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[February 20, 2014]
HSN, INC. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion should be read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere in this annual report. Historical results and trends which might appear should not be taken as indicative of future operations. Our results of operations and financial condition, as reflected in the accompanying consolidated financial statements and related notes, are subject to management's evaluation and interpretations of business conditions, changing market conditions and other factors.
Management Overview HSNi offers innovative, differentiated retail experiences and markets and sells a wide range of third party and proprietary merchandise directly to consumers through its two operating segments, HSN and Cornerstone. HSN's business platforms include (i) the television home shopping programming broadcast on the HSN television networks; (ii) the HSN.com website; (iii) mobile applications; and (iv) outlet stores. Cornerstone's business platforms include (i) catalogs, consisting primarily of the Cornerstone portfolio of leading print catalogs which includes Ballard Designs, Chasing Fireflies, Frontgate, Garnet Hill, Grandin Road, Improvements and TravelSmith; (ii) websites, consisting primarily of the eight branded websites operated by Cornerstone; (iii) retail and outlet stores; and (iv) mobile devices.
Sources of Revenue HSN revenue includes merchandise sales originating from the live television broadcasts of its programming 24 hours per day, seven days a week; HSN2, a network that primarily distributes taped programming on a limited distribution basis; the HSN.com website; mobile handheld devices; and through outlet stores.
HSN also sells merchandise through its "Autoship" program under which customers receive scheduled merchandise shipments according to a pre-determined calendar.
Cornerstone sells private label and third party merchandise through its assortment of catalogs, digital sites and retail and outlet stores. Cornerstone consists of the brands of Ballard Designs, Chasing Fireflies, Frontgate, Garnet Hill, Grandin Road, Improvements and TravelSmith.
Products HSNi sells a wide array of merchandise across its various channels of distribution. HSN merchandise categories primarily consist of jewelry, fashion (apparel & accessories), beauty & health, and home & other (including household, home design, electronics, culinary and other). HSN manages its product mix to provide a balance between satisfying existing customer demand, generating interest from potential viewers and customers, providing new merchandise to its viewership and maximizing airtime and internet efficiency. Cornerstone merchandise categories generally consist of home and outdoor furnishings and apparel & accessories.
HSNi management believes that merchandise diversification, combined with an interactive multi-channel distribution strategy, appeals to a broader segment of potential customers and is an important part of its overall business strategy.
HSNi is continually developing new merchandise offerings from existing, potential and future suppliers, to supplement its existing product lines.
19 -------------------------------------------------------------------------------- Results of Operations Net Sales Net sales primarily relate to the sale of merchandise, including shipping and handling fees, and are reduced by incentive discounts and actual and estimated sales returns. Sales taxes collected are not included in net sales. Digital sales include sales placed through our internet websites and our mobile applications, including tablets and smart phones.
Revenue is recorded when delivery to the customer has occurred. Delivery is considered to have occurred when the customer takes title and assumes the risks and rewards of ownership, which is on the date of shipment. HSNi's sales policy allows customers to return virtually all merchandise for a full refund or exchange, subject to pre-established time restrictions.
Year Ended December 31, 2013 Change 2012 Change 2011 (Dollars in thousands) HSN $ 2,312,382 2% $ 2,265,026 5% $ 2,160,341 Cornerstone 1,091,601 9% 1,001,713 10% 909,015Total HSNi net sales $ 3,403,983 4% $ 3,266,739 6% $ 3,069,356 HSNi net sales in 2013 increased 4%, or $137.2 million, due to 2% sales growth at HSN and 9% sales growth at Cornerstone. Digital sales grew 9% with penetration increasing 200 basis points to 46.5%, up from 44.5% in the prior year. The number of units shipped in 2013 increased 4% to 62.0 million and the average price point decreased 1% to $62.37.
HSNi net sales in 2012 increased 6%, or $197.4 million, due to 5% sales growth at HSN and 10% sales growth at Cornerstone. Digital sales grew 13% with penetration increasing 270 basis points to 44.5%, up from 41.8% in the prior year. The number of units shipped in 2012 increased 8% to 59.6 million and the average price point decreased 2% to $62.92.
HSN HSN net sales in 2013 increased 2%, or $47.4 million. Sales grew in beauty & health, home design and household, offset by lower sales in jewelry, culinary and electronics. HSN repositioned the jewelry and culinary businesses in 2013 through changes in product and brand assortment and, as a result, dedicated lower airtime to these product categories. Digital sales grew 7% and penetration increased 160 basis points to 37.0%, up from 35.4% in the prior year. Digital sales were tempered in the first quarter by the launch of the digital site redesign across all HSN digital platforms while HSN implemented its new technology and our customers acclimated themselves with the new website design and capabilities. The return rate decreased 80 basis points to 18.7% from 19.5% in the prior year primarily due to the shift in product mix to categories with lower return rates as well as experiencing lower than historical return rates in many of its product categories. The gross units shipped increased 5% to 46.9 million while average price point decreased 4% to $58.21 primarily due to an increase in clearance activity and changes in product mix.
HSN net sales in 2012 increased 5%, or $104.7 million, driven by sales growth in home design, household, beauty and culinary, offset by lower sales in jewelry.
During 2012, HSN focused on several key initiatives targeted at customer acquisition and retention. Pricing strategies and product selection were designed to appeal to potential and current customers with lower overall price points and product selection to drive higher volumes; we offered entertainment events designed to reinforce our brand and company awareness in the marketplace; we continued to invest in digital marketing initiatives to appeal to the growing number of digital consumers; and we provided our customers with payment alternatives designed to make the shopping experience with HSN easier and flexible. As a result of these and other initiatives, the number of units shipped increased 8% to 44.7 million and average price point decreased 4% to $60.57. Digital sales grew 10% with penetration increasing 160 basis points to 35.4%, up from 33.8% in the prior year. Shipping and handling revenues decreased 4% driven by an increase in shipping and handling promotions, particularly in the second half of the year. The return rate decreased 50 basis points to 19.5% from 20.0% in the prior year.
20--------------------------------------------------------------------------------Divisional product mix at HSN is provided in the table below: Year Ended December 31, 2013 2012 2011 Jewelry 11.1 % 13.1 % 14.0 % Fashion (apparel & accessories) 13.9 % 13.1 % 13.3 % Beauty & Health 24.5 % 22.7 % 22.9 % Home & Other (including household, home design, electronics, culinary and other) 50.5 % 51.1 % 49.8 % Total 100.0 % 100.0 % 100.0 % Cornerstone Cornerstone net sales in 2013 increased 9%, or $89.9 million. The increase in net sales was driven by sales growth in the home brands. Digital sales grew 11% with penetration increasing 150 basis points to 66.5%, up from 65.0% in the prior year. The return rate decreased 50 basis points to 12.9% due primarily to changes in product mix. Catalog circulation increased 5% compared to the prior year.
Cornerstone's net sales in 2012 increased 10% in 2012, or $92.7 million, compared to the prior year. Fiscal year 2012 included 52 weeks compared to fiscal year 2011 which included 53 weeks. Excluding the incremental sales from the additional week in 2011, net sales increased 12% primarily due to strength in the home brands, the addition of Chasing Fireflies to the portfolio in April 2012 and an increase in catalog circulation. Digital sales grew 18% with penetration increasing 430 basis points to 65.0%, up from 60.7% in the prior year. The return rate decreased 130 basis points to 13.4% due to changes in product mix and a heightened focus on quality assurance efforts. Catalog circulation increased 10% compared to the prior year.
The brand mix at Cornerstone is provided in the table below: Year Ended December 31, 2013 2012 2011 Home brands (Ballard Designs, Frontgate, Grandin Road and Improvements) 73.9 % 71.8 % 71.5 % Apparel brands (Chasing Fireflies, Garnet Hill and TravelSmith) (a) 26.1 % 28.2 % 28.5 % Total 100.0 % 100.0 % 100.0 % (a) Chasing Fireflies was acquired in April 2012.
Cost of Sales and Gross Profit Cost of sales consists primarily of the cost of products sold, shipping and handling costs and compensation and other employee-related costs for personnel engaged in warehouse functions. Cost of products sold includes merchandise cost, inbound freight and duties and certain allocable general and administrative costs, including certain warehouse costs.
Year Ended December 31, 2013 Change 2012 Change 2011 (Dollars in thousands) Gross profit: HSN $ 796,705 1% $ 786,650 6% $ 741,308 HSN gross margin 34.5 % (20 bp) 34.7 % 40 bp 34.3 % Cornerstone $ 433,110 9% $ 397,074 11% $ 358,954 Cornerstone gross margin 39.7 % 10 bp 39.6 % 10 bp 39.5 % HSNi $ 1,229,815 4% $ 1,183,724 8% $ 1,100,262 HSNi gross margin 36.1 % (10 bp) 36.2 % 40 bp 35.8 % bp = basis points HSN Gross profit for HSN in 2013 increased 1%, or $10.1 million, compared to the prior year. Gross margin decreased 20 basis points to 34.5% primarily due to lower shipping margins due to increases in shipping and handling promotions and shipping costs.
21 -------------------------------------------------------------------------------- Gross profit for HSN in 2012 increased 6%, or $45.3 million, compared to the prior year. Gross margin improved 40 basis points to 34.7% from 34.3%. The margin increase was primarily attributable to an increase in product margins driven by product mix but were largely offset by the decrease in shipping margins primarily due to an increase in shipping promotions. The increase was also due to lower transaction costs related to debit card fees.
Cornerstone Gross profit for Cornerstone in 2013 increased 9%, or $36.0 million, compared to the prior year. Gross margin increased 10 basis points from 39.6% to 39.7% primarily due to an increase in product margins driven by product mix and selective price increases.
Gross profit for Cornerstone in 2012 increased 11%, or $38.1 million, compared to the prior year. Gross margin improved 10 basis points to 39.6% from 39.5% in the prior year. The margin was positively impacted by lower inbound freight costs in the home brands, lower return rates and lower inventory reserves, offset by a decrease in net shipping margins driven by the increase in shipping promotions.
Selling and Marketing Expense Selling and marketing expense consists primarily of advertising and promotional expenditures, compensation and other employee-related costs (including stock-based compensation) for personnel engaged in customer service, sales and merchandising, production and programming functions and on-air distribution costs. Advertising and promotional expenditures primarily include catalog production and distribution costs and online marketing, including fees paid to search engines and third-party distribution partners.
Year Ended December 31, 2013 Change 2012 Change 2011 (Dollars in thousands) HSN $ 392,715 2% $ 385,243 4% $ 368,915 As a percentage of HSN net sales 17.0 % 0 bp 17.0 % (10 bp) 17.1 % Cornerstone $ 303,079 9% $ 277,079 12% $ 247,501 As a percentage of Cornerstone net sales 27.8 % 10 bp 27.7 % 50 bp 27.2 % HSNi $ 695,794 5% $ 662,322 7% $ 616,416 As a percentage of HSNi net sales 20.4 % 10 bp 20.3 % 20 bp 20.1 % HSNi's selling and marketing expense in 2013 increased 5%, or $33.5 million, and was 20.4% of net sales compared to 20.3% in the prior year. The increase was primarily due to additional catalog costs associated with a 5% increase in Cornerstone's catalog circulation and increases in employee-related and digital marketing costs.
HSNi's selling and marketing expense in 2012 increased 7%, or $45.9 million, and was 20.3% of net sales compared to 20.1% in 2011. The increase was primarily due to additional catalog costs associated with a 10% increase in Cornerstone's catalog circulation and increases in employee-related and digital marketing costs.
22 -------------------------------------------------------------------------------- General and Administrative Expense General and administrative expense consists primarily of compensation and other employee-related costs (including stock-based compensation) for personnel engaged in finance, legal, tax, human resources, information technology and executive management functions, bad debts, facilities costs and fees for professional services.
Year Ended December 31, 2013 Change 2012 Change 2011 (Dollars in thousands) HSN $ 154,434 (5)% $ 162,417 7% $ 151,813 As a percentage of HSN net sales 6.7 % (50 bp) 7.2 % 20 bp 7.0 % Cornerstone $ 56,344 (9)% $ 62,236 9% $ 57,169 As a percentage of Cornerstone net sales 5.2 % (100 bp) 6.2 % (10 bp) 6.3 % HSNi $ 210,778 (6)% $ 224,653 7% $ 208,982 As a percentage of HSNi net sales 6.2 % (70 bp) 6.9 % 10 bp 6.8 % HSNi's general and administrative expense in 2013 decreased 6%, or $13.9 million, and was 6.2% of net sales compared to 6.9% in the prior year. The decrease in expense was primarily due to a $7.8 million sales tax settlement at Cornerstone that occurred in the prior year and lower bad debt expense related to HSN's extended payment program ("Flexpay"), partially offset by an increase in employee-related costs. There was also an increase in severance-related costs that was offset by a decrease in stock-based compensation expense.
Additionally, Cornerstone recognized non-cash fair value adjustments in the fourth quarter of 2013 related to a contingent consideration obligation and certain intangible assets associated with its 2012 acquisition of Chasing Fireflies. The net impact of the reduction of the contingent consideration obligation and the intangible asset impairment charge was a reduction of expense of $0.6 million which is included in "General and administrative expenses." HSNi's general and administrative expense in 2012 increased 7%, or $15.7 million, and was 6.9% of net sales compared to 6.8% in the prior year. The increase in expense was primarily due to a $7.8 million sales tax settlement at Cornerstone, an increase in bad debt expense due to higher usage of Flexpay and technology-related costs, partially offset by a $6.1 million decrease in stock-based compensation.
Depreciation and Amortization Year Ended December 31, 2013 Change 2012 Change 2011 (Dollars in thousands) HSN $ 28,372 7% $ 26,486 (4)% $ 27,652 Cornerstone 12,217 6% 11,519 41% 8,170 HSNi $ 40,589 7% $ 38,005 6% $ 35,822 As a percentage of HSNi net sales 1.2 % 0 bp 1.2 % 0 bp 1.2 % Depreciation and amortization in 2013 increased 7%, or $2.6 million, compared to the prior year. The increase was primarily due to the incremental depreciation associated with recent capital expenditures for information and digital technology.
Depreciation and amortization in 2012 increased 6%, or $2.2 million, compared to the prior year. The increase was primarily due to depreciation on leasehold improvements and equipment related to a new leased Cornerstone warehouse facility opened in 2012 and amortization of intangibles acquired in the second quarter related to the Chasing Fireflies acquisition, partially offset by certain fixed assets becoming fully depreciated during 2012.
23 --------------------------------------------------------------------------------Adjusted EBITDA Adjusted EBITDA is a non-GAAP measure and is defined in Note 6 of Notes to Consolidated Financial Statements.
Year Ended December 31, 2013 Change 2012 Change 2011 (Dollars in thousands) HSN $ 261,292 4% $ 250,836 7% $ 235,164 As a percentage of HSN net sales 11.3 % 20 bp 11.1 % 20 bp 10.9 % Cornerstone $ 76,574 4% $ 73,441 9% $ 67,595 As a percentage of Cornerstone net sales 7.0 % (30 bp) 7.3 % (10 bp) 7.4 % HSNi $ 337,866 4% $ 324,277 7% $ 302,759 As a percentage of HSNi net sales 9.9 % 0 bp 9.9 % 0 bp 9.9 % HSNi's Adjusted EBITDA in 2013 increased 4%, or $13.6 million, and was 9.9% of net sales, consistent with the prior year. The increase in Adjusted EBITDA was due to a 4% increase in net sales, partially offset by a 4% increase in operating expenses (excluding non-cash charges and $7.8 million sales tax settlement in the prior year). HSN's Adjusted EBITDA increased 4%, or $10.5 million, primarily due to a 2% increase in net sales, partially offset by a 20 basis point decline in gross margin. HSN's operating expenses (excluding non-cash charges) were 23.2% of net sales compared to 23.7% in the prior year.
Decreases in HSN's professional services fees and bad debt expense were offset by increases in employee-related and digital marketing costs. Cornerstone's Adjusted EBITDA increased 4%, or $3.1 million, primarily due to a 9% increase in net sales, partially offset by a 10% increase in operating expenses (excluding non-cash charges and a $7.8 million sales tax settlement in the prior year). The increase in operating expenses was largely due to catalog costs associated with the 5% increase in circulation; employee-related costs; the incremental expenses from the addition of Chasing Fireflies to the portfolio in April 2012 and investments in digital marketing.
HSNi's Adjusted EBITDA in 2012 increased 7%, or $21.5 million, and was 9.9% of net sales, consistent with the prior year. The increase in Adjusted EBITDA was primarily due to a 6% increase in net sales and a 40 basis point improvement in gross margin, partially offset by an 8% increase in operating expenses (excluding non-cash charges and a $7.8 million sales tax settlement). HSN's Adjusted EBITDA increased 7%, or $15.7 million, primarily due to a 5% increase in net sales and a 40 basis point improvement in gross margin, partially offset by a 6% increase in operating expenses (excluding non-cash charges) primarily for employee-related costs, digital and brand marketing and bad debt expense.
Cornerstone's Adjusted EBITDA increased 9%, or $5.8 million, primarily due to the acquisition of Chasing Fireflies in April 2012.
Operating Income Year Ended December 31, 2013 Change 2012 Change 2011 (Dollars in thousands) HSN $ 221,184 4% $ 212,503 10% $ 192,928 As a percentage of HSN net sales 9.6 % 20 bp 9.4 % 50 bp 8.9 % Cornerstone $ 61,470 33% $ 46,241 -% $ 46,114 As a percentage of Cornerstone net sales 5.6 % 100 bp 4.6 % (50 bp) 5.1 % HSNi $ 282,654 9% $ 258,744 8% $ 239,042 As a percentage of HSNi net sales 8.3 % 40 bp 7.9 % 10 bp 7.8 % HSNi's operating income in 2013 increased 9%, or $23.9 million, and was 8.3% of net sales compared to 7.9% in the prior year. The increase was primarily due to 4% growth in net sales offset by a 2% increase in operating expenses. The increase in operating expenses was primarily due to increases in employee-related costs, catalog costs and digital marketing, partially offset by a $7.8 million unfavorable sales tax settlement at Cornerstone in the prior year and decreases in professional services fees and bad debt expenses at HSN.
HSNi's operating income in 2012 increased 8%, or $19.7 million, and was 7.9% of net sales compared to 7.8% in the prior year. The increase was primarily due to 6% growth in net sales and 40 basis point improvement in gross margin, partially offset by a 7% increase in operating expenses primarily for Cornerstone's catalog circulation and $7.8 million sales tax settlement, digital marketing and technology costs, and employee-related costs.
24 -------------------------------------------------------------------------------- Other Income (Expense) Year Ended December 31, 2013 Change 2012 Change 2011 (Dollars in thousands) Interest income $ 205 (64)% $ 564 (17)% $ 679 Interest expense (6,718 ) (68)% (20,811 ) (35)% (31,963 ) Loss on debt extinguishment - NA (18,627 ) NA - Total other expense, net $ (6,513 ) (83)% $ (38,874 ) 24% $ (31,284 ) As a percentage of HSNi net sales 0.2 % (100 bp) 1.2 % 20 bp 1.0 % Interest Expense On April 24, 2012, HSNi entered into a $600 million five-year syndicated credit agreement ("Credit Agreement") which replaced the credit agreement that was set to expire in July 2013. On July 31, 2012, HSNi drew $250 million from its delayed draw term loan under the Credit Agreement. The proceeds of the term loan were used to fully redeem the $240 million 11.25% Senior Notes due 2016 ("Senior Notes") on August 1, 2012 as discussed below. As a result of these refinancing transactions, interest expense decreased 68% in 2013, or $14.1 million.
Interest expense in 2012 was primarily related to the Senior Notes which bore interest at 11.25% through the August 1, 2012 redemption date and the $250 million term loan outstanding under the Credit Agreement. Interest expense in 2011 primarily related to the Senior Notes and the $69.8 million term loan outstanding under the prior credit agreement.
Loss on Debt Extinguishment On August 1, 2012, HSNi fully redeemed its $240 million Senior Notes. The Senior Notes were redeemed for $253.5 million, or 105.625% of the principal amount.
HSNi reported approximately $18.6 million in "Loss on debt extinguishment" primarily associated with redemption of the Senior Notes in the third quarter of 2012. These charges resulted from the redemption premium of $13.5 million and $5.1 million related to the write-off of unamortized issuance costs and original issue discount.
Income Tax Provision For the years ended December 31, 2013, 2012 and 2011, HSNi recorded tax provisions from continuing operations of $97.7 million, $83.4 million and $80.1 million, respectively, which represent effective tax rates of 35.4%, 37.9% and 38.6%, respectively.
The change in the effective tax rate in 2013 from the prior periods was primarily due to discrete tax benefits of $3.7 million realized in the third quarter of 2013 and the favorable tax treatment of the fair value adjustments related to the 2012 acquisition of Chasing Fireflies recorded in the fourth quarter of 2013. Excluding the impact of these items, the 2013 effective tax rate for continuing operations would have been 37%. The adjusted rate of 37% in 2013, as well as the 2012 and 2011 tax rates, are higher than the federal statutory rate of 35% due principally to state income taxes.
Discontinued Operations In May 2012, substantially all of the assets and certain liabilities of Smith+Noble, a Cornerstone brand specializing in window treatments, were sold for $5.5 million. The operating results for Smith+Noble are included in "Loss from discontinued operations, net of tax" in the consolidated statements of operations for all periods presented. Cornerstone recorded an after-tax loss on the sale of $0.1 million in the second quarter of 2012, which is included in "Loss from discontinued operations, net of tax" in the accompanying consolidated statements of operations.
In July 2012, substantially all of the assets and certain liabilities of The Territory Ahead, a Cornerstone brand specializing in casual apparel for men and women, were sold for approximately $1.1 million. The operating results for The Territory Ahead are included in "Loss from discontinued operations, net of tax" in the consolidated statements of operations for all periods presented. An impairment charge of $5.9 million was recorded in the second quarter of 2012 to reduce the carrying 25 -------------------------------------------------------------------------------- value of the net assets to their estimated net realizable value and is included in "Loss from discontinued operations, net of tax" in the accompanying consolidated statements of operations.
Liquidity and Capital Resources As of December 31, 2013, HSNi had $196.4 million of cash and cash equivalents, down from $222.1 million as of December 31, 2012.
Net cash provided by operating activities attributable to continuing operations was $231.9 million in 2013 compared to $147.4 million in 2012, an increase of $84.5 million. This increase was primarily due to improved operating performance and changes in working capital. Working capital improved primarily as a result of lower inventory receipts, effective inventory management and the timing of collection of credit card receivables, offset by the timing of income tax payments.
Inventory receipts were particularly high in 2012 as both HSN and Cornerstone were increasing their inventory balances to support sales growth. HSN's sales growth in 2013 was lower than expected resulting in additional clearance activity and a reduction in inventory receipts. However, these measures have resulted in inventory in 2013 decreasing by 17% compared to prior year and aged inventories being at their lowest levels since 2010. Cornerstone continued to grow its inventory in 2013 to support its future sales growth. Cornerstone's inventory increased 26% in 2013 and 10% in 2012.
Consistent with prior years, HSN continued to increase its offering of Flexpay, an installment program which allows customers to pay for select merchandise in two to six interest-free, monthly payments. This program increases the Company's cash requirements as the sales proceeds get delayed by using the Flexpay alternative. Despite the increased usage of Flexpay, the Company did not experience any deterioration in the aging of Flexpay receivables or had an increase in its write-offs of receivables in 2013.
Net cash used in investing activities attributable to continuing operations in 2013 was $61.1 million. Capital expenditures in 2013 was $52.0 million and was primarily for investments in information and digital technology. HSNi also made an advance payment of $9.1 million for warehouse improvement projects.
Net cash used in financing activities attributable to continuing operations in 2013 was $196.4 million. During 2013, HSNi repurchased 2.7 million shares of common stock for $146.9 million at an average cost of $53.67. HSNi also paid dividends totaling $0.79 per common share resulting in $42.3 million in payments during 2013. Repayments of $9.4 million of HSNi's term loan were made in 2013.
HSNi had a cash inflow of $8.4 million from the proceeds from stock option exercises and a cash outflow of $14.4 million to cover withholding taxes for stock-based awards. Additionally, in 2013 HSNi had $10.4 million of excess tax benefits from stock-based awards.
HSNi's $600 million Credit Agreement is secured by 100% of the voting equity securities of HSNi's U.S. subsidiaries and 65% of the voting equity securities of HSNi's first-tier foreign subsidiaries. This Credit Agreement replaced the credit agreement that was set to expire in July 2013. Certain HSNi subsidiaries have unconditionally guaranteed HSNi's obligations under the Credit Agreement.
The Credit Agreement, which includes a $350 million revolving credit facility and a $250 million term loan, may be increased up to $850 million subject to certain conditions and expires April 24, 2017. HSNi drew $250 million from its term loan on July 31, 2012 to fund the redemption of the Senior Notes, as discussed below. As of December 31, 2013, $240.6 million was outstanding under the term loan. HSNi capitalized $5.5 million in financing costs related to the Credit Agreement and is amortizing these costs to interest expense over the Credit Agreement's five-year term.
The Credit Agreement contains various covenants, limitations and events of default customary for similar facilities including a maximum leverage ratio of 3.00x and a minimum interest coverage ratio of 3.00x. HSNi was in compliance with all such covenants as of December 31, 2013, with a leverage ratio of 0.73x and an interest coverage ratio of 60.68x.
Loans under the Credit Agreement bear interest at a per annum rate equal to LIBOR plus a predetermined margin that ranges from 1.50% to 2.25% or the Base Rate (as defined in the Credit Agreement) plus a predetermined margin that ranges from 0.50% to 1.25%. HSNi can elect to borrow at either LIBOR or the Base Rate and the predetermined margin is based on HSNi's leverage ratio. The term loan interest rate as of December 31, 2013 was 1.66%. HSNi pays a commitment fee ranging from 0.25% to 0.40% (based on the leverage ratio) on the unused portion of the revolving credit facility.
The amount available under the Credit Agreement is reduced by the amount of commercial and standby letters of credit issued under the revolving credit facility, which totaled $31.7 million as of December 31, 2013. The ability to draw funds under the revolving credit facility is dependent upon meeting the aforementioned financial covenants, which may limit HSNi's ability to draw the full amount of the facility. As of December 31, 2013, the additional amount that could be borrowed under 26 -------------------------------------------------------------------------------- the revolving credit facility, in consideration of the financial covenants and outstanding letters of credit, was approximately $318.3 million.
To reduce our future exposure to rising interest rates under our credit facility, we entered into a forward-starting swap in December 2012 that effectively converts $187.5 million of our variable rate term loan to a fixed-rate of 0.8525%, resulting in an all-in fixed rate of 2.3525% (based on HSNi's leverage ratio as of December 31, 2013), beginning January 2014 through April 2017. For additional information related to our interest rate swaps, refer to Note 8 of Notes to Consolidated Financial Statements.
On July 28, 2008, HSNi issued $240 million of 11.25% Senior Notes due 2016. The Senior Notes were fully redeemed on August 1, 2012 for $253.5 million, or 105.625% of the principal amount. HSNi drew $250 million from its term loan on July 31, 2012 and used its cash on hand to fund the redemption. HSNi reported approximately $18.6 million in pre-tax charges primarily associated with redemption of the Senior Notes. These charges resulted from the redemption premium of $13.5 million and $5.1 million related to the write-off of unamortized issuance costs and original issue discount.
HSNi does not currently have any material commitments for capital expenditures; however, management does anticipate that HSNi will need to make capital and other expenditures in connection with the development and expansion of its operations. HSNi's ability to fund its cash and capital needs will be affected by its ongoing ability to generate cash from operations, the overall capacity and terms of its financing arrangements as discussed above, and access to the capital markets. HSNi believes that its cash on hand, its anticipated operating cash flows, its available unused portion of the revolving credit facility and its access to capital markets will be sufficient to fund its operating needs, capital, investing and other commitments and contingencies for the foreseeable future.
On September 27, 2011, HSNi's Board of Directors approved a share repurchase program which allows HSNi to purchase 10 million shares of its common stock from time to time through privately negotiated and/or open market transactions. The timing of any repurchases and actual number of shares repurchased will depend on a variety of factors, including the stock price, corporate and regulatory requirements, restrictions under HSNi's debt obligations and other market and economic conditions. The repurchase program may be suspended or discontinued by HSNi at any time. For the year ended December 31, 2013, HSNi repurchased approximately 2.7 million shares at a cost of $146.9 million at an average cost of $53.67 per share. As of December 31, 2013, approximately 1.0 million shares remained authorized for repurchase under the program.
In February 2014, HSNi's Board of Directors approved a cash dividend of $0.25 per common share. The dividend will be paid on March 19, 2014 to HSNi's record holders as of March 5, 2014.
Contractual Obligations and Commercial Commitments The following table presents HSNi's contractual obligations as of December 31, 2013: Payments Due by Period Total Amounts Less Than More ThanContractual Obligations Committed 1 Year 1 - 3 Years 3 - 5 Years 5 Years (In thousands) Long-term debt, including current maturities $ 240,625 $ 12,500 $ 35,938 $ 192,187 $ - Interest on debt (a) 16,422 5,187 9,828 1,407 - Operating leases 103,407 24,756 38,285 26,666 13,700 Purchase obligations (b) 141,678 73,610 68,016 52 - Total contractual obligations $ 502,132 $ 116,053 $ 152,067 $ 220,312 $ 13,700 (a) Includes interest on variable rate debt estimated using the rate in effect as of December 31, 2013 through January 31, 2014, at which time the forward-starting interest rate swap goes into effect. An all-in fixed rate of 2.3525% based on HSNi's leverage ratio as of December 31, 2013 is then assumed from February 1, 2014 through April 2017, the date of expiration of the variable rate debt.
(b) The purchase obligations primarily relate to contracts with pay television operators and include obligations for future cable distribution and commission guarantees.
27-------------------------------------------------------------------------------- Amount of Commitments Expiration Per Period Total Amounts Less Than More Than Commercial Commitments Committed 1 Year 1 - 3 Years 3 - 5 Years 5 Years (In thousands) Letters of credit and surety bonds (c) $ 35,711 $ 35,561 $ 150 $ - $ - (c) The letters of credit ("LOCs") primarily consist of trade LOCs which are used for inventory purchases. Trade LOCs are guarantees of payment based upon the delivery of goods. The surety bonds primarily consist of custom bonds which relate to the import of merchandise into the United States.
We issue inventory purchase orders in the normal course of business, which represent authorizations to purchase that are cancelable by their terms. We do not consider purchase orders to be firm inventory commitments; therefore, they are excluded from the table above. If we choose to cancel a purchase order, we may be obligated to reimburse the vendor for unrecoverable outlays incurred prior to cancellation.
At December 31, 2013, we had $1.1 million, including penalties and interest, recorded for uncertain tax positions. We are not able to reasonably estimate the timing of payments in future periods; therefore, the liability of $1.1 million has not been included in the contractual obligations table above.
Off-Balance Sheet Arrangements Other than the items described above, HSNi does not have any material off-balance sheet arrangements as of December 31, 2013.
Seasonality HSNi is affected by seasonality, although historically our business has exhibited less seasonality than many other retail businesses. Our sales levels are generally higher in the fourth quarter. Reported revenues in the fourth quarter were 30% of total reported annual revenues in 2013, 2012 and 2011, respectively.
Non-GAAP Measure HSNi reports Adjusted EBITDA as a supplemental measure to generally accepted accounting principles ("GAAP"). This measure is one of the primary metrics by which HSNi evaluates the performance of its businesses, on which its internal budgets are based and by which management is compensated. HSNi believes that investors should have access to the same information that it uses in analyzing its results.
Adjusted EBITDA is defined as operating income excluding, if applicable: (1) non-cash charges including: (a) stock-based compensation expense, (b) amortization of intangibles, (c) depreciation and gains and losses on asset dispositions, and (d) goodwill, long-lived asset and intangible asset impairments; (2) pro forma adjustments for significant acquisitions; and (3) other significant items. Significant items, while periodically affecting our results, may vary significantly from period to period and have a disproportionate effect in a given period, thereby affecting the comparability of results. Adjusted EBITDA is not a measure determined in accordance with GAAP, and should not be considered in isolation or as a substitute for operating income, net income or any other measure determined in accordance with GAAP.
Adjusted EBITDA is used as a measurement of operating efficiency and overall financial performance and HSNi believes it to be a helpful measure for those evaluating companies in the retail and media industries. Adjusted EBITDA has certain limitations in that it does not take into account the impact to HSNi's consolidated statements of operations of certain expenses, including stock-based compensation, amortization of intangibles, depreciation, gains and losses on asset dispositions, asset impairment charges, acquisition-related accounting and other significant items.
Items That Are Excluded From HSNi's Non-GAAP Measure Stock-based compensation expense consists principally of expense associated with the grants of restricted stock, restricted stock units, stock options and stock appreciation rights. These expenses are not paid in cash, and HSNi includes the related shares in its calculations of diluted shares outstanding. Upon vesting of restricted stock and restricted stock units and the exercise of certain stock options and stock appreciation rights, the awards can be settled, at HSNi's discretion, on a net basis, with HSNi remitting the required tax withholding amount from its current funds.
28 -------------------------------------------------------------------------------- Amortization of intangibles is a non-cash expense relating primarily to acquisitions. At the time of an acquisition, the intangible assets of the acquired company, such as distribution agreements, customer relationships and merchandise agreements, are valued and amortized over their estimated lives.
Depreciation, gains and losses on asset dispositions and long-lived asset impairment charges are non-cash items relating to our long-lived assets and have been excluded from Adjusted EBITDA.
Goodwill and intangible asset impairment charges are also non-cash expenses that have been excluded from Adjusted EBITDA.
Other Significant Items represent transactions that may vary significantly from period to period and have a disproportionate effect in a given period, thereby affecting the comparability of results.
Reconciliation of Adjusted EBITDA See Note 6 of Notes to Consolidated Financial Statements for the reconciliation between Adjusted EBITDA and net income for the years ended December 31, 2013, 2012 and 2011.
Critical Accounting Policies and Estimates The following disclosure is provided to supplement the descriptions of HSNi's accounting policies contained in Note 2 of Notes to Consolidated Financial Statements in regard to significant areas of judgment. HSNi's management is required to make certain estimates and assumptions during the preparation of its consolidated financial statements in accordance with GAAP. These estimates and assumptions impact the reported amount of assets and liabilities and disclosures of contingent assets and liabilities as of the date of the consolidated financial statements. They also impact the reported amount of net income during any period. Actual results could differ from those estimates. Because of the size of the financial statement elements to which they relate, some of HSNi's accounting policies and estimates have a more significant impact on its consolidated financial statements than others. The following is a discussion of some of HSNi's more significant accounting policies and estimates.
Recoverability of Long-Lived Assets HSNi reviews the carrying value of all long-lived assets, primarily property and equipment and definite-lived intangible assets, for impairment whenever triggering events or changes in circumstances indicate that the carrying value of an asset may be impaired. Impairment is considered to have occurred whenever the carrying value of a long-lived asset exceeds the sum of the undiscounted cash flows that is expected to result from the use and eventual disposition of the asset. The impairment is measured by comparing the fair value of the asset to its carrying value. Our valuation methodologies include, but are not limited to, discounting the future cash flows from the asset being tested. Significant judgments include determining if a triggering event has occurred, determining the future cash flows from the assets and applying the appropriate discount rate when measuring the fair value. The determination of cash flows is based upon assumptions that may not occur.
Impairment of Goodwill and Indefinite-Lived Intangible Assets HSNi assesses the impairment of goodwill and identifiable indefinite-lived intangible assets, principally trademarks and trade names, at least annually during the fourth quarter and whenever events or changes in circumstances indicate that the carrying value of an asset may be impaired. In performing this review, HSNi has the option of performing a qualitative assessment to determine whether it is more likely than not that the fair values of the reporting unit and/or indefinite-lived intangible assets are less than the carrying values. In performing the qualitative assessment, HSNi considers various factors including (but not limited to): macroeconomic, industry and market conditions; cost factors affecting the business; the overall financial performance of the business; any relevant changes in management, strategies or customers; and any sustained decreases in its stock price. If HSNi determines based on this assessment that it is not more likely that the fair value is less than its carrying value, then the goodwill and/or the indefinite-lived intangible assets are deemed to be not impaired and no further testings is required until the next annual test date (or sooner if conditions or events before that date raise concerns of potential impairment in the business). If HSNi determines that it is more likely than not that the fair value is less than its carrying value, then the quantitative goodwill and/or indefinite-lived intangible asset impairment tests must be completed.
If necessary, HSNi performs a quantitative assessment of the fair values of its goodwill and intangible assets. In performing this review, HSNi is required to make an assessment of the fair value of its intangible assets. If it is determined that the implied fair value of goodwill and/or indefinite-lived intangible assets is less than the carrying amount, an impairment charge, equal to the excess, is recorded. HSNi determines the fair value of its reporting units by using a discounted cash flow 29 -------------------------------------------------------------------------------- analysis with consideration of an equity analysis based on the trading value of its common stock. HSNi utilizes the relief from royalty method to assess fair values of its trademarks and trade names.
In assessing fair value, HSNi considers, among other indicators, differences between estimated and actual cash flows and revenue streams and changes in the related discount, royalty and terminal growth rates. Determining these rates requires the exercise of significant judgments. These factors used in the determination of fair value are sensitive to, among other things, changes in the retail consumer market and the general economy.
Returns Reserves Net sales from HSNi primarily consist of merchandise sales and are reduced by incentive discounts and sales returns. HSNi's sales policy allows customers to return virtually all merchandise for a full refund or exchange, subject to pre-established time restrictions. Allowances for returned merchandise and other adjustments (including reimbursed shipping and handling costs) are provided based upon past experience. Actual levels of product returns may vary from these estimates. HSNi's estimated return rates were 17.0%, 17.8% and 18.5% in 2013, 2012 and 2011, respectively.
Allowance for Doubtful Accounts HSNi makes judgments as to its ability to collect outstanding receivables and provide allowances when it has determined that all or a portion of the receivable will not be collected. HSNi determines its allowance by considering a number of factors, including the length of time accounts receivable are past due, its previous loss history and the condition of the general economy. HSNi writes off accounts receivable when they are determined to be uncollectible.
Income Taxes Estimates of deferred income taxes and the significant items giving rise to the deferred tax assets and liabilities are shown in Note 12 of Notes to Consolidated Financial Statements, and reflect management's assessment of actual future taxes to be paid on items reflected in the consolidated financial statements, giving consideration to both timing and the probability of realization. Actual income taxes could vary from these estimates due to future changes in income tax law, state income tax apportionment, as well as actual operating results of HSNi that vary significantly from anticipated results.
Valuation allowances are related to items for which it is more likely than not that the tax benefit will not be realized. In assessing the adequacy of a recorded valuation allowance, we consider all positive and negative information and a variety of factors including the scheduled reversal of deferred tax liabilities, historical and projected future taxable income and feasible tax planning strategies. HSNi recognizes liabilities for uncertain tax positions based on a two-step process. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on its technical merits. The second step is to measure the tax benefit as the largest amount which is more than 50% likely of being realized upon ultimate settlement. This measurement step is inherently difficult and requires subjective estimations of such amounts to determine the probability of various possible outcomes. HSNi considers many factors when evaluating and estimating its tax positions and tax benefits, which may require periodic adjustments and which may not accurately anticipate actual outcomes.
Inventory Valuation Inventories are valued at the lower of cost or market, cost being determined based upon the first-in, first-out method. Market is determined on the basis of net realizable value, giving consideration to obsolescence and other factors.
Net realizable value is estimated by HSNi based upon historical sales data, the age of inventory, the quantity of goods on hand and the ability to return merchandise to vendors. The actual net realizable value may vary from estimates due to changes in customer tastes or viewing habits, or judgmental decisions made by merchandising personnel when ordering new products.
30-------------------------------------------------------------------------------- Stock-Based Compensation We measure compensation cost for stock-based awards at fair value and recognize compensation over the service period for awards expected to vest. We consider many factors when estimating expected forfeitures, including types of awards, employee class and historical experience. HSNi grants performance-based equity awards whose value is based on the extent to which certain pre-established performance goals are achieved during a three-year period. Each reporting period prior to the vesting of these awards, management must apply significant judgment when estimating the expected future achievement of the designated performance metrics. The estimation of stock awards that will ultimately vest and the estimation of the value of the performance-based awards require judgment, and to the extent actual results or updated estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. The fair value of restricted stock units is determined based on the number of shares granted and the closing price of our common stock at the grant date. The fair value of stock options, stock appreciation rights and options granted under our employee stock purchase plan are estimated on the grant date using the Black-Scholes option pricing model.
This model incorporates various assumptions, including expected volatility and expected term. Expected stock price volatilities are estimated based on HSNi's historical experience and the historical and implied volatilities of comparable publicly-traded companies. The expected term of awards granted is based on analyses of historical employee termination rates and option exercise patterns, giving consideration to expectations of future employee behavior. Actual results and future estimates may differ substantially from our current estimates.
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