Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Cautionary Notice Regarding Forward-Looking Statements
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties, and we undertake no obligation to update these statements except as required by the federal securities laws. Our actual results may differ materially from the results discussed in the forward-looking statements. These risks and uncertainties include, without limitation, those detailed under the caption “Risk Factors” in the Company’s Annual Report on Form 10-K for the fiscal year ended February 2, 2019, as filed with the SEC, and include the following:
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any decline in general global economic conditions could lead to disproportionately reduced consumer demand for our products, which represent relatively discretionary spending, and have an adverse effect on our liquidity and profitability;
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we may not be able to operate our international corporately-managed locations profitably;
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we depend upon the shopping malls and tourist locations in which we are located to attract guests to our stores and a decline in consumer traffic could adversely affect our financial performance and profitability;
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if we are unable to generate interest in and demand for our interactive retail experience and products, including being able to identify and respond to consumer preferences in a timely manner, our sales, financial condition and profitability could be adversely affected;
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our merchandise is manufactured by foreign manufacturers and we transact business in various foreign countries, and the availability and costs of our products, as well as our product pricing, may be negatively affected by risks associated with international manufacturing and trade, tariffs and foreign currency fluctuations;
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if we are unable to renew, renegotiate or replace our store leases or enter into leases for new stores on favorable terms, or if we violate any of the terms of our current leases, our revenue and profitability could be harmed;
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consumer interests change rapidly and our success depends on the ongoing effectiveness of our marketing and online initiatives to build consumer affinity for our brand and drive consumer demand for key products and services;
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we are subject to a number of risks related to disruptions, failures or security breaches of our information technology infrastructure. If we improperly obtain or are unable to protect our data or violate privacy or security laws or expectations, we could be subject to liability as well as damage to our reputation;
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we may not be able to operate successfully if we lose key personnel, are unable to hire qualified additional personnel, or experience turnover of our management team;
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we are subject to risks associated with technology and digital operations;
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we may not be able to evolve our store locations over time to align with market trends, successfully diversify our store models and formats in accordance with our strategic goals or otherwise effectively manage our overall portfolio of stores which could adversely affect our ability to grow and could significantly harm our profitability;
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we rely on a few global supply chain vendors to supply substantially all of our merchandise, and significant price increases or any disruption in their ability to deliver merchandise could harm our ability to source products and supply inventory to our stores;
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our company-owned distribution center which services the majority of our stores in North America and our third-party distribution center providers used in the western United States and Europe may experience disruptions in their ability to support our stores or may operate inefficiently;
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if we are unable to effectively manage our international franchises, attract new franchisees or if the laws relating to our international franchises change, our growth and profitability could be adversely affected and we could be exposed to additional liability;
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we may fail to renew, register or otherwise protect our trademarks or other intellectual property and may be sued by third parties for infringement or, misappropriation of their proprietary rights, which could be costly, distract our management and personnel and which could result in the diminution in value of our trademarks and other important intellectual property;
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we may suffer negative publicity or be sued if the manufacturers of our merchandise or of Build-A-Bear branded merchandise sold by our licensees ship any products that do not meet current safety standards or production requirements or if such products are recalled or cause injuries;
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we may suffer negative publicity or be sued if the manufacturers of our merchandise violate labor laws or engage in practices that consumers believe are unethical;
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our profitability could be adversely affected by fluctuations in petroleum products prices;
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our business may be adversely impacted at any time by a significant variety of competitive threats;
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we may suffer negative publicity or a decrease in sales or profitability if the products from other companies that we sell in our stores do not meet our quality standards or fail to achieve our sales expectations;
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we may be unsuccessful in acquiring businesses or engaging in other strategic transactions, which may negatively affect our financial condition and profitability;
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fluctuations in our operating results could reduce our cash flow and we may be unable to repurchase shares at all or at the times or in the amounts we desire or the results of our share repurchase program may not be as beneficial as we would like;
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fluctuations in our quarterly results of operations could cause the price of our common stock to substantially decline;
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the market price of our common stock is subject to volatility, which could in turn attract the interest of activist shareholders; and
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our certificate of incorporation and bylaws and Delaware law contain provisions that may prevent or frustrate attempts to replace or remove our current management by our stockholders, even if such replacement or removal may be in our stockholders’ best interests.
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Overview
We are the only global company that offers an interactive “make your own stuffed animal” retail entertainment experience under the Build-A-Bear Workshop brand, in which guests participate in the stuffing, fluffing, dressing, accessorizing and naming of their own teddy bears and other stuffed animals. As of May 4, 2019, we operated 366 stores globally and had 90 franchised stores operating internationally under the Build-A-Bear Workshop brand. In addition to our stores, we sell products on our company-owned e-commerce sites and franchisee sites and through third parties under wholesale agreements.
We operate in three segments that share the same infrastructure, including management, systems, merchandising and marketing, and generate revenues as follows:
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Direct-to-Consumer (“DTC”) – Corporately-managed retail stores located in the U.S., Canada, Puerto Rico, the U.K., Ireland, Denmark and China and two e-commerce sites;
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Commercial – Transactions with other businesses, mainly comprised of wholesale product sales and licensing our intellectual property, including entertainment properties, for third-party use; and
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International franchising – Royalties as well as product and fixture sales from other international operations under franchise agreements.
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Selected financial data attributable to each segment for the thirteen week period ended May 4, 2019 and May 5, 2018 are set forth in the notes to our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q.
Strategy
We expect to improve consolidated sales and profit through the following key initiatives:
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Development of our experiential retail model to diversify and expand the impact and reach of our brand globally:
We expect to continue to diversify our real estate portfolio to focus on places where families are increasingly going to shop or going for entertainment. We have been actively identifying and securing more tourist locations. We also expect to continue to diversify our store portfolio inclusive of our lower capital, more flexible “concourse shop” model. We expect to continue to make improvements to our aging store fleet by leveraging our Discovery format in conjunction with select natural lease events such as lease renewals or terminations. Overall, these reformatted locations continue to perform ahead of heritage locations in both sales and profitability. In addition, we are actively working with a large retailer to expand our reach to a broader array of consumers. We expect to continue to grow e-commerce sales as well as expand globally through existing and new franchise agreements including the recently added franchises in China and India.
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Leverage the power of our brand and intellectual properties to build margin accretive revenue streams:
To meet the needs of our core consumer base (girls and boys ages 3 to 12) while systematically building secondary consumer segments (including collectors, gift-givers and teen-plus), we expect to continue to develop and expand offerings of successful intellectual properties balanced with core products and a comprehensive program of key licensed products. We expect to leverage the power of both our Build-A-Bear brand as well as our other intellectual properties to further develop our outbound licensed programs and expand these and other margin accretive revenue streams. We also expect to build the entertainment aspects of our business model as we continue to develop content to connect with consumers beyond our retail stores including mobile apps, music videos and other entertainment opportunities to increase engagement, improve efficiency and lead to profitable sales growth.
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Long-Term Profitability Improvement:
We are focused on improving profitability through the execution of our stated strategies detailed above as well as disciplined expense management and on-going efforts in process and systems upgrades. While we continue to monitor consolidated comparable sales as an important metric in our business, we believe that total revenue growth and profitability improvement are more indicative of the progress in our business initiatives on a go forward basis.
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Retail Stores:
The table below sets forth the number of Build-A-Bear Workshop corporately-managed stores in North America, Europe and Asia for the periods presented:
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Thirteen weeks ended
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May 4, 2019
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May 5, 2018
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North
America
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Europe
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Asia
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Total
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North
America
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Europe
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Asia
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Total
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Beginning of period
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311
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59
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1
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371
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292
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59
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1
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352
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Opened
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-
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-
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-
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-
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2
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-
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-
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2
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Closed
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(4
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(1
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)
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-
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(5
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(2
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(2
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-
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(4
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End of period
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307
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58
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1
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366
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292
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57
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1
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350
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During 2019, we will continue to make improvements to our aged store fleet by leveraging the Discovery format in conjunction with select natural lease events. As of May 4, 2019, 37% of our store base was in an updated Discovery design. We also expect to close certain stores in accordance with natural lease events as an ongoing part of our real estate management and day-to-day operational plans. Current plans include expansion into more non-traditional locations, made possible in part by concourse shops and expansion in other locations outside traditional malls.
International Franchise Revenue:
Our first franchisee location was opened in November 2003. All franchised stores have similar signage, store layout, merchandise characteristics and guest experience as our corporately-managed stores. As of May 4, 2019, we had nine master franchise agreements, which typically grant franchise rights for a particular country or group of countries, covering an aggregate of 14 countries.
The number of franchised stores opened and closed for the periods presented below are summarized as follows:
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Thirteen weeks ended
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May 4,
2019
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May 5,
2018
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Beginning of period
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97
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100
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Opened
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7
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2
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Closed
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(14
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(6
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End of period
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90
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96
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In the ordinary course of business, we anticipate signing additional master franchise agreements and terminating other such agreements. We believe there is a market potential for approximately 300 international stores outside of the United States, Canada, the U.K., Ireland and Denmark. We continue to expect franchisees to leverage the new formats that have been developed for our corporately-managed operations and sourcing changes that have significantly reduced the capital and expenses required to open stores. We expect to continue to develop market expansion through both new and existing franchisees in 2019 and beyond. For example, our new China franchise partner operates nine locations and plans to open up to 10 locations by the end of fiscal year 2019. In addition, we have made progress in opening six stores in India, and we expect to open stores in Chile.
Results of Operations
The following table sets forth, for the periods indicated, selected income statement data expressed as a percentage of total revenues, except where otherwise indicated. Percentages will not total due to cost of merchandise sold being expressed as a percentage of net retail sales, commercial revenue, international franchising as well as immaterial rounding:
BUILD-A-BEAR WORKSHOP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
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Thirteen weeks ended
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May 4,
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May 5,
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2019
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2018
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Revenues:
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Net retail sales
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96.2
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%
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97.9
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%
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Commercial revenue
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3.1
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1.2
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International franchising
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0.7
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0.9
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Total revenues
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100.0
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100.0
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Costs and expenses:
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Cost of merchandise sold - retail (1)
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54.8
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55.7
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Cost of merchandise sold - commercial (1)
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45.9
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47.0
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Cost of merchandise sold - international franchising (1)
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78.6
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44.9
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Total cost of merchandise sold
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54.7
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55.5
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Consolidated gross profit
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45.3
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44.5
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Selling, general and administrative
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42.4
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43.7
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Interest expense (income), net
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0.0
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0.0
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Income (loss) before income taxes
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2.9
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0.8
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Income tax expense (benefit)
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1.4
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0.4
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Net income (loss)
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1.4
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0.4
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Retail Gross Margin (2)
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45.2
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%
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44.3
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%
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(1)
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Cost of merchandise sold – retail is expressed as a percentage of net retail sales. Cost of merchandise sold – commercial is expressed as a percentage of commercial revenue. Cost of merchandise sold – international franchising is expressed as a percentage of international franchising revenue.
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(2)
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Retail gross margin represents net retail sales less cost of merchandise sold - retail; retail gross margin percentage represents retail gross margin divided by net retail sales.
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Thirteen weeks ended May 4, 2019 compared to thirteen weeks ended May 5, 2018
Total revenues.
Consolidated revenues increased 1.4%, including a 4.5% increase in North America, a 14.8% decrease in Europe, and a double digit increase in consolidated e-commerce sales. We believe that European results continue to reflect the impact of the ongoing uncertainty surrounding Brexit, as well as the May 2018 implementation of new privacy laws, which severely inhibited the Company’s ability to directly market to guests.
Net retail sales for the thirteen weeks ended May 4, 2019 were $81.0 million, compared to $81.4 million for the thirteen weeks ended May 5, 2018, a decrease of $0.4 million, or 0.5%. The components of this decrease are as follows:
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Thirteen weeks ended
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May 4, 2019
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(dollars in millions)
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Decrease in existing store and ecommerce sales
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$
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(1.8
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)
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Increase from new stores
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3.4
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Impact of store closures
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(1.4
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)
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Impact of foreign currency translation
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(0.9
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)
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Change in deferred revenue estimates, including breakage
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0.3
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$
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(0.4
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)
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The revenue decrease was driven primarily by the U.K. as business continued to decline due to a challenging retail environment brought on by Brexit and the May 2018 implementation of new privacy laws that have significantly inhibited our ability to build our contact database and market directly to our guests. As a part of our focused effort to mitigate some of the issues in the market, we recently implemented a new technology-based Bonus Club enrollment process that is compliant with the new European privacy regulations. Since then, we have seen significant growth in the opt-in rates of Bonus Club members which we believe will benefit the business on a go-forward basis.
Commercial revenue was $2.8 million for the thirteen weeks ended May 4, 2019 compared to $1.0 million for the thirteen weeks ended May 5, 2018. The $1.8 million increase includes wholesale merchandise and furniture/fixture sales and outbound licensing fees, reflecting some of the work that has been done to evolve the business model beyond traditional retail.
Retail gross margin.
Retail gross margin dollars increased $0.6 million to $36.6 million compared to the thirteen weeks ended May 5, 2018. The retail gross margin rate increased 90 basis points to 45.2% mainly driven by merchandise margin expansion and lower occupancy costs.
Selling, general and administrative.
Selling, general and administrative expenses were $35.8 million for the thirteen weeks ended May 4, 2019, a decline of $0.5 million compared to the thirteen weeks ended May 5, 2018. The decrease was driven by continued disciplined expense management and focus on controllable spend.
Interest expense (income), net.
Interest expense (income) was $20,000 for the thirteen weeks ended May 4, 2019 compared to $5,000 for the thirteen weeks ended May 5, 2018.
Provision for income taxes.
Income tax expense was $1.2 million with a tax rate of 50.3% for the thirteen weeks ended May 4, 2019 as compared to income tax expense of $0.3 million with a tax rate of 45.2% for the thirteen weeks ended May 5, 2018. In the first quarter of fiscal 2019, the effective tax rate differed from the statutory rate of 21% primarily due to the valuation allowance being recorded in certain foreign jurisdictions and the $0.2 million negative tax impact of equity awards vesting. In the first quarter of fiscal 2018, the effective tax rate differed from the statutory rate of 21% primarily due the $0.1 million tax impact of equity awards vesting.
Seasonality and Quarterly Results
Our operating results for one period may not be indicative of results for other periods, and may fluctuate significantly because of a variety of factors, including, but not limited to: (1) changes in general economic conditions (including tariffs) and consumer spending patterns; (2) increases or decreases in our existing store and e-commerce sales; (3) fluctuations in the profitability of our stores; (4) the timing and frequency of the sales of licensed products tied to major theatrical releases, our marketing initiatives, including national media and other public relations events; (5) changes in foreign currency exchange rates; (6) the timing of our store openings and closings and related expenses; (7) changes in consumer preferences; (8) the effectiveness of our inventory management; (9) the actions of our competitors or mall anchors and co-tenants; (10) seasonal shopping patterns and holiday and vacation schedules; and (11) weather conditions.
The timing of store closures, remodels and openings may result in fluctuations in quarterly results based on the revenues and expenses associated with each store location. Expenses related to store closings are typically incurred in stages: when the decision is made to close the store typically associated with a lease event such as an expiration or lease triggered clause; when the closure is communicated to store associates; and at the time of closure. We typically incur most preopening costs for a new store in the three months immediately preceding the store’s opening.
As a retailer that has toy products as part of our revenue model, our sales are highest in our fourth quarter. The timing of holidays and school vacations can impact our quarterly results. We cannot provide assurance that this will continue to be the case. In addition, for accounting purposes, the quarters of each fiscal year consist of 13 weeks, although we will have a 14-week quarter approximately once every six years. For example, the 2014 fiscal fourth quarter had 14 weeks and the fiscal year transition period ended February 3, 2018 had five weeks.
Liquidity and Capital Resources
Our cash requirements are primarily for the relocation and remodeling of existing stores in our new design, opening of new stores, investments in information technology infrastructure and working capital. Over the past several years, we have met these requirements through capital generated from cash flow provided by operations. We have access to additional cash through our revolving line of credit that has been in place since 2000.
A summary of our operating, investing and financing activities are shown in the following table (dollars in thousands):
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Thirteen weeks ended
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May 4,
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May 5,
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2019
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2018
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Net cash provided by operating activities
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$
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5,141
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$
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1,383
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Net cash used in investing activities
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(2,440
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)
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(2,945
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)
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Net cash used in financing activities
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(258
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)
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(1,157
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)
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Effect of exchange rates on cash
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(99
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)
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101
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Net increase (decrease) in cash and cash equivalents
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$
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2,344
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|
$
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(2,618
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)
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Operating Activities.
Cash provided from operating activities increased $3.8 million for the thirteen weeks ended May 4, 2019, as compared to the thirteen weeks ended May 5, 2018. This increase in cash from operating activities was primarily driven by higher net income and receivable collections for the thirteen weeks ended May 4, 2019 as compared to the thirteen weeks ended May 5, 2018.
Investing Activities.
Cash used in investing activities decreased $0.5 million for the thirteen weeks ended May 4, 2019, as compared to the thirteen weeks ended May 5, 2018. This decrease in cash from investing activities was primarily driven by the timing of cash used related to store construction and upgrades, and purchases of information technology infrastructure for the thirteen weeks ended May 4, 2019 as compared to the thirteen weeks ended May 5, 2018.
Financing Activities.
Cash used in financing activities decreased $0.9 million for the thirteen weeks ended May 4, 2019, as compared to the thirteen weeks ended May 5, 2018. This decrease in cash from financing activities was primarily driven by the purchases of our common stock in the thirteen weeks ended May 5, 2018.
Capital Resources.
As of May 4, 2019, we had a consolidated cash balance of $20.2 million and approximately 65% of this balance was domiciled within the United States. We also have a line of credit which we can use to finance capital expenditures and working capital needs throughout the year. On April 16, 2019, we entered into the nineteenth amendment to this credit agreement with our lender. Under this agreement, the bank line provides availability of up to $35 million. Borrowings under the credit agreement are secured by our assets and a pledge of 66% of our ownership interest in certain of our foreign subsidiaries. The credit agreement expires on December 31, 2020 and contains various restrictions on indebtedness, liens, guarantees, redemptions, mergers, acquisitions or sale of assets, loans, transactions with affiliates and investments. The agreement limits the amount of, and the conditions under which, the Company may declare dividends and repurchase shares as set forth in the agreement. Borrowings bear interest at LIBOR plus 1.25%. Financial covenants include maintaining minimum thresholds for cumulative earnings before interest, taxes, depreciation and amortizations (“EBITDA”) and liquidity for the first three quarters of fiscal 2019 (as defined by the credit agreement), maintaining a minimum fixed charge coverage ratio effective in the fourth quarter of fiscal 2019 (as defined in the credit agreement) and not exceeding a maximum funded debt to EBITDA ratio. As of May 4, 2019: (i) we were in compliance with all covenants; (ii) there were no borrowings under the line of credit; and (iii) there was $35.0 million available for borrowing under the line of credit.
In fiscal 2019, we expect to spend a total of $13 to $15 million on capital expenditures. Capital spending through the thirteen weeks ended May 4, 2019 totaled $2.7 million, on track with our full year plans. Capital spending in fiscal 2019 is expected to primarily support our store activity, including both remodels and new stores, and investments in information technology infrastructure.
We believe that cash generated from operations and borrowings under our credit agreement will be sufficient to fund our working capital and other cash flow requirements for the near future. Our credit agreement expires on December 31, 2020.
In August 2017, our Board of Directors adopted a share repurchase program authorizing the repurchase of up to $20 million of our common stock. From the date of the program approval through May 4, 2019, we repurchased a total of 1.3 million shares at an average price of $8.75 per share for an aggregate amount of $11.2 million. As of May 4, 2019, we had $8.8 million of availability under the 2017 Share Repurchase Program.
Off-Balance Sheet Arrangements
None.
Inflation
We do not believe that inflation has had a material adverse impact on our business or operating results during the periods presented. We cannot provide assurance, however, that our business will not be affected by inflation in the future.
Critical Accounting Estimates
The preparation of financial statements in conformity with U.S. GAAP requires the appropriate application of certain accounting policies, which require us to make estimates and assumptions about future events and their impact on amounts reported in our financial statements and related notes. Since future events and their impact cannot be determined with certainty, the actual results will inevitably differ from our estimates. Such differences could be material to the financial statements.
We believe application of accounting policies, and the estimates inherently required therein, are reasonable. These accounting policies and estimates, including those related to inventory, long-lived assets, leases, revenue recognition and income taxes, are reevaluated on an ongoing basis, and adjustments are made when facts and circumstances dictate a change. Historically, we have found our application of accounting policies to be appropriate, and actual results have not differed materially from those determined using necessary estimates.
Our critical accounting policies and estimates are discussed in and should be read in conjunction with our Annual Report on Form 10-K, as filed with the Securities and Exchange Commission (SEC) on April 18, 2019, which includes audited consolidated financial statements for our 2018 and 2017 fiscal years and the five weeks ended February 3, 2018. Except for changes resulting from the adoption of new accounting standards during the period, including the new lease standard (See footnote 3 to the Condensed Consolidated Financial Statements), there have been no material changes to the critical accounting estimates disclosed in the 2018 Form 10-K.
Recent Accounting Pronouncements
See Note 1 to the Condensed Consolidated Financial Statements — Basis of Presentation — Recent Accounting Pronouncements – Adopted in the Current Year
Item 4. Controls and Procedures.
Our management, with the participation of our President and Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures, as of the end of the period covered by this report. Our disclosure controls and procedures are designed to ensure that information required to be disclosed by us in the reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and is accumulated and communicated to management, including our certifying officers, as appropriate to allow timely decisions regarding required disclosure. Based on the foregoing evaluation, our management, including the President and Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of May 4, 2019, the end of the period covered by this Quarterly Report.
It should be noted that our management, including the President and Chief Executive Officer and the Chief Financial Officer, does not expect that our disclosure controls and procedures or internal controls will prevent all error and all fraud. A control system, no matter how well conceived or operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.
Changes in Internal Control Over Financial Reporting.
The Company’s management, with the participation of the Company’s President and Chief Executive Officer and Chief Financial Officer, also conducted an evaluation of the Company’s internal control over financial reporting to determine whether any changes occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. We implemented internal controls to ensure we adequately evaluated our contracts and properly assessed the impact of the new accounting standard related to leases on our financial statements to facilitate its adoption on February 3, 2019. We implemented a new software solution to support our accounting for leases and have implemented new internal controls in response. There has been no other change in our internal control over financial reporting during the quarter covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.