UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

 

 

 

Form 10-Q

 

 

 

 

Commission file number 001-33608

 

 

 

 

lululemon athletica inc.
(Exact name of registrant as specified in its charter)

 

 

 

 

 

 

Registrant’s telephone number, including area code:

604-732-6124

 

Former name, former address and former fiscal year, if changed since last report:

N/A

 

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

At September 8, 2008, there were 47,892,534 shares of the registrant’s common stock, par value $0.01 per share, outstanding.

 

Exchangeable and Special Voting Shares:

 

At September 8, 2008 there were outstanding 20,312,272 exchangeable shares of Lulu Canadian Holding, Inc., a wholly-owned subsidiary of the registrant. Exchangeable shares are exchangeable for an equal number of shares of the registrant’s common stock.

 

In addition, at September 8, 2008, the registrant had outstanding 20,312,272 shares of special voting stock, through which the holders of exchangeable shares of Lulu Canadian Holding, Inc. may exercise their voting rights with respect to the registrant. The special voting stock and the registrant’s common stock generally vote together as a single class on all matters on which the common stock is entitled to vote.

 

 

TABLE OF CONTENTS

 

 

 

lululemon athletica inc. and Subsidiaries

 

CONSOLIDATED BALANCE SHEETS

 

 

See accompanying notes to the interim consolidated financial statements

lululemon athletica inc. and Subsidiaries

 

CONSOLIDATED STATEMENTS OF OPERATIONS

 

 

See accompanying notes to the interim consolidated financial statements

lululemon athletica inc. and Subsidiaries

 

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

 

 

See accompanying notes to the interim consolidated financial statements

lululemon athletica inc. and Subsidiaries

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

 

See accompanying notes to the interim consolidated financial statements

lululemon athletica inc. and Subsidiaries

 

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS

 

 

Nature of operations

 

lululemon athletica inc., a Delaware corporation (“lululemon” or “LAI” and, together with its subsidiaries unless the context otherwise requires, the “Company”) is engaged in the design, manufacture and distribution of healthy lifestyle inspired athletic apparel, which is sold through a chain of corporate-owned and operated retail stores, independent franchises and a network of wholesale accounts. The Company’s primary markets are Canada and the United States where 40 and 39 corporate-owned stores were in operation as at August 3, 2008, respectively. There were a total of 80 and 71 corporate-owned stores in operation as of August 3, 2008, and February 3, 2008 respectively.

 

Basis of presentation

 

The unaudited interim consolidated financial statements as of August 3, 2008 and for the 26-week period ended August 3, 2008 and as of July 31, 2007 and for the six months ended July 31, 2007 are presented using the United States dollar and have been prepared by the Company under the rules and regulations of the Securities and Exchange Commission (“SEC”). In the opinion of management, the financial information is presented in accordance with United States generally accepted accounting principles (“GAAP”) for interim financial information and, accordingly, do not include all of the information and footnotes required by GAAP for complete financial statements. The financial information as of February 3, 2008 is derived from the Company’s audited consolidated financial statements and notes for the fiscal year ended February 3, 2008, included in Item 8 in the Fiscal 2007 Annual Report on Form 10-K. These unaudited interim consolidated financial statements should be read in conjunction with the Company’s 2007 Annual Report on Form 10-K filed with the SEC on April 8, 2008.

 

The Company reorganized its corporate structure on July 26, 2007. This reorganization was accounted for as a transfer of entities under common control, and accordingly, the financial statements for periods prior to the reorganization have been restated on an “as if” pooling basis. Prior to the reorganization, the Company had prepared combined consolidated financial statements combining LAI and LIPO Investments (Canada) Inc., an entity owned by a principal stockholder of the Company.

 

Through fiscal 2006, the Company’s fiscal year ended on January 31st in the year following the year mentioned. Commencing with fiscal 2007, the Company’s fiscal year ends on the first Sunday following January 30th in the year following the year mentioned.

 

Our business is affected by the pattern of seasonality common to most retail apparel businesses. The results for the periods presented are not necessarily indicative of future financial results.

 

 

In March 2008, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 161, Disclosures about Derivative Instruments and Hedging Activities (“FAS 161”). FAS 161 is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. The provisions of FAS 161 are effective for the fiscal years and interim periods beginning after November 15, 2008. The Company is currently evaluating the impact of adopting FAS 161 on its consolidated financial statement disclosures.

 

In December 2007, the FASB issued SFAS No. 141R, Business Combinations (revised 2007) (“FAS 141R”). FAS 141R replaces FAS 141 and requires the acquirer of a business to recognize and measure the identifiable assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree at fair value. SFAS 141R also requires transaction costs related to the business combination to be expensed as incurred. SFAS 141R is effective for

 

lululemon athletica inc. and Subsidiaries

 

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

business combinations for which the acquisition date is on or after fiscal years beginning after December 15, 2008. The Company is currently evaluating the impact of adopting SFAS 141R on its consolidated financial statements.

 

In December 2007, the FASB issued SFAS No. 160 Noncontrolling Interests in Consolidated Financial Statements (“FAS 160”). FAS 160 changes the classification of non-controlling (minority) interests on the balance sheet and the accounting for and reporting of transactions between the reporting entity and holders of such non-controlling interests. Under the new standard, non-controlling interests are considered equity and are to be reported as an element of stockholders’ equity rather than within the mezzanine or liability sections of the balance sheet. In addition, the current practice of reporting minority interest expense or benefit also will change. Under the new standard, net income will encompass the total income before minority interest expense. The income statement will include separate disclosure of the attribution of income between the controlling and non-controlling interests. Increases and decreases in the non-controlling ownership interest amount are to be accounted for as equity transactions. FAS 160 is effective for fiscal years beginning after December 15, 2008 and earlier application is prohibited. Upon adoption, the balance sheet and the income statement will be recast retrospectively for the presentation of non-controlling interests. The other accounting provisions of the statement are required to be adopted prospectively. The Company is currently evaluating the impact that adopting FAS 160 will have on its financial position and results of operations.

 

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“FAS 159”). This Statement permits entities to choose to measure various financial assets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. The Company adopted FAS 159 on February 4, 2008 and did not elect the fair value option for any of its eligible financial assets or liabilities.

 

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“FAS 157”). FAS 157 defines fair value, establishes a framework for measuring fair value in accordance with GAAP, and expands disclosures about fair value measurements. FAS 157 applies under other accounting pronouncements that require or permit fair value measurements and accordingly does not require any new fair value measurements. The provisions of FAS 157 are to be applied prospectively as of the beginning of the fiscal year in which it is initially applied, with any transition adjustment recognized as a cumulative-effect adjustment to the opening balance of retained earnings. The provisions of FAS 157 are effective for fiscal years beginning after November 15, 2007, however the FASB has delayed the effective date of FAS 157 to fiscal years beginning after November 15, 2008 for nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis. The adoption of FAS 157 for financial assets and liabilities in the first two quarters of fiscal 2008 did not have a material impact on the Company’s consolidated financial statements. The Company is currently evaluating the impact of the adoption of FAS 157 for nonfinancial assets and nonfinancial liabilities on its financial position and results of operations.

 

 

During the thirteen weeks ended August 3, 2008 the Company entered into a Credit Agreement (the “Agreement”) with our Australian franchise partner, under which advances were provided by the Company to the franchisee. The Agreement provides for a secured non-revolving credit facility of up to AUD$3.9 million. As at August 3, 2008 a total of AUD$2.2 million has been drawn on the line of credit.

 

The loan is presented on the Company’s balance sheet as other non-current assets. The loan bears interest at 8% per annum which will accrue and capitalize to the loan principal.

 

The loan will be convertible into equity of the franchise three years after the effective date of the Agreement.

 

lululemon athletica inc. and Subsidiaries

 

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

Share option plans

 

The Company’s employees participate in various stock-based compensation plans which are either provided by a principal stockholder of the Company or by the Company directly.

 

Stock-based compensation expense charged to income for the plans was $3,740,890 and $2,968,524 for the twenty six weeks ended August 3, 2008 and the six months ended July 31, 2007 respectively. Total unrecognized compensation cost at August 3, 2008 was $13,054,308 for all stock option plans, which is expected to be recognized over a weighted-average period of 2.6 years.

 

Company stock options

 

A summary of the Company’s stock options and restricted share activity as of August 3, 2008 and changes during the period then ended is presented below:

 

 

Stockholder-sponsored stock options

 

During the twenty six weeks ended August 3, 2008 there were no grants or exercises related to the stock options issued and outstanding under the stockholder-sponsored awards.

 

Employee stock purchase plan

 

The Company’s Board of Directors and stockholders approved the Company’s Employee Stock Purchase Plan (“ESPP”) in September 2007. The ESPP allows for the purchase of common stock of the Company by all eligible employees. Eligible employees may elect to have whatever portion of his or her base salary that equates, after deduction of applicable taxes, to either 3%, 6% or 9% of his or her base salary withheld during each payroll period for purposes of purchasing shares of our common stock under the ESPP. Additionally, we, or the subsidiary employing the participant, will make a cash contribution as additional compensation to each participant equal to one-third of the aggregate amount of that participant’s contribution for that pay period, which will be used to purchase shares of our common stock, subject to certain limits as defined in the ESPP. The maximum number of shares available under the ESPP is 3,000,000 shares. During the quarter ended August 3, 2008, 8,684 shares were purchased under the ESPP, through open market purchases.

 

Stock option modification

 

Stock options issued to a former officer of the Company were modified during the thirteen weeks ended August 3, 2008. The modification resulted in the cancellation of the last year and one half of the time vested option grant. The Company performed a stock option modification analysis and determined the impact of the modification to be immaterial.

 

lululemon athletica inc. and Subsidiaries

 

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The modification analysis was performed using the Black-Scholes option pricing model and resulted in the following values:

 

 

 

Brian Bacon, a former employee, filed suit against the Company in the Supreme Court of British Columbia, Canada on May 6, 2008. In the action, captioned Brian Bacon v. Lululemon Athletica Canada Inc., Case No. S083254, Mr. Bacon claims that we terminated his employment contract without cause and without reasonable notice resulting in breach of contract, losses and damages. Mr. Bacon seeks damages in an unspecified amount, plus costs and interest related primarily to loss from participation in the stockholder sponsored LIPO USA awards. We believe this claim is without merit and are vigorously defending against it.

 

We are a party to various other legal proceedings arising in the ordinary course of our business, but we are not currently a party to any legal proceeding that management believes would have a material adverse effect on our consolidated financial position or results of operations.

 

 

During the second quarter of fiscal 2008, following an IRC section 956 inclusion, the Company recapitalized its US subsidiary and received distributions from its Canadian subsidiary. This resulted in the utilization of all net operating loss carryforwards (“NOL’s”) generated in the United States prior to February 3, 2008.

 

As of February 3, 2008, we maintained a valuation allowance against substantially all of our net deferred income tax assets generated in the United States prior to February 3, 2008 since we had determined, based primarily on a history of cumulative losses in recent years and uncertainty regarding the timing and amounts of future taxable income together with the utilization of previous years NOL’s, that realization of our deferred income tax assets did not meet the more likely than not criteria. During the second quarter of fiscal 2008, after considering a number of factors, including a history of cumulative earnings, utilization of previously generated NOL’s and estimated taxable income in future years, we determined we would more likely than not realize substantial future tax benefits from our deferred income tax assets. As a result of this analysis the Company recorded deferred tax assets of (i) $1,388,549 related primarily to historical tax differences between financial and tax bases of assets and liabilities, (ii) $902,606 cumulative tax benefit recorded from stock-based compensation expense prior to the second quarter of fiscal 2008, and (iii) $2,660,671 excess tax benefit from the exercise of stock options during and prior to the second quarter of fiscal 2008.

 

lululemon athletica inc. and Subsidiaries

 

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

The details of the computation of basic and diluted earnings per share is as follows:

 

 

Our calculation of weighted-average shares include the common stock of the Company as well as the exchangeable shares. Exchangeable shares are the equivalent of common shares in all respects. All classes of stock have in effect the same rights and share equally in undistributed net income. For the thirteen and twenty six weeks ended August 3, 2008, 419,208 stock options were anti-dilutive to earnings (July 27, 2007 — nil) and therefore have been excluded from the computation of diluted earnings per share.

 

 

A summary of certain balance sheet accounts is as follows:

 

 

lululemon athletica inc. and Subsidiaries

 

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

lululemon athletica inc. and Subsidiaries

 

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

The Company’s reportable segments are comprised of corporate-owned stores, franchises and other. Phone sales, warehouse sales and showrooms sales have been combined into other. Information for these segments from continuing operations is detailed in the table below:

 

 

 

During the first quarter of fiscal 2008 the Company committed to plans to wind-up operations in Japan and in the second quarter of fiscal 2008 the plans were finalized and disposition of the assets commenced with closure of three of the four corporate stores that the Company was operating as a joint venture with Descente Ltd. The fourth store was closed in August 2008. The shut down costs related to the closure of the stores in Japan have been fully accrued in the second quarter of fiscal 2008.

 

lululemon athletica inc. and Subsidiaries

 

NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The results of discontinued operations are summarized as follows:

 

 

Following is the summary of net assets held for discontinued operations as at August 3, 2008:

 

 

The net loss from discontinued operations represents all activity up to August 3, 2008 as well as an accrual for all shut-down costs expected to be incurred subsequent to the end of the second quarter of fiscal 2008.

 

Some of the statements contained in this Form 10-Q and any documents incorporated herein by reference constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and the Private Securities Litigation Reform Act of 1995. All statements, other than statements of historical facts, included or incorporated in this Form 10-Q are forward-looking statements, particularly statements which relate to expectations, beliefs, projections, future plans and strategies, anticipated events or trends and similar expressions concerning matters that are not historical facts, such as statements regarding our future financial condition or results of operations, our prospects and strategies for future growth, the development and introduction of new products, and the implementation of our marketing and branding strategies. In many cases, you can identify forward-looking statements by terms such as “may”, “will”, “should”, “expects”, “plans”, “anticipates”, “believes”, “estimates”, “intends”, “predicts”, “potential” or the negative of these terms or other comparable terminology.

 

The forward-looking statements contained in this Form 10-Q and any documents incorporated herein by reference reflect our current views about future events and are subject to risks, uncertainties, assumptions and changes in circumstances that may cause events or our actual activities or results to differ significantly from those expressed in any forward-looking statement. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future events, results, actions, levels of activity, performance or achievements. Readers are cautioned not to place undue reliance on these forward-looking statements. A number of important factors could cause actual results to differ materially from those indicated by the forward-looking statements, including, but not limited to, those factors described in “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” These factors include without limitation:

 

 

The forward-looking statements contained in this Form 10-Q reflect our views and assumptions only as of the date of this Form 10-Q and are expressly qualified in their entirety by the cautionary statements included in this Form 10-Q. Except as required by applicable securities law, we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events.

 

Overview

 

lululemon is a designer and retailer of technical athletic apparel. Our yoga-inspired apparel is marketed under the lululemon athletica brand name. We offer a comprehensive line of apparel and accessories including fitness pants, shorts, tops and jackets designed for athletic pursuits such as yoga, dance, running and general fitness. As of August 3, 2008, our branded apparel was principally sold through 92 corporate-owned and franchise stores that are primarily located in Canada and the United States. We believe our vertical retail strategy allows us to interact more directly with and gain insights from our customers while providing us with greater control of our brand. For the second quarter of fiscal 2008, 71.8% of our net revenue was derived from sales of our products in Canada and 28.2% of our net revenue was derived from the sales of our products in the United States. After reevaluating our operating performance in Japan and our strategic priorities, we decided to discontinue our operations in Japan in fiscal 2008. In the second quarter of fiscal 2008 we closed three of our stores in Japan and closed our fourth and final store in Japan during the third quarter of fiscal 2008 and classified as discontinued operations in the second quarter of fiscal 2008. We opened our first store in Japan in 2005 and have operated in Japan through a joint venture with Japanese apparel company, Descente, Ltd., since 2006. Japan represented less than 1.5% of our revenues in fiscal 2007 and required a disproportionate amount of management time and attention during fiscal 2007. We believe that our time, attention and capital resources are best spent focused on our top priorities, which are growth in the United States, where we plan to open 22 stores during the third and fourth fiscal quarters of 2008, and the development of an e-commerce business.

 

Our net revenue has grown from $40.7 million for fiscal 2004 to $274.7 million for fiscal 2007. This represents a compound annual growth rate of 88.9%. Our net revenue also increased from $57.9 million for the second quarter of fiscal 2007 to $85.5 million for the second quarter of fiscal 2008, representing a 47.6% increase. By the end of fiscal 2004, we operated 20 stores including 14 corporate-owned stores and six franchise stores in Canada, the United States and Australia. The majority of our stores were located in Canada, with only three corporate-owned stores in the United States and one franchise store in Australia. Our increase in net revenue from fiscal 2004 to fiscal 2007 resulted from the addition of 17 retail locations in fiscal 2005, 14 retail locations in fiscal 2006, 31 retail locations in fiscal 2007, and 14 retail locations in the first two quarters of fiscal 2008 and strong comparable store sales growth of 19%, 25%, 34%, and 22% in fiscal 2005, fiscal 2006, fiscal 2007, and the first two quarters of fiscal 2008, respectively. Our ability to open new stores and grow sales in existing stores has been driven by increasing demand for our technical athletic apparel and a growing recognition of the lululemon athletica brand. We believe our superior products, strategic store locations, inviting store environment, grassroots marketing approach and distinctive corporate culture are responsible for our strong financial performance.

 

We have three reportable segments: corporate-owned stores, franchises and other. We report our segments based on the financial information we use in managing our businesses. While we receive financial information for each corporate-owned store, we have aggregated all of the corporate-owned stores into one reportable segment due to the similarities in the economic and other characteristics of these stores. Our franchises segment accounted for 17.3% of our net revenues for fiscal 2005, 14.3% for fiscal 2006, 6.6% for fiscal 2007 and 5.4% for the first two quarters of fiscal 2008. Opening new franchise stores is not a significant part of our near-term store growth strategy, and we therefore expect that the revenue derived from our franchise stores will continue to comprise less than 10% of the net revenue we report in future fiscal years. Our other operations accounted for less than 10% of our revenues in each of fiscal 2005 and fiscal 2006, fiscal 2007 and the first two quarters of fiscal 2008.

 

For fiscal years through fiscal 2006, our fiscal year ended on January 31st in the year following the year mentioned. Commencing with fiscal 2007, our fiscal year ends on the first Sunday following January 30th in the year following the year mentioned.

Results of Continuing Operations

 

Thirteen weeks ended August 3, 2008 compared to three months ended July 31, 2007

 

The following table summarizes key components of our results of operations for the thirteen weeks ended August 3, 2008 and the three months ended July 31, 2007. The operating results are expressed in dollar amounts as well as relevant percentages, presented as a percentage of net revenue.

 

 

Net Revenue

 

Net revenue increased $27.6 million, or 47.6%, to $85.5 million for the second quarter of fiscal 2008 from $57.9 million for the second quarter of fiscal 2007. This increase was the result of increased comparable store sales and sales from new stores opened. Assuming the average exchange rate between the Canadian and United States dollars for the second quarter of fiscal 2007 remained constant, our net revenue would have increased $24.2 million, or 41.7%, for the second quarter of fiscal 2008.

 

 

Corporate-Owned Stores.  Net revenue from our corporate-owned stores segment increased $26.0 million, or 49.7%, to $78.3 million for the second quarter of fiscal 2008 from $52.3 million for the second quarter of fiscal 2007. The following contributed to the $26.0 million increase in net revenue from our corporate-owned stores segment:

 

 

Franchises.  Net revenue from our franchises segment increased $0.9 million, or 25.4%, to $4.3 million for the second quarter of fiscal 2008 from $3.4 million for the second quarter of fiscal 2007. The increase in net revenue from our franchises segment consisted primarily of increased franchise revenue from our remaining franchise locations.

 

Other.  Net revenue from our other segment increased $0.7 million, or 31.8%, to $2.9 million for the second quarter of fiscal 2008 from $2.2 million for the second quarter of fiscal 2007. The $0.7 million increase was primarily the result of increased wholesale, phone sales and showroom sales.

 

Gross Profit

 

Gross profit increased $13.6 million, or 44.4%, to $44.4 million for the second quarter of fiscal 2008 from $30.7 million for the second quarter of fiscal 2007. The increase in gross profit was driven principally by:

 

 

This amount was partially offset by:

 

 

Gross profit as a percentage of net revenue, or gross margin, decreased 1.2% percentage points, to 51.9% for the second quarter of fiscal 2008 from 53.1% for the second quarter of fiscal 2007. The decrease in gross margin resulted from:

 

 

This amount was partially offset by:

 

 

Our costs of goods sold in the second quarter of fiscal 2008 and the second quarter of fiscal 2007 included $0.4 million and $0.2 million, respectively, of stock-based compensation expense.

Selling, General and Administrative Expenses

 

Selling, general and administrative expenses increased $8.3 million, or 40.7%, to $28.8 million for the second quarter of fiscal 2008 from $20.5 million for the second quarter of fiscal 2007. As a percentage of net revenue, selling, general and administrative expenses decreased 1.7% percentage points, to 33.7% from 35.4%. The $8.3 million increase in selling, general and administrative expenses was principally comprised of:

 

 

Our selling, general and administrative expenses in the second quarter of fiscal 2008 and the second quarter of fiscal 2007 included $1.1 million and $1.4 million, respectively, of stock-based compensation expense.

 

Income from Operations

 

The increase of $5.3 million in income from operations for the second quarter of fiscal 2008 was primarily due to a $13.6 million increase in gross profit resulting from increased comparable store sales and additional sales from corporate-owned stores opened, partially offset by an increase of $8.3 million in selling, general and administrative expenses.

 

On a segment basis, we determine income from operations without taking into account our general corporate expenses such as corporate employee costs, travel expenses and corporate rent. For purposes of our management’s analysis of our financial results, we have allocated some general product expenses to our corporate-owned stores segment. For example, all expenses related to our production, design, merchandise, and distribution departments have been allocated to this segment.

 

Income from operations (before general corporate expenses) from:

 

 

Other income, net increased $0.1 million to $0.2 million for the second quarter of fiscal 2008 from $0.1 million for the second quarter of fiscal 2007. The increase was primarily due to interest income earned on higher cash balances.

 

Provision for Income Taxes

 

Income tax expense for the second quarter of fiscal 2008 was $3.4 million compared to $4.8 million for the corresponding period in fiscal 2007. The Company’s financial statement effective tax rate for the thirteen weeks ended August 3, 2008 was 21.7%. The effective tax rate will vary from the statutory rate because (i) stock option compensation expense recorded is a permanent difference in certain jurisdictions, (ii) the realization of the benefits of the tax assets from stock-based compensation recorded prior to the second quarter of fiscal 2008, and (iii) the

realization of the benefits of the tax assets related primarily to historical tax differences between financial and tax bases of assets and liabilities prior to February 3, 2008.

 

During the second quarter of fiscal 2008, after considering a number of factors, including a history of cumulative earnings, utilization of previously generated NOL’s and estimated taxable income in future years, we determined we would more likely than not realize substantial future tax benefits from our deferred income tax assets generated in the United States prior to February 3, 2008. As a result of this analysis the Company recorded deferred tax assets of (i) $1,388,549 related primarily to historical tax differences between financial and tax bases of assets and liabilities, (ii) $902,606 cumulative tax benefit recorded from stock-based compensation expense prior to the second quarter of fiscal 2008, and (iii) $2,660,671 excess tax benefit from the exercise of stock options during and prior to the second quarter of fiscal 2008.

 

Net Income from Continuing Operations

 

Net income from continuing operations increased $6.8 million, to $12.3 million for the second quarter of fiscal 2008 from $5.5 million for the second quarter of fiscal 2007. The increase in net income of $6.8 million for the second quarter of fiscal 2008 was a result of an increase in gross profit of $13.6 million resulting from increased comparable store sales and additional sales from corporate-owned stores opened, a decrease in the provision for income tax of $1.4 million and offset by increases in selling, general and administrative expenses of $8.3 million.

 

Discontinued Operations

 

During the thirteen weeks ended August 3, 2008, revenues from discontinued operations were $1.3 million and costs and expenses were $1.6 million. The loss from discontinued operations was $1.2 million, resulting in a reduction of basic and diluted earnings per share of $0.02. The shut down costs related to the closure of the stores in Japan have been fully accrued in the second quarter of fiscal 2008.

 

Twenty six weeks ended August 3, 2008 compared to six months ended July 31, 2007

 

The following table summarizes key components of our results of operations for the twenty six weeks ended August 3, 2008 and the six months ended July 31, 2007. The operating results are expressed in dollar amounts as well as relevant percentages, presented as a percentage of net revenue.

 

Net Revenue

 

Net revenue increased $60.4 million, or 59.2%, to $162.4 million for the first twenty six weeks of fiscal 2008 from $102.0 million for the first six months of fiscal 2007. This increase was the result of increased comparable store sales and sales from new stores opened. Assuming the average exchange rate between the Canadian and United States dollars for the first six months of fiscal 2007 remained constant, our net revenue would have increased $49.9 million, or 48.7%, for the first twenty six weeks of fiscal 2008.

 

 

Corporate-Owned Stores.  Net revenue from our corporate-owned stores segment increased $58.0 million, or 64.7%, to $147.7 million for the first twenty six weeks of fiscal 2008 from $89.7 million for the first six months of fiscal 2007. The following contributed to the $58.0 million increase in net revenue from our corporate-owned stores segment:

 

 

Franchises.  Net revenue from our franchises segment increased $0.5 million, or 5.8%, to $8.8 million for the first twenty six weeks of fiscal 2008 from $8.3 million for the first six months of fiscal 2007. The increase in net revenue from our franchises segment consisted primarily of increased franchise revenue from our remaining franchise locations.

 

Other.  Net revenue from our other segment increased $1.8 million, or 46.5%, to $5.9 million for the first twenty six weeks of fiscal 2008 from $4.1 million for the first six months of fiscal 2007. The $1.8 million increase was primarily the result of increased wholesale, phone sales and showroom sales.

 

Gross Profit

 

Gross profit increased $32.3 million, or 60.9%, to $85.5 million for the first twenty six weeks of fiscal 2008 from $53.1 million for the first six months of fiscal 2007. The increase in gross profit was driven principally by:

 

 

This amount was partially offset by:

 

 

 

Gross profit as a percentage of net revenue, or gross margin, increased 0.5% percentage points, to 52.6% for the first twenty six weeks of fiscal 2008 from 52.1% for the first six months of fiscal 2007. The increase in gross margin resulted from a reduction in product costs as a percentage of net revenue, which included a write-down of raw materials in the first six months of fiscal 2007 as well as duty refunds of $0.7 million received in the first twenty six weeks of fiscal 2008, that contributed to an increase in gross margin of 2.9%.

 

This amount was partially offset by:

 

 

Our costs of goods sold in the first twenty six weeks of fiscal 2008 and the first six months of fiscal 2007 included $0.6 million and $0.4 million, respectively, of stock-based compensation expense.

 

Selling, General and Administrative Expenses

 

Selling, general and administrative expenses increased $22.2 million, or 62.1%, to $58.0 million for the first twenty six weeks of fiscal 2008 from $35.8 million for the first six months of fiscal 2007. As a percentage of net revenue, selling, general and administrative expenses increased 0.6% percentage points, to 35.7% from 35.1%. The $22.2 million increase in selling, general and administrative expenses was principally comprised of:

 

 

Our selling, general and administrative expenses in the first twenty six weeks of fiscal 2008 and the first six months of fiscal 2007 included $3.0 million and $2.6 million, respectively, of stock-based compensation expense.

 

Income from Operations

 

The increase of $10.1 million in income from operations for the first twenty six weeks of fiscal 2008 was primarily due to a $32.3 million increase in gross profit resulting from increased comparable store sales and additional sales from corporate-owned stores opened, partially offset by an increase of $22.2 million in selling, general and administrative expenses.

 

On a segment basis, we determine income from operations without taking into account our general corporate expenses such as corporate employee costs, travel expenses and corporate rent. For purposes of our management’s

analysis of our financial results, we have allocated some general product expenses to our corporate-owned stores segment. For example, all expenses related to our production, design and distribution departments have been allocated to this segment.

 

Income from operations (before general corporate expenses) from:

 

 

Other income, net increased $0.3 million to $0.5 million for the first twenty six weeks of fiscal 2008 from $0.2 million for the first six months of fiscal 2007. The increase was primarily due to interest income earned on higher cash balances.

 

Provision for Income Taxes

 

Income tax expense for the twenty six weeks ended August 3, 2008 was $7.2 million compared to $8.2 million for the corresponding period in fiscal 2007. The Company’s financial statement effective tax rate for the twenty six weeks ended August 3, 2008 was 25.7%. The effective tax rate will vary from the statutory rate because (i) stock option compensation expense recorded is a permanent difference in certain jurisdictions, (ii) the realization of the benefits of the tax assets from stock-based compensation recorded prior to the second quarter of fiscal 2008, and (iii) the realization of the benefits of the tax assets related primarily to historical tax differences between financial and tax bases of assets and liabilities prior to February 3, 2008.

 

During the second quarter of fiscal 2008, after considering a number of factors, including a history of cumulative earnings, utilization of previously generated NOL carryforwards and estimated taxable income in future years, we determined we would more likely than not realize substantial future tax benefits from our deferred income tax assets generated in the United States prior to February 3, 2008. As a result of this analysis the Company recorded deferred tax assets of (i) $1,388,549 related primarily to historical tax differences between financial and tax bases of assets and liabilities, (ii) $902,606 cumulative tax benefit recorded from stock-based compensation expense prior to the second quarter of fiscal 2008, and (iii) $2,660,671 excess tax benefit from the exercise of stock options during and prior to the second quarter of fiscal 2008.

 

Net Income from Continuing Operations

 

Net income from continuing operations increased $11.5 million to $20.8 million for the first twenty six weeks of fiscal 2008 from $9.3 million for the first six months of fiscal 2007. The increase in net income of $11.5 million for the first twenty six weeks of fiscal 2008 was a result of an increase in gross profit of $32.3 million resulting from increased comparable store sales and additional sales from corporate-owned stores opened, a decrease in provision for income taxes of $1.1 million, and an increase of $0.3 million in other income, which was offset by increases in selling, general and administrative expenses of $22.2 million.

 

Discontinued Operations

 

During the twenty six weeks ended August 3, 2008, revenues from discontinued operations were $2.5 million and costs and expenses were $2.6 million. The loss from discontinued operations was $1.2 million, resulting in a

reduction of basic and diluted earnings per share of $0.02. The shut down costs related to the closure of the stores in Japan have been fully accrued in the second quarter of fiscal 2008.

 

Seasonality

 

Historically, we have recognized a significant portion of our income from operations in the fourth fiscal quarter of each year as a result of increased sales during the holiday selling season. Despite the fact that we have experienced a significant amount of our net revenue and gross profit in the fourth quarter of each fiscal year, we believe that the true extent of the seasonality or cyclical nature of our business may have been overshadowed by our rapid growth to date.

 

Liquidity and Capital Resources

 

Our cash requirements are principally for working capital and capital expenditures, including the build out cost of new stores, renovations of existing stores, and improvements to our distribution facility and corporate infrastructure. Our need for working capital is seasonal, with the greatest requirements from August through the end of November each year as a result of our inventory build-up and concentration of new store openings during this period for our holiday selling season. Historically, our main sources of liquidity have been cash flow from operating activities and borrowings under our existing and previous revolving credit facilities, and our initial public offering that closed on August 2, 2007.

 

At August 3, 2008, our working capital (excluding cash and cash equivalents) was $28.0 million and our cash and cash equivalents were $43.7 million.

 

The following presents the major components of net cash flows provided by and used in operating, investing and financing activities for the periods indicated:

 

Operating Activities

 

Operating Activities consist primarily of net income adjusted for certain non-cash items, including depreciation and amortization, deferred income taxes, stock-based compensation expense and the effect of the changes in non-cash working capital items, principally prepaid expenses, inventories, accounts payable and accrued expenses.

 

For the twenty six weeks ended August 3, 2008, cash provided by operating activities decreased $1.5 million to $11.1 million compared to $12.7 million in the six months ended July 31, 2007. The $1.5 million decrease was due to a net decrease in non-cash working capital items of $12.0 million, a net decrease in items not affect cash of $2.6 million partially offset by an increase in net income of $11.5 million and a decrease in cash used by discontinued operations of $1.5 million. The increase in non-cash working capital items was primarily driven by:

 

 

These amounts were partially offset by:

 

 

 

Items not affecting cash decreased in the twenty six weeks ended August 3, 2008 as compared to the six months ended July 31, 2007 as a result of an increase in deferred income taxes and the excess tax benefits from stock-based compensation which was partially offset by higher depreciation and amortization expense related to a higher store count and the implementation of our inventory ERP system and higher stock-based compensation expense due to the one-time acceleration of performance based options.

 

Investing Activities

 

Investing Activities relate entirely to capital expenditures, investments in and advances to affiliates, and acquisitions of franchises. Cash used in investing activities increased $6.7 million, to $22.1 million, for the twenty six weeks ended August 3, 2008 from $15.3 million for the six months ended July 31, 2007. The $6.7 million increase was a result of additional purchases of property and equipment of $8.9 million resulting primarily from new store openings and IT capital expenditures including capitalized software costs, an increase of $2.8 million in investment in and advances to our Australian franchise offset by a decrease in the acquisition of franchises of $5.0 million, as the three Calgary franchises were purchased in the first quarter of fiscal 2007.

 

Financing Activities

 

Financing Activities consist primarily of costs related to our initial public offering, cash received on the exercise of stock options and excess tax benefits from stock-based compensation. Cash provided by financing activities increased to $3.0 million for the twenty six weeks ended August 3, 2008 from $4.7 million of cash used by financing activities for the six months ended July 31, 2007.

 

We believe that our cash from operations and borrowings available to us under our revolving credit facility will be adequate to meet our liquidity needs and capital expenditure requirements for at least the next 24 months. Our cash from operations may be negatively impacted by a decrease in demand for our products as well as the other factors described in “Risk Factors.” In addition, we may make discretionary capital improvements with respect to our stores, distribution facility, headquarters, or other systems, which we would expect to fund through the issuance of debt or equity securities or other external financing sources to the extent we were unable to fund such capital expenditures out of our cash from operations.

 

Revolving Credit Facility

 

In April 2007, we executed a new credit facility with the Royal Bank of Canada that provided for a CDN$20,000,000 uncommitted demand revolving credit facility to fund our working capital requirements. This agreement cancels our previous CDN$8,000,000 credit facility. Borrowings under the uncommitted credit facilities are made on a when-and-as-needed basis at our discretion.

 

Borrowings under the credit facility can be made either as i) Revolving Loans — Revolving loan borrowings will bear interest at a rate equal to the Bank’s CA$ or US$ annual base rate (defined as zero% plus the lender’s annual prime rate) per annum, ii) Offshore Loans — Offshore rate loan borrowings will bear interest at a rate equal to a base rate based upon LIBOR for the applicable interest period, plus 1.125% per annum, iii) Bankers Acceptances — Bankers acceptance borrowings will bear interest at the bankers acceptance rate plus 1.125% per annum, or iv) Letters of Credit and Letters of Guarantee — Borrowings drawn down under letters of credit or guarantee issued by the banks will bear a 1.125% per annum fee.

 

At August 3, 2008, there were no borrowings outstanding under this credit facility.

Off-Balance Sheet Arrangements

 

We enter into documentary letters of credit to facilitate the international purchase of merchandise. We also enter into standby letters of credit to secure certain of our obligations, including insurance programs and duties related to import purchases. As of August 3, 2008, letters of credit and letters of guarantee totaling $1.5 million have been issued.

 

Other than these standby letters of credit, we do not have any off-balance sheet arrangements, investments in special purpose entities or undisclosed borrowings or debt. In addition, we have not entered into any derivative contracts or synthetic leases.

 

Critical Accounting Policies

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions. Predicting future events is inherently an imprecise activity and, as such, requires the use of judgment. Actual results may vary from estimates in amounts that may be material to the financial statements. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used, or changes in the accounting estimates that are reasonably likely to occur periodically, could materially impact our consolidated financial statements. Our critical accounting policies and estimates are discussed in our recently filed Annual Report on Form 10-K for our 2007 fiscal year end. We believe that there have been no other significant changes during the twenty six weeks ended August 3, 2008 to our critical accounting policies.

 

Operating Locations

 

Our operating locations by country, state and province as of August 3, 2008, and the overall totals as of August 3, 2008, are summarized in the table below.