other commitments is initially deferred and amortized ratably to cost of sales and occupancy over the life of the contract or as performance of the activities specified by the vendor to earn the fee is completed.

Property and Equipment

Property and equipment are recorded at cost, less accumulated depreciation. Additions and substantial improvements are capitalized and include expenditures that materially extend the useful lives of existing facilities and equipment. Maintenance and repairs that do not materially improve or extend the lives of the respective assets are expensed as incurred.

Property and equipment consist of the following:

 

In thousands    February 2, 2019      February 3, 2018  

Land

   $ 409      $ 512  

Buildings and improvements

     30,517        33,329  

Furniture, fixtures and equipment

     16,438        20,014  

Construction in progress

     1,056        1,016  

Capitalized leases

     436        —    
  

 

 

    

 

 

 

Total property and equipment

     48,856        54,871  

Less: accumulated depreciation

     (31,954      (32,462
  

 

 

    

 

 

 

Total property and equipment, net

   $ 16,902      $ 22,409  
  

 

 

    

 

 

 

Depreciation expense is recorded over the estimated useful lives of the respective assets using the straight-line method for financial statement purposes and accelerated methods for tax purposes. The range of lives are generally 15 to 25 years for buildings, 3 to 10 years for furniture, fixtures, and equipment, and 3 to 5 years for computer systems and equipment. Leasehold improvements are depreciated over the shorter of the associated lease term or the estimated useful life of the asset. Total depreciation expense was $6.0 million and $6.4 million, for fiscal years 2018 and 2017, respectively.

Impairment of Long-Lived Assets and Costs Associated with Exit Activities

In accordance with accounting standards governing the impairment or disposal of long-lived assets, the carrying value of long-lived assets, including property and equipment, is evaluated whenever events or changes in circumstances indicate that a potential impairment has occurred. Factors that could result in an impairment review include, but are not limited to, a current period cash flow loss combined with a history of cash flow losses, current cash flows that may be insufficient to recover the investment in the property over the remaining useful life, or a projection that demonstrates continuing losses associated with the use of a long-lived asset, significant changes in the manner of use of the assets, or significant changes in business strategies. An impairment loss is recognized when the estimated undiscounted cash flows expected to result from the use of the asset plus net proceeds expected from disposition of the asset (if any) are less than the carrying value of the asset. When an impairment loss is recognized, the carrying amount of the asset is reduced to its estimated fair value as determined based on quoted market prices or through the use of other valuation techniques. We recorded impairment charges with respect to long-lived assets of $1.1 million in fiscal year 2018, included in Impairment of property and equipment in the accompanying Combined Statements of Operations. No impairment charges were recorded in fiscal 2017.

 

11


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

NOTES TO COMBINED FINANCIAL STATEMENTS

(Amounts in thousands)

 

We account for costs associated with location closings in accordance with accounting standards pertaining to accounting for costs associated with exit or disposal activities and compensation. When management makes a decision to close a location, we record a reserve as of that date for the expected inventory markdowns associated with the closing. We also record a liability for future lease costs (net of estimated sublease income) when we cease to use the location. As of February 2, 2019 and February 3, 2018, this liability was approximately $0.2 million and $3.2 million, respectively. See Note 8.

Leases

We lease certain stores, office facilities, computers and transportation equipment. The determination of operating and capital lease obligations is based on the expected durations of the leases and contractual minimum lease payments specified in the lease agreements. For certain stores, amounts in excess of these minimum lease payments are payable based upon a specified percentage of sales. Contingent rent is accrued during the period it becomes probable that a particular store will achieve a specified sales level thereby triggering a contingent rental obligation. Certain leases also include an escalation clause or clauses and renewal option clauses calling for increased rents. Where the lease contains an escalation clause or concession such as a rent holiday, rent expense is recognized using the straight-line method over the term of the lease. We recorded rent expense for operating leases in fiscal years 2018 and 2017 of $36.3 million and $46.8 million, respectively, included in Cost of sales and occupancy in the accompanying Combined Statements of Operations.    

We have subleases with Transform Holdco (as assignee) for three locations. We had rent expense paid to Sears Holdings (Transform Holdco after February 11, 2019) of $0.6 million and $1.1 million in fiscal years 2018 and 2017, respectively.

Minimum lease obligations excluding taxes, insurance and other expenses under the operating lease in effect as of February 2, 2019 are as follows:

 

Fiscal Year (in thousands)

   Operating
Leases
 

2019

   $ 35,591  

2020

     31,369  

2021

     25,169  

2022

     18,262  

2023

     9,351  

Thereafter

     4,374  
  

 

 

 

Total Minimum Lease Payments

     124,116  

Less - Sublease Income on Leased Properties

     (2,979
  

 

 

 

Net Minimum Lease Payments

   $ 121,137  
  

 

 

 

Insurance Programs

Our Parent maintains its own insurance arrangements with third-party insurance companies for exposures incurred for a number of risks including worker’s compensation and general liability claims. In fiscal years 2018 and 2017, the Company recorded insurance expense of $0.6 million and $0.3 million, respectively, which was allocated to the Company consistent with the allocations discussed in Notes 1 and 7.    

Loss Contingencies

We account for contingent losses in accordance with accounting standards pertaining to loss contingencies. Under accounting standards, loss contingency provisions are recorded for probable losses at management’s best estimate of a loss; or when a best estimate cannot be made, a minimum loss contingency amount is recorded. These estimates are often initially developed substantially earlier than the ultimate loss is known, and the estimates are refined each accounting period as additional information is known.

 

12


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

NOTES TO COMBINED FINANCIAL STATEMENTS

(Amounts in thousands)

 

Revenue Recognition

Revenues from contracts with customers include sales of merchandise, commissions on merchandise sales made through www.sears.com, Company websites, services and extended-service plans, financing programs, and delivery and handling revenues related to merchandise sold. Revenue is measured based on the amount of fixed consideration that we expect to receive, reduced by estimates for variable consideration such as returns. Revenue also excludes any amounts collected from customers and remitted or payable to governmental authorities. In arrangements where we have multiple performance obligations, the transaction price is allocated to each performance obligation using the relative stand-alone selling price.

We recognize revenues from retail operations upon the transfer of control of goods to the customer. We satisfy our performance obligations at the point of sale for retail store transactions and upon delivery for online transactions. We defer revenue for retail store and online transactions including commissions on extended-service plans, where we have received consideration but have not transferred control of the goods to the customer at the end of the period. The performance obligation is generally satisfied in the following reporting period. The balance of deferred revenue was $2.2 million and $1.2 million at February 2, 2019 and February 3, 2018, respectively. The change in deferred revenue represents revenue recognized during fiscal year 2018.

We recognize revenues from commissions on services, and delivery and handling revenues related to merchandise sold, at the point of sale as we are not the primary obligor with respect to such services and have no future obligations for future performance.    Commissions earned on services, and delivery and handling revenues, are presented net of related costs because we are acting as an agent in arranging the services for the customer and do not control the services being rendered.

The Company accepts Transform Holdco (Sears Holdings prior to February 11, 2019) gift cards as tender for purchases and is reimbursed weekly by Transform Holdco for gift cards tendered.

Refund Liability and Right of Return Asset

Fiscal 2018. Revenues from merchandise sales and services are reported net of estimated returns and allowances and exclude sales taxes. The typical return period is 30 days. The refund liability for returns is calculated as a percentage of sales based on historical return percentages and recognized at the transaction price as a reduction of revenues. The refund liability was $1.5 million at February 2, 2019. We also recognize a return asset, and corresponding adjustment to cost of sales, for our right to recover the goods returned by the customer, measured at the former carrying amount of the goods, less any expected recovery cost. The right of return asset was $0.6 million at February 2, 2019.

At each financial reporting date, we assess our estimates of expected returns, refund liabilities, and return assets.

Reserve for Sales Returns and Allowances

Fiscal 2017. Revenues from merchandise sales and services are reported net of estimated returns and allowances and exclude sales taxes. The refund liability for returns and allowances, including the impact to gross profit, is calculated as a percentage of sales based on historical return percentages. Estimated returns are recorded as a reduction of sales and cost of sales. The reserve for returns and allowances was $0.5 million at February 3, 2018.

Cost of Sales and Occupancy

Cost of sales and occupancy is comprised principally of merchandise costs, warehousing and distribution (including receiving and store delivery) costs, retail store occupancy costs, home services and installation costs, warranty cost, royalties payable to Transform Holdco related to our sale of products branded with one of the KENMORE®, CRAFTSMAN®, and DIEHARD® marks (the “KCD Marks”), customer shipping and handling costs, vendor allowances, markdowns, and physical inventory losses. The KCD Marks are owned by, or licensed to, subsidiaries of Transform Holdco.

 

13


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

NOTES TO COMBINED FINANCIAL STATEMENTS

(Amounts in thousands)

 

Selling and Administrative Expenses

Selling and administrative expenses are comprised principally of franchisee commissions, payroll and benefits costs for retail and support employees, advertising, pre-opening costs, and other administrative expenses.

Franchisee Commissions

In accordance with our agreements with our franchisees, we pay commissions to our franchisees on the net sales of merchandise and extended-service plans. In addition, each franchisee can earn marketing support, home improvement referrals, rent support, and other items. Commission costs are expensed as incurred and reflected within selling and administrative expenses. Commission costs were $6.4 million and $22.2 million in fiscal years 2018 and 2017, respectively. Commission costs vary based on factors including store count, number of dealer and franchise locations, sales mix, sales volume, and commission rates.

Pre-Opening Costs

Pre-opening and start-up activity costs are expensed in the period in which they occur.

Advertising Costs

Advertising costs are expensed as incurred, generally the first time the advertising occurs, and were $14.6 million and $17.0 million for 2018 and 2017, respectively. These costs are included within selling and administrative expenses in the accompanying Combined Statements of Operations.

Income Taxes

We provide deferred income tax assets and liabilities based on the estimated future tax effects of differences between the financial and tax basis of assets and liabilities based on currently enacted tax laws. The tax balances and income tax expense recognized by us are based on management’s interpretation of the tax laws of multiple jurisdictions. Income tax expense also reflects our best estimates and assumptions regarding, among other things, the level of future taxable income, tax planning, and any valuation allowance. For the year ended February 2, 2019, a valuation allowance of $37.0 million has been recorded for the full amount of the net deferred tax assets. In the future, we may record additional net deferred tax assets; and if future utilization of deferred tax assets is uncertain, we may record additional valuation allowance against such deferred tax assets. In evaluating our ability to recover our deferred tax assets within the jurisdiction from which they arise, we consider all available positive and negative evidence, including scheduled reversals of deferred tax liabilities, projected future taxable income, tax planning strategies, and results of recent operations. In projecting future taxable income, we begin with historical results and incorporate assumptions including the amount of future federal, state and foreign pre-tax operating income (loss), the reversal of temporary differences, and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income.

Tax benefits are recognized when they are more-likely-than-not to be sustained upon examination. The amount recognized is measured as the largest amount of benefit that is more-likely-than-not of being recognized upon settlement. We will be subject to periodic audits by the Internal Revenue Service (“IRS”) and other state local and foreign taxing authorities. Theses audits may challenge certain of the Company’s tax positions such as the timing and amount of income and deductions and the allocation of taxable income to various tax jurisdictions. We evaluate our tax positions and establish liabilities in accordance with the applicable guidance on uncertainty in income taxes. These tax uncertainties are reviewed as facts and circumstances change and are adjusted accordingly. This requires significant management judgment in estimating final outcomes. Actual results could materially differ from these estimates and could significantly affect the effective tax rate and cash flows in future years. Interest and penalties are classified as income tax expense in the Combined Statements of Operations.

Prior to the 2012 Separation, our taxable income was included in the consolidated federal, state and foreign income tax returns of Sears Holdings or its affiliates. Income taxes in these combined financial statements have been recognized on a separate return basis. Under a Tax Sharing Agreement between the Company and Transform Holdco (the “Tax Sharing Agreement”), Transform Holdco is responsible for any federal, state or foreign income tax liability relating to tax periods ending on or before the 2012 Separation; and the Company is responsible for any federal, state or foreign tax liability relating to tax periods ending after the 2012 Separation.

 

14


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

NOTES TO COMBINED FINANCIAL STATEMENTS

(Amounts in thousands)

 

Fair Value of Financial Instruments

We determine the fair value of financial instruments in accordance with standards pertaining to fair value measurements. Such standards define fair value and establish a framework for measuring fair value under U.S. GAAP. Under fair value measurement accounting standards, fair value is considered to be the exchange price in an orderly transaction between market participants to sell an asset or transfer a liability at the measurement date. We report the fair value of financial assets and liabilities based on the fair value hierarchy prescribed by accounting standards for fair value measurements, which prioritizes the inputs to valuation techniques used to measure fair value into three levels, as follows:

Level 1 inputs—unadjusted quoted prices in active markets for identical assets or liabilities that we have the ability to access. An active market for the asset or liability is one in which transactions for the asset or liability occurs with sufficient frequency and volume to provide ongoing pricing information.

Level 2 inputs—inputs other than quoted market prices included in Level 1 that are observable, either directly or indirectly, for the asset or liability. Level 2 inputs include, but are not limited to, quoted prices for similar assets or liabilities in an active market, quoted prices for identical or similar assets or liabilities in markets that are not active, and inputs other than quoted market prices that are observable for the asset or liability, such as interest-rate curves and yield curves observable at commonly quoted intervals, volatilities, credit risks, and default rates.

Level 3 inputs—unobservable inputs for the asset or liability.

Cash and cash equivalents, accounts payable, accrued expenses (Level 1), and accounts and franchisee notes receivable are reflected in the balance sheets at cost, which approximates fair value due to the short-term nature of these instruments. The carrying value of long-term notes receivable approximates fair value.

We may be required, on a nonrecurring basis, to adjust the carrying value of the Company’s long-lived assets. When necessary, these valuations are determined by the Company using Level 3 inputs. These assets are subject to fair value adjustments in certain circumstances as when there is evidence that impairment may exist. As disclosed in Note 1, the Company recorded impairment charges of $1.1 million and $0.0 million on its property and equipment in fiscal years 2018 and 2017, respectively. The Company utilized Level 3 inputs to measure the fair value of property and equipment, and intangible assets.

Recently Issued Accounting Pronouncements

ASU 2016-02 “Leases (Topic 842)”

In February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-02, “Leases (Topic 842)”, which establishes a right-of-use model and requires an entity that is a lessee to recognize the right-of-use assets and liabilities arising from leases on the balance sheet. ASU No. 2016-02 also requires disclosures about the amount, timing, and uncertainty of cash flows arising from leases. Leases will be classified as finance or operating, with classification affecting both the pattern and classification of expense recognition in the statements of earnings. This guidance was subsequently amended by ASU No. 2018-01, Land Easement Practical Expedient for Transition to Topic 842; ASU No. 2018-10, Codification Improvements to Topic 842; and ASU No. 2018-11, Targeted Improvements. ASU No. 2016-02 and subsequent updates require a modified retrospective transition, with the cumulative effect of transition, including initial recognition of lease assets and liabilities for existing operating leases, as of (i) the effective date or (ii) the beginning of the earliest comparative period presented. These updates also provide a number of practical expedients for implementation which we are applying, as discussed below.

 

15


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

NOTES TO COMBINED FINANCIAL STATEMENTS

(Amounts in thousands)

 

Our leases primarily consist of retail space and distribution centers. We completed our initial assessment of the standard as well as implementation of our leasing software, including data upload, and are continuing to finalize our calculations, including validation procedures. We continue establishing new processes and internal controls required to comply with the new lease accounting and disclosure requirements set by the new standard.

On February 3, 2019, we adopted ASU 2016-02. We are using the package of practical expedients that allows companies to not reassess: (1) whether any expired or existing contracts are or contain leases, (2) lease classification for any expired or existing leases, and (3) initial direct costs for any expired or existing leases. We have made accounting policy elections to treat the lease and non-lease components of leases as a single lease component and to exempt leases with an initial term of twelve months or less from balance sheet recognition. Consequently, short-term leases are expensed over the lease term. We did not elect to adopt the hindsight practical expedient and, therefore, will maintain the lease terms previously determined under ASC 840.

The most significant and material impact of adoption was the recognition of right-of-use (“ROU”) assets and lease liabilities on our balance sheet for operating leases. As a result of adopting Topic 842 in our 2019 fiscal year, we recognized an operating ROU asset and lease liability of $116.0 million and $116.4 million, respectively. Existing prepaid rent, accrued rent, and deferred rent were recorded as an offset to our gross operating lease right of use assets. The standard did not have a material impact on our results of operations or cash flows.

Recently Adopted Accounting Pronouncements

ASU 2014-09, “Revenue from Contracts with Customers (Topic 606)”

In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers (Topic 606)”, which supersedes the revenue recognition requirements in Accounting Standards Codification (“ASC”) 605, “Revenue Recognition”. Several additional ASUs have subsequently been issued amending and clarifying the standard. The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance provides a five-step process to achieve that core principle and to determine when and how revenue is recognized. The updates may be applied retrospectively for each period presented or as a cumulative-effect adjustment at the date of adoption.

We adopted this standard on February 4, 2018, using the modified retrospective approach. The impact of the adoption of ASU 2014-09 on our combined financial statements is as follows:

 

   

Our revenue is primarily generated from the sales of merchandise to customers through the retail, e-commerce or wholesale channels. Our performance obligations underlying such sales, and the timing of revenue recognition related thereto, remain substantially unchanged following the adoption of this ASU.

 

   

The adoption of ASU No. 2014-09 requires that we recognize our sales return allowance on a gross basis rather than as a net liability. As such, we now recognize (i) a return asset for the right to recover the goods returned by the customer, measured at the former carrying amount of the goods, less any expected recovery costs (recorded as an increase to prepaid expenses and other current assets), (ii) a return liability for the amount of expected returns (recorded as an increase to other current liabilities), and (iii) deferred revenue for commissions earned on extended protection agreements (recorded as an increase to other current liabilities).

We have made accounting policy elections to (1) exclude from the measurement of transaction price all taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue-producing transaction and collected by us from a customer (sales tax, value added tax, etc.) and (2) account for shipping and handling activities performed after a customer obtains control of the good as activities to fulfill the promise to transfer the good.

We applied ASU No. 2014-09 only to contracts that were not completed prior to fiscal year 2018. The cumulative effect of applying ASU No. 2014-09 was immaterial. The comparative prior period information continues to be reported under the accounting standards in effect during those periods.

 

16


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

NOTES TO COMBINED FINANCIAL STATEMENTS

(Amounts in thousands)

 

NOTE 2—NET SALES

During fiscal year 2018, approximately 98% of our net sales were generated in the United States.

Net sales of merchandise and services were as follows:

 

     Fiscal years ended  
In thousands    February 2, 2019      February 3, 2018  

Merchandise

   $ 453,217      $ 497,143  

Services

     35,424        40,197  

Other

     6,633        6,516  
  

 

 

    

 

 

 

Net sales

   $ 495,274      $ 543,856  
  

 

 

    

 

 

 

NOTE 3—ACCOUNTS AND FRANCHISEE RECEIVABLES AND OTHER ASSETS

Accounts and franchisee receivables and other assets consist of the following:

 

In thousands    February 2, 2019      February 3, 2018  

Short-term franchisee receivables

   $ 393      $ 698  

Miscellaneous receivables

     2,027        1,117  

Long-term franchisee receivables

     930        5,786  

Other assets

     458        420  

Allowance for losses on short-term franchisee receivables

     (394      (340

Allowance for losses on long-term franchisee receivables

     (930      (2,752
  

 

 

    

 

 

 

Net accounts and franchisee receivables and other assets

   $ 2,484      $ 4,929  
  

 

 

    

 

 

 

NOTE 4—ALLOWANCE FOR LOSSES ON FRANCHISEE RECEIVABLES

The allowance for losses on franchisee receivables consists of the following:

 

     Fiscal Years Ended  
In thousands    February 2, 2019      February 3, 2018  

Allowance for losses on franchisee receivables, beginning of period

   $ 3,092      $ 4,299  

Provisions during the period

     2,839        7,561  

Write off of franchisee receivables

     (4,607      (8,768
  

 

 

    

 

 

 

Allowance for losses on franchisee receivables, end of period

   $ 1,324      $ 3,092  
  

 

 

    

 

 

 

On November 2, 2018, the Company and a franchisee entered into a transaction consisting of agreements that terminated all of the franchisee’s franchise agreements and sublease arrangements for 5 franchised locations. The agreements provided that the franchisee transferred ownership of all assets, management of stores, and certain rights to property leases. The assets the Company purchased included all store furniture, fixtures, and equipment. As of the transaction date, the franchisee was the obligor on promissory notes to the Company with a total carrying value, net of reserves, of $2.7 million. As part of the transaction, the Company waived the remaining unpaid principal on these promissory notes. During fiscal year 2018, the Company recognized a loss of $2.7 million on the transaction.

On June 7, 2017, the Company and a franchisee entered into a transaction consisting of agreements that terminated all of the franchisee’s franchise agreements and sublease arrangements for 14 franchised locations (except with respect to one location as to which the Company would either assume the lease or enter into a lease directly with the landlord). The agreements provided that the franchisee transferred ownership of all assets, management of stores, and certain rights to property leases (in one instance

 

17


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

NOTES TO COMBINED FINANCIAL STATEMENTS

(Amounts in thousands)

 

pursuant to an occupancy agreement). The assets the Company purchased included all store furniture, fixtures, and equipment. As of the transaction date, the franchisee was the obligor on promissory notes to the Company with a total carrying value, net of reserves, of $5.5 million. As part of the transaction, the Company waived the remaining unpaid principal on these promissory notes and received a new promissory note from the franchisee in the amount of $1.5 million, which is payable in installments through December 11, 2022. During fiscal year 2017, the Company recognized a loss of $5.5 million on the transaction.

NOTE 5—OTHER CURRENT AND LONG-TERM LIABILITIES

Other current and long-term liabilities consist of the following:

 

In thousands    February 2, 2019      February 3, 2018  

Customer deposits

   $ 1,533      $ 1,226  

Sales and other taxes

     4,927        5,338  

Accrued expenses

     11,751        4,701  

Payroll and related items

     7,593        5,585  

Store closing and severance costs

     213        3,180  
  

 

 

    

 

 

 

Total other current and long-term liabilities

   $ 26,017      $ 20,030  
  

 

 

    

 

 

 

NOTE 6—INCOME TAXES

The Company is included in the Parent’s federal, state and local income tax returns and in its own Puerto Rico partnership return with its corresponding pass through taxable income included in the Parent’s Puerto Rico corporate income tax return. For purposes of these carve-out financial statements, income taxes related to the Company have been presented as if it were a separate taxpayer. Under this approach, the Company determines its current tax liability, deferred tax assets and liabilities and related tax expense as if it were filing separate tax returns in each tax jurisdiction.

Income tax expense in the carve-out statement of operations represents the sum of current tax and deferred tax. Income taxes are presented on a separate tax return basis as if the Company were a standalone entity. The financial statement presentation assumes that in the event a tax attribute was utilized on a combined return of the Parent, the Company has not realized the benefits of the tax attribute unless it could realize the benefit as a standalone taxpayer. Likewise, in the event the Company could utilize a tax attribute on a standalone basis, the Company has realized the benefits of the tax attribute even though it may not have been utilized on the Parent’s combined return.

Tax attributes such as net operating loss carryovers have been recognized by the Parent and by the Company. Because the Company is part of the same legal entity that generated many of these tax attributes, the Parent has estimated the amount of certain attributes attributable to the Company. These attributes, although disclosed herein, may not be transferred in certain transactions.

 

18


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

NOTES TO COMBINED FINANCIAL STATEMENTS

(Amounts in thousands)

 

The provisions for income tax expense for fiscal years 2018 and 2017 consist of the following:

 

     Fiscal Years Ended  
In thousands    February 2, 2019      February 3, 2018  

Loss before income taxes:

     

U.S.

   $ (267    $ (49,727

Foreign

     (2,534      (617
  

 

 

    

 

 

 

Total

   $ (2,801    $ (50,344
  

 

 

    

 

 

 

Income tax expense (benefit):

     

Current:

     

Federal

   $ —        $ —    

State

     98        84  

Foreign

     165        (47
  

 

 

    

 

 

 

Total

     263        37  

Deferred:

     

Federal

     —          (145
  

 

 

    

 

 

 

Total

     —          (145
  

 

 

    

 

 

 

Income tax expense (benefit)

   $ 263      $ (108
  

 

 

    

 

 

 

The provisions for income taxes for financial reporting purposes is different from the tax provision computed by applying the statutory federal tax rate. The reconciliation of the tax rate follows:

 

     Fiscal Years Ended  
     February 2, 2019     February 3, 2018  

Federal tax rate

     21.0     33.7

State income tax (net of federal benefit)

     (2.8 )%      (0.1 )% 

Federal tax rate change

         (23.8 )% 

Valuation allowance

     (21.2 )%      (9.6 )% 

Foreign taxes

     (6.0 )%      0.1

Other

     (0.5 )%      (0.1 )% 
  

 

 

   

 

 

 

Effective tax rate

     (9.5 )%      0.2
  

 

 

   

 

 

 

 

19


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

NOTES TO COMBINED FINANCIAL STATEMENTS

(Amounts in thousands)

 

The major components of the deferred tax assets and liabilities as of February 2, 2019 and February 3, 2018 are as follows:

 

     Fiscal Year Ended  
In thousands    February 2, 2019      February 3, 2018  

Deferred tax assets

     

Bad debts

   $ 355      $ 785  

Inventory

     4,081        2,556  

Deferred compensation

     1,201        442  

Net operating loss

     21,950        21,187  

Property

     1,763        2,201  

Royalty-free license

     5,168        5,796  

Other

     3,028        3,771  
  

 

 

    

 

 

 

Subtotal deferred tax assets

     37,546        36,738  

Valuation allowance

     (37,023      (36,291
  

 

 

    

 

 

 

Total deferred tax assets

     523        447  
  

 

 

    

 

 

 

Deferred tax liabilities

     

Other

     (523      (447
  

 

 

    

 

 

 

Total deferred tax liabilities

     (523      (447
  

 

 

    

 

 

 

Net deferred tax assets

   $ —        $ —    
  

 

 

    

 

 

 

On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act made broad and complex changes to the U.S. tax code that affected our fiscal year ended February

3, 2018, including, but not limited to, (1) reducing the U.S. federal corporate tax rate, (2) eliminating the corporate alternative minimum tax (AMT) and changing how existing AMT credits can be realized, and (3) various other miscellaneous changes that were effective in fiscal 2017. The Tax Act reduced the federal corporate tax rate to 21% in the fiscal year ended February 3, 2018. Based on Section 15 of the Internal Revenue Code, our fiscal year ended February 3, 2018 had a blended corporate tax rate of 33.7%, which is based on the applicable tax rates before and after the Tax Act and the number of days in the year.

The Tax Act also established new tax rules that affect fiscal 2018, including, but not limited to, (1) reduction of the U.S. federal corporate tax rate; (2) the elimination of corporate AMT; (3) a new limitation on deductible interest expense; (4) limitations on the deductibility of certain executive compensation; (5) limitations on the use of foreign tax credits to reduce the U.S. income tax liability; and (6) limitations on net operating losses (“NOL”s) generated in tax years beginning after December 31, 2017, to 80% of taxable income.

The SEC staff issued Staff Accounting Bulletin (“SAB”) No. 118 (“SAB 118”), which provides guidance on accounting for the tax effects of the Tax Act. SAB 118 provides a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under ASC 740, “Income Taxes”. In accordance with SAB 118, a company must reflect the income tax effects of those aspects of the Tax Act for which the accounting under ASC 740 is complete. To the extent that a company’s accounting for certain income tax effects of the Tax Act is incomplete but is able to determine a reasonable estimate, it must record a provisional estimate in the financial statements. If a company cannot determine a provisional estimate to be included in the financial statements, it should continue to apply ASC 740 on the basis of the provisions of the tax laws that were in effect immediately before the enactment of the Tax Act.

In connection with our initial analysis of the impact of the Tax Act, we have recorded a discrete net tax benefit of $0.1 million in the period ended February 3, 2018. This net tax benefit consisted of a reduction in the valuation allowance by $0.1 million as a result of the elimination of the AMT credit as a deferred tax asset and corresponding establishment of a long-term receivable.

All accounting for the Tax Act is complete.

 

20


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

NOTES TO COMBINED FINANCIAL STATEMENTS

(Amounts in thousands)

 

The Tax Act reduces the corporate rate to 21%, effective January 1, 2018. Our net deferred tax assets (“DTA”) and deferred tax liabilities (“DTL”) decreased by $12.0 million with a corresponding net adjustment to the valuation allowance for the year ended February 3, 2018. A deferred tax benefit of $0.1 million was recorded in the period ended February 3, 2018 as a result of a reduction in the valuation allowance due to the elimination of the AMT credit as a deferred tax asset and corresponding establishment of a long-term receivable. During fiscal 2018, the balance of the receivable was increased $0.1million due to an IRS adjustment and related payment of additional AMT associated with a recently completed IRS exam and $0.1 million of the receivable was reclassed to a current asset reflecting the portion expected to be received within 12 months.

We account for income taxes in accordance with accounting standards for such taxes, which require that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the financial reporting and tax bases of recorded assets and liabilities. Accounting standards also require that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax assets will not be realized.

Management assesses the available positive and negative evidence to estimate if sufficient future taxable income will be generated to use the existing deferred tax assets. In performing the assessment for 2017 and 2018, a significant piece of negative evidence evaluated was the cumulative loss incurred over each of the three-year periods ended February 3, 2018 and February 2, 2019. The loss was evaluated as book loss adjusted for non-deductible and non-recurring items such as sale of property, store closing costs, franchise income/expense and software expenses. Such objective evidence limits the ability to consider other subjective evidence such as our projections for future growth.

On the basis of this analysis and significant negative objective evidence, management has determined a full valuation allowance is still necessary for each of the years ended February 3, 2018 and February 2, 2019. The valuation allowance increased by $0.7 million for the current year which was offset by the corresponding increase in net DTA. As of February 2, 2019, a valuation allowance of $37.0 million is recorded for the full amount of the net deferred tax assets. Changes in the valuation allowance are recorded as a non-cash charge for increases or credit for decreases to income tax expense or benefit. A valuation allowance release resulted in a tax benefit of $0.1 million in the year ended February 3, 2018 due to the elimination of the AMT DTA and corresponding establishment of a long-term receivable.

At the end of 2018 and 2017, we had federal NOL carryforwards of $86.8 million and $83.4 million, respectively, which will expire between 2036 and 2038 though the 2018 NOL has an indefinite life. At the end of 2018 and 2017, we had state NOL carryforwards of $4.7 million and $4.6 million, respectively, which will expire between 2019 and 2039 though some of the 2018 state NOLs have an indefinite life. We have credit carryforwards of $0.2 million which will expire between 2023 and 2039.

The operations of the Company are included in the SHO’s federal, state and city income tax returns in the United States and foreign tax returns in Puerto Rico as well as its own partnership return in Puerto Rico. SHO was also a part of the Sears Holdings combined state returns for the years ended February 2, 2013 and February 1, 2014. SHO has completed its federal audit for the tax return ended January 30, 2016 and all matters have been resolved. Currently, SHO is under audit for one separate state returns for fiscal years 2013 through 2016.

NOTE 7—RELATED PARTY AGREEMENTS AND TRANSACTIONS

As the Company is a carve-out business of SHO, SHO and its subsidiaries would be considered related parties to the Company. As discussed in Note 1, SHO provides certain buying, distribution and administrative services to the Company on a centralized basis including finance, legal, information technology, human resources, corporate services and other overhead functions. If not billed directly to the Company, these costs are allocated to the Company to approximate the Company’s proportionate share of such costs and expenses. Allocated costs and expenses include shared occupancy space, interest expense, corporate payroll, business process outsourcing, and liability insurance. The Company is charged for purchases of merchandise made from SHO.

Employees of the Company participate in benefit plans that are sponsored by SHO. See Note 10 – Defined Contribution Plan for more information. SHO also provides stock-based compensation for management of the Company.

 

21


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

NOTES TO COMBINED FINANCIAL STATEMENTS

(Amounts in thousands)

 

Transactions with Parent for the years ended February 3, 2019 and February 2, 2018 consist of the following:

 

In thousands    February 2, 2019      February 3, 2018  

Net Commissions from Transform Holdco

   $ 18,629      $ 22,562  

Purchases from Transform Holdco related to cost of sales and occupancy

     83,039        106,169  

Services from Transform Holdco included in selling and administrative

     13,812        19,890  

Cost of sales and occupancy cost allocations from Parent

     27        (32

Selling and administrative cost allocations from Parent

     14,815        7,812  

Interest expense allocation from Parent

     6,054        2,508  

The Company depends on SHO to provide key products and services to the Company and SHO depends on Transform Holdco (Sears Holdings prior to Transform Holdco acquiring most of the operating assets and assuming the related operative agreements and obligations of Sears Holdings from bankruptcy in mid-February 2019) for most of its key products and services. As of February 2, 2019 and February 3, 2018, the Company recorded $2.8 million and $4.2 million of payable to related party representing an allocation of the Company’s portion of the amount owed by SHO to Transform Holdco (Sears Holdings from bankruptcy in mid-February 2019).

NOTE 8—STORE CLOSING CHARGES

Accelerated Closed Store Charges

Our Parent completed steps to reduce costs, make the best use of capital, and improve our profitability by closing, or seeking the closure of under-performing stores.

In accordance with accounting standards governing costs associated with exit or disposal activities, expenses related to future rent payments for which we no longer expect to receive any economic benefit are accrued when we cease to use the leased space and have been reduced for estimated sublease income.

Accelerated (prior to lease expiration) store closure costs for the fiscal years ended February 2, 2019 and February 3, 2018, respectively, were as follows:

 

In thousands    Lease
Termination
Costs (1)
    Inventory
Related (1)
     Impairment and
Accelerated
Depreciation (2)
     Other
Charges
(3)
     Total Store
Closing Costs
 

Fiscal years ended February 2, 2019

   $ (406   $ —        $ 83      $ 45      $ (278

Fiscal years ended February 3, 2018

     7,148       409        979        168        8,704  

 

(1)

Recorded within cost of sales and occupancy in the Combined Statements of Operations. Lease termination costs are net of estimated sublease income, and include the reversal of closed store reserves when a lease agreement is terminated for an amount less than the remaining reserve established for the store.

(2)

Recorded within depreciation and amortization in the Combined Statements of Operations.

(3)

Recorded within selling and administrative in the Combined Statements of Operations.

 

22


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

NOTES TO COMBINED FINANCIAL STATEMENTS

(Amounts in thousands)

 

Closed Store Reserves

The store closing reserves included within other current liabilities in the Balance Sheets, consists of the following:

 

In thousands    February 2, 2019      February 3, 2018  

Store closing and severance costs reserve, beginning of period

   $ 3,180      $ 634  

Store closing (recovery) costs

     (361      7,725  

Payments/utilization

     (2,606      (5,179
  

 

 

    

 

 

 

Store closing and severance costs reserve, end of period

   $ 213      $ 3,180  
  

 

 

    

 

 

 

NOTE 9—SALE OF ASSETS

On August 10, 2018, we completed the sale of a property in Newington, Connecticut. The sale price of the property was $2.8 million net of closing costs, and we recorded a gain on the sale of approximately $1.4 million when the sale was completed in accordance with the terms and conditions of the Purchase and Sale Agreement. We did not sell any owned property in fiscal year 2017.

NOTE 10 — DEFINED CONTRIBUTION PLAN

Our Parent sponsors a Sears Hometown and Outlet Stores, Inc, 401(k) savings plan for employees meeting service eligibility requirements which offers a discretionary matching contribution. In fiscal years ended February 2, 2019 and February 3, 2018, the Company incurred expenses for the retirement savings plan in the amount of $0.6 million and $0.5 million, respectively. The expense was allocated to the Company consistent with the allocations discussed in Note 7—Related Party Agreements and Transactions.

NOTE 11—COMMITMENTS AND CONTINGENCIES

We are subject to various legal and governmental proceedings arising out of the ordinary course of business, the outcome of which, individually and in the aggregate, in the opinion of management, would not have a material adverse effect on our business, financial position, or results of operations, or cash flows.

NOTE 12 — SUBSEQUENT EVENTS

On October 23, 2019, SHO completed the sale of the Company, including substantially all of the assets and liabilities comprising SOS, to Franchise Group Newco S, LLC (the “Purchaser”), an indirect subsidiary of Franchise Group, LLC (formerly known as Liberty Tax, Inc.), pursuant to an Equity and Asset Purchase Agreement, dated as of August 27, 2019. Pursuant to the terms of the Purchase Agreement, the Purchaser paid SHO an aggregate purchase price, after giving effect to a customary working capital adjustment, of $119,960,000 in cash, and in addition reimbursed SHO for certain costs it incurred in connection with the sale of the Company and certain employee payments and insurance costs incurred by SHO in connection with the Merger.

 

23

EX-99.2

Exhibit 99.2

SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

Combined Financial Statements

For the Twenty Six Weeks Ended

August 3, 2019 and August 4, 2018


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

TABLE OF CONTENTS

 

     Page  

Combined Statements of Operations for the Twenty Six Weeks Ended August 3, 2019 and August 4, 2018

     2  

Combined Balance Sheets as of August 3, 2019 and August 4, 2018

     3  

Combined Statements of Changes in Equity for the Twenty Six Weeks Ended August 3, 2019 and August 4, 2018

     4  

Combined Statements of Cash Flows for the Twenty Six Weeks Ended August 3, 2019 and August 4, 2018

     5  

Notes to Combined Financial Statements

     6  

 

1


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

COMBINED STATEMENTS OF OPERATIONS

 

     26 Weeks Ended  
In thousands    August 3, 2019     August 4, 2018  

NET SALES

   $  234,185     $  257,210  

COST and EXPENSES

    

Cost of sales and occupancy

     169,325       189,098  

Selling and administrative

     51,582       59,321  

Impairment of property and equipment

     —         56  

Depreciation and amortization

     2,113       2,733  

Gain on sale of assets

     (2,877     —    
  

 

 

   

 

 

 

Total costs and expenses

     220,143       251,208  
  

 

 

   

 

 

 

Operating income

     14,042       6,002  

Interest expense

     (1,786     (2,038

Other income

     6       106  
  

 

 

   

 

 

 

Income before taxes

     12,262       4,070  

Income tax expense (benefit)

     290       386  
  

 

 

   

 

 

 

NET INCOME

   $ 12,552     $ 4,456  
  

 

 

   

 

 

 

See Notes to Combined Financial Statements.

 

2


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

COMBINED BALANCE SHEETS

 

In thousands    August 3, 2019      August 4, 2018  

ASSETS

     

CURRENT ASSETS

     

Cash and cash equivalents

   $ 1,413      $ 248  

Accounts and franchisee receivables, net

     1,131        7,112  

Merchandise inventories

     97,027        89,420  

Due from parent

     2,485        3,277  

Prepaid expenses and other current assets

     2,247        6,893  
  

 

 

    

 

 

 

Total current assets

     104,303        106,950  
  

 

 

    

 

 

 

PROPERTY AND EQUIPMENT, net

     15,484        20,132  

OPERATING LEASE RIGHT OF USE ASSET

     108,427     

OTHER ASSETS, net

     798        3,117  
  

 

 

    

 

 

 

TOTAL ASSETS

   $ 229,012      $ 130,199  
  

 

 

    

 

 

 

LIABILITIES

     

CURRENT LIABILITIES

     

Payable to related party

   $ 1,339      $ 3,660  

Accounts payable

     20,018        11,154  

Current operating lease liabilities

     29,274        —    

Other current liablities

     8,640        20,797  
  

 

 

    

 

 

 

Total current liabilities

     59,271        35,611  

LONG TERM OPERATING LEASE LIABILITIES

     79,676     

OTHER LONG-TERM LIABILITIES

     837        1,705  
  

 

 

    

 

 

 

TOTAL LIABILITIES

     139,784        37,316  

EQUITY

     

Net Parent investment

     89,228        92,883  
  

 

 

    

 

 

 

TOTAL LIABILITIES AND EQUITY

   $  229,012      $  130,199  
  

 

 

    

 

 

 

See Notes to Combined Financial Statements.

 

3


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

COMBINED STATEMENTS OF CHANGES IN EQUITY

 

In thousands    August 3, 2019     August 4, 2018  

Net Parent Investment Balance at February 2, 2019 and February 3, 2018

   $  83,072     $  100,109  

Net income

     12,552       4,456  

Transfers (to)/from parent

     (5,876     (11,178

Cumulative effect of adjustment from adoption of new revenue recognition standard

     (520     (504
  

 

 

   

 

 

 

Net Parent Investment Balance at August 3, 2019 and August 4, 2018

   $ 89,228     $ 92,883  

See Notes to Combined Financial Statements.

 

4


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

COMBINED STATEMENTS OF CASH FLOWS

 

In thousands    August 3, 2019     August 4, 2018  

CASH FLOW FROM OPERATING ACTIVITIES

    

Net loss

   $ 12,552     $ 4,456  

Adjustments to reconcile net loss to net cash provided by (used in) operating activities:

    

Depreciation and amortization

     2,368       2,988  

Gain on the sale of assets

     (2,877     —    

Impairment of property and equipment

     —         56  

Provision for lossess on franchisee receivables

     19       99  

Changes in operating assets and liabilitiels:

    

Accounts and franchisee receivables

     876       (5,929

Merchandise inventories

     1,210       10,329  

Payable to related party

     (1,504     (557

Accounts payable

     3,581       (353

Store closing accrual

     (2,967     (2,967

Customer deposits

     971       971  

Due from parent

     (167     (744

Other Operating assets

     (105,423     (5,676

Other Operating liabilities

     (14,544     4,469  
  

 

 

   

 

 

 
     (105,905     7,142  
  

 

 

   

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES

    

Proceeds from sale of property and investments

     2,837       2,837  

Purchase of property and equipment

     1,482       1,482  
  

 

 

   

 

 

 
     4,319       4,319  
  

 

 

   

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES

    

(Distributions to) contributions from Parent, net

     (6,395     (11,683

Net borrowings from capital lease obligations

     108,949       —    
  

 

 

   

 

 

 
     102,554       (11,683
  

 

 

   

 

 

 

NET CHANGE IN CASH AND CASH EQUIVALENTS

     968       (222

CASH AND CASH EQUIVALENTS - Beginning of Period

     445       470  
  

 

 

   

 

 

 

CASH AND CASH EQUIVALENTS - End of Period

   $ 1,413     $ 248  
  

 

 

   

 

 

 

See Notes to Combined Financial Statements.

 

5


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

NOTES TO COMBINED FINANCIAL STATEMENTS

(Amounts in thousands)

NOTE 1—BACKGROUND, BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Background

Sears Outlet Stores, (“SOS,” the “Company,” the “Business”, “we,” “our,” or “us”) is a carve-out business of Sears Hometown and Outlet Stores, Inc. (“SHO” or “Parent”) which combines the accounts of Sears Outlet Stores, L.L.C., Leasing Operations, LLC, Outlet Merchandise, LLC, and the operations of eight Buddy’s Home Furnishings stores where we are a franchisee. On April 23, 2012, SHO was formed as a wholly owned subsidiary of Sears Holdings, and on October 11, 2012, Sears Holdings completed the separation of SHO. On October 23, 2019, SHO completed the sale of the Company, including substantially all of the assets and liabilities to Franchise Group Newco S, LLC (the “Purchaser”), an indirect subsidiary of Franchise Group, LLC (formerly known as Liberty Tax, LLC), pursuant to the Equity and Asset Purchase Agreement, dated as of August 27, 2019.

The Company is a national retailer primarily focused on providing customers with in-store and online access to purchase, at prices that are significantly lower than list prices, new, one-of-a-kind, out-of-carton, discontinued, obsolete, used, reconditioned, overstocked, and scratched and dented products across a broad assortment of merchandise categories, including home appliances, apparel, mattresses, lawn and garden equipment, sporting goods and tools.

As of August 3, 2019, we operated [14] distribution centers and [123] Sears Outlet retail stores in the United States including one distribution center and store in Puerto Rico. Our independent franchisees operated [five] of our Sears Outlet retail stores. The business model and economic structure of the franchisee operated stores, which are independently owned, are substantially similar to Company-operated stores in many respects. The Company requires all of the stores to operate under specified circumstances according to the Company’s standards. Stores must display the required merchandise, offer all required products and services, and use the Company’s point of sale system. Also, the Company has the right to approve advertising and promotional and marketing materials and imposes specified advertising requirements on the owners. The Company owns the merchandise, establishes all selling prices for the merchandise, and bears general inventory risk (with specific exceptions) until sale of the merchandise and if the customer returns the merchandise. In addition, because each transaction is recorded in the Company’s point of sale system, the Company bears customer credit risk. The Company establishes a commission structure for stores operated by our franchisees and pays commissions when our franchisees sell the merchandise and services. Several of the primary differences between Company-operated stores and franchisee-operated stores are that (1) the Company is responsible for occupancy and payroll costs associated with Company-operated stores while our franchisees are responsible for these costs for their stores, (2) the Company is responsible for all terms and conditions of employment for the employees in the Company-operated stores and our franchisees are responsible for all terms and conditions of employment for the employees in their stores, and (3) we pay commissions to our franchisees.

We also operated [eight] Buddy’s Home Furnishings stores where we are a franchisee, enabling us to benefit from Buddy’s expertise and system infrastructure in the rent-to-own business which we own the inventory that we rent to our customers.

Basis of Presentation

Stand-alone financial statements have not been historically prepared for the business. The accompanying Combined Financial Statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States of America. These Combined Financial Statements are presented as carve-out financial statements and reflect the combined historical results of operations, balance sheets and cash flows of the Company. All intercompany balances and transactions within the Company have been eliminated in these Combined Financial Statements. As described in Note 7 Related Party Agreements and Transactions, certain transactions between the Company and our Parent have been included in these Combined Financial Statements.

The Combined Balance Sheets reflect, among other things, all the assets and liabilities of the Company that are specifically identifiable as being directly attributable to the Company, including net Parent investment as a component of equity. Net Parent Investment represents our Parent’s historical investment in the Company and includes accumulated net earnings (loss) attributable to our Parent, the net effect of certain transactions with our Parent and our Parent’s subsidiaries, and cost allocations from our Parent that were not historically allocated to the Company.

SHO uses a centralized approach to cash management and financing of its operations. These arrangements are not reflective of the manner in which the Company would have financed its operations had it been a stand-alone business separate from SHO

during the periods presented. Cash pooling arrangements are excluded from the asset and liability balances in the Combined Balance Sheets. These amounts have instead been reported as Net Parent Investment.

 

6


SEARS HOMETOWN AND OUTLET STORES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

SHO and its subsidiaries provide a variety of services to the Company. The Combined Statements of Operations includes expense

allocations for services and certain support functions that are provided on a centralized basis within SHO such as legal, information technology, human resources, corporate audit, treasury and various other SHO corporate functions that are allocated to the Company and reflected in the Combined Statements of Operations within total costs and expenses. Where allocations of amounts were necessary, the Company believes the allocation of these amounts were determined on a reasonable basis, reflecting all of the costs of the Company, and consistently applied in the periods presented. These allocated amounts, however, are not necessarily indicative of the actual amounts that might have been incurred or realized had the Company operated as a separate stand-alone entity during the periods presented. Consequently, these Combined Financial Statements do not necessarily represent the results the Company would have achieved if the Company had operated as a separate stand-alone entity from SHO during the periods presented.

As noted above, the Company depends on SHO to provide all key products and services to the Company and SHO depends on Transform Holdco (Sears Holdings prior to Transform Holdco acquiring most of the operating assets and assuming the related operative agreements and obligations of Sears Holdings from bankruptcy in mid-February 2019) for most of its key products and services. Consequently, if Transform Holdco is unwilling, unable, or otherwise fails to provide these key products and services or if Transform Holdco’s brands are impaired, the Company could be materially and adversely affected. These key products and services include:

 

   

inventory procurement, including KCD (KENMORE®, CRAFTSMAN®, and DIEHARD®) products and other products, which collectively account for a majority of SHO’s revenue. For the twenty-six weeks ended August 3, 2019, products which SHO acquired through Transform Holdco (Sears Holdings prior to mid-February 2019) accounted for approximately 78% of SHO’s merchandise purchases,

 

   

logistical, supply chain, and inventory support services,

 

   

online, computer and information technology infrastructure (including the point-of-sale system used by the Company and dealers and franchisees), and support,

 

   

use of the Sears brand name and other intellectual property owned by Transform Holdco.

The Company has evaluated for subsequent events through to the date the Combined Financial Statements were available to be issued as at January 7, 2020.

Variable Interest Entities

On an ongoing basis the Company evaluates its business relationships, such as those with its franchisees, to identify potential variable interest entities. Generally, these businesses qualify for a scope exception under the consolidation guidance, or, where a variable interest exists, the Company does not possess the power to direct the activities that most significantly impact the economic performance of these businesses. The Company has not consolidated any of such entities in the periods presented.

SIGNIFICANT ACCOUNTING POLICIES

Fiscal Year

Our second fiscal quarter ends on the Saturday closest to July 31. For 2019 and 2018, our second fiscal quarter ended as follows: The following fiscal periods are presented herein.

 

Fiscal Year

  

Ended

  

Weeks

2019

   August 3, 2019    52

2018

   August 4, 2018    53

Our fiscal years end on the Saturday closest to January 31. Unless otherwise stated, references to specific years and quarters in these notes are to fiscal years and fiscal quarters.

 

7


SEARS HOMETOWN AND OUTLET STORES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions about future events. The estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as reported amounts of revenues and expenses during the reporting period. We evaluate our estimates and assumptions on an ongoing basis using historical experience and other factors that management believes to be reasonable under the circumstances. Adjustments to estimates and assumptions are made when facts and circumstances dictate. As future events and their effects cannot be determined with absolute certainty, actual results may differ from the estimates used in preparing the accompanying financial statements. Significant estimates and assumptions are required as part of determining inventory and accounts and franchisee receivables valuation, estimating depreciation and recoverability of long-lived assets, establishing insurance, warranty, legal and other reserves, performing long-lived asset impairment analysis, and establishing valuation allowances on deferred income tax assets and reserves for tax examination exposures.

Cash and Cash Equivalents

Cash equivalents include deposits in-transit from banks for payments related to third-party credit card and debit card transactions.

Under SHO’s cash management system, the Company utilizes available borrowings from the Parent, on an as-needed basis, to fund the clearing of checks as they are presented for payment. As of August 3, 2019 and August 4, 2018, outstanding deposits totaling $2.5 million and $3.3 million, respectively, were included in Due from Parent in the Combined Balance Sheets.

Allowance for Doubtful Accounts

We provide an allowance for doubtful accounts based on both historical experience and a specific identification basis. Allowances for doubtful accounts on accounts and franchisee receivable balances were $1.3 million and $1.3 million at August 3, 2019 and August 4, 2018, respectively. Our accounts receivable balance is comprised of various vendor-related and customer-related accounts receivable. Our franchisee receivable balance is comprised of promissory notes that relate primarily to the sale of assets for our franchised locations.

The Company provides an allowance for losses on franchisee receivables (which consist primarily of franchisee promissory notes) in an amount equal to estimated probable losses net of recoveries. The allowance is based on an analysis of expected future write-offs, existing economic conditions, and an assessment of specific identifiable franchisee promissory notes and other franchisee receivables considered at risk or uncollectible. The expense associated with the allowance for losses on franchisee receivables is recognized as selling and administrative expense. As of August 3, 2019 and August 4, 2018, all franchisee receivables have been fully reserved.

Merchandise Inventories

Merchandise inventories are valued at the lower of cost or market. Merchandise inventories are valued under the retail inventory method, or “RIM,” using primarily a last-in, first-out, or “LIFO,” cost-flow assumption.

Inherent in RIM calculations are certain significant management judgments and estimates including, among others, merchandise markons, markups, markdowns, and shrinkage, which significantly impact the ending inventory valuation at cost and resulting gross margins. The methodologies utilized by us in our application of RIM are consistent for all periods presented. Such methodologies include the development of the cost-to-retail ratios, the groupings of homogeneous classes of merchandise, the development of shrinkage and obsolescence reserves, the accounting for price changes, and the computations inherent in the LIFO adjustment (where applicable). Management believes that RIM provides an inventory valuation that reasonably approximates cost and results in carrying inventory at the lower of cost or market.

In connection with our LIFO calculation, we estimate the effects of inflation on inventories by utilizing external price indices determined by the U.S. Bureau of Labor Statistics. If we had used the first-in, first-out, or “FIFO” method of inventory valuation instead of the LIFO method, merchandise inventories would have been insignificantly higher at August 3, 2019 and August 4, 2018.

 

8


SEARS HOMETOWN AND OUTLET STORES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

Vendor Rebates and Allowances

We receive rebates and allowances from vendors through a variety of programs and arrangements intended to offset the costs of promoting and selling the vendors’ products. In addition, Transform Holdco (Sears Holdings prior to February 11, 2019) allocates a portion of the rebates and allowances it receives from vendors based on shipments to or sales of the related products to the Company. Vendor payments are recognized and recorded as a reduction to the cost of merchandise inventories when earned and, thereafter, as a reduction of cost of sales and occupancy as the merchandise is sold. Up-front consideration received from vendors linked to purchases or other commitments is initially deferred and amortized ratably to cost of sales and occupancy over the life of the contract or as performance of the activities specified by the vendor to earn the fee is completed.

Property and Equipment

Property and equipment are recorded at cost, less accumulated depreciation. Additions and substantial improvements are capitalized and include expenditures that materially extend the useful lives of existing facilities and equipment. Maintenance and repairs that do not materially improve or extend the lives of the respective assets are expensed as incurred.

Property and equipment consist of the following:

 

In thousands    August 3, 2019      August 4, 2018  

Land

   $ 409      $ 512  

Buildings and improvements

     28,424        33,919  

Furniture, fixtures and equipment

     16,966        16,107  

Construction in progress

     450        913  

Capitalized leases

     436        150  
  

 

 

    

 

 

 

Total property and equipment

     46,685        51,600  

Less: accumulated depreciation

     (31,201      (31,468
  

 

 

    

 

 

 

Total property and equipment, net

   $ 15,484      $ 20,132  
  

 

 

    

 

 

 

Depreciation expense is recorded over the estimated useful lives of the respective assets using the straight-line method for financial statement purposes and accelerated methods for tax purposes. The range of lives are generally 15 to 25 years for buildings, 3 to 10 years for furniture, fixtures, and equipment, and 3 to 5 years for computer systems and equipment. Leasehold improvements are depreciated over the shorter of the associated lease term or the estimated useful life of the asset. Total depreciation expense was $2.1 million and $2.7 million, for twenty six weeks ended August 3, 2019 and August 4, 2018, respectively.

Impairment of Long-Lived Assets and Costs Associated with Exit Activities

In accordance with accounting standards governing the impairment or disposal of long-lived assets, the carrying value of long-lived assets, including property and equipment, is evaluated whenever events or changes in circumstances indicate that a potential impairment has occurred. Factors that could result in an impairment review include, but are not limited to, a current period cash flow loss combined with a history of cash flow losses, current cash flows that may be insufficient to recover the investment in the property over the remaining useful life, or a projection that demonstrates continuing losses associated with the use of a long-lived asset, significant changes in the manner of use of the assets, or significant changes in business strategies. An impairment loss is recognized when the estimated undiscounted cash flows expected to result from the use of the asset plus net proceeds expected from disposition of the asset (if any) are less than the carrying value of the asset. When an impairment loss is recognized, the carrying amount of the asset is reduced to its estimated fair value as determined based on quoted market prices or through the use of other valuation techniques.

 

9


SEARS HOMETOWN AND OUTLET STORES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

We account for costs associated with location closings in accordance with accounting standards pertaining to accounting for costs associated with exit or disposal activities and compensation. When management makes a decision to close a location, we record a reserve as of that date for the expected inventory markdowns associated with the closing. We also record a liability for future lease costs (net of estimated sublease income) when we cease to use the location. As of August 3, 2019 and August 4, 2018, this liability was approximately $0.2 million and $0.2 million, respectively. See Note 8.

Leases

We lease certain stores, office facilities, computers and transportation equipment. The determination of operating and capital lease obligations is based on the expected durations of the leases and contractual minimum lease payments specified in the lease agreements. For certain stores, amounts in excess of these minimum lease payments are payable based upon a specified percentage of sales. Contingent rent is accrued during the period it becomes probable that a particular store will achieve a specified sales level thereby triggering a contingent rental obligation. Certain leases also include an escalation clause or clauses and renewal option clauses calling for increased rents. Where the lease contains an escalation clause or concession such as a rent holiday, rent expense is recognized using the straight-line method over the term of the lease.

Insurance Programs

Our Parent maintains its own insurance arrangements with third-party insurance companies for exposures incurred for a number of risks including worker’s compensation and general liability claims. In the twenty six weeks ended August 3, 2019 and August 4, 2018, the Company recorded insurance expense of $1.5 million and $0.7 million, respectively, which was allocated to the Company consistent with the allocations discussed in Notes 1 and 7.

Loss Contingencies

We account for contingent losses in accordance with accounting standards pertaining to loss contingencies. Under accounting standards, loss contingency provisions are recorded for probable losses at management’s best estimate of a loss; or when a best estimate cannot be made, a minimum loss contingency amount is recorded. These estimates are often initially developed substantially earlier than the ultimate loss is known, and the estimates are refined each accounting period as additional information is known.

Revenue Recognition

Revenues from contracts with customers include sales of merchandise, commissions on merchandise sales made through www.sears.com, Company websites, services and extended-service plans, financing programs, and delivery and handling revenues related to merchandise sold. Revenue is measured based on the amount of fixed consideration that we expect to receive, reduced by estimates for variable consideration such as returns. Revenue also excludes any amounts collected from customers and remitted or payable to governmental authorities. In arrangements where we have multiple performance obligations, the transaction price is allocated to each performance obligation using the relative stand-alone selling price.

We recognize revenues from retail operations upon the transfer of control of goods to the customer. We satisfy our performance obligations at the point of sale for retail store transactions and upon delivery for online transactions. We defer revenue for retail store and online transactions including commissions on extended-service plans, where we have received consideration but have not transferred control of the goods to the customer at the end of the period. The performance obligation is generally satisfied in the following reporting period. The balance of deferred revenue was $2.8 million and $1.9 million at August 3, 2019 and August 4, 2018, respectively. The change in deferred revenue represents revenue recognized during the twenty six weeks ended August 3, 2019.

We recognize revenues from commissions on services, and delivery and handling revenues related to merchandise sold, at the point of sale as we are not the primary obligor with respect to such services and have no future obligations for future performance. Commissions earned on services, and delivery and handling revenues, are presented net of related costs because we are acting as an agent in arranging the services for the customer and do not control the services being rendered.

 

10


SEARS HOMETOWN AND OUTLET STORES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

The Company accepts Transform Holdco (Sears Holdings prior to February 11, 2019) gift cards as tender for purchases and is reimbursed weekly by Transform Holdco for gift cards tendered.

Refund Liability and Right of Return Asset

Revenues from merchandise sales and services are reported net of estimated returns and allowances and exclude sales taxes. The typical return period is 30 days. The refund liability for returns is calculated as a percentage of sales based on historical return percentages and recognized at the transaction price as a reduction of revenues. The refund liability was $1.3 million and $1.9 million at August 3, 2019 and August 4, 2018, respectively. We also recognize a return asset, and corresponding adjustment to cost of sales, for our right to recover the goods returned by the customer, measured at the former carrying amount of the goods, less any expected recovery cost. The right of return asset was $0.5 million and $0.7 million at August 3, 2019 and August 4, 2018, respectively.

At each financial reporting date, we assess our estimates of expected returns, refund liabilities, and return assets.

Cost of Sales and Occupancy

Cost of sales and occupancy is comprised principally of merchandise costs, warehousing and distribution (including receiving and store delivery) costs, retail store occupancy costs, home services and installation costs, warranty cost, royalties payable to Transform Holdco related to our sale of products branded with one of the KENMORE®, CRAFTSMAN®, and DIEHARD® marks (the “KCD Marks”), customer shipping and handling costs, vendor allowances, markdowns, and physical inventory losses. The KCD Marks are owned by, or licensed to, subsidiaries of Transform Holdco.

Selling and Administrative Expenses

Selling and administrative expenses are comprised principally of franchisee commissions, payroll and benefits costs for retail and support employees, advertising, pre-opening costs, and other administrative expenses.

Franchisee Commissions

In accordance with our agreements with our franchisees, we pay commissions to our franchisees on the net sales of merchandise and extended-service plans. In addition, each franchisee can earn marketing support, home improvement referrals, rent support, and other items. Commission costs are expensed as incurred and reflected within selling and administrative expenses. Commission costs were $1.3 million and $4.0 million in the twenty six weeks ended August 3, 2019 and August 4, 2018, respectively. Commission costs vary based on factors including store count, number of dealer and franchise locations, sales mix, sales volume, and commission rates.

Pre-Opening Costs

Pre-opening and start-up activity costs are expensed in the period in which they occur.

Advertising Costs

Advertising costs are expensed as incurred, generally the first time the advertising occurs, and were $7.5 million and $6.0 million for twenty six weeks ended August 3, 2019 and August 4, 2018, respectively. These costs are included within selling and administrative expenses in the accompanying Combined Statements of Operations.

Income Taxes

We provide deferred income tax assets and liabilities based on the estimated future tax effects of differences between the financial and tax basis of assets and liabilities based on currently enacted tax laws. The tax balances and income tax expense recognized by us are based on management’s interpretation of the tax laws of multiple jurisdictions. Income tax expense also reflects our best estimates and assumptions regarding, among other things, the level of future taxable income, tax planning, and any valuation allowance. As of August 3, 2019, a valuation allowance has been recorded for the full amount of the net deferred tax assets. In the future, we may record additional net deferred tax assets; and if future utilization of deferred tax assets is uncertain, we may

 

11


SEARS HOMETOWN AND OUTLET STORES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

record additional valuation allowance against such deferred tax assets. In evaluating our ability to recover our deferred tax assets within the jurisdiction from which they arise, we consider all available positive and negative evidence, including scheduled reversals of deferred tax liabilities, projected future taxable income, tax planning strategies, and results of recent operations. In projecting future taxable income, we begin with historical results and incorporate assumptions including the amount of future federal, state and foreign pre-tax operating income (loss), the reversal of temporary differences, and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income.

Tax benefits are recognized when they are more likely than not to be sustained upon examination. The amount recognized is measured as the largest amount of benefit that is more likely than not of being recognized upon settlement. We will be subject to periodic audits by the Internal Revenue Service and other state local and foreign taxing authorities. Theses audits may challenge certain of the Company’s tax positions such as the timing and amount of income and deductions and the allocation of taxable income to various tax jurisdictions. We evaluate our tax positions and establish liabilities in accordance with the applicable guidance on uncertainty in income taxes. These tax uncertainties are reviewed as facts and circumstances change and are adjusted accordingly. This requires significant management judgment in estimating final outcomes. Actual results could materially differ from these estimates and could significantly affect the effective tax rate and cash flows in future years. Interest and penalties are classified as income tax expense in the Combined Statements of Operations.

Prior to the 2012 Separation, our taxable income was included in the consolidated federal, state and foreign income tax returns of Sears Holdings or its affiliates. Income taxes in these consolidated financial statements have been recognized on a separate return basis. Under a Tax Sharing Agreement between the Company and Transform Holdco (the “Tax Sharing Agreement”), Transform Holdco is responsible for any federal, state or foreign income tax liability relating to tax periods ending on or before the 2012 Separation; and the Company is responsible for any federal, state or foreign tax liability relating to tax periods ending after the 2012 Separation.

Fair Value of Financial Instruments

We determine the fair value of financial instruments in accordance with standards pertaining to fair value measurements. Such standards define fair value and establish a framework for measuring fair value under GAAP. Under fair value measurement accounting standards, fair value is considered to be the exchange price in an orderly transaction between market participants to sell an asset or transfer a liability at the measurement date. We report the fair value of financial assets and liabilities based on the fair value hierarchy prescribed by accounting standards for fair value measurements, which prioritizes the inputs to valuation techniques used to measure fair value into three levels, as follows:

Level 1 inputs—unadjusted quoted prices in active markets for identical assets or liabilities that we have the ability to access. An active market for the asset or liability is one in which transactions for the asset or liability occurs with sufficient frequency and volume to provide ongoing pricing information.

Level 2 inputs—inputs other than quoted market prices included in Level 1 that are observable, either directly or indirectly, for the asset or liability. Level 2 inputs include, but are not limited to, quoted prices for similar assets or liabilities in an active market, quoted prices for identical or similar assets or liabilities in markets that are not active, and inputs other than quoted market prices that are observable for the asset or liability, such as interest-rate curves and yield curves observable at commonly quoted intervals, volatilities, credit risks, and default rates.

Level 3 inputs—unobservable inputs for the asset or liability.

Cash and cash equivalents, accounts payable, accrued expenses (Level 1), and accounts and franchisee notes receivable are reflected in the balance sheets at cost, which approximates fair value due to the short-term nature of these instruments. The carrying value of long-term notes receivable approximates fair value.

 

12


SEARS HOMETOWN AND OUTLET STORES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

We may be required, on a nonrecurring basis, to adjust the carrying value of the Company’s long-lived assets. When necessary, these valuations are determined by the Company using Level 3 inputs. These assets are subject to fair value adjustments in certain circumstances as when there is evidence that impairment may exist. As disclosed in Note 1, the Company recorded impairment charges of $0.0 million and $0.1 million on its property and equipment in the twenty six weeks ended August 3, 2019 and August 4, 2018, respectively. The Company utilized Level 3 inputs to measure the fair value of property and equipment, and intangible assets.

Recently Issued Accounting Pronouncements

ASU 2016-02 “Leases (Topic 842)”

In February 2016, the FASB issued Accounting Standards Update (“ASU”) 2016-02, “Leases (Topic 842)”, which establishes a right-of-use model and requires an entity that is a lessee to recognize the right-of-use assets and liabilities arising from leases on the balance sheet. ASU No. 2016-02 also requires disclosures about the amount, timing, and uncertainty of cash flows arising from leases. Leases will be classified as finance or operating, with classification affecting both the pattern and classification of expense recognition in the statements of earnings. This guidance was subsequently amended by ASU No. 2018-01, Land Easement Practical Expedient for Transition to Topic 842; ASU No. 2018-10, Codification Improvements to Topic 842; and ASU No. 2018-11, Targeted Improvements. ASU No. 2016-02 and subsequent updates require a modified retrospective transition, with the cumulative effect of transition, including initial recognition of lease assets and liabilities for existing operating leases, as of (i) the effective date or (ii) the beginning of the earliest comparative period presented. These updates also provide a number of practical expedients for implementation which we are applying, as discussed below.

Our leases primarily consist of retail space and distribution centers. We completed our initial assessment of the standard as well as implementation of our leasing software, including data upload, and are continuing to finalize our calculations, including validation procedures. We continue establishing new processes and internal controls required to comply with the new lease accounting and disclosure requirements set by the new standard.

On February 3, 2019, we adopted ASU 2016-02. We are using the package of practical expedients that allows companies to not reassess: (1) whether any expired or existing contracts are or contain leases, (2) lease classification for any expired or existing leases, and (3) initial direct costs for any expired or existing leases. We have made accounting policy elections to treat the lease and non-lease components of leases as a single lease component and to exempt leases with an initial term of twelve months or less from balance sheet recognition. Consequently, short-term leases are expensed over the lease term. We did not elect to adopt the hindsight practical expedient and, therefore, will maintain the lease terms previously determined under ASC 840.

The most significant and material impact of adoption was the recognition of right-of-use (“ROU”) assets and lease liabilities on our balance sheet for operating leases. As a result of adopting Topic 842 in our 2019 fiscal year, we recognized an operating ROU asset and lease liability of $116.0 million and $116.4 million, respectively. Existing prepaid rent, accrued rent, and deferred rent were recorded as an offset to our gross operating lease right of use assets. The standard did not have a material impact on our results of operations or cash flows.

Recently Adopted Accounting Pronouncements

ASU 2014-09, “Revenue from Contracts with Customers (Topic 606)”

In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers (Topic 606)”, which supersedes the revenue recognition requirements in Accounting Standards Codification (ASC) 605, Revenue Recognition. Several additional ASUs have subsequently been issued amending and clarifying the standard. The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance provides a five-step process to achieve that core principle and to determine when and how revenue is recognized. The updates may be applied retrospectively for each period presented or as a cumulative effect adjustment at the date of adoption.

 

13


SEARS HOMETOWN AND OUTLET STORES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

We adopted this standard on February 4, 2018, using the modified retrospective approach. The impact of the adoption of ASU 2014-09 on our consolidated financial statements is as follows:

 

   

Our revenue is primarily generated from the sales of merchandise to customers through the retail, e-commerce or wholesale channels. Our performance obligations underlying such sales, and the timing of revenue recognition related thereto, remain substantially unchanged following the adoption of this ASU.

 

   

The adoption of ASU No. 2014-09 requires that we recognize our sales return allowance on a gross basis rather than as a net liability. As such, we now recognize (i) a return asset for the right to recover the goods returned by the customer, measured at the former carrying amount of the goods, less any expected recovery costs (recorded as an increase to prepaid expenses and other current assets), (ii) a return liability for the amount of expected returns (recorded as an increase to other current liabilities), and (iii) deferred revenue for commissions earned on extended protection agreements (recorded as an increase to other current liabilities).

We have made accounting policy elections to (1) exclude from the measurement of transaction price all taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue-producing transaction and collected by us from a customer (sales tax, value added tax, etc.) and (2) account for shipping and handling activities performed after a customer obtains control of the good as activities to fulfill the promise to transfer the good.

We applied ASU No. 2014-09 only to contracts that were not completed prior to fiscal year 2018. The cumulative effect of applying ASU No. 2014-09 was immaterial. The comparative prior period information continues to be reported under the accounting standards in effect during those periods.

NOTE 2—NET SALES

During the twenty six weeks ended August 4, 2019, approximately 98% of our net sales were generated in the United States.

Net sales of merchandise and services were as follows:

 

     26 Weeks Ended  
In thousands    August 3, 2019      August 4, 2018  

Merchandise

   $ 217,187      $ 235,104  

Services

     12,295        19,141  

Other

     3,703        2,965  
  

 

 

    

 

 

 

Net sales

   $ 234,185      $ 257,210  
  

 

 

    

 

 

 

NOTE 3—ACCOUNTS AND FRANCHISEE RECEIVABLES AND OTHER ASSETS

Accounts and franchisee receivables and other assets consist of the following:

 

In thousands    August 3, 2019      August 4, 2018  

Short-term franchisee receivables

   $ 379      $ 640  

Miscellaneous receivables

     601        6,423  

Long-term franchisee receivables

     813        5,203  

Other assets

     798        3,141  

Allowance for losses on short-term franchisee receivables

     (379      (330

Allowance for losses on long-term franchisee receivables

     (819      (2,503
  

 

 

    

 

 

 

Net accounts and franchisee receivables and other assets

   $ 1,393      $ 12,574  
  

 

 

    

 

 

 

 

14


SEARS HOMETOWN AND OUTLET STORES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

NOTE 4—ALLOWANCE FOR LOSSES ON FRANCHISEE RECEIVABLES

The allowance for losses on franchisee receivables consists of the following:

 

     26 Weeks Ended  
In thousands    August 3, 2019      August 4, 2018  

Allowance for losses on franchisee receivables, beginning of period

   $ 1,324      $ 3,092  

Provisions during the period

        100  

Write off of franchisee receivables

     (126      (259
  

 

 

    

 

 

 

Allowance for losses on franchisee receivables, end of period

   $ 1,198      $ 2,833  
  

 

 

    

 

 

 

On November 2, 2018, the Company and a franchisee entered into a transaction consisting of agreements that terminated all of the franchisee’s franchise agreements and sublease arrangements for 21 franchised locations. The agreements provided that the franchisee transferred ownership of all assets, management of stores, and certain rights to property leases. The assets the Company purchased included all store furniture, fixtures, and equipment. As of the transaction date, the franchisee was the obligor on promissory notes to the Company with a total carrying value, net of reserves, of $2.7 million. As part of the transaction, the Company waived the remaining unpaid principal on these promissory notes. During the second half of fiscal year 2018, the Company recognized a loss of $2.7 million on the transaction.

NOTE 5—OTHER CURRENT AND LONG-TERM LIABILITIES

Other current and long-term liabilities consist of the following:

 

In thousands    August 3, 2019      August 4, 2018  

Customer deposits

   $ 2,139      $ 1,246  

Sales and other taxes

     1,672        5,676  

Accrued expenses

     8,486        (7,223

Payroll and related items

     670        603  

Store closing and severance costs

     0        1309  
  

 

 

    

 

 

 

Total other current and long-term liabilities

   $ 12,964      $ 1,611  
  

 

 

    

 

 

 

NOTE 6—INCOME TAXES

The Business is included in the Parent’s federal, state and local income tax returns and in its own Puerto Rico partnership return with its corresponding pass through taxable income included in the Parent’s Puerto Rico corporate income tax return. For purposes of these carve-out financial statements, income taxes related to the Business have been presented as if it were a separate taxpayer. Under this approach, the Business determines its current tax liability, deferred tax assets and liabilities and related tax expense as if it were filing separate tax returns in each tax jurisdiction. Current income taxes payable for any federal, state, or foreign income taxes are reported in the period incurred.

Tax in the carve-out statement of operations represents the sum of current tax and deferred tax. Income taxes are presented on a separate tax return basis as if the Business were a standalone entity. The financial statement presentation assumes that in the event a tax attribute was utilized on a combined return of the Parent, the Business has not realized the benefits of the tax attribute unless it could realize the benefit as a standalone taxpayer. Likewise, in the event the Business could utilize a tax attribute on a standalone basis, the Business has realized the benefits of the tax attribute even though it may not have been utilized on the Parent’s combined return.    

 

15


SEARS HOMETOWN AND OUTLET STORES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

Tax attributes such as net operating loss carryovers have been recognized by the Parent and by the Business. Because the Business is part of the same legal entity that generated many of these tax attributes, the Parent has estimated the amount of certain attributes attributable to the Business. These attributes may not be transferred in certain transactions.

We account for uncertainties in income taxes according to accounting standards for uncertain tax positions. The Company is present in a large number of taxable jurisdictions and, at any point in time, can have tax audits underway at various stages of completion in one or more of these jurisdictions. We evaluate our tax positions and establish liabilities for uncertain tax positions that may be challenged by local authorities and may not be fully sustained, despite our belief that the underlying tax positions are fully supportable. Unrecognized tax benefits are reviewed on an ongoing basis and are adjusted in light of changing facts and circumstances, including progress of tax audits, developments in case law, and closings of statutes of limitation. Such adjustments are reflected in the tax provision as appropriate. For the twenty-six weeks ended August 3, 2019 and August 4, 2018, no unrecognized tax benefits have been identified and reflected in the Condensed Consolidated Financial Statements.

We classify interest expense and penalties related to unrecognized tax benefits and interest income on tax overpayments as components of income tax expense. As no unrecognized tax benefits have been identified and reflected in the Condensed Consolidated Financial Statements, no interest or penalties related to unrecognized tax benefits are reflected in the Condensed Consolidated Balance Sheets or Statements of Operations.

We account for income taxes in accordance with accounting standards for such taxes, which require that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the financial reporting and tax bases of recorded assets and liabilities. Accounting standards also require that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion of or all of the deferred tax assets will not be realized.

Management assesses the available positive and negative evidence to estimate whether sufficient future taxable income will be generated to realize the benefit of the existing deferred tax assets. A significant piece of objective negative evidence evaluated was the cumulative loss for the three years ended February 2, 2019. Such objective evidence limits the ability to consider other subjective evidence such as our projections for future income. On the basis of this analysis, management has established a full valuation allowance to offset the net deferred tax assets that are not expected to be realized. Management will continue to evaluate objective and subjective evidence for changes in circumstances that cause a change in judgment about the realizability of the deferred tax assets.

The operations of the Business are included in the SHO’s federal, state and city income tax returns in the United States and foreign tax returns in Puerto Rico as well as its own partnership return in Puerto Rico. SHO was also a part of the Sears Holdings combined state returns for the years ended February 2, 2013 and February 1, 2014. SHO has completed its federal audit for the tax return ended January 30, 2016 and all matters have been resolved. Currently, SHO is under audit for one separate state returns for fiscal years 2013 through 2016.

NOTE 7—RELATED PARTY AGREEMENTS AND TRANSACTIONS

As the Company is a carve-out business of SHO, SHO and its subsidiaries would be considered related parties to the Company. As discussed in Note 1, SHO provides certain buying, distribution and administrative services to the Company on a centralized basis including finance, legal, information technology, human resources, corporate services and other overhead functions. If not billed directly to the Company, these costs are allocated to the Company to approximate the Company’s proportionate share of such costs and expenses. Allocated costs and expenses include shared occupancy space, interest expense, corporate payroll, business process outsourcing, and liability insurance. The Company is charged for purchases of merchandise made from SHO.

 

16


SEARS HOMETOWN AND OUTLET STORES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

Employees of the Company participate in benefit plans that are sponsored by SHO. See Note 10 – Defined Contribution Plan for more information. SHO also provides stock-based compensation for management of the Company.

The Company depends on SHO to provide key products and services to the Company and SHO depends on Transform Holdco (Sears Holdings prior to Transform Holdco acquiring most of the operating assets and assuming the related operative agreements and obligations of Sears Holdings from bankruptcy in mid-February 2019) for most of its key products and services. As of August 3, 2019 and August 4, 2018, the Company recorded $1.3 million and $3.7 million of payable to related party representing an allocation of the Company’s portion of the amount owed by SHO to Transform Holdco (Sears Holdings from bankruptcy in mid-February 2019).

NOTE 8—LEASES

We lease retail locations, office space, and vehicles. While most of these leases are operating leases, some of our vehicles are leased under finance leases. We consider various factors such as market conditions and the terms of any renewal options that may exist to determine whether we will renew or replace the lease. A majority of our leases have remaining lease terms of one to ten years, typically with the option to extend the leases for up to five years. Some of our leases may include the option to terminate in less than five years. If we are reasonably certain to exercise the option to extend a lease, we will include the extended terms in the operating lease right-of-use asset and operating lease liability. Real estate taxes, insurance, maintenance, and operating expenses applicable to the leased property are our obligations under the lease agreements.

Our lease agreements do not contain any material residual value guarantees or material restrictive covenants.

The gross amounts of assets and liabilities related to both operating and finance leases are as follows:

 

Thousands   

Balance Sheet Caption

   August 3, 2019  

Assets:

     

Operating lease assets

   Operating lease right-of-use assets    $ 108,426  

Finance lease assets

   Net property and equipment      273  
     

 

 

 

Total lease assets

      $ 108,699  
     

 

 

 

Liabilities:

     

Current:

     

Operating lease liabilities

   Current operating lease liabilities    $ 29,274  

Finance lease liabilities

   Other current liabilities      95  

Long-term:

     

Operating lease liabilities

   Long-term operating lease liabilities      79,676  

Finance lease liabilities

   Other long-term liabilities      179  
     

 

 

 

Total lease liabilities

      $ 109,224  
     

 

 

 

 

17


SEARS HOMETOWN AND OUTLET STORES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

The components of lease costs are as follows:

 

Thousands   

Statement of Operations Caption

   26 Weeks Ended
August 3, 2019
 

Operating lease cost

   Cost of sales and occupancy    $ 18,631  

Finance lease cost:

     

Amortization of leased assets

   Depreciation and amortization      56  

Interest on lease liabilities

   Interest expense      12  
     

 

 

 

Net lease cost

      $ 3,755  
     

 

 

 

ASU 2016-02 requires that public companies use a secured incremental borrowing rate as the discount rate for present value of lease payments. Lease terms and discount rates are as follows:

 

     August 3, 2019  

Weighted Average Remaining Lease Term (Years)

  

Operating leases

     3.1  

Finance leases

     2.3  

Weighted Average Discount Rate:

  

Operating leases

     11.2

Finance leases

     7.1

 

18


SEARS HOMETOWN AND OUTLET STORES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

The approximate future minimum lease payments under finance and operating leases at August 3, 2019 are as follows:

 

Fiscal Year (thousands)

   Finance Leases      Operating Leases  

Remainder of 2019

   $ 154      $ 1,192  

2020

     399        2,543  

2021

     106        1,482  

2022

     42        949  

2023

     19        229  

Thereafter

     3        —    
  

 

 

    

 

 

 

Total lease payments

     723        6,395  

Less imputed interest

     52        280  
  

 

 

    

 

 

 

Net Minimum Lease Payments

   $ 671      $ 6,115  
  

 

 

    

 

 

 

Finance lease obligations

     671     

Less Current Portion of Finance Lease Obligations

     (319   
  

 

 

    

Long-term Finance Lease Obligations

   $ 352     
  

 

 

    

Note: Amounts presented do not include payments relating to immaterial leases excluded from the balance sheets as part of transition elections adopted upon implementation of Topic 842.

The approximate future minimum lease payments under capital and operating leases at August 3, 2019 were as follows:

 

Fiscal Year (thousands)

   Capital Leases      Operating Leases  

2019

   $ 259      $ 3,041  

2020

     359        2,037  

2021

     21        1,214  

2022

     14        775  

2023

     5        135  

Thereafter

     —          —    
  

 

 

    

 

 

 

Net Minimum Lease Payments

   $ 658      $ 7,202  
  

 

 

    

 

 

 

Capital lease obligations

     658     

Less Current Portion of Capital Lease Obligations

     (259   
  

 

 

    

Long-term Capital Lease Obligations

   $ 399     
  

 

 

    

Other lease information as follows:

 

Thousands    26 Weeks Ended
August 3, 2019
 

Cash paid for amounts included in the measurement of lease liabilities:

  

Operating cash flows - operating leases

   $ 976  

Operating cash flows - finance leases

     10  

Financing cash flows - finance leases

     62  

 

19


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

NOTES TO COMBINED FINANCIAL STATEMENTS

(Amounts in thousands)

NOTE 9—STORE CLOSING CHARGES

Accelerated Closed Store Charges

Our Parent completed steps to reduce costs, make the best use of capital, and improve our profitability by closing, or seeking the closure of under-performing stores.

In accordance with accounting standards governing costs associated with exit or disposal activities, expenses related to future rent payments for which we no longer expect to receive any economic benefit are accrued when we cease to use the leased space and have been reduced for estimated sublease income.

Accelerated (prior to lease expiration) store closure costs for the twenty six weeks ended August 3, 2019 and August 4, 2018, respectively, were as follows:

 

In thousands    Lease
Termination
Costs (1)
     Inventory
Related (1)
     Impairment and
Accelerated
Depreciation (2)
     Other
Charges (3)
     Total Store
Closing Costs
 

26 weeks ended August 3, 2019 $

     0        0        0        0        0  

26 weeks ended August 4, 2018

   $ 1,309      $ 0      $ 0      $ 0      $ 1,309  

 

(1)

Recorded within cost of sales and occupancy in the Combined Statements of Operations. Lease termination costs are net of estimated sublease income, and include the reversal of closed store reserves when a lease agreement is terminated for an amount less than the remaining reserve established for the store.

(2)

Recorded within depreciation and amortization in the Combined Statements of Operations.

(3)

Recorded within selling and administrative in the Combined Statements of Operations.

Closed Store Reserves

The store closing reserves included within other current liabilities in the Balance Sheets, consists of the following:

 

In thousands    August 3, 2019      August 4, 2018  

Store closing and severance costs reserve, beginning of period

   $ 0      $ 3,180  

Store closing (recovery) costs

     0        0  

Payments/utilization

     0        (1,871
  

 

 

    

 

 

 

Store closing and severance costs reserve, end of period

   $ 0      $ 1,309  
  

 

 

    

 

 

 

NOTE 10—SALE OF ASSETS

On August 10, 2018, we completed the sale of a property in Newington, Connecticut. The sale price of the property was $2.8 million net of closing costs, and we recorded a gain on the sale of approximately $1.4 million when the sale was completed in accordance with the terms and conditions of the Purchase and Sale Agreement. This gain was recognized subsequent to the end of the twenty six weeks ended August 4, 2018. We did not sell any owned property in fiscal year 2017.

NOTE 11 — DEFINED CONTRIBUTION PLAN

Our Parent sponsors a Sears Hometown and Outlet Stores, 401(k) savings plan for employees meeting service eligibility requirements which offers a discretionary matching contribution. In the twenty-six weeks ended August 3, 2019 and August 4, 2018, the Company incurred expenses for the retirement savings plan in the amount of $0.9 million and $0.5 million, respectively. The expense was allocated to the Company consistent with the allocations discussed in Note 7- Related Party Agreements and Transactions.

NOTE 12—COMMITMENTS AND CONTINGENCIES

We are subject to various legal and governmental proceedings arising out of the ordinary course of business, the outcome of which, individually and in the aggregate, in the opinion of management, would not have a material adverse effect on our business, financial position, or results of operations, or cash flows.

 

20


SEARS OUTLET STORES

(a carve-out business of Sears Hometown and Outlet Stores, Inc.)

NOTES TO COMBINED FINANCIAL STATEMENTS

(Amounts in thousands)

 

NOTE 13 — SUBSEQUENT EVENTS

On October 23, 2019, SHO completed the sale of the Company, including substantially all of the assets and liabilities comprising SOS, to Franchise Group Newco S, LLC (the “Purchaser”), an indirect subsidiary of (formerly known as Liberty Tax, Inc.) pursuant to an Equity and Asset Purchase Agreement, dated as of August 27, 2019. Pursuant to the terms of the Purchase Agreement, the Purchaser paid SHO an aggregate purchase price, after giving effect to a customary working capital adjustment, of $119,960,000 in cash, and in addition reimbursed SHO for certain costs it incurred in connection with the Outlet Sale and certain employee payments and insurance costs incurred by SHO in connection with the Merger.

 

21

EX-99.3

Exhibit 99.3

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of

Vitamin Shoppe, Inc.

Secaucus, New Jersey

Opinion on the Financial Statements

We have audited the accompanying consolidated balance sheets of Vitamin Shoppe, Inc. and Subsidiary (the “Company”) as of December 29, 2018 and December 30, 2017, and the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity, and cash flows for each of the three fiscal years in the period ended December 29, 2018, and the related notes (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 29, 2018 and December 30, 2017, and the results of its operations and its cash flows for each of the three years in the period ended December 29, 2018, in conformity with accounting principles generally accepted in the United States of America.

Basis for Opinion

These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.

/s/ Deloitte & Touche LLP

Parsippany, New Jersey

February 26, 2019

We have served as the Company’s auditor since 1997.

 

1


VITAMIN SHOPPE, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data)

 

     December 29,
2018
    December 30,
2017
 

ASSETS

    

Current assets:

    

Cash and cash equivalents

   $ 2,668     $ 1,947  

Inventories

     189,273       218,087  

Prepaid expenses and other current assets

     27,921       39,473  

Current assets held for sale

     —          22,625  
  

 

 

   

 

 

 

Total current assets

     219,862       282,132  

Property and equipment, net

     123,002       141,520  

Intangibles, net

     11,088       11,040  

Deferred taxes

     31,659       37,278  

Other long-term assets

     2,468       2,572  

Noncurrent assets held for sale

     —         16,891  
  

 

 

   

 

 

 

Total assets

   $ 388,079     $ 491,433  
  

 

 

   

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

    

Current liabilities:

    

Revolving credit facility

   $ —       $ 12,000  

Accounts payable

     39,789       46,921  

Deferred sales

     5,455       5,710  

Accrued expenses and other current liabilities

     60,553       56,935  

Current liabilities held for sale

     —         5,337  
  

 

 

   

 

 

 

Total current liabilities

     105,797       126,903  

Convertible notes, net

     55,570       126,415  

Deferred rent

     37,034       40,832  

Other long-term liabilities

     1,337       1,916  

Commitments and contingencies

    

Stockholders’ equity:

    

Preferred stock, $0.01 par value; 250,000,000 shares authorized and no shares issued and outstanding at December 29, 2018 and December 30, 2017

     —         —    

Common stock, $0.01 par value; 400,000,000 shares authorized, 24,234,651 shares issued and 23,974,031 shares outstanding at December 29, 2018, and 24,220,509 shares issued and 24,021,948 shares outstanding at December 30, 2017

     242       242  

Additional paid-in capital

     85,853       88,823  

Treasury stock, at cost; 260,620 shares at December 29, 2018 and 198,561 shares at December 30, 2017

     (7,314     (7,010

Retained earnings

     109,560       113,312  
  

 

 

   

 

 

 

Total stockholders’ equity

     188,341       195,367  
  

 

 

   

 

 

 

Total liabilities and stockholders’ equity

   $ 388,079     $ 491,433  
  

 

 

   

 

 

 

See accompanying notes to consolidated financial statements.

 

2


VITAMIN SHOPPE, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except share and per share data)

 

     Fiscal Year Ended  
     December 29,
2018
    December 30,
2017
    December 31,
2016
 

Net sales

   $ 1,114,160     $ 1,146,499     $ 1,239,226  

Cost of goods sold

     759,367       783,932       819,690  
  

 

 

   

 

 

   

 

 

 

Gross profit

     354,793       362,567       419,536  

Selling, general and administrative expenses

     344,947       332,199       328,939  

Goodwill, tradename and store fixed-assets impairment charges

     3,017       274,876       797  
  

 

 

   

 

 

   

 

 

 

Income (loss) from operations

     6,829       (244,508     89,800  

Gain on extinguishment of debt

     16,902       —         —    

Interest expense, net

     6,602       9,701       9,523  
  

 

 

   

 

 

   

 

 

 

Income (loss) before provision (benefit) for income taxes

     17,129       (254,209     80,277  

Provision (benefit) for income taxes

     3,588       (18,882     29,065  
  

 

 

   

 

 

   

 

 

 

Net income (loss) from continuing operations

     13,541       (235,327     51,212  

Net loss from discontinued operations, net of tax

     (17,293     (16,824     (26,248
  

 

 

   

 

 

   

 

 

 

Net income (loss)

   $ (3,752   $ (252,151   $ 24,964  
  

 

 

   

 

 

   

 

 

 

Weighted average common shares outstanding

      

Basic

     23,496,841       23,137,977       23,875,540  

Diluted

     23,496,841       23,137,977       24,067,686  

Net income (loss) from continuing operations per common share

      

Basic

   $ 0.58     $ (10.17   $ 2.14  

Diluted

   $ 0.58     $ (10.17   $ 2.13  

Net loss from discontinued operations per common share

      

Basic

   $ (0.74   $ (0.73   $ (1.10

Diluted

   $ (0.74   $ (0.73   $ (1.09

Net income (loss) per common share

      

Basic

   $ (0.16   $ (10.90   $ 1.05  

Diluted

   $ (0.16   $ (10.90   $ 1.04  

See accompanying notes to consolidated financial statements.

 

3


VITAMIN SHOPPE, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(In thousands)

 

     Fiscal Year Ended  
     December 29,
2018
    December 30,
2017
    December 31,
2016
 

Net income (loss)

   $ (3,752   $ (252,151   $ 24,964  

Other comprehensive income:

      

Foreign currency translation adjustments

     —         —         60  
  

 

 

   

 

 

   

 

 

 

Other comprehensive income

     —         —         60  
  

 

 

   

 

 

   

 

 

 

Comprehensive income (loss)

   $ (3,752   $ (252,151   $ 25,024  
  

 

 

   

 

 

   

 

 

 

See accompanying notes to consolidated financial statements.

 

4


VITAMIN SHOPPE, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(In thousands, except share data)

Figures may not sum due to rounding

 

     Common Stock     Treasury Stock     Additional
Paid-In
Capital
    Accumulated
Other
Comprehensive
(Loss) Income
    Retained
Earnings
       
     Shares     Amounts     Shares     Amounts     Total  

Balance at December 26, 2015

     25,993,715     $ 260       (120,134   $ (5,225   $ 139,827     $ (60   $ 340,499     $ 475,301  

Comprehensive income

     —         —         —         —         —         60       24,964       25,024  

Equity compensation

     —         —         —         —         6,380       —         —         6,380  

Issuance of restricted shares

     196,777       2       —         —         (2     —         —         —    

Issuance of shares

     11,942       —         —         —         333       —         —         333  

Purchases of treasury stock

     —         —         (41,051     (1,205     —         —         —         (1,205

Purchases of shares under Share Repurchase Programs

     (2,552,556     (26     —         —         (65,985     —         —         (66,011

Cancellation of restricted shares

     (103,362     (1     —         —         1       —         —         —    

Issuance of shares under employee stock purchase plan

     33,442       1       —         —         822       —         —         823  

Exercises of stock options

     5,282       —         —         —         90       —         —         90  

Tax benefits on exercise of equity awards

     —         —         —         —         (739     —         —         (739
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 31, 2016

     23,585,240       236       (161,185     (6,430     80,727       —         365,463       439,996  

Comprehensive loss

     —         —         —         —         —         —         (252,151     (252,151

Equity compensation

     —         —         —         —         6,122       —         —         6,122  

Issuance of restricted shares

     607,161       6       —         —         (6     —         —         —    

Purchases of treasury stock

     —         —         (37,376     (580     —         —         —         (580

Cancellation of restricted shares

     (140,391     (2     —         —         2       —         —         —    

Issuance of shares under employee stock purchase plan

     68,499       1       —         —         468       —         —         469  

Exercises of stock options

     100,000       1       —         —         1,510       —         —         1,511  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 30, 2017

     24,220,509       242       (198,561     (7,010     88,823       —         113,312       195,367  

Comprehensive loss

     —         —         —         —         —         —         (3,752     (3,752

Equity compensation

     —         —         —         —         2,663       —         —         2,663  

Issuance of restricted shares

     375,182       4       —         —         (4     —         —         —    

Purchases of treasury stock

     —         —         (62,059     (304     —         —         —         (304

Cancellation of restricted shares

     (431,728     (4     —         —         4       —         —         —    

Issuance of shares under employee stock purchase plan

     70,688       1       —         —         289       —         —         290  

Repurchases of Convertible Notes

     —         —         —         —         (5,922     —         —         (5,922
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 29, 2018

     24,234,651     $ 242       (260,620   $ (7,314   $ 85,853     $ —       $ 109,560     $ 188,341  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

See accompanying notes to consolidated financial statements.

 

5


VITAMIN SHOPPE, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

 

     Fiscal Year Ended  
     December 29,
2018
    December 30,
2017
    December 31,
2016
 

Cash flows from operating activities:

      

Net income (loss)

   $ (3,752   $ (252,151   $ 24,964  

Adjustments to reconcile net income (loss) to net cash provided by operating activities:

      

Depreciation and amortization of fixed and intangible assets

     42,114       39,204       38,780  

Impairment charges on goodwill

     —         210,633       32,636  

Impairment charges on intangible assets

     8,174       59,405       6,594  

Impairment charges on fixed assets

     11,057       6,658       797  

Loss on sale of FDC Vitamins, LLC

     203       —         —    

Amortization of deferred financing fees

     604       898       957  

Gain on extinguishment of debt

     (16,902     —         —    

Amortization of debt discount on convertible notes

     3,170       4,781       4,690  

Deferred income taxes

     5,619       (19,834     (13,683

Deferred rent

     (3,881     (2,431     (3,226

Equity compensation expense

     2,663       6,122       6,292  

Issuance of shares for services rendered

     —         —         333  

Tax benefits on exercises of equity awards

     792       1,017       739  

Changes in operating assets and liabilities:

      

Accounts receivable

     (1,458     1,102       70  

Inventories

     33,052       10,573       (13,078

Prepaid expenses and other current assets

     11,691       (5,916     (8,521

Other long-term assets

     (16     (598     116  

Accounts payable

     (7,104     (12,916     26,522  

Deferred sales

     (255     501       (15,277

Accrued expenses and other current liabilities

     4,873       7,047       2,921  

Other long-term liabilities

     (497     2,094       747  
  

 

 

   

 

 

   

 

 

 

Net cash provided by operating activities

     90,147       56,189       93,373  
  

 

 

   

 

 

   

 

 

 

Cash flows from investing activities:

      

Capital expenditures

     (28,138     (55,020     (40,068

Net proceeds on sale of FDC Vitamins, LLC

     14,847       —         —    

Trademarks and other intangible assets

     (372     (428     (291
  

 

 

   

 

 

   

 

 

 

Net cash used in investing activities

     (13,663     (55,448     (40,359
  

 

 

   

 

 

   

 

 

 

Cash flows from financing activities:

      

Borrowings under revolving credit facility

     163,000       118,000       82,000  

Repayments of borrowings under revolving credit facility

     (175,000     (117,000     (79,000

Purchases of convertible notes

     (63,891     —         —    

Bank overdraft

     601       (3,265     (1,041

Payments of capital lease obligations

     (477     (451     (207

Proceeds from exercises of common stock options

     —         1,511       90  

Issuance of shares under employee stock purchase plan

     290       469       823  

Purchases of treasury stock

     (304     (580     (1,205

Purchases of shares under Share Repurchase Programs

     —         —         (66,011

Tax benefits on exercises of equity awards

     —         —         (739

Deferred financing fees and other

     17       (346     (14
  

 

 

   

 

 

   

 

 

 

Net cash used in financing activities

     (75,764     (1,662     (65,304
  

 

 

   

 

 

   

 

 

 

Effect of exchange rate changes on cash and cash equivalents

     1       35       19  
  

 

 

   

 

 

   

 

 

 

Net increase (decrease) in cash and cash equivalents

     721       (886     (12,271

Cash and cash equivalents beginning of year

     1,947       2,833       15,104  
  

 

 

   

 

 

   

 

 

 

Cash and cash equivalents end of year

   $ 2,668     $ 1,947     $ 2,833  
  

 

 

   

 

 

   

 

 

 

Supplemental disclosures of cash flow information:

      

Interest paid

   $ 3,186     $ 3,953     $ 3,715  

Income taxes (refunded) paid

   $ (14,915   $ 6,610     $ 33,655  

Supplemental disclosures of non-cash investing activities:

      

Liability for purchases of property and equipment

   $ 1,935     $ 4,457     $ 4,630  

Assets acquired under capital leases

   $ —       $ 891     $ 1,589  

Assets acquired under tenant incentives

   $ —       $ 2,986     $ —    

See accompanying notes to consolidated financial statements.

 

6


VITAMIN SHOPPE, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of Presentation

Vitamin Shoppe, Inc. (“VSI”), is incorporated in the State of Delaware, and through its wholly-owned subsidiary, Vitamin Shoppe Industries Inc. (“Subsidiary” or “Industries” together with VSI, the “Company”), is an omni-channel specialty retailer of nutritional products. Sales of both national brands and our own brands of vitamins, minerals, herbs, specialty supplements, sports nutrition and other health and wellness products (“VMS products”) are made through VSI-operated retail stores, the internet and mobile devices to customers located primarily in the United States.

The Company’s fiscal year ends on the last Saturday in December. As used herein, the term “Fiscal Year” or “Fiscal” refers to a 52-week or 53-week period, ending on the last Saturday in December. Fiscal 2016 was a 53-week fiscal year.

The consolidated financial statements for the fiscal years ended December 29, 2018, December 30, 2017 and December 31, 2016 include the accounts of VSI and Subsidiary. All intercompany transactions and balances have been eliminated in consolidation. The consolidated financial statements for Fiscal 2017 and Fiscal 2016 have been restated, where appropriate, to reflect discontinued operations. Refer to Note 3., “Discontinued Operations” for additional information. As a result of the discontinued operations, the Company currently operates through one business segment.

2. Summary of Significant Accounting Policies

Use of Estimates—The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosures of contingent assets and liabilities at the date of the financial statements, and revenue and expenses during the reporting period. Actual results could differ from those estimates.

Cash and Cash Equivalents—Cash and cash equivalents include all highly liquid investments with original maturities of ninety days or less. The Company reclassifies cash overdrafts to accounts payable.

Inventories—Inventories are stated at the lower of cost or market value. Cost is determined using the weighted average method. Inventory includes costs of freight on internally transferred merchandise, and costs associated with our buying department and distribution facilities which are capitalized into inventory and then expensed as merchandise is sold. In addition, the cost of inventory is reduced by purchase discounts and other allowances received from certain of our vendors. The Company estimates losses for expiring inventory and the net realizable value of inventory based on when a product is close to expiration and not expected to be sold, when a product has reached its expiration date, or when a product is not expected to be saleable. In determining the reserves for these products, consideration is given to such factors as the amount of inventory on hand, the remaining shelf life, current and expected market conditions, historical trends and the likelihood of recovering the inventory costs based on anticipated demand. The following table details the activity and balances for the Company’s reserve for inventory for the years ended December 29, 2018, December 30, 2017 and December 31, 2016 (in thousands):

 

     Balance at
Beginning
of Fiscal
Year
     Amounts
Charged to
Cost of
Goods Sold
     Write-Offs
Against
Reserves
     Balance at
End of
Fiscal Year
 

Fiscal Year Ended December 29, 2018

   $ 3,667      $ 14,157      $ (14,753    $ 3,071  

Fiscal Year Ended December 30, 2017

   $ 5,189      $ 14,274      $ (15,796    $ 3,667  

Fiscal Year Ended December 31, 2016

   $ 4,939      $ 8,888      $ (8,638    $ 5,189  

Property and Equipment, Net—Property and equipment, net is stated at cost less accumulated depreciation and amortization. Depreciation and amortization are provided for on a straight-line basis over the estimated useful lives of the related assets. Furniture, fixtures and equipment are generally depreciated over seven years. Leasehold improvements are amortized generally over the shorter of their useful lives or related lease terms. The direct internal and external costs associated with the development of the features and functionality of the Company’s website, transaction processing systems,

 

7


telecommunications infrastructure and network operations, are capitalized and are amortized on a straight line basis over the estimated useful lives of generally five years. Capitalization of costs begins when the preliminary project stage is completed and management authorizes and commits to funding the computer software project and that it is probable that the project will be completed and the software will be used to perform the function intended. Depreciation of the assets commences when they are put into use. Expenditures for repairs and maintenance are expensed as incurred and expenditures for major renovations and improvements are capitalized. Upon retirement or disposition of property and equipment, the applicable cost and accumulated depreciation are removed from the accounts and any resulting gains or losses are included in the results of operations.

Impairment of Long-Lived Assets—The Company reviews its long-lived assets for impairment whenever events or changes in circumstances, including store closures, indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets held and used is measured by a comparison of the carrying amount of an asset to undiscounted pre-tax future net cash flows expected to be generated by that asset. If the undiscounted future cash flows are not adequate to recover the carrying value of the asset, an impairment loss is recognized for the amount by which the carrying amount of the assets exceeds the fair value of the assets.

Intangibles—Indefinite-lived intangibles are not amortized. Evaluations for impairment are performed at least annually, in the fourth quarter of each year, or whenever impairment indicators exist. The evaluation of indefinite-lived intangibles may first consider qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value is less than its carrying value. A quantitative evaluation is performed if the qualitative evaluation results in a more likely than not determination or if a qualitative evaluation is not performed. For the Company’s indefinite-lived tradename, we utilize the royalty relief method in our quantitative evaluations. Under the royalty relief method, a royalty rate is determined based on comparable licensing arrangements which is applied to the revenue projections for the indefinite-lived tradename and the fair value is calculated using a discounted cash flow analysis. Cash flows are discounted using an internally derived weighted average cost of capital which reflects the costs of borrowing as well as the associated risk. Impairment tests between annual tests may be undertaken if an event occurs or circumstances change that could reduce the fair value of the indefinite-lived tradename below its carrying value. The valuation of indefinite-lived intangible assets is affected by, among other things, the Company’s projections for the future and estimated results of future operations. Changes in the business plan or operating results that are different than the estimates used to develop the valuation of the assets may impact these valuations. For those intangible assets which have definite lives, the Company amortizes their cost on a straight-line basis over their estimated useful lives, the periods of which vary based on their particular contractual terms.

During Fiscal 2017, the Company performed quantitative analyses of its retail reporting unit and determined the carrying value of the retail reporting unit exceeded its fair value, resulting in an impairment of the corresponding goodwill of $210.6 million and an impairment charge on the Vitamin Shoppe tradename of $59.4 million. Refer to Note 4. Goodwill and Intangible Assets for additional information.

Rent Expenses, Deferred Rent and Landlord Construction Allowances—Rent expense and rent incentives, including landlord construction allowances, are recognized on a straight-line basis over the lease term. The Company records rent expense for stores and distribution centers as a component of cost of goods sold. The Company accounts for landlord construction allowances as lease incentives and records them as a component of deferred rent, which is recognized in cost of goods sold over the lease term.

Revenue Recognition—The Company recognizes revenue from retail customers when merchandise is sold “at point of sale” in retail stores or upon delivery to a customer. Substantially all revenue from customers represents goods transferred at a point in time. The Company considers control of retail products to have transferred upon delivery, at the retail location or the place of delivery, because the Company has a present right to payment at that time, the customer has legal title to the products, the Company has transferred physical possession of the products, and the customer has significant risks and rewards of ownership of the products. In addition, the Company classifies amounts billed to customers that represent shipping fees as sales. Amount recognized as shipping revenue during Fiscal 2018, Fiscal 2017 and Fiscal 2016, were $2.3 million, $2.1 million and $2.1 million respectively. To arrive at net sales, gross sales are reduced by deferred sales, customer discounts, actual customer returns, and a provision for estimated future customer returns, which is based on management’s review of historical information. Sales taxes collected from customers are presented on a net basis and as such are excluded from revenue. During Fiscal 2018, the Company adopted Financial Accounting Standards Board Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”). For additional information regarding our adoption of ASU 2014-09, refer to Note 8., “Revenue Recognition”.

 

8


Cost of Goods Sold—The Company includes the cost of inventory sold, costs of warehousing, distribution and store occupancy costs. Warehousing and distribution costs, which are capitalized into inventory and then expensed as merchandise is sold, include freight to transfer merchandise, costs associated with our buying department and distribution facilities. Store occupancy costs include rent, common area maintenance, real estate taxes and utilities.

Vendor Allowances—Vendor allowances include discounts, allowances and rebates received from vendors and are based on various contract terms. Vendor allowances are recognized as either purchase discounts which represent a reduction of product cost, funding which is capitalized into inventory and recognized in the statement of operations as the merchandise is sold, or direct offset which represents funding subject to immediate recognition in the statement of operations, depending on the nature of the allowance.

Frequent Buyer Program—The Company has a frequent buyer program (“Healthy Awards Program”), whereby customers earn points toward free merchandise based on the dollar volume of purchases. Points are earned each calendar quarter and must be redeemed within the subsequent calendar quarter or they expire. Sales are deferred at the time points are earned based on the value of points that are projected to be redeemed, which are based on historical redemption data. The Company records a liability in the period points are earned with a corresponding reduction of sales.

Store Pre-opening Costs—Costs associated with the opening of new retail stores and start up activities are expensed as incurred.

Advertising Costs—The costs of advertising for online marketing arrangements, magazines, direct mail and radio are expensed as incurred, or the first time the advertising takes place. Advertising expense was $24.0 million, $27.3 million and $20.7 million for Fiscal 2018, Fiscal 2017 and Fiscal 2016, respectively.

Online Marketing Arrangements—The Company has entered into online marketing arrangements with various online companies. These agreements are established for periods of 24 months, 12 months or, in some cases, a lesser period and generally provide for compensation based on revenue sharing upon the attainment of stipulated revenue amounts, a percentage of the media expenditure managed by the online partner, or based on the number of visitors that the online company refers to the Company and are expensed as incurred. The Company had no fixed payment commitments during Fiscal 2018, Fiscal 2017 and Fiscal 2016.

Income Taxes—Deferred income tax assets and liabilities are recorded in accordance with the liability method. Deferred income taxes have been provided for temporary differences between the tax bases and financial reporting bases of the Company’s assets and liabilities using the tax rates and laws in effect for the periods in which the differences are expected to reverse.

The Tax Cut and Jobs Act of 2017 was enacted on December 22, 2017, reducing the statutory federal income tax rate from 35% to 21%, effective January 1, 2018. As required, the Company determined the effects of tax reform and recorded a provisional amount in Fiscal 2017 and final amount in Fiscal 2018. The Company expects no further impacts resulting from the Tax Cut and Jobs Act of 2017.

The Company accounts for tax positions based on the provisions of the accounting literature related to accounting for uncertainty in income tax positions. Such literature provides guidance for the recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. For tax positions that are not more likely than not sustainable upon audit, the Company recognizes the largest amount of the benefit that is more likely than not to be sustained. The Company makes estimates of the potential liability based on our assessment of all potential tax exposures. In addition, the Company uses factors such as applicable tax laws and regulations, current information and past experience with similar issues to make these assessments. The tax positions are analyzed regularly and adjustments are made as events occur that warrant adjustments for those positions. These tax positions were not significant for Fiscal 2018, 2017 and 2016. The Company records interest expense and penalties payable to relevant tax authorities as income tax expense.

 

9


Concentrations of Credit Risk—Financial instruments, which potentially subject the Company to concentrations of credit risk, include debit and credit card processors of retail transactions. Accounts receivable from debit and credit card processors, included in prepaid expenses and other current assets on the consolidated balance sheets, totaled $8.1 million at December 29, 2018 and $10.7 million at December 30, 2017.

The Company had two suppliers from whom we purchased at least 5% of our merchandise during Fiscal 2018, two suppliers from whom we purchased at least 5% of our merchandise during Fiscal 2017 and one supplier from whom we purchased at least 5% of our merchandise during Fiscal 2016. We purchased approximately 15% of our total merchandise from these suppliers during Fiscal 2018, approximately 15% during Fiscal 2017 and 11% during Fiscal 2016.

The Company is subject to concentrations of credit risk associated with cash and cash equivalents, and at times holds cash balances in excess of Federal Deposit Insurance Corporation limits.

Stock-Based Compensation—Stock-based compensation cost is measured at the grant date based on the fair value of awards and is recognized as expense on a straight-line basis over the requisite service period for each separately vesting portion of the award, net of anticipated forfeitures. With the exception of restricted shares, performance share units and restricted share units, determining the fair value of stock-based awards at the grant date requires considerable judgment, including estimating expected volatility, expected term and risk-free rate. Compensation expense resulting from the granting of restricted shares, performance share units and restricted share units is based on the grant date fair value of those common shares and is recognized generally over the two to three year vesting period for restricted shares, the approximately three year vesting period for performance share units and over the quarterly to three year vesting periods for restricted share units. For accounting purposes, the expense for performance based stock options, performance based restricted shares and performance share units is calculated and recorded, based on the determination that the achievement of the pre-established performance targets are probable, over the relevant service period.

Expense related to shares purchased under the Company’s Employee Stock Purchase Plan (“ESPP”) is accounted for based on fair value recognition requirements similar to stock options. ESPP participation occurs each calendar quarter (the “Participation Period”) and the expense of which is subject to employee participation in the plan. Under the ESPP, participating employees are allowed to purchase shares at 85% of the lower of the market price of the Company’s common stock at either the first or last trading day of the Participation Period. Compensation expense related to the ESPP is based on the estimated fair value of the discount and purchase price offered on the estimated shares to be purchased under the ESPP. Expense is calculated quarterly, based on the employee contributions made over the applicable three-month Participation Period, using volatility and risk free rates applicable to that three-month period.

Net Income (Loss) Per Share—The Company’s basic net income (loss) per share excludes the dilutive effect of stock options, unvested restricted shares, unvested performance share units, unvested restricted share units and warrants. It is based upon the weighted average number of common shares outstanding during the period divided into net income (loss).

Diluted net income (loss) per share reflects the potential dilution that would occur if securities or other contracts to issue common stock were exercised or converted into common stock. Stock options, unvested restricted shares, unvested performance share units, warrants and unvested restricted share units are included as potential dilutive securities for the periods applicable, using the treasury stock method to the extent dilutive.

 

10


The components of the calculation of basic net income (loss) per common share and diluted net income (loss) per common share are as follows (in thousands except share and per share data):

 

     Fiscal Year Ended  
     December 29,
2018
     December 30,
2017
     December 31,
2016
 

Numerator:

        

Net income (loss) from continuing operations

   $ 13,541      $ (235,327    $ 51,212  

Net loss from discontinued operations

     (17,293      (16,824      (26,248
  

 

 

    

 

 

    

 

 

 

Net income (loss)

   $ (3,752    $ (252,151    $ 24,964  
  

 

 

    

 

 

    

 

 

 

Denominator:

        

Basic weighted average common shares outstanding

     23,496,841        23,137,977        23,875,540  

Effect of dilutive securities (a):

        

Stock options

     —          —          68,272  

Restricted shares

     —          —          115,287  

Performance share units

     —          —          7,173  

Restricted share units

     —          —          1,414  
  

 

 

    

 

 

    

 

 

 

Diluted weighted average common shares outstanding

     23,496,841        23,137,977        24,067,686  

Basic net income (loss) from continuing operations per common share

   $ 0.58      $ (10.17    $ 2.14  

Diluted net income (loss) from continuing operations per common share

   $ 0.58      $ (10.17    $ 2.13  

Basic net loss from discontinued operations per common share

   $ (0.74    $ (0.73    $ (1.10

Diluted net loss from discontinued operations per common share

   $ (0.74    $ (0.73    $ (1.09

Basic net income (loss) per common share

     (0.16    $ (10.90    $ 1.05  

Diluted net income (loss) per common share

     (0.16    $ (10.90    $ 1.04  

 

(a)

For Fiscal 2018 and 2017, due to a loss for the period, no incremental shares are included because the effect would be anti-dilutive.

Securities for the fiscal years ended December 29, 2018, December 30, 2017 and December 31, 2016 for 560,807, 657,823 and 24,140 shares, respectively, have been excluded from the above calculation as they were anti-dilutive.

The Company has the intent and ability to settle the principal portion of its Convertible Notes in cash, and as such, has applied the treasury stock method, which has resulted in the underlying convertible shares, and related warrants, being anti-dilutive in Fiscal 2018, 2017 and 2016 as the Company’s average stock price from the date of issuance of the Convertible Notes through December 29, 2018 was less than the conversion price as well as less than the strike price of the warrant transaction. Refer to Note 7. Credit Arrangements for additional information on the Convertible Notes.

Recent Accounting Pronouncements—Except as noted below, the Company has considered all new accounting pronouncements and has concluded that there are no new pronouncements that may have a material impact on its results of operations, financial condition, or cash flows, based on current information.

In February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2016-02, Leases (Topic 842) (“ASU 2016-02”). ASU 2016-02 was issued by the FASB to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The main difference between previous GAAP and Topic 842 is the recognition of lease assets and lease liabilities by lessees for those leases classified as operating leases under previous GAAP. The Company has elected to adopt ASU 2016-02 in accordance with Accounting Standards Update No. 2018-11, Leases (Topic 842) Targeted Improvements (“ASU 2018-11”). Under the transition method included in ASU 2018-11, the Company will initially apply ASU 2016-02 at the adoption date of December 30, 2018, which is the first day of Fiscal 2019, and will recognize a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. The Company’s reporting for the

 

11


comparative periods presented in its financial statements will continue to be in accordance with previous GAAP (Topic 840, Leases). Under this transition method, the Company will provide the required Topic 840 disclosures for all periods that continue to be in accordance with Topic 840. The Company is in the process of finalizing its adoption of ASU 2016-02. Generally, the Company expects ASU 2016-02 will not have a material impact on its results of operations, however, the Company expects to recognize a cumulative-effect charge of approximately $4.0 million to $6.0 million to the opening balance of retained earnings in the period of adoption which represents impairment charges to the right-of-use assets. This cumulative-effect charge will result in lower rent expense related to the applicable store locations in subsequent periods. During the period of adoption, the Company expects to recognize a right-of-use assets opening balance of approximately $450.0 million to $470.0 million and a lease liabilities opening balance of approximately $490.0 million to $510.0 million. The adoption of ASU 2016-02 is expected to have no impact on the Company’s debt covenants or liquidity. In addition, the Company is making the following modifications to internal controls over financial reporting, beginning in Fiscal 2019, and changes to its accounting policies and procedures, operational processes, and documentation practices:

 

   

Implementing a new information technology system to capture, calculate, and account for leases.

 

   

Enhanced the risk assessment process to take into account risks associated with Topic 842.

 

   

Modified existing controls that address risks associated with accounting for lease assets and liabilities and the related income and expense. This included modifying our contract review controls to consider the new criteria for determining whether a contract is or contains a lease, specifically to clarify the definition of a lease and align with the concept of control.

 

   

Updating our policies and procedures related to accounting for lease assets and liabilities and related income and expense.

 

   

Added controls to address related required disclosures regarding leases, including our significant assumptions and judgments used in applying Topic 842.

3. Discontinued Operations

On May 7, 2018, the Company sold certain assets, including the Betancourt Nutrition® brand, and liabilities of FDC Vitamins, LLC d/b/a Nutri-Force Nutrition (“Nutri-Force”) to Arizona Nutritional Supplements, LLC (“ANS”). Proceeds from the sale, net of transaction costs, were approximately $14.8 million. The Company recognized a pre-tax loss on the sale of Nutri-Force of $0.2 million. In addition, the parties executed supply agreements in which the Company has agreed to purchase a total of $53.0 million annually of its private label products and Betancourt Nutrition® brand products from ANS for a term of five years.

The results of operations of Nutri-Force for the fiscal year ended December 29, 2018 are classified as discontinued operations in the consolidated statements of operations. The consolidated balance sheet as of December 30, 2017 and the statements of operations for the fiscal years ended December 30, 2017 and December 31, 2016 have been restated to reflect the discontinued operations.

 

12


Reconciliation of the Carrying Amounts of Major Classes of Assets and Liabilities of the Discontinued Operation to Total Assets and Liabilities of the Disposal Group Classified as Held for Sale That Are Presented Separately in the Balance Sheet

(in thousands)

 

 

     As of
December 30, 2017
 

Carrying amounts of the major classes of assets included in discontinued operations:

  

Accounts receivable

   $ 6,265  

Inventories

     16,200  

Prepaid expenses and other current assets

     160  
  

 

 

 

Total current assets

     22,625  

Property and equipment, net

     8,513  

Intangible assets, net

     8,378  
  

 

 

 

Total noncurrent assets

     16,891  
  

 

 

 

Total assets of the disposal group classified as held for sale

   $ 39,516  
  

 

 

 

Carrying amounts of the major classes of liabilities included in discontinued operations:

  

Accounts payable

   $ 2,704  

Accrued liabilities

     2,633  
  

 

 

 

Total current liabilities of the disposal group classified as held for sale

   $ 5,337  
  

 

 

 

Reconciliation of the Major Line Items Constituting Loss of Discontinued Operations to the After-Tax Loss of Discontinued Operations That Are Presented in the Statements of Operations

(in thousands)

 

 

     Fiscal Year Ended  
     December 29, 2018     December 30, 2017     December 31, 2016  

Major classes of line items constituting net loss on discontinued operations:

      

Net sales (1)

   $ 11,186     $ 32,195     $ 50,017  

Cost of goods sold

     10,133       35,385       43,197  

Fixed assets impairment charges

     7,236       1,820       —    
  

 

 

   

 

 

   

 

 

 

Gross profit (loss)

     (6,183     (5,010     6,820  

Selling, general and administrative expenses

     5,090       13,295       11,813  

Intangible assets and fixed assets impairment charges

     8,978       —         39,230  

Discontinued operations loss

     203       —         —    
  

 

 

   

 

 

   

 

 

 

Loss before benefit for income taxes

     (20,454     (18,305     (44,223

Benefit for income taxes

     (3,161     (1,481     (17,975
  

 

 

   

 

 

   

 

 

 

Net loss

   $ (17,293   $ (16,824   $ (26,248
  

 

 

   

 

 

   

 

 

 

 

(1)

Includes $2.4 million related to a transition services agreement during the fiscal year ended December 29, 2018.

 

13


Cash Flow Disclosures for Discontinued Operations

(in thousands)

 

 

     Fiscal Year Ended  
     December 29,
2018
    December 30,
2017
    December 31,
2016
 

Cash flows provided by (used in) operating activities

   $ (14,176   $ 2,240     $ 3,678  

Cash flows provided by (used in) investing activities

   $ 14,752     $ (1,630   $ (2,544

Depreciation and amortization

   $ 769     $ 1,126     $ 1,676  

Capital expenditures

   $ 94     $ 1,630     $ 2,544  

4. Goodwill and Intangible Assets

The following table discloses the carrying value of all intangible assets (in thousands):

 

     December 29, 2018      December 30, 2017  
     Gross
Carrying
Amount
     Accumulated
Amortization
     Accumulated
Impairment
Charges (1)
     Net      Gross
Carrying
Amount
     Accumulated
Amortization
     Accumulated
Impairment
Charges (1)
     Net  

Intangible assets:

                       

Goodwill

   $ 210,633      $ —        $ 210,633      $ —        $ 210,633      $ —        $ 210,633      $ —    

Tradenames - Indefinite-lived

     68,405        —          59,405        9,000        68,405        —          59,405        9,000  

Tradenames - Definite-lived

     5,764        3,676        —          2,088        5,392        3,352        —          2,040  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
   $ 284,802      $ 3,676      $ 270,038      $ 11,088      $ 284,430      $ 3,352      $ 270,038      $ 11,040  
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1)

During the second quarter of Fiscal 2017, the Company experienced a significant reduction to its market capitalization. As a result of changed market conditions and the Company’s updated initiatives for the second half of Fiscal 2017, the Company revised the outlook for Fiscal 2017 and updated its long-range plan to reflect its operations in this increasingly competitive environment. Based on these factors, the Company concluded that an impairment trigger occurred for the retail reporting unit and therefore interim impairment tests of goodwill and other intangible assets were performed. The results of the interim goodwill impairment test indicated that the carrying value of the retail reporting unit exceeded its fair value, and in accordance with the early adoption of ASU 2017-04, Intangibles—Goodwill and Other—Simplifying the Test for Goodwill Impairment, the Company recorded an impairment charge on the goodwill of its retail segment of $164.3 million, of which $130.9 million was not deductible for income tax purposes.

During the third quarter of Fiscal 2017, the Company experienced another significant reduction to its market capitalization. As a result, the Company concluded that an impairment trigger occurred for the retail reporting unit and therefore interim impairment tests of goodwill and other intangible assets were performed. The Company also had recently updated its long-range plan. The results of the interim goodwill and other intangible assets impairment tests indicated that the carrying value of the Vitamin Shoppe tradename exceeded its fair value and that the carrying value of the retail reporting unit exceeded its fair value. The Company recorded an impairment charge on the Vitamin Shoppe tradename of $59.4 million. The Company also recorded an impairment charge for the remaining goodwill of its retail segment of $46.3 million, which was not deductible for income tax purposes.

 

14


Total goodwill impairment charges during Fiscal 2017 were $210.6 million, of which $177.2 million was not deductible for income tax purposes, as reflected in the effective tax rate benefit for the fiscal year ended December 30, 2017. In addition, the tradename impairment charge of $59.4 million and the tax deductible portion of the goodwill impairment charges of $33.4 million resulted in an increase to the Company’s net deferred tax assets of $23.7 million for the fiscal year ended December 30, 2017.

Intangible amortization expense for Fiscal 2018, Fiscal 2017 and Fiscal 2016 was $0.3 million in each of these fiscal years.

The useful lives of the Company’s definite-lived intangible assets are 10 years. The expected amortization expense on definite-lived intangible assets on the Company’s consolidated balance sheet at December 29, 2018, is as follows (in thousands):

 

Fiscal 2019

   $ 334  

Fiscal 2020

     334  

Fiscal 2021

     334  

Fiscal 2022

     331  

Fiscal 2023

     285  

Thereafter

     470  
  

 

 

 
   $ 2,088  
  

 

 

 

5. Property and Equipment

Property and equipment consists of the following (in thousands):

 

     December 29,
2018
     December 30,
2017
 

Leasehold improvements

   $ 166,397      $ 176,025  

Furniture, fixtures and equipment

     174,878        197,774  

Software

     88,943        98,128  
  

 

 

    

 

 

 
     430,218        471,927  

Less: accumulated depreciation and amortization

     (312,977      (334,082
  

 

 

    

 

 

 

Subtotal

     117,241        137,845  

Construction in progress

     5,761        3,675  
  

 

 

    

 

 

 
   $ 123,002      $ 141,520  
  

 

 

    

 

 

 

Depreciation and amortization expense on property and equipment for the fiscal years ended December 29, 2018, December 30, 2017 and December 31, 2016 was approximately $41.0 million, $37.8 million and $36.8 million, respectively. The Company recognized store impairment charges of $3.0 million during Fiscal 2018 on fixed assets related to thirty of its underperforming retail locations still in use in the Company’s operations. The Company recognized store impairment charges of $4.8 million during Fiscal 2017 on fixed assets related to thirty-four of its underperforming retail locations, thirty-one of which are still in use in the Company’s operations. The Company recognized store impairment charges of $0.8 million during Fiscal 2016 on fixed assets related to five of its underperforming retail locations still in use in the Company’s operations. Impairment charges on the fixed assets of retail locations during Fiscal 2018, 2017 and 2016 represented the full net book value of the fixed assets of these retail locations.

 

15


6. Accrued Expenses and Other Current Liabilities

Accrued expenses and other current liabilities consist of the following (in thousands):

 

     December 29,
2018
     December 30,
2017
 

Accrued salaries and related expenses

   $ 24,048      $ 18,094  

Sales tax payable and related expenses

     7,092        7,088  

Other accrued expenses

     29,413        31,753  
  

 

 

    

 

 

 
   $ 60,553      $ 56,935  
  

 

 

    

 

 

 

7. Credit Arrangements

Convertible Senior Notes due 2020

On December 9, 2015, the Company issued $143.8 million of its 2.25% Convertible Senior Notes due 2020 (the “Convertible Notes”). The Convertible Notes are senior unsecured obligations of VSI. Interest on the Convertible Notes is payable on June 1 and December 1 of each year until their maturity date of December 1, 2020. The Company may not redeem the Convertible Notes prior to the maturity date.

Prior to July 1, 2020, the Convertible Notes will be convertible only under the following circumstances: (1) during any calendar quarter if the last reported sale price of the common stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is greater than or equal to 130% of the conversion price on each applicable trading day; (2) during the 5 business day period after any 10 consecutive trading day period in which the trading price per $1,000 principal amount of Convertible Notes for such trading day was less than 98% of the product of the last reported sale price of our common stock and the conversion rate on each such trading day; or (3) upon the occurrence of specified corporate events. On or after July 1, 2020 until the close of business on the second scheduled trading day immediately preceding the maturity date, holders may convert all or any portion of their notes, in multiples of $1,000 principal amount, at the option of the holder regardless of the foregoing circumstances.

The Convertible Notes are convertible at an initial conversion rate of 25.1625 shares of the Company’s common stock per $1,000 principal amount of the Convertible Notes, which is equivalent to a conversion price of approximately $39.74. The conversion rate is subject to adjustment in some events but will not be adjusted for any accrued and unpaid interest. In addition, following certain corporate events that occur prior to the maturity date, the Company is required to increase, in certain circumstances, the conversion rate for a holder who elects to convert its Convertible Notes in connection with such a corporate event including customary conversion rate adjustments in connection with a “make-whole fundamental change” as defined. Upon conversion, the Company may satisfy its conversion obligation by paying or delivering, as applicable, cash, shares of its common stock or a combination of cash and shares of its common stock, at its election.

The Company allocated the principal amount of the Convertible Notes between its liability and equity components (see table below). The carrying amount of the liability component was determined by measuring the fair value of a similar debt instrument of similar credit quality and maturity that did not have the conversion feature. The carrying amount of the equity component, representing the embedded conversion option, was determined by deducting the fair value of the liability component from the principal amount of the Convertible Notes as a whole. The equity component was recorded to additional paid-in capital and is not remeasured as long as it continues to meet the conditions for equity classification. The excess of the principal amount of the Convertible Notes over the carrying amount of the liability component was recorded as a debt discount, and is being amortized to interest expense using an effective interest rate of 3.8% over the term of the Convertible Notes. The Company allocated the total amount of transaction costs incurred to the liability and equity components using the same proportions as the proceeds from the Convertible Notes. Transaction costs attributable to the liability component were recorded as a direct deduction from the liability component of the Convertible Notes, and are being amortized to interest expense using the effective interest method through the maturity date. Transaction costs attributable to the equity component were netted with the equity component of the Convertible Notes in additional paid-in capital.

 

16


During Fiscal 2018, the Company repurchased $83.3 million in aggregate principal amount of its Convertible Notes for an aggregate purchase price of $63.9 million, which includes accrued interest of $0.4 million. The gain on extinguishment of the repurchased Convertible Notes was $16.9 million.

The Convertible Notes consist of the following components (in thousands):

 

     December 29,
2018
     December 30,
2017
 

Liability component:

     

Principal

   $ 60,439      $ 143,750  

Conversion feature

     (17,115      (24,800

Liability portion of debt issuance costs

     (2,675      (3,802

Amortization

     14,921        11,267  
  

 

 

    

 

 

 

Net carrying amount

   $ 55,570      $ 126,415  
  

 

 

    

 

 

 

Equity component:

     

Conversion feature

   $ 18,862      $ 24,800  

Equity portion of debt issuance costs

     (793      (793

Deferred taxes

     941        941  
  

 

 

    

 

 

 

Net carrying amount

   $ 19,010      $ 24,948  
  

 

 

    

 

 

 

In connection with the issuance of the Convertible Notes, the Company entered into convertible note hedge transactions for which it paid an aggregate $26.4 million. In addition, the Company sold warrants for which it received aggregate proceeds of $13.0 million. The convertible note hedge transactions are expected generally to reduce potential dilution of the Company’s common stock upon any conversion of notes and/or offset any cash payments the Company is required to make in excess of the principal amount of converted notes. However, the warrant transaction could separately have a dilutive effect to the extent that the market value per share of the Company’s common stock exceeds the applicable strike price of the warrant transactions, which is approximately $52.99 at inception. As these transactions meet certain accounting criteria, the convertible note hedge and warrant transactions are recorded in stockholders’ equity, are not accounted for as derivatives and are not remeasured each reporting period.

The net proceeds from the Convertible Notes and related transactions of $125.7 million, net of commissions and offering costs of $4.6 million, were used to repurchase shares of the Company’s common stock under the Company’s share repurchase programs. Refer to Note 12. Share Repurchase Programs for additional information.

In connection with the repurchases of Convertible Notes, the convertible note hedge transactions and the warrant transaction noted above were reduced in ratable proportion to the face amount of Convertible Notes that were repurchased. The net proceeds received by the Company from these transactions were de minimis.

Revolving Credit Facility

As of December 29, 2018 and December 30, 2017, the Company had zero and $12.0 million of borrowings outstanding on its Revolving Credit Facility, respectively.

In May 2017, the Company executed an amendment to its Revolving Credit Facility, which provides for an extension of the maturity date to May 9, 2022, provided that the maturity date would be any day on or after September 2, 2020 only if the Company did not on any such day have enough liquidity to retire its Convertible Notes then outstanding, if any. The amendment also provides for a reduction of the interest rate under the Revolving Credit Facility, as noted below.

Subject to the terms of the Revolving Credit Facility, the Company may borrow up to $90.0 million, with a Company option to increase the facility up to a total of $150.0 million. The availability under the Revolving Credit Facility is subject to a borrowing base calculated on the value of certain inventory as well as certain accounts receivable of the Company. The obligations thereunder are secured by a security interest in substantially all of the assets of the Company. Under the Revolving Credit Facility, VSI has guaranteed the Company’s obligations, and Industries and its wholly-owned subsidiaries have each

 

17


guaranteed the obligations of the other respective entities. The Revolving Credit Facility provides for affirmative and negative covenants affecting the Company. The Revolving Credit Facility restricts, among other things, the Company’s ability to incur indebtedness, create or permit liens on the Company’s assets, declare or pay dividends and make certain other restricted payments, consolidate, merge or recapitalize, sell assets, make certain investments, loans or other advances, enter into transactions with affiliates, change our line of business, and restricts the types of hedging activities the Company can enter into. The largest amount borrowed during Fiscal 2018 was $44.0 million. The unused available line of credit under the Revolving Credit Facility at December 29, 2018 was $85.9 million.

Borrowings under the Revolving Credit Facility accrue interest, at the Company’s option, at the rate per annum based on an “alternative base rate” plus 0.00%, 0.125% or 0.25% or the adjusted Eurodollar rate plus 1.00%, 1.125% or 1.25%, in each case with the highest spread applicable in the event that the average excess collateral availability under the Revolving Credit Facility is less than 33% of the borrowing base availability under the Revolving Credit Facility, the second highest spread applicable in the event that the average excess collateral availability under the Revolving Credit Facility is less than 66% and greater than or equal to 33% of the borrowing base availability under the Revolving Credit Facility and the lowest spread applicable in the event that the average excess collateral availability under the Revolving Credit Facility is greater than or equal to 66% of the borrowing base availability under the Revolving Credit Facility. The weighted average interest rate for the Revolving Credit Facility for Fiscal 2018 was 3.02%. The commitment fee on the undrawn portion of the $90.0 million Revolving Credit Facility was 0.25% as of December 29, 2018 and December 30, 2017.

Interest expense, net for Fiscal 2018, 2017 and 2016 consists of the following (in thousands):

 

     Fiscal Year Ended  
     December 29,
2018
     December 30,
2017
     December 31,
2016
 

Amortization of debt discount on Convertible Notes

   $ 3,170      $ 4,781      $ 4,690  

Interest on Convertible Notes

     2,054        3,270        3,335  

Amortization of deferred financing fees

     604        898        957  

Interest / fees on the Revolving Credit Facility and other interest

     774        752        541  
  

 

 

    

 

 

    

 

 

 

Interest expense, net

   $ 6,602      $ 9,701      $ 9,523  
  

 

 

    

 

 

    

 

 

 

8. Revenue Recognition

The Company recognizes revenue from retail customers when merchandise is sold “at point of sale” in retail stores or upon delivery to a customer. Substantially all revenue from customers represents goods transferred at a point in time.

The Company applied the modified retrospective method for the transition to FASB Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606). The modified retrospective method requires application of the revenue standard only to the current year financial statements (i.e., the financial statements for the year in which the revenue standard is first implemented). Under the modified retrospective method, an entity records a cumulative-effect adjustment on the opening balance sheet to retained earnings. The opening adjustment to retained earnings is determined on the basis of the impact of the revenue standard’s application on contracts that were not completed as of the date of initial application. The Company did not record an opening adjustment to retained earnings as the impact of the application of the revenue standard was de minimis.

Disaggregation of Revenue

The Company disaggregates revenue from contracts with customers into two categories, sales fulfilled in stores and direct to consumer sales. The Company determines that disaggregating revenue into these categories achieves the disclosure objective to depict how the nature, amount, timing, and uncertainty of revenue and cash flows are affected by economic factors.

 

18


The following table contains net sales by fulfillment category (in thousands):

 

     Fiscal Year Ended  
     December 29,
2018
     December 30,
2017
     December 31,
2016 (a)
 

Net sales:

        

Sales fulfilled in stores

   $ 967,258      $ 1,022,954      $ 1,109,202  

Direct to consumer sales

     146,902        123,545        130,024  
  

 

 

    

 

 

    

 

 

 

Net sales

   $ 1,114,160      $ 1,146,499      $ 1,239,226  
  

 

 

    

 

 

    

 

 

 

 

(a)

Fiscal 2016 includes a 53rd week.

The following table represents net sales by major product category (in thousands):

 

     Fiscal Year Ended  

Product Category

   December 29,
2018
     December 30,
2017
     December 31,
2016 (a)
 

Vitamins, Minerals, Herbs and Homeopathy

   $ 331,017      $ 328,986      $ 339,597  

Sports Nutrition

     328,826        353,578        408,288  

Specialty Supplements

     288,939        294,546        308,945  

Other

     163,043        167,251        180,271  
  

 

 

    

 

 

    

 

 

 
     1,111,825        1,144,361        1,237,101  

Delivery Revenue

     2,335        2,138        2,125  
  

 

 

    

 

 

    

 

 

 

Total Net sales

   $ 1,114,160      $ 1,146,499      $ 1,239,226  
  

 

 

    

 

 

    

 

 

 

 

(a)

Fiscal 2016 includes a 53rd week.

Delivery revenue represents shipping fees billed to customers which are included in net sales in the consolidated statements of operations.

Contract Balances

Receivables primarily consist of amounts due from debit and credit card processors and amounts due from third-party e-commerce marketplaces. These receivables balances are included in prepaid expenses and other current assets in the consolidated balance sheets.

For the periods presented, the Company does not have contract assets. A contract asset would exist when an entity has a contract with a customer for which revenue has been recognized but payment is contingent on a future event other than the passage of time (e.g., unbilled receivables).

Contract liabilities primarily include deferred sales related to the loyalty program, a liability for future gift card redemptions and a liability for sales in transit. These liabilities are included in accrued expenses and other current liabilities in the consolidated balance sheets.

 

19


The opening and closing balances of the Company’s receivables and contract liabilities are as follows (in thousands):

 

     Receivables      Contract
Liabilities
 

Balances as of December 30, 2017

   $ 10,937      $ 7,511  

Increase

     1,055        899  
  

 

 

    

 

 

 

Balances as of March 31, 2018

     11,992        8,410  

Increase / (Decrease)

     (560      1,013  
  

 

 

    

 

 

 

Balances as of June 30, 2018

     11,432        9,423  

Decrease

     (515      (2,498
  

 

 

    

 

 

 

Balances as of September 29, 2018

     10,917        6,925  

Increase / (Decrease)

     (2,706      362  
  

 

 

    

 

 

 

Balances as of December 29, 2018

   $ 8,211      $ 7,287  
  

 

 

    

 

 

 

Balances as of December 31, 2016

   $ 11,012      $ 6,901  

Increase / (Decrease)

     744        (503
  

 

 

    

 

 

 

Balances as of April 1, 2017

     11,756        6,398  

Increase / (Decrease)

     (672      983  
  

 

 

    

 

 

 

Balances as of July 1, 2017

     11,084        7,381  

Increase / (Decrease)

     466        (957
  

 

 

    

 

 

 

Balances as of September 30, 2017

     11,550        6,424  

Increase / (Decrease)

     (613      1,087  
  

 

 

    

 

 

 

Balances as of December 30, 2017

   $ 10,937      $ 7,511  
  

 

 

    

 

 

 

The amounts of revenue recognized during the three month periods ended March 31, 2018 and April 1, 2017 that were included in the opening contract liability balances were $6.5 million and $6.0 million, respectively. The amounts of revenue recognized during the three month periods ended June 30, 2018 and July 1, 2017 that were included in the opening contract liability balances were $6.4 million and $5.6 million, respectively. The amounts of revenue recognized during the three month periods ended September 29, 2018 and September 30, 2017 that were included in the opening contract liability balances were $8.4 million and $6.5 million, respectively. The amounts of revenue recognized during the three month periods ended December 29, 2018 and December 30, 2017 that was included in the opening contract liability balances was $5.8 million in both periods. This revenue consists primarily of loyalty point redemptions, the delivery of sales in transit and gift card redemptions.

Performance Obligations

For retail sales, the performance obligation is the transfer of retail merchandise to the customer at the retail store or at the time of delivery to the customer. Variable consideration for retail sales is primarily related to our loyalty program. Under the loyalty program, sales are deferred at the time points are earned based on the value of points that are projected to be redeemed, which are based on historical redemption data and current trends. The Company records a liability in the period points are earned with a corresponding reduction of sales. Under this program, loyalty points are earned each calendar quarter and must be redeemed within the subsequent calendar quarter or they expire. During Fiscal 2018, the Company tested potential changes to the loyalty program, such as extending the redemption period on loyalty points, in order to improve the effectiveness of the program. Enhancements to the loyalty program will be rolled out in Fiscal 2019.

Performance obligations are typically satisfied at the point in time when the Company transfers control of the merchandise to the customer and at such point in time the customer is able to direct the use of and obtains substantially all of the benefits from the merchandise transferred to the customer. For retail sales, payment is due at the time the customer purchases retail merchandise. For retail sales, the Company establishes a provision for estimated returns of retail products, based on historical information.

 

20


The Company considers shipping and handling costs as fulfillment costs, and does not consider such activities as a separate performance obligation. When applicable, the Company is responsible for shipment and delivery of the merchandise, even when using a third-party shipping company.

Significant Judgments and Estimates

The Company considers control of retail products to have transferred upon delivery, at the retail location or the place of delivery, because the Company has a present right to payment at that time, the customer has legal title to the products, the Company has transferred physical possession of the products, and the customer has significant risks and rewards of ownership of the products.

Under the loyalty program, the value of points projected to be redeemed is dependent on the estimated redemption rates which are based on both historical information and current trends.

For retail sales in transit, the Company defers the recognition of revenue based on an estimate of the respective anticipated timing of delivery.

Practical Expedients

The Company has elected to use the following practical expedients affecting the measurement and recognition of revenue:

Significant financing component - As substantially all of the Company’s contracts with customers have an original duration of one year or less, the Company uses the practical expedient applicable to such contacts and does not consider the time value of money.

Sales taxes - Consistent with prior periods, sales taxes collected from customers are presented on a net basis and as such are excluded from revenue.

Contract costs - Due to the short term duration of the Company’s contracts with customers, such incremental costs of obtaining or fulfilling a contract are recognized as an expense when incurred since the amortization period of the asset that the Company otherwise would have recognized is one year or less.

Portfolio approach - For its retail contracts with customers, the Company has applied the revenue standard to a portfolio of contracts with similar characteristics since the Company reasonably expects that the effects on the financial statements of applying this guidance to the portfolio would not differ materially from applying this guidance to the individual contracts within that portfolio.

Disclosure of remaining performance obligations - Due to the short duration of its contracts with customers of one year or less, the Company has elected not to disclose the information regarding the remaining performance obligations as of the end of each reporting period or when the Company expects to recognize this revenue.

 

21


9. Income Taxes

The provision (benefit) for income taxes for Fiscal 2018, Fiscal 2017 and Fiscal 2016 consists of the following (in thousands):

 

     Fiscal Year Ended  
     December 29,
2018
     December 30,
2017
     December 31,
2016
 

Current:

        

Federal

   $ (4,925    $ (501    $ 20,923  

State

     (267      (28      3,850  
  

 

 

    

 

 

    

 

 

 

Total current

     (5,192      (529      24,773  
  

 

 

    

 

 

    

 

 

 

Deferred:

        

Federal

     2,839        (14,461      (11,655

State

     2,780        (5,373      (2,028
  

 

 

    

 

 

    

 

 

 

Total deferred

     5,619        (19,834      (13,683
  

 

 

    

 

 

    

 

 

 

Provision (benefit) for income taxes

   $ 427      $ (20,363    $ 11,090  
  

 

 

    

 

 

    

 

 

 

Provision (benefit) for income taxes is included in the consolidated financial statements as follows (in thousands):

 

     Fiscal Year Ended  
     December 29,
2018
     December 30,
2017
     December 31,
2016
 

Continuing operations

   $ 3,588      $ (18,882    $ 29,065  

Discontinued operations

     (3,161      (1,481      (17,975
  

 

 

    

 

 

    

 

 

 

Provision (benefit) for income taxes

   $ 427      $ (20,363    $ 11,090  
  

 

 

    

 

 

    

 

 

 

A reconciliation of the statutory Federal income tax rate and effective rate for income taxes for continuing operations is as follows:

 

     Fiscal Year Ended  
     December 29,
2018
    December 30,
2017
    December 31,
2016
 

Federal statutory rate

     21.0     35.0     35.0

State income taxes, net of Federal income tax benefit

     9.3     3.9     4.5

Federal tax credit

     (8.6 )%      —        —   

Revaluation of deferred tax assets and liabilities

     (6.6 )%      (3.9 )%      —   

Stock compensation

     4.6     (0.4 )%      —   

Impairment of goodwill

     —        (27.3 )%      —   

Write-off of Canada investment

     —        (0.1 )%      (3.7 )% 

Other

     1.2     0.2     0.4
  

 

 

   

 

 

   

 

 

 

Effective tax rate

     20.9     7.4     36.2
  

 

 

   

 

 

   

 

 

 

 

22


Deferred income taxes reflect the net tax effects of temporary differences between the carrying value of assets and liabilities for financial reporting purposes and amounts used for income tax purposes. The temporary differences and carryforwards that give rise to deferred tax assets and liabilities at December 29, 2018 and December 30, 2017 are as follows (in thousands):

 

     December 29,
2018
     December 30,
2017
 

Deferred tax assets:

     

Net operating loss carryforward

   $ 12,104      $ 2,820  

Deferred rent

     6,452        7,012  

Tenant allowance

     3,268        3,659  

General accrued liabilities

     4,097        4,660  

Deferred wages and compensation

     2,494        1,594  

Inventory

     6,984        8,078  

Equity compensation expense

     1,979        2,582  

Debt

     —          583  

Trade name and goodwill

     3,029        10,850  

Other

     705        2,830  
  

 

 

    

 

 

 
     41,112        44,668  

Valuation allowance

     (5,434      (2,820
  

 

 

    

 

 

 

Deferred tax assets

     35,678        41,848  
  

 

 

    

 

 

 

Deferred tax liabilities:

     

Debt

     (1,214      —    

Accumulated depreciation

     (1,104      (3,078

Prepaid expenses

     (1,701      (1,492
  

 

 

    

 

 

 

Deferred tax liabilities

     (4,019      (4,570
  

 

 

    

 

 

 

Net deferred tax asset

   $ 31,659      $ 37,278  
  

 

 

    

 

 

 

Management periodically assesses whether the Company is more likely than not to realize some or all of its deferred tax assets. As of December 29, 2018, with the exception of $5.4 million of deferred tax assets arising from a foreign and state net operating loss carryforward against which there is a valuation allowance (see above table), management determined that the Company is more likely than not to realize the deferred tax assets detailed above. Realization of deferred tax assets associated with the state net operating loss carryforwards is dependent upon generating sufficient taxable income prior to their expiration by tax jurisdiction.

The Company and its subsidiaries file income tax returns in the U.S. federal jurisdiction, various state jurisdictions, Puerto Rico and Canada. The Company recognizes interest related to uncertain tax positions in income tax expense. The Company is no longer subject to U.S. federal examinations by tax authorities for years before 2015 and for state examinations before 2012. However, the tax authorities still have the ability to review the relevance of net operating loss carryforwards created in closed years if such tax attributes are utilized in open years (subsequent to 2012).

The Company has domestic federal operating losses of approximately $31.8 million which will be carried forward indefinitely. The Company also has domestic (U.S. state) and foreign net operating losses of approximately $72.3 million and $7.9 million at December 29, 2018, against which a full valuation allowance is recorded. Domestic net operating losses generated will continue to expire annually through Fiscal 2034. The Company’s foreign net operating loss was generated through operations in Canada, and will expire in Fiscal 2035.

10. Stock Based Compensation

Equity Incentive Plans - In June 2018, the Company’s shareholders approved the 2018 Long-term Incentive Plan (the “2018 Plan”) to provide stock based compensation to certain directors, officers, consultants and employees of the Company. The 2018 Plan replaces the two previous plans, the 2006 Stock Option Plan and the Vitamin Shoppe 2009 Equity Incentive

 

23


Plan, as amended and restated effective April 6, 2012. Upon adoption of the 2018 Plan, 1,410,928 additional shares were authorized to grant under this plan. As of December 29, 2018, there were 2,995,168 shares available to grant under the 2018 Plan, which includes 240,900 shares currently held by the Company as treasury stock. During Fiscal 2018, the Company granted inducement awards to certain executives, which were granted outside of the 2018 Plan, but generally incorporate the terms and conditions of the 2018 Plan. These inducement awards consisted of 104,510 performance share units and 31,250 restricted share units. Restricted shares, performance share units and restricted share units are issued at a value not less than the fair market value of the common shares on the date of the grant and stock options are exercisable at no less than the fair market value of the underlying shares on the date of grant. Equity awards of restricted shares generally shall become vested between two and three years subsequent to the date on which such equity grants were awarded. Performance share units shall become vested approximately three years subsequent to the date on which such equity grants were awarded. Stock options awarded shall become vested in three equal increments on each of the anniversaries of the date on which such equity grants were awarded and generally have a maximum term of 10 years. However, regarding performance based restricted shares, performance share units and performance based stock options, vesting is dependent not only on the passage of time, but also on the attainment of certain internal performance metrics or market conditions. For accounting purposes, the expense for performance based stock options, performance based restricted shares and performance share units is calculated and recorded, based on the determination that the achievement of the pre-established performance targets or market conditions are probable, over the relevant service period. Restricted share units generally shall become vested quarterly, or up to three years, subsequent to the date on which such equity grants were awarded.

The following table summarizes restricted shares for the 2018 Plan as of December 29, 2018 and changes during Fiscal 2018:

 

     Number of
Unvested
Restricted
Shares
     Weighted
Average Grant
Date Fair
Value
 

Unvested at December 30, 2017

     724,104      $ 18.65  

Granted

     302,275      $ 4.74  

Vested

     (158,254    $ 23.05  

Canceled/forfeited

     (431,728    $ 14.32  
  

 

 

    

Unvested at December 29, 2018

     436,397      $ 11.70  
  

 

 

    

The total intrinsic value of restricted shares vested during Fiscal 2018, Fiscal 2017 and Fiscal 2016 was $0.8 million, $1.5 million and $2.5 million, respectively.

The following table summarizes stock options for the 2018 Plan as of December 29, 2018 and changes during Fiscal 2018:

 

     Number of
Options
     Weighted
Average
Exercise Price
     Weighted
Average
Remaining
Contractual
Life (years)
     Aggregate
Intrinsic Value
(in thousands)
 

Outstanding at December 30, 2017

     308,888      $ 27.74        

Granted

     141,777      $ 4.65        

Exercised

     —        $ —          

Canceled/forfeited

     (178,665    $ 25.58        
  

 

 

          

Outstanding at December 29, 2018

     272,000      $ 17.13        7.31      $ —    
  

 

 

    

 

 

    

 

 

    

 

 

 

Vested or expected to vest at December 29, 2018

     255,158      $ 17.71        7.22        —    
  

 

 

    

 

 

    

 

 

    

 

 

 

Vested and exercisable at December 29, 2018

     103,581      $ 31.44        4.91      $ —    
  

 

 

    

 

 

    

 

 

    

 

 

 

 

24


No options were exercised during Fiscal 2018. The total intrinsic value of options exercised during Fiscal 2017 and Fiscal 2016 was $0.7 million and $0.1 million, respectively. The cash received from options exercised during Fiscal 2017 and Fiscal 2016 was $1.5 million and $0.1 million, respectively.

No stock options were granted in Fiscal 2017. The weighted average grant date fair value of stock options was $1.76 for Fiscal 2018 and $7.96 for Fiscal 2016. During Fiscal 2018, the fair value of each option grant was estimated on the date of grant using the Monte Carlo option-pricing model, because these awards contain a market condition based on the achievement of predetermined targets related to the share price of our common stock. During Fiscal 2016, the fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model.

The weighted average grant date fair values of stock options were based on the following assumptions:

 

     Fiscal Year Ended  
     December 29, 2018     December 31, 2016  

Expected dividend yield

     —        —   

Weighted average expected volatility

     42.6     32.4

Weighted average risk-free interest rate

     2.5     1.2

Expected holding period

     6.02 years       4.00 years  

The following table summarizes performance share units for the 2018 Plan, as well as inducement awards, as of December 29, 2018 and changes during Fiscal 2018:

 

     Number of
Unvested
Performance
Share Units
     Weighted
Average Grant
Date Fair Value
 

Unvested at December 30, 2017

     288,365      $ 22.43  

Granted

     657,586      $ 6.01  

Vested

     —        $ —    

Canceled/forfeited

     (502,082    $ 11.34  
  

 

 

    

Unvested at December 29, 2018

     443,869      $ 10.64  
  

 

 

    

Performance share units granted during Fiscal 2018 shall vest on December 26, 2020 and December 25, 2021 if the performance criteria are achieved. Performance share units granted during Fiscal 2017 shall vest on December 28, 2019 if the performance criteria are achieved. Performance share units can vest at a range of 0% to 150% based on the achievement of pre-established performance targets. Performance share units granted during Fiscal 2016 vested at 11% in February 2019 upon board of directors approval based on the percentage achievement of the performance criteria.

The following table summarizes restricted share units for the 2018 Plan, as well as inducement awards, as of December 29, 2018 and changes during Fiscal 2018:

 

     Number of
Unvested
Restricted
Share Units
     Weighted
Average Grant
Date Fair
Value
 

Unvested at December 30, 2017

     39,708      $ 11.90  

Granted

     160,560      $ 7.45  

Vested

     (87,205    $ 9.25  

Canceled/forfeited

     (23,723    $ 6.85  
  

 

 

    

Unvested at December 29, 2018

     89,340      $ 7.84  
  

 

 

    

The total intrinsic value of restricted share units vested during Fiscal 2018, Fiscal 2017 and Fiscal 2016 was $0.4 million, $0.1 million and $0.4 million, respectively.

 

25


Compensation expense attributable to stock-based compensation for Fiscal 2018 was $2.7 million, for Fiscal 2017 was $6.1 million and for Fiscal 2016 was $6.3 million. As of December 29, 2018, the remaining unrecognized stock based compensation expense for non-vested stock options, restricted shares, performance share units and restricted share units to be expensed in future periods is $4.2 million, and the related weighted average period over which it is expected to be recognized is 1.5 years. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The Company estimates forfeitures based on its historical forfeiture rate since the inception of granting stock based awards. The estimated value of future forfeitures for stock options, restricted shares, performance share units and restricted share units as of December 29, 2018 is approximately $0.3 million.

Treasury Stock—As part of the Company’s equity incentive plans, the Company makes required tax payments on behalf of employees as their restricted shares vest. The Company withholds the number of vested shares having a value on the date of vesting equal to the minimum statutory tax obligation. The shares withheld are recorded as treasury shares. During Fiscal 2018, the Company purchased 62,059 shares in settlement of employees’ tax obligations for a total of $0.3 million. The Company accounts for treasury stock using the cost method. 240,900 treasury shares are available to grant under the Company’s equity incentive plan.

11. Restructuring Costs

Closing of Distribution Center

In August 2017, the Company announced its intention to close the North Bergen, New Jersey distribution center, which it closed on August 31, 2018, upon lease expiration. The transition of distribution operations to the Company’s other distribution centers was substantially completed during Fiscal 2017.

Costs related to this closure, including occupancy, severance and other expenses, for the fiscal year ended December 29, 2018 were $2.7 million, of which approximately $1.6 million is included in cost of goods sold and approximately $1.1 million is included in selling, general and administrative expenses in the consolidated statements of operations. Costs related to this closure, including inventory obsolescence charges, severance and other expenses, for the fiscal year ended December 30, 2017 were $3.1 million, and substantially all of these costs are included in cost of goods sold in the consolidated statements of operations. As of December 29, 2018, the Company had no remaining liabilities related to the closing of the North Bergen, New Jersey distribution center.

12. Share Repurchase Programs

Beginning in August 2014, the Company’s board of directors approved share repurchase programs that enable the Company to purchase up to an aggregate of $370 million of its shares of common stock and/or its Convertible Notes, from time to time. As of December 29, 2018, 8,064,325 shares of common stock pursuant to these programs, and 83,311 Convertible Notes, have been repurchased for a total of $333.8 million. There is approximately $36.2 million remaining in this program. On October 31, 2018, the Company’s board of directors approved a two year extension of the remaining repurchase program. This repurchase program will expire on November 22, 2020.

The repurchase programs do not obligate the Company to acquire any specific number of securities and may be suspended, terminated or modified at any time for any reason, including market conditions, the cost of repurchasing securities, the availability of alternative investment opportunities, liquidity, restrictions under the Company’s credit agreement, applicable law and other factors deemed appropriate.

No shares of the Company were repurchased under these programs during Fiscal 2018. During Fiscal 2018, the Company repurchased $83.3 million in aggregate principal amount of its Convertible Notes for an aggregate purchase price of $63.9 million, which includes accrued interest of $0.4 million.

No shares or other securities of the Company were repurchased under these programs during Fiscal 2017. During Fiscal 2016, the Company repurchased 1,670,837 shares of its common stock in the open market. The shares were retired upon repurchase. Open market share repurchases were $47.0 million in Fiscal 2016 with an average repurchase price per share of $28.13. In Fiscal 2016, the Company also repurchased 646,666 shares of its common stock for $19.0 million, or $29.40 per share, under a 10b5-1 program which the Company entered into to purchase shares under predetermined criteria.

 

26


Additionally, the Company has entered into accelerated share repurchase (“ASR”) arrangements with financial institutions. In exchange for an up-front payment, the financial institutions initially deliver shares of the Company’s common stock. The total number of shares ultimately delivered, and therefore the average repurchase price paid per share, is determined at the end of the purchase period of each ASR based on the volume weighted-average price of the Company’s common stock during that period. The shares are retired in the periods they are delivered, and each up-front payment is accounted for as a reduction to stockholders’ equity in the Company’s Consolidated Balance Sheet in the period the payment was made. The Company reflects each ASR as a repurchase of common stock in the period delivered for purposes of calculating earnings per share and as a forward contract indexed to its own common stock. The ASRs met all of the applicable criteria for equity classification, and therefore, were not accounted for as derivative instruments.

The following table summarizes the Company’s ASR arrangements:

 

Beginning

of ASR

Period

  

Up-front

Payment

(in millions)

    

Initial Share

Deliveries

    

End

of ASR

Period

    

Final

Shares

Delivered

    

Average

Repurchase

Price

 

December, 2015

   $ 50.0        1,391,940        February, 2016        235,053      $ 30.73  

13. Benefit Plans

The Company sponsors the Vitamin Shoppe Industries, Inc. 401(k) Plan (“401k Plan”). Employees who have completed one month of service are eligible to participate in the 401k Plan. The 401k Plan provides for participant contributions of 1% to 100% of participant compensation into deferred savings, subject to IRS limitations. The 401k Plan provides for Company contributions upon the participant meeting the eligibility requirements. Participants are 100% vested in the Company matching contribution upon receipt. The Company matching contribution is 100% of the first 3% of participant compensation contributed to the 401k Plan and 50% of the next 2% of participant compensation contributed to the 401k Plan. The Company may make discretionary contributions for each 401k Plan year.

The Company recognized expenses for the 401k Plan of $2.3 million in Fiscal 2018, $2.1 million in Fiscal 2017 and $2.0 million in Fiscal 2016.

14. Lease Commitments

The Company has non-cancelable real estate operating leases, which expire through 2036. These leases generally contain renewal options for periods ranging from 1 to 10 years and require the Company to pay costs such as real estate taxes and common area maintenance. Contingent rentals are paid based on a percentage of gross sales as defined by lease agreements. The following table provides the net rental expense for all real estate operating leases (in thousands):

 

     Fiscal Year Ended  
     December 29,
2018
     December 30,
2017
     December 31,
2016
 

Minimum rentals

   $ 126,219      $ 124,150      $ 122,039  

Contingent rentals

     83        88        88  
  

 

 

    

 

 

    

 

 

 
     126,302        124,238        122,127  

Less: Sublease rentals

     (1,389      (360      (274
  

 

 

    

 

 

    

 

 

 

Net rental expense

   $ 124,913      $ 123,878      $ 121,853  
  

 

 

    

 

 

    

 

 

 

 

27


As of December 29, 2018, the Company’s real estate lease commitments are as follows (in thousands):

 

Fiscal year    Total
Operating
Leases (1)
 

2019

   $ 121,227  

2020

     108,993  

2021

     95,529  

2022

     80,274  

2023

     61,847  

Thereafter

     115,852  
  

 

 

 
   $ 583,722  
  

 

 

 

 

(1)

Store operating leases included in the above table do not include contingent rent based upon sales volume. Operating leases do not include common area maintenance costs or real estate taxes that are paid to the landlord during the year, which combined represented approximately 18.5% of our minimum lease obligations for Fiscal 2018.

15. Legal Proceedings

The Company is party to various lawsuits arising from time to time in the normal course of business, some of which are covered by insurance. Although the impact of the final resolution of these matters on the Company’s financial condition, results of operations or cash flows is not known, management does not believe that the resolution of these lawsuits will have a material adverse effect on the financial condition, results of operations or liquidity of the Company.

16. Fair Value of Financial Instruments

The fair value hierarchy requires the categorization of assets and liabilities into three levels based upon the assumptions (inputs) used to price the assets or liabilities. Level 1 provides the most reliable measure of fair value, while Level 3 generally requires significant management judgment. The three levels are defined as follows:

 

   

Level 1: Unadjusted quoted prices in active markets for identical assets and liabilities.

 

   

Level 2: Observable inputs other than those included in Level 1. For example, quoted prices for similar assets or liabilities in active markets or quoted prices for identical assets or liabilities in inactive markets.

 

   

Level 3: Unobservable inputs reflecting management’s own assumptions about the inputs used in pricing the asset or liability.

The Company’s financial instruments include cash, accounts receivable, accounts payable, contract liabilities and its Revolving Credit Facility. The Company believes that the recorded values of these financial instruments approximate their fair values due to their nature and respective durations.

The Company’s financial instruments also include its Convertible Notes (in thousands):

 

     December 29, 2018      December 30, 2017  

Fair Value

   $ 50,914      $ 91,612  

Carrying Value (1)

     55,570        126,415  

 

(1)

Represents the net carrying amount of the liability component of the Convertible Notes. The Company repurchased a portion of its Convertible Notes during the fiscal year ended December 29, 2018. Refer to Note 7., “Credit Arrangements” for additional information.

The fair value of the Convertible Notes was determined based on inputs that are observable in the market or that could be derived from, or corroborated with, observable market data, including the trading price of the Company’s Convertible Notes, when available, the Company’s stock price and interest rates based on similar debt issued by parties with credit ratings similar to the Company (Level 1 or 2).

 

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Intangible assets and fixed assets are measured at fair value on a non-recurring basis, that is, the assets are subject to fair value adjustments in certain circumstances such as when there is evidence of impairment. These measures of fair value, and related inputs, are considered Level 3 measures under the fair value hierarchy.

17. Selected Quarterly Financial Information (unaudited)

The following table summarizes the Fiscal 2018 and Fiscal 2017 quarterly results from continuing operations (in thousands, except for share data):

 

     Fiscal Quarter Ended  
     March      June      September (1)      December (2)  

Fiscal Year Ended December 29, 2018

           

Net sales

   $ 295,964      $ 293,103      $ 276,636      $ 248,457  

Gross profit

     93,111        94,236        86,691        80,755  

Income (loss) from operations

     3,811        5,187        3,226        (5,395

Net income (loss)

     9,657        5,283        1,880        (3,279

Net income (loss) per common share:

           

Basic

   $ 0.41      $ 0.22      $ 0.08      $ (0.14

Diluted

   $ 0.41      $ 0.22      $ 0.08      $ (0.14

Fiscal Year Ended December 30, 2017

           

Net sales

   $ 305,772      $ 296,420      $ 282,407      $ 261,900  

Gross profit

     98,982        97,321        86,618        79,646  

Income (loss) from operations

     18,841        (152,373      (103,805      (7,171

Net income (loss)

     9,895        (146,416      (83,364      (15,442

Net income (loss) per common share:

           

Basic

   $ 0.43      $ (6.30    $ (3.60    $