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[March 25, 2014]
LANDS END INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(Edgar Glimpses Via Acquire Media NewsEdge) You should read the following discussion in conjunction with the audited combined financial statements and accompanying notes included elsewhere in Item 8 to this Annual Report on Form 10-K. This Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements. The matters discussed in these forward-looking statements are subject to risk, uncertainties, and other factors that could cause actual results to differ materially from those made, projected or implied in the forward-looking statements. See "Item 1A. Risk Factors" and "Cautionary Statement Concerning Forward-Looking Statements" for a discussion of the uncertainties, risks and assumptions associated with these statements.
Introduction Management's discussion and analysis of financial condition and results of operations accompanies our combined financial statements and provides additional information about our business, financial condition, liquidity and capital resources, cash flows and results of operations. We have organized the information as follows: • Executive overview. This section provides a brief description of the spin-off, our business, accounting basis of presentation and a brief summary of our results of operations.
• Discussion and analysis. This section highlights items affecting the comparability of our financial results and provides an analysis of our combined and segment results of operations for the three fiscal years ended January 31, 2014, February 1, 2013 and January 27, 2012.
• Liquidity and capital resources. This section provides an overview of our historical and anticipated cash and financing activities in connection with the spin-off. We also review our historical sources and uses of cash in our operating, investing and financing activities.
• Quantitative and qualitative disclosures about market risk. This section discusses how we monitor and manage market risk related to changing currency rates. We also provide an analysis of how adverse changes in market conditions could impact our results based on certain assumptions we have provided.
• Critical accounting policies and estimates. This section summarizes the accounting policies that we consider important to our financial condition and results of operations and which require significant judgment or estimates to be made in their application.
Executive Overview Spin-Off On March 14, 2014, the Sears Holdings board of directors approved the distribution of the issued and outstanding shares of Lands' End common stock on the basis of 0.300795 shares of Lands' End common stock for each share of Sears Holdings common stock held on March 24, 2014, the record date.
Following the spin-off, we will operate as a separate, publicly traded company.
The spin-off is subject to a number of conditions as described in our previously filed Registration Statement on Form 10, as amended. We expect to complete the spin-off on April 4, 2014; however, we cannot assure you that the spin-off will be completed on the anticipated timeline, or at all, or that the terms of the spin-off will not change.
Description of the Company Lands' End is a leading multi-channel retailer of casual clothing, accessories and footwear, as well as home products. We offer products through catalogs, online at www.landsend.com and affiliated specialty and international websites, and through retail locations, primarily at Lands' End Shops at Sears and standalone Lands' End Inlet stores. We are a classic American lifestyle brand with a passion for quality, legendary service 38-------------------------------------------------------------------------------- Table of Contents and real value, and we seek to deliver timeless style for men, women, kids and the home. Lands' End was founded over 50 years ago in Chicago by Gary Comer and his partners to sell sailboat hardware and equipment by catalog. While our product focus has shifted significantly over the years, we have continued to adhere to our founder's motto as one of our guiding principles: "Take care of the customer, take care of the employee and the rest will take care of itself." We conduct our operations in two reportable business segments: Direct (sold through e-commerce websites and direct-mail catalogs) and Retail (sold through stores), and offer a product mix that includes outerwear, swimwear, specialty apparel, kids clothing, accessories, footwear and home products. The nature of operations conducted within each of these segments is discussed in Note 12-Segment Reporting, of the combined financial statements.
Basis of Presentation Our historical combined financial statements have been prepared on a standalone basis and have been derived from the consolidated financial statements of Sears Holdings and accounting records of Sears Holdings. The combined financial statements include Lands' End, Inc. and subsidiaries and certain other items related to the Lands' End business which are currently held by Sears Holdings, primarily the Lands' End Shops at Sears. These items will be contributed by Sears Holdings to Lands' End, Inc. prior to the separation. These historical combined financial statements reflect our financial position, results of operations and cash flows in conformity with GAAP.
Impacts from Our Spin-Off from Sears Holdings Our business currently consists of the Lands' End business. Sears Holdings has determined to separate Lands' End from Sears Holdings by distributing 100% of the shares of our common stock to the stockholders of Sears Holdings.
Immediately following completion of the distribution, Sears Holdings stockholders will own 100% of the outstanding shares of our common stock. We expect that ESL will beneficially own approximately 48.4% of our outstanding common stock following completion of the distribution. After completion of the distribution, we will operate as a publicly traded company independent from Sears Holdings, which will have a range of impacts on our operations: General administrative and separation costs. Historically, we have used the corporate functions of Sears Holdings for a variety of shared services. We were allocated (1) $0.4 million in 2013; (2) $0.8 million in 2012; and (3) $0.5 million in 2011 of shared services costs incurred by Sears Holdings. We will continue to pay Sears Holdings a fee for a variety of shared services (approximately $0.4 million in 2014) following the completion of the spin-off.
We believe that the assumptions and methodologies underlying the allocation of these expenses from Sears Holdings are reasonable. However, such expenses may not be indicative of the actual level of expense that would have been or will be incurred by us when we operate as a publicly traded company independent from Sears Holdings. We expect to enter into agreements with Sears Holdings or its subsidiaries for the continuation of certain of these services on a transitional basis. We believe that the existing arrangements, as reflected in the historical combined financial statements contained herein, are not materially different from the arrangements that will be entered into as part of the spin-off.
Standalone costs. We will also incur increased costs as a result of becoming a publicly traded company independent from Sears Holdings. As a standalone company, we expect to incur incremental annual operating costs estimated to be approximately $8.0 million to $10.0 million to support our businesses, including management personnel, legal, finance, and human resources as well as certain costs associated with being a public company. We believe cash flows from operations will be sufficient to fund these additional operating charges, the majority of which will be realized as selling and administrative expenses.
In addition, we estimate one-time information technology costs related to the spin-off to be approximately $2.0 million to $3.0 million. These one-time costs include costs to support our business and certain costs associated with being a standalone company. A portion of these expenditures may be capitalized and amortized over their useful lives and others will be expensed as incurred, depending on their nature.
39 -------------------------------------------------------------------------------- Table of Contents Sears Holdings Agreements. Following the spin-off, Lands' End and Sears Holdings will operate separately, each as an independent company. Prior to spin-off, we intend to enter into certain agreements with Sears Holdings or its subsidiaries that will effect the spin-off, provide a framework for our relationship with Sears Holdings after the spin-off and provide for the allocation between us and Sears Holdings of Sears Holdings' assets, employees, liabilities and obligations (including its investments, property and tax-related assets and liabilities) attributable to periods prior to, at and after the spin-off. See "Item 13.
Certain Relationships and Related Transactions, and Director Independence." The aggregate historical costs of these related party transactions are summarized in Note 11-Related Party, of the combined financial statements included elsewhere in this Annual Report on Form 10-K. The aggregate net costs (which approximate cash payments) were $71.8 million in 2013. We expect that the existing arrangements, as reflected in the historical combined financial statements contained herein, are not materially different from the arrangements that will be entered into with Sears Holdings in connection with the spin-off, with the exception of the Shop Your Way program. Net annual costs associated with the Shop Your Way program are estimated to increase by approximately $11.0 to $13.0 million in 2014. The additional investment in the Shop Your Way program is anticipated to be offset by increased profits from incremental revenue and reductions in promotions and advertising expense, as we expect to reduce our dependency on other marketing efforts as member engagement through the program continues to grow.
Following completion of the spin-off, we do not believe that it will be necessary to employ a significant number of new employees to perform additional standalone or transition services. With respect to our retail operations, prior to the spin-off, Sears Holdings and its subsidiaries provided retail staff for the Lands' End Shops at Sears. Pursuant to a retail operations agreement, Sears Holdings or one of its subsidiaries will continue to provide such staff following the completion of the spin-off. See "Item 13. Certain Relationships and Related Transactions, and Director Independence-Other Agreements-Lands' End Shops at Sears Retail Operations Agreement". Following completion of the spin-off, we will continue to rely on our existing field management working in conjunction with retail staff provided by Sears Holdings or its subsidiaries to manage our Lands' End Shops at Sears.
Debt Service Costs. We will also incur increased costs as a result of interest charges on the expected borrowings under the ABL Facility to fund short-term working capital needs and on a senior secured term loan facility (the "Term Loan Facility" and, together with the ABL Facility, the ("Facilities") of approximately $515 million. We anticipate interest costs related to these Facilities to be approximately $21.0 to $23.0 million for 2014. The interest costs include approximately $2.3 million of non-cash expense. Expected annual payments under the Facilities are expected to be the cash interest charges plus the Term Loan Facility seven year amortization of principal at a rate equal to 1% per annum, or approximately $4.0 million in 2014 and approximately $5.0 million per year over the remaining term.
The aggregate of our standalone operating costs, the costs associated with our agreements with Sears Holdings and its subsidiaries, and the debt service costs that we expect to incur in connection with the spin-off are not expected to significantly impact our liquidity following the completion of the spin-off. We expect that our cash flows from operations and the expected borrowing capacity of $175 million under the ABL Facility, which is anticipated to be used for seasonal working capital needs as discussed in "Management's Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources," will provide adequate resources to meet our capital requirements and operational needs for the next fiscal year. Beyond the next fiscal year, we believe that our cash flows from operations, along with prospective financing arrangements entered into in connection with the spin-off or otherwise, will be adequate to meet our capital requirements and operational needs.
Due to these and other changes we anticipate in connection with the spin-off, the historical financial information included in this Annual Report on Form 10-K may not necessarily reflect our financial position, results of operations and cash flows in the future or what our financial position, results of operations and cash flows would have been had we been an independent, publicly traded company during the periods presented.
40-------------------------------------------------------------------------------- Table of Contents Results of Operations Fiscal Year. Our fiscal year end is on the Friday preceding the Saturday closest to January 31 each year. Fiscal years 2013 and 2011 consisted of 52 weeks.
Fiscal year 2012 consisted of 53 weeks. Unless the context otherwise requires, references to years in this Annual Report on Form 10-K relate to fiscal years rather than calendar years. The following fiscal periods are presented herein: Fiscal year ended Ended Weeks 2013 January 31, 2014 52 2012 February 1, 2013 53 2011 January 27, 2012 52 The following table sets forth items derived from our combined results of operations for 2013, 2012 and 2011.
Fiscal Year 2013 2012 2011 % of % of % of (in thousands) $'s Net Sales $'s Net Sales $'s Net Sales Merchandise sales and services, net $ 1,562,876 100.0 % $ 1,585,927 100.0 % $ 1,725,627 100.0 % Cost of sales (excluding depreciation and amortization) 852,539 54.5 % 881,817 55.6 % 959,611 55.6 % Gross margin 710,337 45.5 % 704,110 44.4 % 766,016 44.4 % Selling and administrative 560,327 35.9 % 598,916 37.8 % 621,020 36.0 % Depreciation and amortization 21,599 1.4 % 23,121 1.5 % 22,686 1.3 % Other operating expense, net 70 - 70 - 502 - Operating income 128,341 8.2 % 82,003 5.2 % 121,808 7.1 % Other income, net 50 - 67 - 95 - Income before income taxes 128,391 8.2 % 82,070 5.2 % 121,903 7.1 % Income tax expense 49,544 3.2 % 32,243 2.0 % 45,669 2.6 % Net income $ 78,847 5.0 % $ 49,827 3.1 % $ 76,234 4.4 % Depreciation and amortization is not included in our cost of sales because we are a reseller of inventory and do not believe that including depreciation and amortization is meaningful. As a result, our gross margins may not be comparable to other entities that include depreciation and amortization related to the sale of their product in their gross margin measure.
Net Income and Adjusted EBITDA We recorded net income of $78.8 million, $49.8 million, and $76.2 million for 2013, 2012 and 2011, respectively. In addition to our net income determined in accordance with GAAP, for purposes of evaluating operating performance, we use an Adjusted EBITDA measurement. Adjusted EBITDA is computed as net income appearing on the Combined Statements of Comprehensive Operations net of income tax expense, interest expense, depreciation and amortization, and certain significant items set forth below. Our management uses Adjusted EBITDA to evaluate the operating performance of our businesses, as well as executive compensation metrics, for comparable periods. Adjusted EBITDA should not be used by investors or other third parties as the sole basis for formulating investment decisions as it excludes a number of important cash and non-cash recurring items.
While Adjusted EBITDA is a non-GAAP measurement, management believes that it is an important indicator of ongoing operating performance, and useful to investors, because: • EBITDA excludes the effects of financings and investing activities by eliminating the effects of interest and depreciation costs.
41 -------------------------------------------------------------------------------- Table of Contents • Other significant items, while periodically affecting our results, may vary significantly from period to period and have a disproportionate effect in a given period, which affects comparability of results. We have adjusted our results for these items to make our statements more comparable and therefore more useful to investors as the items are not representative of our ongoing operations. These adjustments are shown below: • Restructuring costs-costs associated with a call center and administrative reorganization in 2012. Management considers these costs to be infrequent and affecting comparability of results between reporting periods.
• Gain or loss on the sale of property and equipment-management considers the gains or losses on sale of assets to result from investing decisions rather than ongoing operations.
Fiscal Year 2013 2012 2011 % of % of % of (in thousands) $'s Net Sales $'s Net Sales $'s Net Sales Net income $ 78,847 5.0 % $ 49,827 3.1 % $ 76,234 4.4 % Income tax expense 49,544 3.2 % 32,243 2.0 % 45,669 2.6 % Other income, net (50 ) - (67 ) - (95 ) - Operating income 128,341 8.2 % 82,003 5.2 % 121,808 7.1 % Depreciation and amortization 21,599 1.4 % 23,121 1.5 % 22,686 1.3 % Restructuring costs - - 2,479 0.2 % - - Loss on sale of property and equipment 70 - 70 - 502 - Adjusted EBITDA $ 150,010 9.6 % $ 107,673 6.8 % $ 144,996 8.4 % In assessing the operational performance of our business, we consider a variety of financial measures. We operate in two reportable segments, Direct (sold through e-commerce websites and direct mail catalogs) and Retail (sold through stores). A key measure in the evaluation of our business is revenue performance by segment. We also consider gross margin and selling and administrative expenses in evaluating the performance of our business.
To evaluate revenue performance for the Direct segment we use total revenue of merchandise sales and services, net. For our Retail segment, we use same store sales as a key measure in evaluating performance. Same store sales amounts within the following discussion include sales for all stores operating for a period of at least 12 full months where selling square footage has not changed by 15% or more within the past year. A store is included in same store sales calculations on the first day it has comparable prior year sales. Stores in which the selling square footage has changed by 15% or more as a result of a remodel, expansion or reduction are excluded from same store calculations until the first day they have comparable prior year sales. Online sales and sales generated through our in-store computer kiosks are considered revenue in our Direct segment and are excluded from same store sales.
2013 Compared to 2012 Merchandise Sales and Services, Net 2013 had 52 weeks versus 53 weeks in 2012. Total revenues for 2013 were $1.56 billion, compared to $1.59 billion in the prior year, a decrease of $23.1 million, or 1%. The Company recorded approximately $24.0 million in revenues during the 53rd week of 2012. When adjusting 2012 to account for the 53rd week, revenues during 2013 increased $0.9 million compared to 2012; with revenue increases in our Direct segment of $19.8 million largely offset by revenue decreases of $18.9 million in our Retail segment.
Direct segment revenues were $1.3 billion in 2013, essentially flat compared to 2012. Improvement in our U.S. Direct and Lands' End Outfitters businesses of $23.3 million was offset by a decline in our International 42-------------------------------------------------------------------------------- Table of Contents businesses. The decline in our International businesses was largely due to decreases in our Germany and Japan businesses. The decrease in Germany was due to lower response rates to our product offerings in the German market. The decrease in Japan was attributable to changes in currency exchange rates.
Retail segment revenues were $258.9 million in 2013, a decrease of $22.9 million, or 8%, compared to 2012. Same store sales decreased 7% compared to the prior year. Retail segment revenues decreased across apparel and home products.
Gross Margin Gross margin for 2013 was $710.3 million, or 45.5% in 2013, compared to $704.1 million or 44.4% in the prior year. The increase in gross margin rate of 110 basis points was attributable to a 210 basis point improvement in gross margin performance of our fall and winter product offerings, partially offset by increased spring and summer markdowns in our Direct segment. The increased spring and summer business markdowns were in response to increased promotional activity in the marketplace as a result of an unseasonably cold spring.
Direct segment gross margin was $603.5 million, or 46.3% of total Direct segment revenues, compared to $598.0 million or 45.9% of total Direct segment revenues for 2013 and 2012, respectively. The Direct segment gross margin rate improvement of 40 basis points in 2013 was primarily attributable to an increase in our U.S. consumer business due to improvement in our fall and winter product offerings, partially offset by increased markdowns in our International business and increased promotional activity in the spring.
Retail segment gross margin was $106.8 million, or 41.2% of total Retail segment revenues, compared to $106.0 million or 37.6% of total Retail segment revenues for 2013 and 2012, respectively. The Retail segment gross margin rate increased 360 basis points primarily due to our fall and winter product offerings and decreased markdowns.
Selling and Administrative Expenses Selling and administrative expenses were $560.3 million for 2013 compared to $598.9 million for the prior year. The decrease of $38.6 million in selling and administrative expense was primarily due to declines in payroll, third-party costs, the favorable impact in 2013 of restructuring costs incurred in 2012 and decreased advertising expenses.
Selling and administrative expenses as a percentage of total revenues were 35.9% in 2013 and 37.8% in 2012. The decrease was primarily due to increased leverage as a result of the expense declines noted above and the impact of the restructuring activities.
Operating Income We recorded operating income of $128.3 million in 2013, compared to operating income of $82.0 million in 2012. The increase in operating income of $46.3 million was primarily attributable to lower Selling and administrative costs and gross margin improvement of our fall and winter product offerings during the second half of 2013.
Adjusted EBITDA Adjusted EBITDA was $150.0 million for 2013, compared to Adjusted EBITDA of $107.7 million for 2012. The increase was primarily attributable to the increase in operating income of $46.3 million.
Income Tax Expense Our effective tax rate was 38.6% in 2013 compared to 39.3% in 2012. The decreased rate was primarily due to decreased effective state tax rates for our Direct segment.
43 -------------------------------------------------------------------------------- Table of Contents 2012 Compared to 2011 Merchandise Sales and Services, Net Total revenues for 2012 were $1.6 billion, compared to $1.7 billion in the prior year, a decrease of $139.7 million, or 8%. The Company recorded approximately $24.0 million in revenues during the 53rd week of 2012. The decrease was attributable to decreases in our Direct segment of $123.9 million and our Retail segment of $15.7 million.
Direct segment revenues were $1.3 billion in 2012, a decrease of $123.9 million, or 9%, compared to 2011. The decrease in Direct segment revenues was due to lower sales in our U.S. consumer and International businesses of $147.9 million, primarily due to lower revenue from of our fall/winter assortment resulting from changes in our merchandising strategy, partially offset by growth in our School Uniform and Lands' End Business Outfitters business of $24.0 million.
Retail segment revenues were $281.8 million in 2012, a decrease of $15.7 million, or 5%, compared to 2011. Same store sales decreased 3% compared to the prior year. Retail segment revenues declined primarily due to a decrease in same store sales and were also impacted by the closure of 13 Lands' End Shops at Sears, which accounted for approximately $7.2 million of the decline. Sales were affected in the second half of the year due to lower than expected sales of our fall/winter product assortment as a result of changes to our merchandising strategy.
Gross Margin Gross margin for 2012 was $704.1 million, or 44.4% in 2012, compared to $766.0 million or 44.4% in the prior year.
Direct segment gross margin was $598.0 million, or 45.9% of total Direct segment revenues, compared to $645.6 million or 45.2% of total Direct segment revenues for 2012 and 2011, respectively. The Direct segment gross margin rate improved 70 basis points in 2012 primarily in our U.S. consumer business due to lower markdowns, partially offset by increased markdowns in our International business.
Retail segment gross margin was $106.0 million, or 37.6% of total Retail segment revenues, compared to $120.1 million or 40.4% of total Retail segment revenues for 2012 and 2011, respectively. The Retail segment gross margin rate decreased 280 basis points primarily due to increased markdowns as a result of a competitive marketplace.
Selling and Administrative Expenses Selling and administrative expenses were $598.9 million for 2012 compared to $621.0 million for the prior year. The decrease of $22.1 million was primarily due to lower advertising expenses and decreases in variable expenses resulting from lower revenues, partially offset by higher information technology project expenses and the impact of corporate restructuring costs associated with a call center and administrative reorganization of approximately $2.5 million.
Selling and administrative expenses as a percentage of total revenues were 37.8% in 2012 and 36.0% in 2011. This increase was primarily driven by lower leverage of fixed costs due to the lower revenues noted above.
Operating Income We recorded operating income of $82.0 million in 2012, compared to operating income of $121.8 million in 2011. The decline in operating income of $39.8 million was primarily driven by the overall lower revenues.
44-------------------------------------------------------------------------------- Table of Contents Adjusted EBITDA Adjusted EBITDA was $107.7 million for 2012, compared to Adjusted EBITDA of $145.0 million for 2011. The decrease was primarily driven by the decrease in operating income of $39.8 million, partially offset by the exclusion of the corporate restructuring costs of approximately $2.5 million described above.
Income Tax Expense Our effective tax rate was 39.3% in 2012 compared to 37.5% in 2011. The increased rate was primarily due to increased effective state tax rates for our Direct segment.
Liquidity and Capital Resources Our primary need for liquidity is to fund working capital requirements of our business, capital expenditures and for general corporate purposes. Our working capital needs have been met primarily through funds generated from operations, with additional funding from our parent company to meet short-term working capital needs, mainly for our seasonal inventory builds. Our parent company uses a centralized approach to its U.S. domestic cash management and financing of its operations. The majority of our cash is transferred to the parent daily and the parent company has been our only source of funding for our operating and investing activities. The principal methods by which our parent company funds Lands' End are to cover corporate and other expenses and to fund our seasonal inventory builds. Contributions to fund our seasonal inventory build were approximately $35.0 million and $45.0 million in 2013 and 2012, respectively.
These contributions were more than offset by distributions made by Lands' End to the parent company primarily from cash flows from our operations. Net distributions of funds were made to the parent company in the amounts of $110.9 million, $68.8 million and $5.3 million in 2013, 2012, and 2011, respectively.
Lands' End is in the process of pursuing an ABL Facility, which would serve as a source of liquidity, including for short-term working capital needs, following the spin-off. We believe that our cash flow from operations and any other financing arrangements entered into in connection with the spin-off will provide adequate resources to meet our capital requirements and operational needs for the next fiscal year. Beyond the next fiscal year, we believe that our cash flow from operations, along with prospective financing arrangements entered into in connection with the spin-off or otherwise, will be adequate to meet our capital requirements and operational needs. Cash generated from our net sales and profitability, and somewhat to a lesser extent our changes in working capital, are driven by the seasonality of our business, with a disproportionate amount of net merchandise sales and operating cash flows occurring in the fourth fiscal quarter of each year.
Description of Material Indebtedness From and after the spin-off, each of Lands' End and Sears Holdings will generally, pursuant to a separation and distribution agreement and other agreements we will enter into with Sears Holdings or its subsidiaries, be responsible for the debts, liabilities and obligations related to the businesses it owns and operates following completion of the spin-off. See "Item 13. Certain Relationships and Related Transactions, and Director Independence-Our Relationship with Sears Holdings Following the Spin-Off".
ABL and Term Loan Facilities In connection with the spin-off, we are pursuing an ABL Facility which would provide for maximum borrowings of approximately $175 million for Lands' End, subject to a borrowing base, with a $30.0 million subfacility for a United Kingdom subsidiary borrower of Lands' End (the "UK Borrower"). We expect the ABL Facility to have a letter of credit sub-limit of approximately $70.0 million for domestic letters of credit and a letter of credit sub-limit of approximately $15.0 million for letters of credit for the UK Borrower. The ABL Facility would be available following the spin-off for working capital and other general corporate purposes, and is expected to be undrawn at closing, other than for letters of credit.
45 -------------------------------------------------------------------------------- Table of Contents Lands' End is also pursuing a Term Loan Facility of approximately $515 million, the proceeds of which we expect will be used to pay a dividend of $500 million to a subsidiary of Sears Holdings immediately prior to the distribution and to pay fees and expenses associated with the Facilities. We do not expect the financing transactions we enter into in connection with the spin-off, including the payment of the dividend to Sears Holdings and regular interest and debt service payments under the Term Loan Facility, to significantly impact our cash flow requirements for 2014. We expect our operating free cash flows combined with cash on hand to be sufficient to meet our working capital needs, with anticipated borrowings under the ABL Facility only for seasonal inventory needs, which we expect to repay prior to the fiscal year-end.
The Facilities will be documented in credit agreements to be entered into substantially concurrently with the spin-off. Such credit agreements will be filed with the SEC as exhibits to a current or periodic report at the appropriate time. We have retained Bank of America, N.A. to assist us in arranging a syndicate of institutional lenders to provide the Facilities. Based on discussions with and feedback from Bank of America and potential syndicate members, we expect the Facilities to have the terms described below.
Maturity: Amortization and Prepayments The ABL Facility is expected to mature on the five year anniversary of the closing date of the facility. The Term Loan Facility is expected to mature on the seven year anniversary of the closing date of the facility and it is expected to amortize at a rate equal to 1% per annum, and to be subject to mandatory prepayment in an amount equal to a percentage of the borrower's excess cash flows in each fiscal year, ranging from 0% to 50% depending on our secured leverage ratio, and with the proceeds of certain asset sales and casualty events.
Guarantees; Security All domestic obligations under the Facilities will be unconditionally guaranteed by Lands' End and, subject to certain exceptions, each of its existing and future direct and indirect domestic subsidiaries. In addition, the obligations of the U.K. Borrower under the ABL Facility will be guaranteed by its existing and future direct and indirect subsidiaries organized in the United Kingdom. The ABL Facility will be secured by a first priority security interest in certain working capital of the borrowers and guarantors consisting primarily of accounts receivable and inventory. The Term Loan Facility will be secured by a second priority security interest in the same collateral, with certain exceptions.
The Term Loan Facility also will be secured by a first priority security interest in certain property and assets of the borrowers and guarantors, including certain fixed assets and stock of subsidiaries. The ABL Facility will be secured by a second priority security interest in the same collateral.
Interest; Fees The interest rates per annum applicable to the loans under the Facilities are expected to be based on a fluctuating rate of interest measured by reference to, at the borrowers' election, either (1) an adjusted London inter-bank offered rate (LIBOR) plus a borrowing margin, or (2) an alternative base rate plus a borrowing margin. The borrowing margin will be fixed for the Term Loan Facility and is expected to be between approximately 3.0% and 4.0% in the case of LIBOR loans and between approximately 2.0% and 3.0% in the case of base rate loans.
The borrowing margin for the ABL Facility is expected to be subject to adjustment based on the average excess availability under the facility for the preceding fiscal quarter, and is expected to range from approximately 1.5% to 2.0% in the case of LIBOR borrowings and from 0.5% to 1.0% in the case of base rate borrowings.
Customary fees are expected to be payable in respect of both facilities. The ABL Facility fees will include (1) commitment fees, based on a percentage ranging from approximately 0.25% to 0.375% of the daily unused portions of the facility, and (2) customary letter of credit fees.
46-------------------------------------------------------------------------------- Table of Contents Representations and Warranties; Covenants The Facilities will contain various representations and warranties and restrictive covenants that, among other things and subject to specified exceptions, restrict the ability of Lands' End and its subsidiaries to incur indebtedness (including guarantees), grant liens, make investments, make dividends or distributions with respect to capital stock, make prepayments on the other indebtedness, engage in mergers or change the nature of their business. In addition, if excess availability under the ABL Facility falls below a certain level, expected to be a range from approximately $15.0 million to $20.0 million, we expect to be required to comply with a minimum fixed charge coverage ratio of approximately 1.0 to 1.0. The Facilities will not otherwise contain financial maintenance covenants.
Both Facilities are expected to contain certain affirmative covenants, including reporting requirements such as delivery of financial statements, certificates and notices of certain events, maintaining insurance, and providing additional guarantees and collateral in certain circumstances.
Events of Default The Facilities are expected to include customary events of default including non-payment of principal, interest or fees, violation of covenants, inaccuracy of representations or warranties, cross default to certain other material indebtedness, bankruptcy and insolvency events, invalidity or impairment of guarantees or security interests, material judgments and change of control.
Cash Flows from Operating Activities Operating activities generated net cash of $114.9 million, $96.2 million and $14.5 million in 2013, 2012 and 2011, respectively. Our primary source of operating cash flows is the sale of merchandise goods and services to customers, while the primary use of cash in operations is the purchase of merchandise inventories.
In 2013, net cash provided by operating activities increased $18.7 million compared to 2012 primarily due to higher net income and increases in accounts payable due to timing and volume of payments partially offset by an increase in accounts receivables and the impact of the change in deferred tax liabilities.
In 2012, net cash provided by operating activities increased $81.7 million compared to 2011 primarily due to decreases in net inventory levels as a result of improved inventory management coupled with increases in accounts payable due to timing and volume of payments partially offset by a decrease in net income.
Cash Flows from Investing Activities Net cash used in investing activities was $9.9 million, $14.9 million and $15.0 million for 2013, 2012 and 2011, respectively. Cash used in investing activities in all three years was primarily used for purchases of property and equipment.
For 2014, we plan to invest a total of approximately $25.0 million in capital expenditures for strategic investments and infrastructure, primarily in technology and the distribution center.
Cash Flows from Financing Activities Net cash used in financing activities was $110.9 million, $68.8 million and $5.3 million in 2013, 2012 and 2011, respectively. Financing activities in all three years represented intercompany activity with our parent company.
47-------------------------------------------------------------------------------- Table of Contents Contractual Obligations and Off-Balance-Sheet Arrangements We have no material off-balance-sheet arrangements other than the guarantees and contractual obligations that are discussed below.
Information concerning our obligations and commitments to make future payments under contracts such as lease agreements, and under contingent commitments, as of January 31, 2014, is aggregated in the following table: Payments Due by Period Less than 2-3 4-5 After (in thousands) Total 1 Year Years Years 5 Years Operating leases(1) $ 152,898 $ 32,160 $ 57,532 $ 45,692 $ 17,514 Postretirement funding obligations 2,031 172 307 288 1,264 Purchase obligations(2) 219,777 219,777 - - - Total contractual obligations $ 374,706 $ 252,109 $ 57,839 $ 45,980 $ 18,778 (1) Operating lease obligations consist primarily of future minimum lease commitments related to store operating leases (refer to Note 4-Leases, of our combined financial statements).
(2) Purchase obligations primarily represent open purchase orders to purchase inventory.
At the end of 2013, Lands' End had gross unrecognized tax benefits of $8.7 million, which are not reflected in the table above. Lands' End and Sears Holdings will enter into a tax sharing agreement prior to the separation which will govern the rights and obligations of the parties with respect to pre-separation and post-separation tax matters. Under the tax sharing agreement, Sears Holdings will be responsible for any U.S. federal or state income tax liability and Lands' End will be responsible for any foreign income tax liability relating to tax periods ending on or before the separation. For all periods after the separation, Lands' End will be responsible for any federal, state or foreign tax liability.
Financial Instruments with Off-Balance-Sheet Risk On October 21, 2002, we entered into a letter of credit facility (the "LC Facility") with Bank of America ("BofA") pursuant to which BofA may, on a discretionary basis and with no commitment, agree to issue letters of credit upon our request in an aggregate amount not to exceed $5.0 million for inventory purchases. The terms for the letters of credit issued under the LC Facility are "at site" and are secured by a standby letter of credit, with an expiration date of less than one year, issued by Sears Roebuck Acceptance Corp. ("SRAC"), a wholly owned subsidiary of Sears Holdings, on our behalf for the benefit of BofA. BofA or Lands' End may terminate the LC Facility at any time. Outstanding letters of credit balances under the LC Facility were $4.0 million and $5.0 million as of January 31, 2014 and February 1, 2013, respectively. Upon completion of the separation, we anticipate that Sears Holdings will terminate its support of the LC Facility and that SRAC will no longer issue letters of credit to secure the LC Facility.
From time to time, at our request, Sears Holdings causes standby letters of credit to be issued for our benefit under Sears Holdings' revolving credit facility. There were $6.9 million and $2.4 million in standby letter of credit issuances as of January 31, 2014 and February 1, 2013, respectively. Upon completion of the separation, we anticipate that Sears Holdings will no longer cause letters of credit to be issued for our benefit. Lands' End is in the process of pursuing the ABL Facility, which would provide for the issuance of letters of credit and otherwise serve as a source of liquidity following the spin-off. See Liquidity and Capital Resources- ABL and Term Loan Facilities.
We participate in the Sears Private Label Letters of Credit program, which provides up to $50.0 million for vendor financing as an alternative to bank-issued letters of credit or standby letters of credit. There were no outstanding balances as of January 31, 2014 and February 1, 2013. We plan to terminate our participation in this program upon the completion of the spin-off.
48 -------------------------------------------------------------------------------- Table of Contents In addition, Lands' End has a $2.3 million foreign subsidiary credit facility that is supported by a Lands' End, Inc. guarantee. This credit facility guarantees and allows for deferred payment of custom duties and fulfills short-term in-country borrowing needs. This credit facility was not utilized during the fiscal years ended 2013, 2012, and 2011.
Application of Critical Accounting Policies and Estimates Our combined financial statements have been prepared in accordance with GAAP, which requires management to make estimates and judgments that affect amounts reported in the combined financial statements and accompanying notes. While our estimates and assumptions are based on our knowledge of current events and actions we may undertake in the future, actual results may ultimately differ from our estimates and assumptions. Our estimation processes contain uncertainties because they require management to make assumptions and apply judgment to make these estimates. Should actual results be different than our estimates, we could be exposed to gains or losses from differences that may be material.
For a summary of our significant accounting policies, please refer to "Note 2-Summary of Significant Accounting Policies" of our combined financial statements. We believe the accounting policies discussed below represent the accounting policies we apply that are the most critical to understanding our combined financial statements.
Inventory Valuation Our inventories consist of merchandise purchased for resale and are recorded at the lower of cost or market. The nature of our business requires that we make a significant amount of our merchandising decisions and corresponding inventory purchase commitments with vendors several months in advance of the time in which a particular merchandise item is intended to be included in the merchandise offerings. These decisions and commitments are based upon, among other possible considerations, historical sales with identical or similar merchandise, our understanding of then-prevailing fashion trends and influences, and an assessment of likely economic conditions and various competitive factors. We continually make assessments as to whether the carrying cost of inventory exceeds its market value, and, if so, by what dollar amount. Excess inventories may be disposed of through our Direct segment and Retail segment. Based on historical results experienced through various methods of disposition, we write down the carrying value of inventories that are not expected to be sold at or above cost. The excess and obsolete reserve balances were $26.0 million and $28.0 million as of January 31, 2014 and February 1, 2013, respectively. For the inventory marked down to net realizable value, a one percentage point increase in our adjustment rate at January 31, 2014 would have had an immaterial impact on our combined financial statements.
Goodwill and Intangible Asset Impairment Assessments Goodwill, trade name and other intangible assets are generally tested separately for impairment on an annual basis, or are evaluated for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. The majority of our goodwill and intangible assets relate to Kmart's acquisition of Sears Roebuck in March 2005. The calculation for an impairment loss compares the carrying value of the asset to that asset's estimated fair value, which may be based on estimated future discounted cash flows or quoted market prices. We recognize an impairment loss if the asset's carrying value exceeds its estimated fair value.
Frequently our impairment loss calculations contain multiple uncertainties because they require management to make assumptions and to apply judgment to estimate future cash flows and asset fair values, including forecasting cash flows under different scenarios. As required by accounting standards, we perform annual goodwill and indefinite-lived intangible asset impairment tests on the last day of our November accounting period each year and update the tests between annual tests if events or circumstances occur that would more likely than not reduce the fair value of a reporting unit or indefinite-lived intangible asset below its carrying amount. However, if actual results are not consistent with our estimates and assumptions used in estimating future cash flows and asset fair values, we may be exposed to losses that could be material.
49 -------------------------------------------------------------------------------- Table of Contents Goodwill impairment assessments. Our goodwill resides in the Direct reporting unit. The goodwill impairment test involves a two-step process. The first step is a comparison of the reporting unit's fair value to its carrying value. We estimate fair value using the best information available, using both a market approach, as well as a discounted cash flow model, commonly referred to as the income approach. The market approach determines the value of the reporting unit by deriving market multiples for the reporting unit based on assumptions potential market participants would use in establishing a bid price for the reporting unit. This approach therefore assumes strategic initiatives will result in improvements in operational performance in the event of purchase, and includes the application of a discount rate based on market participant assumptions with respect to capital structure and access to capital markets. The income approach uses a reporting unit's projection of estimated operating results and cash flows that is discounted using a weighted-average cost of capital that reflects current market conditions appropriate to our reporting unit. The projection uses management's best estimates of economic and market conditions over the projected period, including growth rates in sales, costs, estimates of future expected changes in operating margins and cash expenditures.
Other significant estimates and assumptions include terminal value growth rates, future estimates of capital expenditures and changes in future working capital requirements. Our final estimate of the fair value of the reporting unit is developed by weighting the fair values determined through both the market participant and income approaches, where comparable market participant information is available.
If the carrying value of the reporting unit is higher than its fair value, there is an indication that impairment may exist and the second step must be performed to measure the amount of impairment loss. The amount of impairment is determined by comparing the implied fair value of the reporting unit goodwill to the carrying value of the goodwill in the same manner as if the reporting unit was being acquired in a business combination. Specifically, we allocate the fair value to all of the assets and liabilities of the reporting unit, including any unrecognized intangible assets, in a hypothetical analysis that would calculate the implied fair value of goodwill. If the implied fair value of goodwill is less than the recorded goodwill, we record an impairment charge for the difference.
During 2013, 2012 and 2011, the fair value of the reporting unit exceeded the carrying value and, as such, we did not record any goodwill impairment charges.
The use of different assumptions, estimates or judgments in the first step of the goodwill impairment testing process, such as the estimated future cash flows of our reporting units, the discount rate used to discount such cash flows, and the market multiples of comparable companies, could significantly increase or decrease the estimated fair value of a reporting unit. At the 2013 annual impairment test date, the conclusion that no indication of goodwill impairment existed for the reporting unit would not have changed had the test been conducted assuming: (1) a 100 basis point increase in the discount rate used to discount the aggregate estimated cash flows of our reporting units to their net present value in determining their estimated fair values and/or (2) a 100 basis point decrease in the estimated sales growth rate and/or terminal period growth rate.
Based on our sensitivity analysis, we do not believe that the goodwill balance is at risk of impairment because the fair value is substantially in excess of the carrying value and not at risk of failing step one. However, goodwill impairment charges may be recognized in future periods to the extent changes in factors or circumstances occur, including deterioration in the macroeconomic environment, retail industry or in the equity markets, deterioration in our performance or our future projections, or changes in our plans for one or more reporting units.
Indefinite-lived intangible asset impairment assessments. We review our indefinite-lived intangible asset, the Lands' End trade name, for impairment by comparing the carrying amount of the asset to the sum of undiscounted cash flows expected to be generated by the asset. We consider the income approach when testing the intangible asset with indefinite life for impairment on an annual basis. We determined that the income approach, specifically the relief from royalty method, was most appropriate for analyzing our indefinite-lived asset.
This method is based on the assumption that, in lieu of ownership, a firm would be willing to pay a royalty 50 -------------------------------------------------------------------------------- Table of Contents in order to exploit the related benefits of this asset class. The relief from royalty method involves two steps: (1) estimation of reasonable royalty rates for the assets and (2) the application of these royalty rates to a net sales stream and discounting the resulting cash flows to determine a value. We multiplied the selected royalty rate by the forecasted net sales stream to calculate the cost savings (relief from royalty payment) associated with the asset. The cash flows are then discounted to present value by the selected discount rate and compared to the carrying value of the asset.
During 2013, 2012, and 2011, the fair value of the indefinite-lived intangible asset exceeded its carrying values and, as such, we did not record any intangible asset impairment charges.
The use of different assumptions, estimates or judgments in our intangible asset impairment testing process, such as the estimated future cash flows of assets and the discount rate used to discount such cash flows, could significantly increase or decrease the estimated fair value of the asset, and therefore, impact the related impairment charge. At the 2013 annual impairment test date, the above-noted conclusion that no indication of intangible asset impairment existed at the test date would not have changed had the test been conducted assuming: (1) a 100 basis point increase in the discount rate used to discount the aggregate estimated cash flows of our assets to their net present value in determining their estimated fair values (without any change in the aggregate estimated cash flows of our intangibles), (2) a 100 basis point decrease in the terminal period growth rate without a change in the discount rate of each intangible, or (3) a 10 basis point decrease in the royalty rate applied to the forecasted net sales stream of our assets.
We do not believe that the indefinite-lived intangible asset balance is at risk of impairment at the end of the year based on the analysis described above.
However, indefinite-lived intangible asset impairment charges may be recognized in future periods to the extent changes in factors or circumstances occur, including deterioration in the macroeconomic environment, retail industry, deterioration in our performance or our future projections, or changes in our plans for our indefinite-lived intangible asset.
Income Taxes Deferred income tax assets and liabilities are based on the estimated future tax effects of differences between the financial and tax basis of assets and liabilities based on currently enacted tax laws. The tax balances and income tax expense recognized are based on management's interpretation of the tax laws of multiple jurisdictions. Income tax expense also reflects best estimates and assumptions regarding, among other things, the level of future taxable income and tax planning. Future changes in tax laws, changes in projected levels of taxable income, tax planning, and adoption and implementation of new accounting standards could impact the effective tax rate and tax balances recorded.
For purposes of these combined financial statements, the tax provision represents the tax attributable to these operations as if it were required to file a separate tax return. In cases where the actual cash taxes are paid by another subsidiary of Sears Holdings, the related taxes payable and tax payments are reflected directly in parent company equity.
Tax positions are recognized when they are more likely than not to be sustained upon examination. The amount recognized is measured as the largest amount of benefit that is more likely than not to be realized upon settlement. We are subject to periodic audits by the Internal Revenue Service and other state and local taxing authorities. These audits may challenge certain of our tax positions such as the timing and amount of income and deductions and the allocation of taxable income to various tax jurisdictions. Lands' End evaluates its tax positions and establishes liabilities in accordance with the applicable accounting guidance on uncertainty in income taxes. These tax uncertainties are reviewed as facts and circumstances change and are adjusted accordingly. This requires significant management judgment in estimating final outcomes. Interest and penalties are classified as income tax expense in the combined statements of comprehensive operations.
51 -------------------------------------------------------------------------------- Table of Contents Lands' End and Sears Holdings will enter into a tax sharing agreement prior to the separation which will generally govern Sears Holdings' and Lands' End's respective rights, responsibilities and obligations after the separation with respect to liabilities for U.S. federal, state, local and foreign taxes attributable to the Lands' End business. In addition to the allocation of tax liabilities, the tax sharing agreement will address the preparation and filing of tax returns for such taxes and disputes with taxing authorities regarding such taxes. Generally, Sears Holdings will be liable for all pre-separation U.S.
federal, state and local income taxes. Lands' End generally will be liable for all other income taxes attributable to its business, including all foreign taxes.
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