ITEM 1.
BUSINESS
GENERAL.
Abercrombie & Fitch Co. (“A&F”), a company incorporated in Delaware in 1996, through its subsidiaries (collectively, A&F and its subsidiaries are referred to as the “Company” and “we”), is a global, multi-brand specialty retailer, which primarily sells its products through its wholly-owned store and direct-to-consumer channels, as well as through various third-party wholesale, franchise and licensing arrangements. The Company offers a broad assortment of apparel, personal care products and accessories for men, women and kids under the Hollister, Abercrombie & Fitch and abercrombie kids brands. The brands share a commitment to offering products of enduring quality and exceptional comfort that allows customers around the world to express their own individuality and style. The Company has operations in North America, Europe, Asia and the Middle East. For the fifty-three week period ended February 3, 2018, 63.2% of the Company’s net sales were attributable to the United States (“U.S.”).
The Company’s fiscal year ends on the Saturday closest to January 31, typically resulting in a fifty-two week year, but occasionally giving rise to an additional week, resulting in a fifty-three week year, as was the case for the year ended February 3, 2018. Fiscal years are designated in the consolidated financial statements and notes, as well as the remainder of this Annual Report on Form 10-K, by the calendar year in which the fiscal year commenced. All references herein to the Company’s fiscal years are as follows:
A&F makes available free of charge on its website, corporate.abercrombie.com, under “Investors, Financials, SEC Filings,” its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or Section 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as well as A&F’s definitive proxy materials filed pursuant to Section 14 of the Exchange Act, as soon as reasonably practicable after A&F electronically files such material with, or furnishes it to, the Securities and Exchange Commission (“SEC”). The SEC maintains a website that contains electronic filings by A&F and other issuers at www.sec.gov. In addition, the public may read and copy any materials A&F files with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.
The Company has included certain of its website addresses throughout this filing as textual references only. The information contained within these websites is not incorporated into this Annual Report on Form 10-K.
BRANDS.
Hollister. The quintessential apparel brand of the global teen consumer, Hollister celebrates the liberating spirit of the endless summer inside everyone. Inspired by California’s laidback attitude, Hollister’s clothes are designed to be lived in and made your own, for wherever life takes you. Hollister provides an engaging, welcoming and unique shopping experience around the globe. Hollister also carries intimates brand, Gilly Hicks, “the brand to start and end your day with.” Gilly Hicks product is designed to be effortless and comfortable to align with customers’ on-the-go, busy lifestyle.
Abercrombie & Fitch. Abercrombie & Fitch is a specialty retailer of high-quality apparel and accessories for men and women. For 125 years, the iconic brand has outfitted innovators, explorers and entrepreneurs. Today, it reflects an updated attitude of the 21 to 24-year old customer, while remaining true to its heritage of creating expertly crafted products with an effortless, American style.
abercrombie kids. abercrombie kids creates smart and creative apparel of enduring quality that celebrates the wide-eyed wonder of children from 5 to 14 years. Its products are made for play - tough enough to stand up to everyday adventures.
SEASONAL BUSINESS.
The retail industry has two principal selling seasons: the Spring season, which includes the first and second fiscal quarters (“Spring”); and the Fall season, which includes the third and fourth fiscal quarters (“Fall”). As is common in the retail industry, the Company experiences its greatest sales activity during the Fall season due to Back-to-School and Back-to-Fall in August for Hollister and Abercrombie, respectively, and the holiday sales periods in November and December.
COMPETITION.
The Company operates in a rapidly evolving and highly competitive retail business environment. Competitors include individual and chain specialty apparel retailers, local, regional, national and international department stores, discount stores and online businesses. Additionally, the Company competes for consumers’ discretionary spending with businesses in other product and experiential categories, such as technology, restaurants, travel and media content. The Company competes primarily on the basis of quality, fashion, brand experience and selection.
Operating in a highly competitive industry environment can cause the Company to engage in greater promotional activity, resulting in pressure on average unit retail and gross profit. Refer to “ITEM 1A.
ITEM 1A.
RISK FACTORS
FORWARD-LOOKING STATEMENTS AND RISK FACTORS.
We caution that any forward-looking statements (as such term is defined in the Private Securities Litigation Reform Act of 1995) contained in this Annual Report on Form 10-K or made by us, our management or our spokespeople involve risks and uncertainties and are subject to change based on various factors, many of which may be beyond our control. Words such as “estimate,” “project,” “plan,” “believe,” “expect,” “anticipate,” “intend” and similar expressions may identify forward-looking statements. Except as may be required by applicable law, we undertake no obligation to publicly update or revise any forward-looking statements.
Forward-looking statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. The following factors, categorized by the primary nature of the associated risk, could affect our financial performance and cause actual results to differ materially from those expressed or implied in any of the forward-looking statements.
Macroeconomic and industry risks include:
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Changes in global economic and financial conditions, and the resulting impact on consumer confidence and consumer spending, as well as other changes in consumer discretionary spending habits, could have a material adverse effect on our business, results of operations and liquidity;
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Failure to anticipate customer demand and changing fashion trends and to manage our inventory commensurately could adversely impact our sales levels and profitability;
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Our market share may be negatively impacted by increasing competition and pricing pressures from companies with brands or merchandise competitive with ours;
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Fluctuations in foreign currency exchange rates could adversely impact our financial condition and results of operations;
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Our ability to attract customers to our stores depends, in part, on the success of the shopping malls or area attractions that our stores are located in or around; and,
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The impact of war, acts of terrorism or civil unrest could have a material adverse effect on our operating results and financial condition.
Strategic risks include:
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The expansion of our direct-to-consumer sales channels and omnichannel initiatives are significant components of our growth strategy, and the failure to successfully develop our position across all channels could have an adverse impact on our results of operations;
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Our international growth strategy and ability to conduct business in international markets may be adversely affected by legal, regulatory, political and economic risks; and,
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Failure to successfully implement our strategic plans could have a negative impact on our growth and profitability.
Operational risks include:
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Failure to protect our reputation could have a material adverse effect on our brands;
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Our business could suffer if our information technology systems are disrupted or cease to operate effectively;
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We may be exposed to risks and costs associated with cyber-attacks, credit card fraud and identity theft that would cause us to incur unexpected expenses and reputation loss;
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Our reliance on DCs makes us susceptible to disruptions or adverse conditions affecting our supply chain;
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Changes in cost, availability and quality of raw materials, labor, transportation, and trade relations could cause manufacturing delays and increase our costs;
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We depend upon independent third parties for the manufacture and delivery of all our merchandise, and a disruption of the manufacture or delivery of our merchandise could result in lost sales and could increase our costs;
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We rely on the experience and skills of our senior executive officers and associates, the loss of whom could have a material adverse effect on our business; and,
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Extreme weather conditions, including natural disasters, pandemic disease and other unexpected events, could negatively impact our facilities, systems and stores, as well as the facilities and systems of our vendors and manufacturers, which could result in an interruption to our business and adversely affect our operating results.
Legal, tax, regulatory and compliance risks include:
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Fluctuations in our tax obligations and effective tax rate may result in volatility in our results of operations;
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Our litigation exposure could have a material adverse effect on our financial condition and results of operations;
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Failure to adequately protect our trademarks could have a negative impact on our brand image and limit our ability to penetrate new markets;
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Changes in the regulatory or compliance landscape and compliance with changing regulations for accounting, corporate governance and public disclosure could adversely affect our business, results of operations and reported financial results; and,
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Our Asset-Based Revolving Credit Agreement and our Term Loan Agreement include restrictive covenants that limit our flexibility in operating our business.
The factors listed above are not our only risks. Additional risks may arise and current evaluations of risks may change, which could lead to material, adverse effects on our business, operating results and financial condition. The following sets forth a description of the preceding risk factors that we believe may be relevant to an understanding of our business. These risk factors could cause actual results to differ materially from those expressed or implied in any of our forward-looking statements.
MACROECONOMIC AND INDUSTRY RISKS.
Changes in global economic and financial conditions, and the resulting impact on consumer confidence and consumer spending, as well as other changes in consumer discretionary spending habits, could have a material adverse effect on our business, results of operations and liquidity.
Our business depends on consumer demand for our merchandise. Consumer purchases of discretionary items, including our merchandise, can be adversely impacted by recessionary periods and other periods where disposable income is adversely affected. Our performance is subject to factors that affect worldwide economic conditions including unemployment, consumer credit availability, consumer debt levels, reductions in net worth based on declines in the financial, residential real estate and mortgage markets, sales and personal income tax rates, fuel and energy prices, interest rates, consumer confidence in future economic and political conditions, consumer perceptions of personal well-being and security, the value of the U.S. Dollar versus foreign currencies and other macroeconomic factors. Additionally, changes in consumer preferences and discretionary spending habits may negatively impact the specialty apparel retail market. Global economic uncertainty and changing consumer preferences and discretionary spending habits could have a material adverse effect on our results of operations, liquidity and capital resources if reduced consumer demand for our merchandise should occur. It could also impact our ability to fund growth and/or result in our becoming reliant on external financing, the availability and cost of which may be uncertain.
The economic conditions and factors described above could adversely affect the profitability of our business, as well as adversely affect the pace of opening new stores, or their productivity once opened. Finally, the economic environment may exacerbate some of the risks noted below, including consumer demand, strain on available resources, our international growth strategy, availability of real estate, interruption of the flow of merchandise from key vendors and manufacturers, and foreign currency exchange rate fluctuations.
Failure to anticipate customer demand and changing fashion trends and to manage our inventory commensurately could adversely impact our sales levels and profitability.
Our success largely depends on our ability to anticipate and gauge the fashion preferences of our customers and provide merchandise that satisfies constantly shifting demands in a timely manner. Because we enter into agreements for the manufacture and purchase of merchandise well in advance of the applicable selling season, we are vulnerable to changes in consumer preferences and demand, pricing shifts, and the sub-optimal selection and timing of merchandise purchases. Moreover, there can be no assurance that we will continue to anticipate consumer demands and accurately plan inventory successfully in the future. Changing consumer preferences and fashion trends, whether we are able to anticipate, identify and respond to them or not, could adversely impact our sales. Inventory levels for certain merchandise styles no longer considered to be “on trend” may increase, leading to higher markdowns to sell through excess inventory and therefore, lower than planned margins. A distressed economic and retail environment, in which many of our competitors continue to engage in aggressive promotional activities increases the importance of reacting appropriately to changing consumer preferences and fashion trends. Conversely, if we underestimate consumer demand for our merchandise, or if our manufacturers fail to supply quality products in a timely manner, we may experience inventory shortages, which may negatively impact customer relationships, diminish brand loyalty and result in lost sales. In addition, we could be at a competitive disadvantage if we are unable to leverage data analytics to retrieve timely, customer insights to appropriately respond to customer demands. Any of these events could significantly harm our operating results and financial condition.
Our market share may be negatively impacted by increasing competition and pricing pressures from companies with brands or merchandise competitive with ours.
The sale of apparel and personal care products through stores and direct-to-consumer channels is a highly competitive business with numerous participants, including individual and chain specialty apparel retailers, local, regional, national and international department stores, discount stores and online businesses. Proliferation of the direct-to-consumer channel within the last few years has encouraged the entry of many new competitors and an increase in competition from established companies. We face a variety of competitive challenges, including:
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anticipating and quickly responding to changing consumer demands or preferences better than our competitors, including being able to adapt to new, emerging technologies that alter customer experience expectations;
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maintaining favorable brand recognition and effective marketing of our products to consumers in several diverse demographic markets;
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sourcing merchandise efficiently;
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developing innovative, high-quality merchandise in styles that appeal to our consumers and in ways that favorably distinguish us from our competitors; and,
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countering the aggressive pricing and promotional activities of many of our competitors without diminishing the aspirational nature of our brands and brand equity.
In light of the competitive challenges we face, we may not be able to compete successfully in the future. Further, increases in competition could reduce our sales and harm our operating results and business.
Fluctuations in foreign currency exchange rates could adversely impact our financial condition and results of operations.
The functional currency of our foreign subsidiaries is generally the local currency in which each entity operates, while our consolidated financial statements are presented in U.S. Dollars. Therefore, we must translate revenues, expenses, assets and liabilities from functional currencies into U.S. Dollars at exchange rates in effect during, or at the end of the reporting period. In addition, our international subsidiaries transact in currencies other than their functional currency, including intercompany transactions, which results in foreign currency transaction gains or losses. Furthermore, we purchase substantially all of our inventory in U.S. Dollars. As a result, our sales and gross profit rate from international operations will be negatively impacted during periods of a strengthened U.S. dollar relative to the functional currencies of our foreign subsidiaries. Additionally, tourism spending may be affected by changes in foreign currency exchange rates, and as a result, sales in our flagship stores and other stores with higher tourism traffic have, at times, been adversely impacted, and may continue to be adversely impacted, by fluctuations in foreign currency exchange rates. Certain events, such as the June 2016 decision by the United Kingdom to leave the European Union and the November 2016 U.S. elections, have increased global economic and political uncertainty and caused volatility in foreign currency exchange rates. Our business and results of operations may be impacted by these developments. For Fiscal 2017, 63.2%, 23.2% and 13.5% of the Company’s net sales were attributable to the U.S., Europe and other geographic areas, respectively.
Our ability to attract customers to our stores depends, in part, on the success of the shopping malls or area attractions that our stores are located in or around.
In order to generate customer traffic, we locate many of our stores in prominent locations within successful shopping malls or street locations. Our stores benefit from the ability of the malls’ “anchor” tenants, generally large department stores and other area attractions, to generate consumer traffic in the vicinity of our stores. We cannot control the loss of an anchor or other significant tenant in a shopping mall in which we have a store; the development of new shopping malls in the U.S. or around the world, the availability or cost of appropriate locations, competition with other retailers for prominent locations or the success of individual shopping malls. All of these factors may impact our ability to meet our productivity targets for our domestic stores and our growth objectives for our international stores and could have a material adverse effect on our financial condition or results of operations. In addition, some malls that were in prominent locations when we opened our stores may cease to be viewed as prominent. If this trend continues or if the popularity of mall shopping continues to decline generally among our customers, our sales may decline, which would impact our gross profits and net income.
Part of our future growth is dependent on our ability to operate stores in desirable locations with capital investment and lease costs providing the opportunity to earn a reasonable return. We cannot be sure as to when or whether such desirable locations will become available at reasonable costs.
The impact of war, acts of terrorism or civil unrest could have a material adverse effect on our operating results and financial condition.
The continued threat of terrorism and the associated heightened security measures and military actions in response to acts of terrorism have disrupted commerce. Further acts of terrorism, future conflicts or civil unrest may disrupt commerce and undermine consumer confidence and consumer spending by causing domestic and/or tourist traffic in malls and the Company’s flagship and other stores to decline, which could negatively impact our sales revenue. Furthermore, war or an act of terrorism, or the threat thereof, or any other unforeseen interruption of commerce, could negatively impact our business by interfering with our ability to obtain merchandise from foreign manufacturers. With a substantial portion of our merchandise being imported from foreign countries, failure to obtain merchandise from our foreign manufacturers or substitute other manufacturers, at similar costs and in a timely manner, could adversely affect our operating results and financial condition.
STRATEGIC RISKS.
The expansion of our direct-to-consumer sales channels and omnichannel initiatives are significant components of our growth strategy, and the failure to successfully develop our position across all channels could have an adverse impact on our results of operations.
Consumers are increasingly shopping online and via mobile devices, and we have made significant investments in capital spending and labor to develop these channels globally, invested in digital media to attract new customers and developed localized fulfillment, shipping and customer service operations. As omnichannel retailing continues to grow and evolve, our customers increasingly interact with our brands through a variety of media including smart phones and tablets, and expect seamless integration across all touchpoints. Our success depends on our ability to introduce innovative means of engaging our customers and our ability to respond to shifting consumer traffic patterns and direct-to-consumer buying trends. There is no assurance that we will be able to continue to successfully maintain or expand our direct-to-consumer sales channels and omnichannel initiatives and failure to adequately respond to these risks and uncertainties or to successfully maintain and expand our direct-to-consumer business may have an adverse impact on our results of operations.
In addition, direct-to-consumer operations are subject to numerous risks, including reliance on third-party computer hardware/software and service providers, data breaches, violations of state, federal or international laws, including those relating to online privacy, credit card fraud, telecommunication failures and electronic break-ins and similar disruptions, and disruption of Internet service. Changes in foreign governmental regulations may also negatively impact our ability to deliver product to our customers. Failure to successfully respond to these risks may adversely affect sales in our direct-to-consumer business as well as damage our reputation and brands.
Our international growth strategy and ability to conduct business in international markets may be adversely affected by legal, regulatory, political and economic risks.
International expansion is a significant component of our growth strategy and may require significant capital investment, which could strain our resources and adversely impact current store performance, while adding complexity to our current operations. We are subject to domestic laws, including the Foreign Corrupt Practices Act, in addition to the laws of the foreign countries in which we operate. If any of our overseas operations, or our associates or agents, violate such laws, we could become subject to sanctions or other penalties that could negatively affect our reputation, business and operating results.
Additionally, we may face operational issues that could have a material adverse effect on our reputation, business and results of operations if we fail to address certain factors including, but not limited to, the following:
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address the different operational characteristics present in each country in which we operate, including employment and labor, transportation, logistics, real estate, lease provisions and local reporting or legal requirements;
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hire, train and retain qualified personnel;
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maintain good relations with individual associates and groups of associates;
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avoid work stoppages or other labor-related issues in our European stores where associates are represented by workers’ councils and unions;
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retain acceptance from foreign customers;
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manage inventory effectively to meet the needs of existing stores on a timely basis; and
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manage foreign currency exchange rate risks effectively.
Failure to successfully implement our strategic plans could have a negative impact on our growth and profitability.
Our ability to execute our long-term strategies successfully and in a timely fashion is subject to various risks and uncertainties as described under this “Risk Factors” section. Specifically, these risks can be categorized into macroeconomic risk, strategic risk, operational risk and legal, tax, regulatory and compliance risk. Achieving the goals of our long-term strategy is also dependent on us executing the strategy successfully. Finally, it may take longer than anticipated to generate the expected benefits from our long-term strategy, the initiatives we implement in connection with our long-term strategy may not resonate with our customers and there can be no guarantee that these initiatives will result in improved operating results. In addition, failure to successfully implement our long-term strategy could have a negative impact on our growth and profitability.
OPERATIONAL RISKS.
Failure to protect our reputation could have a material adverse effect on our brands.
Our ability to maintain our reputation is critical to our brands. Our reputation could be jeopardized if we fail to maintain high standards for merchandise quality and integrity, if our third-party vendors fail to comply with our vendor code of conduct, if any third parties with which we have a business relationship fail to represent our brands in a manner consistent with our brand image and customer experience standards or as a result of a cyber-attack. In addition, the increasing use of social media platforms allows for rapid communication and any negative publicity related to the aforementioned concerns may reduce demand for our merchandise. Failure to comply with ethical, social, product, labor, health and safety, accounting or environmental standards, or related political considerations, could also jeopardize our reputation and potentially lead to various adverse consumer actions, including boycotts. Public perception about our products or our stores, whether justified or not, could impair our reputation, involve us in litigation, damage our brands and have a material adverse effect on our business. Damage to our reputation or loss of consumer confidence for any of these or other reasons could have a material adverse effect on our results of operations and financial condition, as well as require additional resources to rebuild our reputation.
Our business could suffer if our information technology systems are disrupted or cease to operate effectively.
We rely heavily on our information technology systems to operate our websites; record and process transactions; respond to customer inquiries; manage inventory; purchase, sell and ship merchandise on a timely basis; and maintain cost-efficient operations. Given the significant number of transactions that are completed annually, it is vital to maintain constant operation of our computer hardware and software systems and maintain cyber security. Despite efforts to prevent such an occurrence, our information technology systems may be vulnerable from time to time to damage or interruption from computer viruses, power outages, third-party intrusions, inadvertent or intentional breach by our employees and other technical malfunctions. If our systems are damaged, or fail to function properly, we may have to make monetary investments to repair or replace the systems, and we could endure delays in our operations.
While we regularly evaluate our information technology systems and requirements, we are aware of the inherent risks associated with replacing and modifying these systems, including inaccurate system information, system disruptions and user acceptance and understanding. Any material disruption or slowdown of our systems, including a disruption or slowdown caused by our failure to successfully upgrade our systems could cause information to be lost or delayed, including data related to customer orders. Such a loss or delay, especially if the disruption or slowdown occurred during our peak selling seasons, could have a material adverse effect on our results of operations.
We may be exposed to risks and costs associated with cyber-attacks, credit card fraud and identity theft that would cause us to incur unexpected expenses and reputation loss.
In the standard course of business, we process customer information, including payment information, through our stores and direct-to-consumer channels. Rapidly evolving technologies, payment capabilities offered and types of cyber-attacks may result in this information being compromised or breached. The retail industry in particular has been the target of many recent cyber-attacks, and as a result, there is heightened concern over the security of personal information transmitted over or accessible through the Internet, consumer identity theft and user privacy. We endeavor to protect consumer identity and payment information through the implementation of security technologies, processes and procedures, including training programs for employees to raise awareness about phishing, malware and other cyber risks and could experience increased costs associated with maintaining these protections as threats of cyber-attacks increase in sophistication and complexity. It is possible that an individual or group could defeat our security measures and access sensitive customer and associate information. Actual or anticipated cyber-attacks may cause us to incur increased costs, including costs to deploy additional personnel and protective technologies, train employees and engage third-party experts and consultants. Exposure of customer data through any means, including through third-party service providers and vendors, could materially harm the Company by, but not limited to, reputation loss, regulatory fines and penalties, legal liability and costs of litigation.
Our reliance on DCs makes us susceptible to disruptions or adverse conditions affecting our supply chain.
We rely on two Company-owned DCs and five third-party DCs to manage the receipt, storage, sorting, packing and distribution of our merchandise. The Company utilizes primarily one contract carrier to ship merchandise and related materials to its North American stores and direct-to-consumer customers, and several contract carriers for its European and Asian stores and direct-to-consumer customers. As a result, our operations are susceptible to local and regional factors, such as system failures, accidents, economic and weather conditions, natural disasters, demographic and population changes, as well as other unforeseen events and circumstances. If our distribution operations were disrupted, our ability to replace inventory in our stores and process direct-to-consumer and wholesale orders could be interrupted negatively impacting sales and could experience increased costs related to these disruptions. Refer to “ITEM 1. BUSINESS,” for a listing of the DCs we rely on.
Changes in cost, availability and quality of raw materials, labor, transportation, and trade relations could cause manufacturing delays and increase our costs.
Changes in the cost, availability and quality of the fabrics or other raw materials used to manufacture our merchandise could have a material adverse effect on our cost of sales, or our ability to meet customer demand. The prices for such fabrics depend largely on the market prices for the raw materials used to produce them, particularly cotton, as well as the cost of compliance with sourcing laws. The price and availability of such raw materials may fluctuate significantly, depending on many factors, including crop yields and weather patterns. Such factors may be exacerbated by legislation and regulations associated with global climate change. In addition, the cost of labor at many of our third-party manufacturers has been increasing significantly, and as the middle class in developing countries continues to grow, it is unlikely such cost pressure will abate. The Company is also susceptible to fluctuations in the cost of transportation. We may not be able to pass all or a portion of higher raw materials prices or labor or transportation costs on to our customers, which could adversely affect our gross margin and results of our operations. Recently, there has been greater uncertainty with respect to trade policies, tariffs and government regulations affecting trade between the U.S. and other countries, such as the threat of additional tariffs on imported consumer goods from China. Major developments in trade policies, such as the imposition of unilateral tariffs on imported products, could have a material adverse effect on our business, results of operations and liquidity.
We depend upon independent third parties for the manufacture and delivery of all our merchandise, and a disruption of the manufacture or delivery of our merchandise could result in lost sales and could increase our costs.
We do not own or operate any manufacturing facilities. As a result, the continued success of our operations is tied to our timely receipt of quality merchandise from third-party manufacturers. We source the majority of our merchandise outside of the U.S. through arrangements with approximately 150 vendors which includes foreign manufacturers located throughout the world, primarily in Asia and Central America. Political, social or economic instability in Asia and Central America, or in other regions in which our manufacturers are located, could cause disruptions in trade, including exports to the U.S. A manufacturer’s inability to ship orders in a timely manner or meet our quality standards could cause delays in responding to consumer demands and negatively affect consumer confidence or negatively impact our competitive position, any of which could have a material adverse effect on our financial condition and results of operations.
Other events that could disrupt the timely delivery of our merchandise include new trade law provisions or regulations, reliance on a limited number of shipping carriers, significant labor disputes and significant delays in the delivery of cargo due to port security considerations. Furthermore, we are susceptible to increases in fuel costs which may increase the cost of distribution. If we are not able to pass this cost on to our customers, our financial condition and results of operations could be adversely affected.
We rely on the experience and skills of our senior executive officers and associates, the loss of whom could have a material adverse effect on our business.
Our ability to succeed may be adversely impacted if we are not able to attract, retain and develop talent and future leaders, including our senior executive officers and associates. Our senior executive officers closely supervise all aspects of our business including the design of our merchandise and the operation of our stores and have substantial experience and expertise in the retail business and have an integral role in the growth and success of our brands. If we were to lose the benefit of the involvement of multiple senior executives or other personnel, our business could be adversely affected. In addition, if unexpected turnover occurs at the associate level without adequate succession plans, the loss of the services of any of these individuals, or any resulting negative perceptions of our business, could damage our reputation and our business. Competition for such qualified talent is intense, and we cannot be sure we will be able to attract, retain and develop a sufficient number of qualified individuals in future periods.
Extreme weather conditions, including natural disasters, pandemic disease and other unexpected events, could negatively impact our facilities, systems and stores, as well as the facilities and systems of our vendors and manufacturers, which could result in an interruption to our business and adversely affect our operating results.
Our retail stores, corporate offices, distribution centers, infrastructure projects and direct-to-consumer operations, as well as the operations of our vendors and manufacturers, are vulnerable to damage from natural disasters, pandemic disease and other unexpected events. If any of these events result in damage to our facilities, systems or stores, or the facilities or systems of our vendors or manufacturers, we may experience interruptions in our business until the damage is repaired, resulting in the potential loss of customers and revenues. In addition, we may incur costs in repairing any damage which exceed our applicable insurance coverage.
In addition, historically, our operations have been seasonal, with a significant amount of net sales and operating income occurring in the fourth fiscal quarter. Severe weather conditions and changes in weather patterns can influence customer trends, consumer traffic and shopping habits. Unseasonable weather may diminish demand for our seasonal merchandise. In addition, severe weather can also decrease customer traffic in our stores and reduce sales and profitability. As a result of this seasonality, net sales and net income during any fiscal quarter cannot be used as an accurate indicator of our annual results. Any factors negatively affecting us during the third and fourth fiscal quarters of any year, including inclement weather, could have a material adverse effect on our financial condition and results of operations for the entire year.
LEGAL, TAX, REGULATORY AND COMPLIANCE RISKS.
Fluctuations in our tax obligations and effective tax rate may result in volatility in our results of operations.
We are subject to income taxes in many U.S. and foreign jurisdictions. In addition, our products are subject to import and excise duties and/or sales, consumption or value-added taxes (“VAT”) in many jurisdictions. We record tax expense based on our estimates of future payments, which include reserves for estimates of probable settlements of foreign and domestic tax audits. At any one time, many tax years are subject to audit by various taxing jurisdictions. The results of these audits and negotiations with taxing authorities may affect the ultimate settlement of these issues. As a result, we expect that throughout the year there could be ongoing variability in our quarterly tax rates as taxable events occur and exposures are evaluated. In addition, our effective tax rate in any given financial reporting period may be materially impacted by changes in the mix and level of earnings or losses by taxing jurisdictions or by changes to existing accounting rules or regulations. Fluctuations in duties could also have a material impact on our financial condition, results of operations or cash flows. In some international markets, we are required to hold and submit VAT to the appropriate local tax authorities. Failure to correctly calculate or submit the appropriate amounts could subject us to substantial fines and penalties that could have an adverse effect on our financial condition, results of operations or cash flows. In addition, tax law may be enacted in the future, domestically or abroad, that impacts our current or future tax structure and effective tax rate.
On December 22, 2017, the Tax Cuts and Jobs Act of 2017 (the “Act”) was enacted into law. The Act makes broad and significantly complex changes to the U.S. corporate income tax system. Given the complexities associated with the Act, the estimated financial impacts for fiscal 2017 are provisional and subject to further analysis, interpretation and clarification of the Act. In addition, the U.S. Treasury Department, the Internal Revenue Service and other standard-setting bodies could interpret or issue guidance on how provisions of the Act will be applied or otherwise administered that differs from our interpretations and could result in changes to our estimates. Changes to these estimates during Fiscal 2018 could have a material adverse effect on our business, results of operations and liquidity. Refer to Note 10, “INCOME TAXES,” for further discussion.
Our litigation exposure could have a material adverse effect on our financial condition and results of operations.
We, along with third parties we do business with, are involved, from time to time, in litigation arising in the ordinary course of business. Litigation matters may include, but are not limited to, contract disputes, employment-related actions, labor relations, commercial litigation, intellectual property rights and shareholder actions. Any litigation that we become a party to could be costly and time consuming and could divert our management and key personnel from our business operations. Our current litigation exposure could be impacted by litigation trends, discovery of damaging facts with respect to legal matters pending against us or determinations by judges, juries or other finders of fact that are not in accordance with management’s evaluation of existing claims. Should management’s evaluation prove incorrect, our exposure could greatly exceed expectations and have a material adverse effect on our financial condition, results of operations or cash flows.
Failure to adequately protect our trademarks could have a negative impact on our brand image and limit our ability to penetrate new markets.
We believe our core trademarks, Abercrombie & Fitch®, abercrombie®, Hollister®, Gilly Hicks® and the “Moose” and “Seagull” logos, are essential to the effective implementation of our strategy. We have obtained or applied for federal registration of these trademarks with the U.S. Patent and Trademark Office and the registries of countries where stores are located or likely to be located in the future. In addition, we own registrations and have pending applications for other trademarks in the U.S. and have applied for or obtained registrations from the registries in many foreign countries in which our stores or our manufacturers are located. There can be no assurance that we will obtain registrations that have been applied for or that the registrations we obtain will prevent the imitation of our products or infringement of our intellectual property rights by others. Although brand security initiatives are in place, we cannot guarantee that our efforts against the counterfeiting of our brands will be successful. If a third-party copies our products in a manner that projects lesser quality or carries a negative connotation, our brand image could be materially adversely affected.
Because we have not yet registered all of our trademarks in all categories, or in all foreign countries in which we source or offer our merchandise now, or may in the future, our international expansion and our merchandising of products using these marks could be limited. The pending applications for international registration of various trademarks could be challenged or rejected in those countries because third parties of whom we are not currently aware have already registered similar marks in those countries. Accordingly, it may be possible, in those foreign countries where the status of various applications is pending or unclear, for a third-party owner of the national trademark registration for a similar mark to prohibit the manufacture, sale or exportation of branded goods in or from that country. Failure to register our trademarks or purchase or license the right to use our trademarks or
logos in these jurisdictions could limit our ability to obtain supplies from, or manufacture in, less costly markets or penetrate new markets should our business plan include selling our merchandise in those non-U.S. jurisdictions.
Changes in the regulatory or compliance landscape and compliance with changing regulations for accounting, corporate governance and public disclosure could adversely affect our business, results of operations and reported financial results.
We are subject to numerous laws and regulations, including customs, truth-in-advertising, securities laws, consumer protection, general privacy, health information privacy, identity theft, online privacy, employee health and safety, international minimum wage laws, unsolicited commercial communication and zoning and occupancy laws and ordinances that regulate retailers generally and/or govern the importation, intellectual property, promotion and sale of merchandise and the operation of retail stores, direct-to-consumer operations and distribution centers. Laws and regulations at the local, state, federal and various international levels frequently change, and the ultimate cost of compliance cannot be precisely estimated. If these laws and regulations were to change, or were violated by our management, associates, suppliers, vendors or other parties with whom we do business, the costs of certain merchandise could increase, or we could experience delays in shipments of our merchandise, be subject to fines or penalties, temporary or permanent store closures, increased regulatory scrutiny or suffer reputational harm, which could reduce demand for our merchandise and adversely affect our business and results of operations. Any changes in regulations, the imposition of additional regulations, or the enactment of any new or more stringent legislation including the areas referenced above, could adversely affect our business and results of operations.
In addition, changing regulatory requirements for corporate governance and public disclosure, including SEC regulations and the Financial Accounting Standards Board’s Accounting Standards Codification (“ASC”) are creating additional complexities for public companies. For example, in July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (“the Dodd-Frank Act”), was enacted. There are significant corporate governance and executive compensation related provisions in the Dodd-Frank Act that have required the SEC to adopt additional rules and regulations in these areas.
Stockholder activism, the current political environment, financial reform legislation and the current high level of government intervention and regulatory reform may lead to substantial new regulations and disclosure obligations. In addition, the potential requirement to transition to, or converge with, international financial reporting standards in the future may create uncertainty and additional complexities. These changing regulatory requirements may lead to additional compliance costs, as well as the diversion of our management’s time and attention from strategic business activities and could have a significant effect on our reported results for the affected periods.
Our Asset-Based Revolving Credit Agreement and our Term Loan Agreement include restrictive covenants that limit our flexibility in operating our business.
Our Asset-Based Revolving Credit Agreement, as amended, expires on October 19, 2022 and our Term Loan Agreement, as amended, has a maturity date of August 7, 2021. Both our Asset-Based Revolving Credit Agreement and our Term Loan Agreement contain restrictive covenants that, subject to specified exemptions, restrict our ability to incur indebtedness, grant liens, make certain investments, pay dividends or distributions on our capital stock and engage in mergers. The inability to obtain credit on commercially reasonable terms in the future when these facilities expire could adversely impact our liquidity and results of operations. In addition, market conditions could potentially impact the size and terms of a replacement facility or facilities.
ITEM 1B.
ITEM 1B.
UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2.
PROPERTIES
The Company’s headquarters and support functions occupy 501 acres, consisting of the home office, distribution and shipping facilities centralized on a campus-like setting in New Albany, Ohio, all of which are owned by the Company. Additionally, the Company leases small facilities to house its human resources, finance, design and sourcing support centers in Hong Kong and New York City, New York, as well as offices in China, Denmark, France, Germany, South Korea, Spain, Switzerland and the United Kingdom. The Company’s home office, distribution and shipping facilities, design support centers and stores are currently suitable and adequate.
All of the retail stores operated by the Company, as of March 28, 2018, are located in leased facilities, primarily in shopping centers. The leases expire at various dates, between 2018 and 2031.
For store count and gross square footage by brand and geography as of February 3, 2018 and January 28, 2017, refer to “STORE ACTIVITY,” in “ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.” As of March 28, 2018, the Company’s 868 stores were located as follows:
Refer to “Distribution of Merchandise Inventory,” in “ITEM 1. BUSINESS,” for information regarding the DCs the Company relies on to manage the receipt, storage, sorting, packing and distribution of its merchandise.
ITEM 3.
ITEM 3.
LEGAL PROCEEDINGS
The Company is a defendant in lawsuits and other adversary proceedings arising in the ordinary course of business. Legal costs incurred in connection with the resolution of claims and lawsuits are generally expensed as incurred, and the Company establishes estimated liabilities for the outcome of litigation where losses are deemed probable and reasonably estimable. The Company’s assessment of the current exposure could change in the event of the discovery of additional facts. As of February 3, 2018, the Company had accrued charges of approximately $18 million for certain legal contingencies, which are classified within other current liabilities on the Consolidated Balance Sheet included in “ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA,” of this Annual Report on Form 10-K. Actual liabilities may differ from the amounts recorded, and there can be no assurance that final resolution of these matters will not have a material adverse effect on the Company’s financial condition, results of operations or cash flows. There are certain claims and legal proceedings pending against the Company for which accruals have not been established.
ITEM 4.
ITEM 4.
MINE SAFETY DISCLOSURES
Not applicable.
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
A&F’s Class A Common Stock (“Common Stock”) is traded on the New York Stock Exchange under the symbol “ANF.” The table below sets forth the high and low sales prices of A&F’s Common Stock on the New York Stock Exchange for Fiscal 2017 and Fiscal 2016:
Dividends are declared at the discretion of A&F’s Board of Directors. A quarterly dividend, of $0.20 per share outstanding, was declared in each of February, May, August and November in Fiscal 2017 and Fiscal 2016. Dividends were paid in each of March, June, September and December in Fiscal 2017 and Fiscal 2016. A&F’s Board of Directors reviews the dividend on a quarterly basis and establishes the dividend rate based on A&F’s financial condition, results of operations, capital requirements, current and projected cash flows, business prospects and other factors which the Board of Directors deem relevant.
As of March 28, 2018, there were approximately 3,000 stockholders of record. However, when including investors holding shares of Common Stock in broker accounts under street name, A&F estimates that there are approximately 28,200 stockholders.
The following table provides information regarding the purchase of shares of the Common Stock of A&F made by or on behalf of A&F or any “affiliated purchaser” as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934, as amended, during each fiscal month of the quarterly period ended February 3, 2018:
(1)
All of the 23,618 shares of A&F’s Common Stock purchased during the fourteen-week period ended February 3, 2018 represented shares that were withheld for tax payments due upon the vesting of restricted stock units.
(2)
No shares were repurchased during the fourteen-week period ended February 3, 2018 pursuant to A&F’s publicly announced stock repurchase authorization. On August 14, 2012, A&F’s Board of Directors authorized the repurchase of up to 10.0 million shares of A&F’s Common Stock, which was announced on August 15, 2012.
(3)
The number shown represents, as of the end of each period, the maximum number of shares of Common Stock that may yet be purchased under A&F’s publicly announced stock repurchase authorization described in footnote 2 above. The shares may be purchased from time-to-time, depending on market conditions.
The following graph shows the changes, over the five-year period ended February 3, 2018 (the last day of A&F’s Fiscal 2017) in the value of $100 invested in (i) shares of A&F’s Common Stock; (ii) Standard & Poor’s 500 Stock Index (the “S&P 500 Index”); (iii) Standard & Poor’s Midcap 400 Stock Index (the “S&P Midcap 400 Index”); and (iv) Standard & Poor’s Apparel Retail Composite Index (the “S&P Apparel Retail Index”), including reinvestment of dividends. The plotted points represent the closing price on the last trading day of the fiscal year indicated.
PERFORMANCE GRAPH (1)
COMPARISON OF FIVE-YEAR CUMULATIVE TOTAL RETURN*
Among Abercrombie & Fitch Co., the S&P 500 Index, the S&P Midcap 400 Index and the S&P Apparel Retail Index
*$100 invested on 2/2/13 in stock or 1/31/13 in index, including reinvestment of dividends. Indexes calculated on month-end basis.
Copyright© 2018 Standard & Poor’s, a division of S&P Global. All rights reserved.
In Fiscal 2013, A&F was removed as a component of the S&P 500 Index and became a component of the S&P Midcap 400 Index.
(1)
This graph shall not be deemed to be “soliciting material” or to be “filed” with the SEC or subject to SEC Regulation 14A or to the liabilities of Section 18 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), except to the extent that A&F specifically requests that the graph be treated as soliciting material or specifically incorporates it by reference into a filing under the Securities Act of 1933, as amended, or the Exchange Act.
ITEM 6.
ITEM 6.
SELECTED FINANCIAL DATA
The following financial information is derived from our Consolidated Financial Statements. The information presented below should be read in conjunction with “ITEM 7.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
BUSINESS SUMMARY
The Company is a global, multi-brand specialty retailer, which primarily sells its products through its wholly-owned store and direct-to-consumer channels, as well as through various third-party wholesale, franchise and licensing arrangements. The Company offers a broad assortment of apparel, personal care products and accessories for men, women and kids under the Hollister, Abercrombie & Fitch and abercrombie kids brands. The brands share a commitment to offering products of enduring quality and exceptional comfort that allows customers around the world to express their own individuality and style. The Company has operations in North America, Europe, Asia and the Middle East.
The Company’s fiscal year ends on the Saturday closest to January 31, typically resulting in a fifty-two week year, but occasionally giving rise to an additional week, resulting in a fifty-three week year, as was the case for Fiscal 2017. For purposes of this “ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS,” Fiscal 2017 is compared to Fiscal 2016 and Fiscal 2016 is compared to Fiscal 2015.
The Company’s two operating segments are brand-based: Hollister and Abercrombie, the latter of which includes the Company’s Abercrombie & Fitch and abercrombie kids brands. These operating segments have similar economic characteristics, classes of consumers, products, production and distribution methods, operate in the same regulatory environments, and have been aggregated into one reportable segment.
SUMMARY RESULTS OF OPERATIONS
The table below summarizes the Company’s results of operations and reconciles financial measures determined in accordance with accounting principles generally accepted in the U.S. (“GAAP”) to non-GAAP financial measures for Fiscal 2017 and Fiscal 2016, respectively. Additional discussion about why the Company believes that these non-GAAP financial measures are useful to investors is provided under “NON-GAAP FINANCIAL MEASURES.”
(1)
Fiscal 2017 was a fifty-three week year.
(2)
Refer to “RESULTS OF OPERATIONS,” in “ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS,” for details on excluded items.
(3)
Comparable sales is defined as the aggregate of: (1) year-over-year sales for stores that have been open as the same brand at least one year and whose square footage has not been expanded or reduced by more than 20% within the past year, with the prior year’s net sales converted at the current year’s exchange rate to remove the impact of currency fluctuation, and (2) year-over-year direct-to-consumer sales with the prior year’s net sales converted at the current year’s exchange rate to remove the impact of currency fluctuation. Excludes revenue other than store and direct-to-consumer sales.
As of February 3, 2018, the Company had $675.6 million in cash and equivalents, and $253.3 million in gross borrowings outstanding under its term loan facility. Net cash provided by operating activities was $285.7 million for Fiscal 2017. The Company used cash of $107.0 million for capital expenditures, $54.4 million to pay dividends and $15.0 million to pay down debt during Fiscal 2017.
As of January 28, 2017, the Company had $547.2 million in cash and equivalents, and $268.3 million in gross borrowings outstanding under its term loan facility. Net cash provided by operating activities was $185.3 million for Fiscal 2016. The Company used cash of $140.8 million for capital expenditures, $54.1 million to pay dividends and $25.0 million to pay down debt during Fiscal 2016.
CURRENT TRENDS AND OUTLOOK
By staying close to our customer, executing to our brand playbooks and maintaining our disciplined approach to expense management we delivered sequential, quarterly comparable sales improvement throughout the year. This culminated in positive comparable sales for the fourth quarter across brands, channels and geographies and operating income growth for the year. Overall, Fiscal 2017 was a year of significant progress. We achieved several important milestones, including Hollister growing to $2 billion in sales, Abercrombie returning to positive comparable sales in the fourth quarter and record digital sales across all brands. We continue to improve the customer experience with ongoing investments in loyalty programs, store and direct-to-consumer experience and omnichannel capabilities.
With a strong balance sheet, proven cost management discipline and a clear plan for building on the foundations we laid to date, we will continue to focus our attention and our investments on engaging our customers with compelling assortments and new experiences, in clearly defined brand voices, positioning our business for sustainable long-term growth.
Additional information pertaining to our results for Fiscal 2015, Fiscal 2016 and Fiscal 2017 follows:
(1)
Refer to “RESULTS OF OPERATIONS,” in “ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS,” for details on excluded items.
(2)
Includes Abercrombie & Fitch and abercrombie kids brands.
For Fiscal 2018, we expect:
•
Comparable sales to be up low-single digits.
•
Net sales to be up low-single digits, with benefits from changes in foreign currency exchange rates largely offset by the adverse impact from the loss of the additional week in Fiscal 2017.
•
Changes in foreign currency exchange rates to benefit net sales and operating income.
•
A gross profit rate up slightly from the Fiscal 2017 rate of 59.7%, with some continuing pressure in the first quarter.
•
Operating expenses, excluding other operating income, to be up approximately 1% from Fiscal 2017 adjusted non-GAAP operating expense of $2 billion, resulting in expense leverage, while still supporting investments in strategic initiatives.
•
Other operating income to not be significant, including as a result of gift card breakage now being recognized within net sales subsequent to the adoption of the new revenue recognition accounting standard.
•
A weighted average diluted share count of approximately 71 million shares, excluding the effect of potential share buybacks.
We estimate the core tax rate to be in the mid-to high-20s based on the Act. However, for Fiscal 2018, we expect to incur discrete non-cash income tax charges of approximately $10 million related to share-based compensation accounting standards that went into effect in Fiscal 2017. As a result, we expect the full year effective tax rate to be in the mid-to high-30s. For the first quarter of Fiscal 2018, we expect the effective tax rate to be in the low double-digits to low teens, including approximately $8 million of the discrete noncash income tax charges related to share-based compensation.
With regard to capital allocation, we are targeting capital expenditures to be approximately $130 million for Fiscal 2018, including approximately $85 million for store updates and new stores and approximately $45 million for direct-to-consumer and omnichannel capabilities, information technology and other projects.
We plan to open 21 full-price stores in Fiscal 2018, including 13 Hollister and eight Abercrombie stores. In addition, we expect to convert ten Abercrombie stores to the new, smaller square-foot prototype formats, and remodel approximately 40 Hollister stores, six of which are expected to be right-sized to smaller footprints. We also anticipate closing up to 60 stores in the U.S. during Fiscal 2018 through natural lease expirations.
STORE ACTIVITY
During Fiscal 2017, the Company opened nine stores, including six Abercrombie and three Hollister stores. In addition, the Company converted four Abercrombie stores to the new, smaller square-foot prototype formats, and remodeled 35 Hollister stores, 12 of which were right-sized to smaller footprints. The Company also closed 39 stores in Fiscal 2017, primarily in the U.S.
Store count and gross square footage by brand and geography for Fiscal 2017 and Fiscal 2016 were as follows:
(1)
Excludes five international franchise stores as of February 3, 2018, three international franchise stores as of January 28, 2017 and two international franchise stores as of January 30, 2016.
(2)
Abercrombie includes the Company’s Abercrombie & Fitch and abercrombie kids brands. Excludes four international franchise stores as of February 3, 2018, and one international franchise store as of both January 28, 2017 and January 30, 2016.
NON-GAAP FINANCIAL MEASURES
This Annual Report on Form 10-K includes discussion of certain financial measures under “RESULTS OF OPERATIONS” on both a GAAP and a non-GAAP basis. The Company believes that each of the non-GAAP financial measures presented in this “ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS” is useful to investors as it provides a measure of the Company’s operating performance excluding the effect of certain items which the Company believes do not reflect its future operating outlook, and therefore supplements investors’ understanding of comparability of operations across periods. Management used these non-GAAP financial measures during the periods presented to assess the Company’s performance and to develop expectations for future operating performance. These non-GAAP financial measures should be used supplemental to, and not as an alternative to, the Company’s GAAP financial results and may not be calculated in the same manner as similar measures presented by other companies.
The Company provides certain financial information on a constant currency basis to enhance investors’ understanding of underlying business trends and operating performance by removing the impact of foreign currency exchange rate fluctuations. The effect from foreign currency exchange rates, calculated on a constant currency basis, is determined by applying the current period's exchange rates to the prior year's results and is net of the year-over-year impact from hedging.
In addition, the Company provides comparable sales, defined as the aggregate of (1) year-over-year sales for stores that have been open as the same brand at least one year and whose square footage has not been expanded or reduced by more than 20% within the past year, with the prior year’s net sales converted at the current year’s foreign currency exchange rates to remove the impact of foreign currency exchange rate fluctuation, and (2) year-over-year direct-to-consumer sales with the prior year’s net sales converted at the current year’s foreign currency exchange rates to remove the impact of foreign currency exchange rate fluctuation. Comparable sales excludes revenue other than store and direct-to-consumer sales. Management uses comparable sales to understand the drivers of net sales year-over-year changes as well as a performance metric for certain performance-based restricted stock units. The Company believes comparable sales is a useful metric as it can assist investors in distinguishing the portion of the Company’s revenue attributable to existing locations from the portion attributable to the opening or closing of stores. The most directly comparable GAAP financial measure is change in net sales.
The Company also discloses free cash flow in this Annual Report on Form 10-K, calculated as cash flows generated from operations less cash flows used for capital expenditures. The Company uses free cash flow as a measure to assess the Company’s liquidity and determine cash remaining for general corporate and strategic purposes as well as the amount of cash available to return to stockholders pursuant to the Company's capital allocation strategy. The most directly comparable GAAP financial measure is net cash provided by operating activities.
The following financial measures are disclosed on a GAAP and on an adjusted non-GAAP basis excluding certain of the following items, as applicable:
(1)
Certain of these financial measures are also expressed as a percentage of net sales.
(2)
The Company also presents income tax expense (benefit) and the effective tax rate on both a GAAP and on an adjusted non-GAAP basis excluding the items listed under “Operating income,” as applicable, in the table above and discrete net tax charges related to the Act. The Company computed the tax effect of excluded items as the difference between the tax provision calculation on a GAAP basis and an adjusted non-GAAP basis.
KEY BUSINESS INDICATORS
The following measurements are among the key business indicators reviewed by various members of management to gauge the Company’s results:
•
Comparable sales;
•
Comparative results of operations with the prior year’s results converted at the current year’s foreign currency exchange rate to remove the impact of foreign currency exchange rate fluctuation;
•
Gross profit and gross profit rate;
•
Cost of sales, exclusive of depreciation and amortization, as a percentage of net sales;
•
Stores and distribution expense as a percentage of net sales;
•
Marketing, general and administrative expense as a percentage of net sales;
•
Operating income and operating income as a percentage of net sales;
•
Net income and net income attributable to A&F;
•
Inventory per gross square foot and inventory to sales ratio;
•
Cash flow and liquidity determined by the Company’s current ratio, working capital and free cash flow;
•
Store metrics such as net sales per gross square foot, average number of transactions per store and store contribution (defined as store sales less direct costs of operating the store);
•
Transactional metrics such as traffic and conversion, performance across key product categories, average unit retail, average unit cost, average units per transaction and average transaction values;
•
Return on invested capital and return on equity; and
•
Customer-centric metrics such as customer satisfaction, brand health scores and certain metrics related to the loyalty programs.
While not all of these metrics are disclosed publicly by the Company due to the proprietary nature of the information, the Company publicly discloses and discusses many of these metrics within this Management’s Discussion and Analysis of Financial Condition and Results of Operations.
RESULTS OF OPERATIONS
FISCAL 2017 COMPARED TO FISCAL 2016 AND FISCAL 2016 COMPARED TO FISCAL 2015
Net Sales
(1)
Comparable sales is defined as the aggregate of: (1) year-over-year sales for stores that have been open as the same brand at least one year and whose square footage has not been expanded or reduced by more than 20% within the past year, with the prior year’s net sales converted at the current year’s exchange rate to remove the impact of currency fluctuation, and (2) year-over-year direct-to-consumer sales with the prior year’s net sales converted at the current year’s exchange rate to remove the impact of currency fluctuation. Excludes revenue other than store and direct-to-consumer sales.
(2)
Includes Abercrombie & Fitch and abercrombie kids brands.
For Fiscal 2017, net sales increased 5% compared to Fiscal 2016, primarily attributable to a 3% increase in comparable sales, with a 8% increase in comparable sales for Hollister, partially offset by a 2% decrease in comparable sales for Abercrombie. In addition, the additional week in Fiscal 2017 benefited net sales by approximately $41 million, or 1%, and changes in foreign currency exchange rates benefited net sales by approximately $20 million, or 1%.
For Fiscal 2016, net sales decreased 5% compared to Fiscal 2015, primarily attributable to a 5% decrease in comparable sales, with flat comparable sales for Hollister offset by a 11% percent decrease in comparable sales for Abercrombie.
Cost of Sales, Exclusive of Depreciation and Amortization
(1)
Inventory write-down charges related to a Fiscal 2015 decision to accelerate the disposition of certain aged merchandise, net of recoveries.
For Fiscal 2017, cost of sales, exclusive of depreciation and amortization, as a percentage of net sales increased by approximately 130 basis points as compared to Fiscal 2016, primarily due to lower average unit retail, including the adverse effects from changes in foreign currency exchange rates of approximately 10 basis points.
For Fiscal 2016, cost of sales, exclusive of depreciation and amortization, as a percentage of net sales increased by approximately 30 basis points as compared to Fiscal 2015, which included a $20.6 million net inventory write-down. Excluding the Fiscal 2015 $20.6 million net inventory write-down, Fiscal 2016 adjusted non-GAAP cost of sales, exclusive of depreciation and amortization, as a percentage of net sales increased by approximately 90 basis points as compared to Fiscal 2015, primarily due to the adverse effects from changes in foreign currency exchange rates of approximately 60 basis points and lower average unit retail.
Stores and Distribution Expense
For Fiscal 2017, stores and distribution expense as a percentage of net sales decreased by approximately 320 basis points as compared to Fiscal 2016, which included lease termination charges of $15.6 million related to the A&F flagship store in Hong Kong, primarily due to the leveraging effect from higher net sales and expense reduction efforts.
For Fiscal 2016, stores and distribution expense as a percentage of net sales increased by approximately 180 basis points as compared to Fiscal 2015, primarily due to the deleveraging effect from lower net sales, higher direct-to-consumer expense and lease termination charges of $15.6 million related to the A&F flagship store in Hong Kong, partially offset by the realization of savings on lower sales and expense reduction efforts. Excluding items presented above, Fiscal 2016 adjusted non-GAAP stores and distribution expense as a percent of net sales increased by approximately 200 basis points as compared to Fiscal 2015.
For Fiscal 2017, shipping and handling costs associated with direct-to-consumer operations, including costs incurred physically move product to the customer and costs to store, move and prepare product for shipment, were $150.7 million as compared to $125.4 million for Fiscal 2016 and $115.0 million for Fiscal 2015.
Marketing, General and Administrative Expense
(1)
Fiscal 2017 includes legal charges of $11.1 million in connection with the settlement of two class action lawsuits, subject to court approval, related to alleged wage and hour practices and accrued charges of $4.0 million related to other alleged wage and hour legal matters. Fiscal 2015 includes accrued expense for certain then proposed legal settlements.
(2)
Includes benefits related to an indemnification recovery of certain legal settlements which were recognized in Fiscal 2015.
For Fiscal 2017, marketing, general and administrative expense as a percentage of net sales decreased by approximately 10 basis points as compared to Fiscal 2016, primarily due to expense reduction efforts and the leveraging effect from higher net sales, partially offset by the net effect of the excluded items presented above and increases in performance-based compensation and marketing expenses. Excluding items presented above, Fiscal 2017 adjusted non-GAAP marketing, general and administrative expense as a percentage of net sales decreased by approximately 70 basis points as compared to Fiscal 2016.
For Fiscal 2016, marketing, general and administrative expense as a percentage of net sales increased by approximately 20 basis points as compared to Fiscal 2015, primarily due to the deleveraging effect from lower net sales and higher marketing expenses, partially offset by the net year-over-year impact of the excluded items presented above, lower compensation expense and expense reduction efforts. Excluding items presented above, Fiscal 2016 adjusted non-GAAP marketing, general and administrative expense as a percentage of net sales increased by approximately 90 basis points as compared to Fiscal 2015.
Restructuring Benefit
There were no restructuring benefits in Fiscal 2017 or Fiscal 2016. For Fiscal 2015, benefits associated with the restructuring of the Gilly Hicks brand were $1.6 million, which were excluded from adjusted non-GAAP results.
Asset Impairment
For Fiscal 2017, the Company incurred store asset impairment charges of $14.4 million, primarily related to certain of the Company's international Abercrombie & Fitch stores in Germany, Spain, Italy and Hong Kong. For Fiscal 2016, the Company incurred store asset impairment charges of $7.9 million, primarily related to the Company’s abercrombie kids flagship store in London. For Fiscal 2015, the Company incurred store asset impairment charges of $18.2 million, primarily related to the Company’s Abercrombie & Fitch flagship store in Hong Kong and the removal of certain store fixtures in connection with changes to the Abercrombie and Hollister store experiences.
Other Operating Income, Net
(1)
Includes benefits related to a settlement of certain economic loss claims associated with the April 2010 Deepwater Horizon oil spill.
(2)
Includes charges related to a release of cumulative translation adjustment as the Company substantially completed the liquidation of its Australian operations.
For Fiscal 2017, other operating income, net, as a percentage of net sales decreased by approximately 30 basis points as compared to Fiscal 2016. Excluding items presented above, Fiscal 2017 adjusted non-GAAP other operating income, net, as a percentage of net sales increased by approximately 10 basis points as compared to Fiscal 2016, as higher foreign currency exchange rate related gains more than offset lower gift card breakage.
For Fiscal 2016, other operating income, net, as a percentage of net sales increased by approximately 60 basis points as compared to Fiscal 2015. Excluding items presented above, Fiscal 2016 adjusted non-GAAP other operating income, net, as a percentage of net sales increased by approximately 20 basis points as compared to Fiscal 2015, primarily due to higher gift card breakage from the initial recognition of international gift card breakage of $4.8 million and higher foreign currency exchange rate related gains in Fiscal 2016, partially offset by insurance recoveries of $2.2 million in Fiscal 2015 .
Operating Income
(1)
Fiscal 2017 includes legal charges of $11.1 million in connection with the settlement of two class action lawsuits, subject to court approval, related to alleged wage and hour practices and accrued charges of $4.0 million related to other alleged wage and hour legal matters. Fiscal 2015 includes accrued expense for certain then proposed legal settlements.
(2)
Includes benefits related to an indemnification recovery of certain legal settlements which were recognized in Fiscal 2015.
(3)
Includes benefits related to a settlement of certain economic loss claims associated with the April 2010 Deepwater Horizon oil spill.
(4)
Includes inventory write-down charges related to a decision to accelerate the disposition of certain aged merchandise, net of recoveries.
(5)
Includes charges related to a release of cumulative translation adjustment as the Company substantially completed the liquidation of its Australian operations.
For Fiscal 2017, operating income as a percentage of net sales increased by approximately 160 basis points as compared to Fiscal 2016, primarily driven by the leveraging effect from higher net sales and expense reduction efforts, partially offset by a reduction in the gross profit rate, increases in performance-based compensation and marketing expenses and the net year-over-year impact of the excluded items in the above table. Excluding items presented above, Fiscal 2017 adjusted non-GAAP operating income as a percentage of net sales increased approximately 280 basis points as compared to Fiscal 2016.
For Fiscal 2016, operating income as a percentage of net sales decreased by approximately 160 basis points as compared to Fiscal 2015, primarily driven by the deleveraging effect due to lower net sales, a reduction in the gross profit rate and higher marketing and direct-to-consumer expense, partially offset by the net year-over-year impact of the excluded items presented above and expense reduction efforts. Excluding items presented above, Fiscal 2016 adjusted non-GAAP operating income as a percentage of net sales decreased approximately 380 basis points as compared Fiscal 2015.
Interest Expense, Net
For Fiscal 2017, interest expense, net was $16.9 million as compared to $18.7 million and $18.2 million for Fiscal 2016 and Fiscal 2015, respectively. In each year, interest expense, net primarily consisted of interest expense on borrowings outstanding under the Company’s term loan facility, partially offset by realized gains from the trust-owned life insurance policies held in the irrevocable rabbi trust (the “Rabbi Trust”) and interest income earned on the Company’s investments and cash holdings.
For Fiscal 2017, interest expense, net decreased as compared to Fiscal 2016, primarily due to higher interest income earned on the Company's investments and cash holdings and a decrease in interest expense, primarily due to a reduction in the average principal balance of debt outstanding.
Income Tax Expense (Benefit)
(1)
Refer to “Operating Income” for details of excluded items. The tax effect of excluded items is the difference between the tax provision calculation on a GAAP basis and an adjusted non-GAAP basis.
(2)
Discrete net tax charges related to the Act, primarily associated with the one-time deemed repatriation tax on accumulated foreign earnings.
For Fiscal 2017, the effective tax rate was 80.9% as compared to 321.9% for Fiscal 2016, which was impacted by jurisdictional mix on low levels of absolute income. In Fiscal 2017, the effective tax rate was impacted by discrete net income tax charges of $19.9 million related to the Act, primarily associated with the one-time deemed repatriation tax on accumulated foreign earnings, and discrete non-cash income tax charges of $10.6 million related to new share-based compensation accounting standards that went into effect in Fiscal 2017. Excluding the tax effect of items presented above under “Operating Income,” and charges related to the Act of $19.9 million, the adjusted non-GAAP effective tax rate was 42.3% for Fiscal 2017 compared to 98.0% for Fiscal 2016.
For Fiscal 2016, the effective tax rate was 321.9% as compared to 29.4% for Fiscal 2015. Excluding the tax effect of items presented above under “Operating Income,” the adjusted non-GAAP effective tax rate was 98.0% for Fiscal 2016 compared to 31.5% for Fiscal 2015. The effective tax rate and the adjusted non-GAAP effective tax rate for Fiscal 2016 reflect a benefit of $4.5 million related to the realization of foreign currency losses and a discrete benefit of $2.4 million related to a tax regulatory change, as well as the impact of jurisdictional mix on low absolute levels of income. In Fiscal 2015, the effective tax rate and the adjusted non-GAAP effective tax rate reflect discrete benefits of $7.4 million and $5.4 million, respectively, related to a release of a valuation allowance and other discrete tax items.
As of February 3, 2018, the Company had approximately $61.4 million in net deferred tax assets, which included approximately $13.3 million and $13.8 million of net deferred tax assets in Japan and the United Kingdom, respectively. As of January 28, 2017, the Company had approximately $90.4 million in net deferred tax assets, which included approximately $13.5 million and $11.3 million of net deferred tax assets in Japan and Switzerland, respectively. The realization of the net deferred tax assets will depend upon the future generation of sufficient taxable profits in these jurisdictions. While the Company believes it is more likely than not that the net deferred tax assets will be realized, it is not certain. Should circumstances change, the net deferred tax assets may become subject to a valuation allowance in the future. Additional valuation allowances would result in additional tax expense.
Refer to Note 10, “INCOME TAXES,” of the Notes to Consolidated Financial Statements included in “ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA” of this Annual Report on Form 10-K, for further discussion.
Net Income and Net Income per Diluted Share Attributable to A&F
(1)
Excludes items presented above under “Operating Income,” and “Income Tax Expense (Benefit).”
LIQUIDITY AND CAPITAL RESOURCES
HISTORICAL SOURCES AND USES OF CASH
Seasonality of Cash Flows
The Company’s business has two principal selling seasons: the Spring season, which includes the first and second fiscal quarters (“Spring”), and the Fall season, which includes the third and fourth fiscal quarters (“Fall”). As is typical in the apparel industry, the Company experiences its greatest sales activity during the Fall season due to Back-to-School and Back-to-Fall sales periods for Hollister and Abercrombie, respectively, and the holiday sales periods. The Company relies on excess operating cash flows, which are largely generated in the Fall season, to fund operations throughout the fiscal year and to reinvest in the business to support future growth. The Company also has an asset-based revolving credit facility available as a source of additional funding.
Credit Facilities
On August 7, 2014, A&F, through its subsidiary Abercrombie & Fitch Management Co. (“A&F Management”) as the lead borrower (with A&F and certain other subsidiaries as borrowers or guarantors), entered into an asset-based revolving credit agreement.
As of October 19, 2017, the Company, through A&F Management, entered into a Second Amendment to Credit Agreement (the “ABL Second Amendment”), amending and extending the maturity date of the asset-based revolving credit agreement. As amended, the asset-based revolving credit agreement continues to provide for a senior secured revolving credit facility of up to $400 million (the “Amended ABL Facility”).
As of February 3, 2018, the borrowing base on the Amended ABL Facility was $261.2 million.
The Company uses, in the ordinary course of business, stand-by letters of credit under the existing Amended ABL Facility. As of March 28, 2018 and February 3, 2018, the Company had not drawn on the Amended ABL Facility, but had approximately $1.1 million and $1.9 million of outstanding stand-by letters of credit under the Amended ABL Facility, respectively. The Company has no other off-balance sheet arrangements.
A&F, through its subsidiary A&F Management as the borrower (with A&F and certain other subsidiaries as guarantors), also entered into a term loan agreement on August 7, 2014, which provides for a term loan facility of $300 million (the “Term Loan Facility” and, together with the Amended ABL Facility, the “Credit Facilities”).
The Credit Facilities are further described in Note 11, “BORROWINGS,” of the Notes to the Consolidated Financial Statements included in “ITEM 8. FINANCIAL STATEMENT AND SUPPLEMENTARY DATA,” of this Annual Report on Form 10-K.
Operating Activities
For Fiscal 2017, net cash provided by operating activities was $285.7 million as compared to $185.3 million for Fiscal 2016. The year-over-year increase in net cash provided by operating activities for Fiscal 2017 as compared to Fiscal 2016 was primarily driven by higher cash receipts from increased net sales, refunds received from prior year tax returns and a year-over-year decrease in incentive compensation payments, partially offset by increased payments to vendors, including the impact of incremental payments made due to the additional week in Fiscal 2017, and a year-over-year decrease in long-term lease deposits returned.
For Fiscal 2016, net cash provided by operating activities was $185.3 million as compared to $310.0 million for Fiscal 2015. The year-over-year decrease in net cash provided by operating activities for Fiscal 2016 as compared to Fiscal 2015 was primarily driven by lower net income, adjusted for non-cash items, the extension of vendor payment terms in the second quarter of Fiscal 2015 and incentive compensation payments in the first quarter of Fiscal 2016, partially offset by the return of long-term lease deposits of $26.6 million and a $25.1 million decrease in cash paid for income taxes.
Investing Activities
For Fiscal 2017, Fiscal 2016 and Fiscal 2015, cash outflows for investing activities were used primarily for store updates and new store construction, direct-to-consumer and omnichannel capabilities and information technology investments. Fiscal 2015 cash investing activities also included proceeds from the sale of a Company-owned aircraft.
Financing Activities
For Fiscal 2017, cash outflows for financing activities consisted primarily of the payment of dividends of $54.4 million and the repayment of borrowings of $15.0 million. For Fiscal 2016, cash outflows for financing activities consisted primarily of the payment of dividends of $54.1 million and the repayment of borrowings of $25.0 million. For Fiscal 2015, cash outflows for financing activities consisted primarily of the payment of dividends of $55.1 million, the repurchase of approximately 2.5 million shares of A&F’s Common Stock in the open market with a market value of approximately $50.0 million and the repayment of borrowings of $6.0 million.
FUTURE CASH REQUIREMENTS AND SOURCES OF CASH
The Company’s capital allocation strategy remains to prioritize investments in the business to build on the foundation for sustainable long-term growth. These investments include the continued development of highly differentiated brand offerings and staying at the forefront of customer engagement. In addition, the Company prioritizes returning cash to stockholders through dividends and share repurchases as appropriate. Capital allocation priorities and investments are reviewed by the Company’s Board of Directors considering both liquidity and valuation factors.
To execute on these priorities, the Company relies on excess operating cash flows, which are largely generated in the Fall season, to fund operations throughout the fiscal year and to reinvest in the business to support future growth. The Company also has availability under the Amended ABL Facility as a source of additional funding. Over the next twelve months, the Company’s primary cash requirements will be to fund operating activities, including the acquisition of inventory, and obligations related to compensation, leases, taxes and other operating activities, as well as to fund capital expenditures, marketing initiatives, quarterly dividends to stockholders subject to approval by A&F’s Board of Directors and debt service, including voluntary repayments, or required repayments, if any, based on annual excess cash flows, as defined in the term loan agreement.
The Company may repurchase shares of its Common Stock and, if it were to do so, would anticipate funding such repurchases by utilizing free cash flow generated from operations or proceeds from the Amended ABL Facility. As of February 3, 2018, A&F had approximately 6.5 million remaining shares available for repurchase as part of the A&F Board of Directors’ previous authorization.
Income Taxes
On December 22, 2017, the Act was signed into law. The Act made changes to U.S. corporate income tax law and transitions U.S. international taxation to a modified territorial tax system, which resulted in the Company incurring a provisional, mandatory one-time repatriation tax charge of $21.7 million on accumulated previously deferred foreign earnings as of December 31, 2017. After the utilization of existing tax credits, the Company expects U.S. federal cash tax payments of approximately $10.6 million on the mandatory one-time deemed repatriation, payable over eight years.
As of February 3, 2018, certain foreign subsidiaries have lent approximately $267.4 million to certain U.S. subsidiaries resulting in $527.2 million of the Company’s $675.6 million of cash and cash equivalents being held by U.S. subsidiaries. The Company is not dependent on dividends from its foreign affiliates to fund its U.S. operations or pay dividends to A&F stockholders. As a result of the adoption of a modified territorial system under the Act, future earnings from foreign subsidiaries are generally not subject to additional federal tax upon repatriation. Additionally, if funds were to be legally repatriated to the U.S. it could have implications at the state and foreign levels. Because of the complexities associated with the Act, the Company has not fully concluded on its position with respect to reinvestment of foreign earnings and whether its existing international structure for the various jurisdictions is the optimal structure for the future, but expects to complete this assessment in Fiscal 2018. Refer to Note 10, “INCOME TAXES,” of the Notes to Consolidated Financial Statements included in “ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA,” for further discussion.
Capital Expenditures
Capital expenditures for Fiscal 2017, Fiscal 2016 and Fiscal 2015 were as follows:
The Company expects capital expenditures to be approximately $130 million for Fiscal 2018, prioritized towards store updates and new stores, as well as direct-to-consumer and omnichannel investments, information technology and other projects.
CONTRACTUAL OBLIGATIONS
As of February 3, 2018, the Company's contractual obligations were as follows:
(1)
Includes leasehold financing obligations of $50.7 million. Refer to Note 2, “SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES,” of the Notes to Consolidated Financial Statements included in “ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA” of this Annual Report on Form 10-K for additional information.
(2)
Includes asset retirement obligations, the Supplemental Executive Retirement Plan, tax payments associated with the provisional, mandatory one-time deemed repatriation tax on accumulated foreign earnings, net payable over eight years pursuant to the Act, and estimated interest payments on the Term Loan Facility based on the interest rate as of February 3, 2018 assuming normally scheduled principal payments. Refer to Note 16, “SAVINGS AND RETIREMENT PLANS,” and Note 10, “INCOME TAXES,” of the Notes to Consolidated Financial Statements included in “ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA” of this Annual Report on Form 10-K, for further discussion.
Operating lease obligations consist primarily of non-cancelable future minimum lease commitments related to store operating leases. Refer to Note 2, “SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--Leased facilities,” of the Notes to Consolidated Financial Statements included in “ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA” of this Annual Report on Form 10-K, for further discussion. Excluded from the obligations above are amounts related to the portions of lease terms that are currently cancelable at the Company’s discretion. While included in the obligations above, in many instances, the Company has options to terminate certain leases if stated sales volume levels are not met or the Company ceases operations in a given country. Operating lease obligations do not include common area maintenance (“CAM”), insurance, marketing or tax payments for which the Company is also obligated. Total expense related to CAM, insurance, marketing and taxes was $153.2 million in Fiscal 2017.
Long-term debt obligations consist of principal payments under the Term Loan Facility. Refer to Note 11, “BORROWINGS,” of the Notes to Consolidated Financial Statements included in “ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA” of this Annual Report on Form 10-K for additional information.
Purchase obligations primarily represents noncancelable purchase orders for merchandise to be delivered during Fiscal 2018 and commitments for fabric expected to be used during upcoming seasons. In addition, purchase obligations include agreements to purchase goods or services, including information technology contracts and third-party distribution center service contracts.
Due to uncertainty as to the amounts and timing of future payments, the contractual obligations table above does not include tax (including accrued interest and penalties) of $1.3 million related to uncertain tax positions at February 3, 2018. Deferred taxes are also not included in the preceding table. For further discussion, refer to Note 10, “INCOME TAXES,” of the Notes to Consolidated Financial Statements included in “ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA” of this Annual Report on Form 10-K.
The Company is a defendant in certain class action lawsuits and has signed a $25.0 million claims-made settlement agreement, subject to final court approval, related to certain legal matters. Due to the uncertainty regarding regarding the actual claims rate experience, court approvals and the terms of any approval by the court, this is not included in the contractual obligations table. Refer to Note 18, “CONTINGENCIES,” of the Notes to Consolidated Financial Statements included in “ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA” of this Annual Report on Form 10-K for further discussion.
A&F has historically paid quarterly dividends on its Common Stock. There are no amounts included in the above table related to dividends due to the fact that future dividends are subject to determination and approval by A&F’s Board of Directors.
RECENT ACCOUNTING PRONOUNCEMENTS
Refer to Note 2, “SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Recent accounting pronouncements,” of the Notes to the Consolidated Financial Statements included in “ITEM 8. FINANCIAL STATEMENT AND SUPPLEMENTARY DATA,” of this Annual Report on Form 10-K for recent accounting pronouncements, including the dates of adoption or expected dates of adoption, as applicable, and anticipated effects on the Company's Consolidated Financial Statements.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The Company’s discussion and analysis of its financial condition and results of operations are based upon the Company’s consolidated financial statements which have been prepared in accordance with GAAP. The preparation of these consolidated financial statements requires the Company to make estimates and assumptions that affect the reported amounts. Since actual results may differ from those estimates, the Company revises its estimates and assumptions as new information becomes available.
The Company believes the following policies are the most critical to the portrayal of the Company’s financial condition and results of operations.
Policy
Effect if Actual Results Differ from Assumptions
Revenue Recognition
The Company reserves for sales returns through estimates based on historical returns experience, recent sales activity and various other assumptions that management believes to be reasonable.
The Company has not made any material changes in the accounting methodology used to determine the sales return reserve over the past three fiscal years.
Income from gift cards is recognized at the earlier of redemption by the customer, as net sales, or when the Company determines that the likelihood of redemption is remote, referred to as gift card breakage, as other operating income. The Company determines the probability of gift card redemption based on historical redemption patterns.
The Company does not expect material changes to the underlying assumptions used to measure the sales return reserve or estimate gift card breakage and deferred revenue associated with loyalty programs as of February 3, 2018. However, actual results could vary from estimates and could result in material gains or losses.
The Company maintains loyalty programs in which customers primarily have the opportunity to earn points toward future merchandise discount rewards based on qualifying purchases. The Company will defer sales revenue equal to the relative selling price of the points issued to customers, taking into account expected future redemptions based on historical redemption patterns. Revenue associated with the issued points from the loyalty programs is recognized at the earlier of redemption or expiration, as net sales.
Inventory Valuation
The Company reviews inventories on a quarterly basis. The Company reduces the inventory valuation when the carrying cost of specific inventory items on hand exceeds the amount expected to be realized from the ultimate sale or disposal of the goods, through a lower of cost and net realizable value (“LCNRV”) adjustment.
The LCNRV adjustment reduces inventory to its net realizable value based on the Company’s consideration of multiple factors and assumptions, including demand forecasts, current sales volumes, expected sell-off activity, composition and aging of inventory, historical recoverability experience and risk of obsolescence from changes in economic conditions or customer preferences.
The Company does not expect material changes to the underlying assumptions used to measure the LCNRV or shrink reserve as of February 3, 2018. However, actual results could vary from estimates and could significantly impact the ending inventory valuation at cost, as well as gross margin.
An increase or decrease in the LCNRV adjustment of 10% would have affected pre-tax income by approximately $1.3 million for Fiscal 2017.
Additionally, as part of inventory valuation, an inventory shrink estimate is made each quarter that reduces the value of inventory for lost or stolen items, based on sales volumes, average unit costs, historical losses and actual shrink results from previous physical inventories.
An increase or decrease in the inventory shrink estimate of 10% would have affected pre-tax income by approximately $0.9 million for Fiscal 2017.
Policy
Effect if Actual Results Differ from Assumptions
Long-lived Assets
Long-lived assets, primarily leasehold improvements, furniture, fixtures and equipment, are tested for recoverability whenever events or changes in circumstances indicate that the carrying amount of the long-lived asset group might not be recoverable. These include, but are not limited to, material declines in operational performance, a history of losses, an expectation of future losses, adverse market conditions and store closure or relocation decisions. On at least a quarterly basis, the Company reviews for indicators of impairment at the individual store level, the lowest level for which cash flows are identifiable.
Impairment loss calculations involve uncertainty due to the nature of the assumptions that management is required to make, including estimating projected cash flows and selecting the discount rate that best reflects the risk inherent in future cash flows. If actual results are not consistent with the estimates and assumptions used, there may be a material impact on the Company’s financial condition or results of operation.
As of February 3, 2018, stores that were tested for impairment and not impaired had a net book value of $46.2 million and had undiscounted cash flows which were in the range of 100% to 150% of their respective net asset values.
Stores that display an indicator of impairment are subjected to an impairment assessment. The Company’s impairment assessment requires management to make assumptions and judgments related, but not limited, to management’s expectations for future operations and projected cash flows. The key assumptions used in the Company’s undiscounted future cash flow models include sales, gross profit and, to a lesser extent, operating expenses.
An impairment loss may be recognized when these undiscounted future cash flows are less than the carrying amount of the asset group. In the circumstance of impairment, any loss would be measured as the excess of the carrying amount of the asset group over its fair value. The key assumptions used in estimating the fair value of impaired assets may include projected store cash flows or market data.
For stores assessed by management as having indicators of impairment, a 10% decrease in the sales assumption used to project future cash flows for the fair value estimates as of February 3, 2018 would have increased the Fiscal 2017 impairment charge by $10.2 million.
Income Taxes
The provision for income taxes is determined using the asset and liability approach. Tax laws often require items to be included in tax filings at different times than the items are being reflected in the financial statements. A current liability is recognized for the estimated taxes payable for the current year. Deferred taxes represent the future tax consequences expected to occur when the reported amounts of assets and liabilities are recovered or paid. Deferred taxes are adjusted for enacted changes in tax rates and tax laws. Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not that a tax benefit will not be realized.
On December 22, 2017, the Act was signed into law and the Company recorded in the fourth quarter provisional charges in the fourth quarter of Fiscal 2017 of $21. 7 million related to the mandatory, one-time deemed repatriation tax on accumulated undistributed foreign subsidiary earnings and profits and $3.8 million as a result of a revaluation of the Company’s deferred tax asset and liabilities. The ultimate outcome may differ from these provisional amounts, possibly materially, due to, among other things, additional analysis, changes in interpretations and assumptions the Company has made, additional regulatory guidance that may be issued and actions the Company may take as a result of the Act.
Legal Contingencies
The Company is a defendant in lawsuits and other adversarial proceedings arising in the ordinary course of business. Legal costs incurred in connection with the resolution of claims and lawsuits are expensed as incurred, and the Company establishes estimated liabilities for the outcome of litigation where it is probable that a loss has been incurred and such loss is reasonably estimable. For probable losses, the Company accrues to the low end of an estimated range of loss, unless another amount within the range is determined to be more likely. Significant judgment may be applied in assessing the probability of loss and in estimating the amount of such loss.
Actual liabilities may differ from the amounts recorded, and there can be no assurance that the final resolution of these matters will not have a material adverse effect on the Company’s financial condition, results of operations or cash flows.
ITEM 7A.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Investment Securities
The Company maintains its cash equivalents in financial instruments, primarily money market funds, with original maturities of three months or less.
Refer to Note 6, “RABBI TRUST ASSETS,” for a discussion of the Company’s Rabbi Trust assets.
Interest Rate Risks
The Company has approximately $253.3 million in gross borrowings outstanding under its term loan facility (the “Term Loan Facility”) and no borrowings outstanding under its senior secured revolving credit facility (the “Amended ABL Facility” and, together with the Term Loan Facility, the “Credit Facilities”). The Credit Facilities carry interest rates that are tied to LIBOR, or an alternate base rate, plus a margin. The interest rate on the Term Loan Facility has a 100 basis point LIBOR floor, and assuming no changes in the Company’s financial structure as it stands, an increase in market interest rates of 100 basis points would increase annual interest expense by approximately $2.6 million. This hypothetical analysis for Fiscal 2017 may differ from the actual change in interest expense due to potential changes in interest rates or gross borrowings outstanding under the Company’s Credit Facilities.
Foreign Currency Exchange Rate Risk
A&F’s international subsidiaries generally operate with functional currencies other than the U.S. Dollar. Since the Company’s Consolidated Financial Statements are presented in U.S. Dollars, the Company must translate all components of these financial statements from functional currencies into U.S. Dollars at exchange rates in effect during or at the end of the reporting period. The fluctuation in the value of the U.S. Dollar against other currencies affects the reported amounts of revenues, expenses, assets and liabilities. The potential impact of foreign currency exchange rate fluctuation increases as international operations relative to domestic operations increase.
A&F and its subsidiaries have exposure to changes in foreign currency exchange rates associated with foreign currency transactions and forecasted foreign currency transactions, including the sale of inventory between subsidiaries and foreign currency denominated assets and liabilities. The Company has established a program that primarily utilizes foreign currency exchange forward contracts to partially offset the risks associated with the effects of certain foreign currency transactions and forecasted transactions. Under this program, increases or decreases in foreign currency exposures are partially offset by gains or losses on forward contracts, to mitigate the impact of foreign currency gains or losses. The Company does not use forward contracts to engage in currency speculation. All outstanding foreign currency exchange forward contracts are recorded at fair value at the end of each fiscal period.
The fair value of outstanding foreign currency exchange forward contracts included in other current assets was insignificant as of February 3, 2018 and was $6.0 million as of January 28, 2017. The fair value of outstanding foreign currency exchange forward contracts included in other liabilities was $9.1 million as of February 3, 2018 and insignificant as of January 28, 2017. Foreign currency exchange forward contracts are sensitive to changes in foreign currency exchange rates. The Company assessed the risk of loss in fair values from the effect of a hypothetical 10% devaluation of the U.S. Dollar against the exchange rates for foreign currencies under contract. The results would decrease derivative contract fair values by approximately $16.6 million. As the Company’s foreign currency exchange forward contracts are primarily designated as cash flow hedges of forecasted transactions, the hypothetical change in fair value would be more than offset by the net change in fair values of the underlying hedged items.
Refer to “ITEM 1A. RISK FACTORS,” for further discussion.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
ABERCROMBIE & FITCH CO.
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
(Thousands, except per share amounts)
The accompanying Notes are an integral part of these Consolidated Financial Statements.
ABERCROMBIE & FITCH CO.
CONSOLIDATED BALANCE SHEETS
(Thousands, except par value amounts)
The accompanying Notes are an integral part of these Consolidated Financial Statements.
ABERCROMBIE & FITCH CO.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(Thousands, except per share amounts)
The accompanying Notes are an integral part of these Consolidated Financial Statements.
ABERCROMBIE & FITCH CO.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Thousands)
The accompanying Notes are an integral part of these Consolidated Financial Statements.
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. NATURE OF BUSINESS
Abercrombie & Fitch Co. (“A&F”), a company incorporated in Delaware in 1996, through its subsidiaries (collectively, A&F and its subsidiaries are referred to as “Abercrombie & Fitch” or the “Company”), is a global, multi-brand specialty retailer, which primarily sells its products through its wholly-owned store and direct-to-consumer channels, as well as through various third-party wholesale, franchise and licensing arrangements. The Company offers a broad assortment of apparel, personal care products and accessories for men, women and kids under the Hollister, Abercrombie & Fitch and abercrombie kids brands. The brands share a commitment to offering products of enduring quality and exceptional comfort that allows customers around the world to express their own individuality and style. The Company has operations in North America, Europe, Asia and the Middle East.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of consolidation
The accompanying Consolidated Financial Statements include historical financial statements of, and transactions applicable to, the Company and reflect its assets, liabilities, results of operations and cash flows.
The Company has interests in a United Arab Emirates business venture and in a Kuwait business venture with Majid al Futtaim Fashion L.L.C. (“MAF”), each of which meets the definition of a variable interest entity (“VIE”). The Company is deemed to be the primary beneficiary of these VIEs; therefore, the Company has consolidated the operating results, assets and liabilities of these VIEs, with MAF’s portion of net income presented as net income attributable to noncontrolling interests (“NCI”) on the Consolidated Statements of Operations and Comprehensive Income (Loss) and MAF’s portion of equity presented as NCI in the Consolidated Balance Sheets.
Fiscal year
The Company’s fiscal year ends on the Saturday closest to January 31. All references herein to the Company’s fiscal years are as follows:
Use of estimates
The preparation of financial statements, in conformity with GAAP, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of net sales and expenses during the reporting period. Due to the inherent uncertainty involved with estimates, actual results may differ.
Cash and equivalents
Cash and equivalents on the Consolidated Balance Sheets include amounts on deposit with financial institutions, U.S. treasury bills and other investments, primarily held in money market accounts, with original maturities of less than three months.
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Receivables
Receivables on the Consolidated Balance Sheets primarily include credit card receivables, construction allowances, value added tax (“VAT”) receivables, trade receivables, income tax receivables and other tax credits or refunds.
As part of the normal course of business, the Company has approximately three to four days of proceeds from sales transactions outstanding with its third-party credit card vendors at any point. The Company classifies these outstanding balances as credit card receivables. Construction allowances are recorded for certain store lease agreements for improvements completed by the Company. VAT receivables are payments the Company has made on purchases of goods that will be recovered as those goods are sold. Trade receivables are amounts billed by the Company to wholesale, franchise and licensing partners in the ordinary course of business. Income tax receivables represent refunds of certain tax payments along with net operating loss and credit carryback claims for which the Company expects to receive refunds within the next 12 months.
Inventories
Inventories on the Consolidated Balance Sheets are valued at the lower of cost and net realizable value on a weighted-average cost basis. The Company reduces the carrying value of inventory through a lower of cost and net realizable value adjustment, the impact of which is reflected in cost of sales, exclusive of depreciation and amortization, on the Consolidated Statements of Operations and Comprehensive Income (Loss). The lower of cost and net realizable value adjustment is based on the Company’s consideration of multiple factors and assumptions including demand forecasts, current sales volumes, expected sell-off activity, composition and aging of inventory, historical recoverability experience and risk of obsolescence from changes in economic conditions or customer preferences.
Additionally, as part of inventory valuation, inventory shrinkage estimates based on historical trends from actual physical inventories are made each quarter that reduce the inventory value for lost or stolen items. The Company performs physical inventories on a periodic basis and adjusts the shrink estimate accordingly. Refer to Note 4, “INVENTORIES.”
Other current assets
Other current assets on the Consolidated Balance Sheets include prepaid rent, current store supplies, derivative contracts and other prepaids.
Property and equipment, net
Depreciation of property and equipment is computed for financial reporting purposes on a straight-line basis using the following service lives:
Leasehold improvements are amortized over either their respective lease terms or their service lives, whichever is shorter. The cost of assets sold or retired and the related accumulated depreciation are removed from the accounts with any resulting gain or loss included in net income on the Consolidated Statements of Operations and Comprehensive Income (Loss). Maintenance and repairs are charged to expense as incurred. Major remodels and improvements that extend the service lives of the related assets are capitalized.
Long-lived assets, primarily leasehold improvements, furniture, fixtures and equipment, are tested for recoverability whenever events or changes in circumstances indicate that the carrying amount of the long-lived asset group might not be recoverable. These include, but are not limited to, material declines in operational performance, a history of losses, an expectation of future losses, adverse market conditions and store closure or relocation decisions. On at least a quarterly basis, the Company reviews for indicators of impairment at the individual store level, the lowest level for which cash flows are identifiable.
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Stores that display an indicator of impairment are subjected to an impairment assessment. The Company’s impairment assessment requires management to make assumptions and judgments related, but not limited, to management’s expectations for future operations and projected cash flows. The key assumptions used in the Company’s undiscounted future cash flow models include sales, gross profit and, to a lesser extent, operating expenses.
An impairment loss may be recognized when these undiscounted future cash flows are less than the carrying amount of the asset group. In the circumstance of impairment, any loss would be measured as the excess of the carrying amount of the asset group over its fair value. Fair value of the Company’s store-related assets is determined at the individual store level, often using a discounted cash flow model that utilizes Level 3 inputs. The key assumptions used in estimating the fair value of impaired assets may include projected store cash flows or market data. In instances where the discounted cash flow analysis indicates a negative value at the store level, the market exit price based on historical experience, and other comparable market data where applicable, is used to determine the fair value by asset type.
The Company capitalizes certain direct costs associated with the development and purchase of internal-use software within property and equipment. Capitalized costs are amortized on a straight-line basis over the estimated useful lives of the software, generally not exceeding seven years.
Refer to Note 5, “PROPERTY AND EQUIPMENT, NET.”
Restricted cash
Cash that is legally restricted from use is recorded in other assets on the Consolidated Balance Sheets. Restricted cash includes various cash deposits with international banks that are used as collateral for customary non-debt banking commitments and deposits into trust accounts to conform to standard insurance security requirements.
Income taxes
Income taxes are calculated using the asset and liability method. Deferred tax assets and liabilities are recognized based on the difference between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using current enacted tax rates in effect for the years in which those temporary differences are expected to reverse. Inherent in the determination of the Company’s income tax liability and related deferred income tax balances are certain judgments and interpretations of enacted tax law and published guidance with respect to applicability to the Company’s operations. The Company is subject to audit by taxing authorities, usually several years after tax returns have been filed, and the taxing authorities may have differing interpretations of tax laws. Valuation allowances are established to reduce deferred tax assets to the amount expected to be realized when it is more likely than not that some portion or all of the deferred tax assets will not be realized.
The Company records tax expense or benefit that does not relate to ordinary income in the current fiscal year discretely in the period in which it occurs. Examples of such types of discrete items include, but are not limited to: changes in estimates of the outcome of tax matters related to prior years, assessments of valuation allowances, return-to-provision adjustments, tax-exempt income, the settlement of tax audits and changes in tax legislation and/or regulations.
Tax benefits from uncertain tax positions are recognized when it is more likely than not that the position will be sustained upon examination, including resolutions of any related appeals or litigation processes, based on the technical merits. The amount recognized is measured as the largest amount of tax benefit that is greater than 50 percent likely of being realized upon settlement. The Company’s effective tax rate includes the impact of reserve provisions and changes to reserves on uncertain tax positions that are not more likely than not to be sustained upon examination as well as related interest and penalties.
A number of years may elapse before a particular matter, for which the Company has established a reserve, is audited and finally resolved. The number of years with open tax audits varies depending on the tax jurisdiction. While it is often difficult to predict the final outcome or the timing of resolution of any particular tax matter, the Company believes that its reserves reflect the probable outcome of known tax contingencies. Unfavorable settlement of any particular issue may require use of the Company’s cash. Favorable resolution would be recognized as a reduction to the Company’s effective tax rate in the period of resolution.
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Company recognizes accrued interest and penalties related to uncertain tax positions as a component of income tax expense on the Consolidated Statements of Operations and Comprehensive Income (Loss).
Refer to Note 10, “INCOME TAXES.”
Foreign currency translation and transactions
The functional currencies of the Company’s foreign subsidiaries are generally the respective local currencies in the countries in which they operate. Assets and liabilities denominated in foreign currencies are translated into U.S. Dollars (the reporting currency) at the exchange rate prevailing at the balance sheet date. Equity accounts denominated in foreign currencies are translated into U.S. Dollars at historical exchange rates. Revenues and expenses denominated in foreign currencies are translated into U.S. Dollars at the monthly average exchange rate for the period. Gains and losses resulting from foreign currency transactions are included in other operating income, net; whereas, translation adjustments and gains and losses associated with measuring inter-company loans of a long-term investment nature are reported as an element of Other comprehensive income (loss).
Derivative instruments
The Company is exposed to risks associated with changes in foreign currency exchange rates and uses derivative instruments, primarily forward contracts, to manage the financial impacts of these exposures. The Company does not use forward contracts to engage in currency speculation and does not enter into derivative financial instruments for trading purposes.
In order to qualify for hedge accounting treatment, a derivative instrument must be considered highly effective at offsetting changes in either the hedged item’s cash flows or fair value. Additionally, the hedge relationship must be documented to include the risk management objective and strategy, the hedging instrument, the hedged item, the risk exposure, and how hedge effectiveness will be assessed prospectively and retrospectively. The extent to which a hedging instrument has been, and is expected to continue to be, effective at offsetting changes in fair value or cash flows is assessed and documented at least quarterly. Any hedge ineffectiveness is reported in current period earnings and hedge accounting is discontinued if it is determined that the derivative instrument is not highly effective.
For derivative instruments that either do not qualify for hedge accounting or are not designated as hedges, all changes in the fair value of the derivative instrument are recognized in earnings. For qualifying cash flow hedges, the effective portion of the change in the fair value of the derivative instrument is recorded as a component of other comprehensive income (loss) (“OCI”) and recognized in earnings when the hedged cash flows affect earnings. The ineffective portion of the derivative instrument gain or loss is recognized in current period earnings. The effectiveness of the hedge is assessed based on changes in the fair value attributable to changes in spot prices. The changes in the fair value of the derivative instrument related to the changes in the difference between the spot price and the forward price are excluded from the assessment of hedge effectiveness and are also recognized in current period earnings. If the cash flow hedge relationship is terminated, the derivative instrument gains or losses that are deferred in OCI will be recognized in earnings when the hedged cash flows occur. However, for cash flow hedges that are terminated because the forecasted transaction is not expected to occur in the original specified time period, or a two-month period thereafter, the derivative instrument gains or losses are immediately recognized in earnings.
The Company uses derivative instruments, primarily forward contracts designated as cash flow hedges, to hedge the foreign currency exchange rate exposure associated with forecasted foreign-currency-denominated intercompany inventory sales to foreign subsidiaries and the related settlement of the foreign-currency-denominated intercompany receivables. Fluctuations in exchange rates will either increase or decrease the Company’s intercompany equivalent cash flows and affect the Company’s U.S. Dollar earnings. Gains or losses on the foreign currency exchange forward contracts that are used to hedge these exposures are expected to partially offset this variability. Foreign currency exchange forward contracts represent agreements to exchange the currency of one country for the currency of another country at an agreed upon settlement date. These forward contracts typically have a maximum term of twelve months. The sale of the inventory to the Company’s customers will result in the reclassification of related derivative gains and losses that are reported in accumulated other comprehensive loss (“AOCL”) on the Consolidated Balance Sheets. Substantially all of the unrealized gains or losses related to designated cash flow hedges as of February 3, 2018 will be recognized in cost of sales, exclusive of depreciation and amortization, on the Consolidated Statements of Operations and Comprehensive Income (Loss) over the next twelve months.
The Company presents its derivative assets and derivative liabilities at their gross fair values on the Consolidated Balance Sheets. However, the Company’s derivative contracts allow net settlements under certain conditions.
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Company also uses foreign currency exchange forward contracts to hedge certain foreign-currency-denominated net monetary assets/liabilities. Examples of monetary assets/liabilities include cash balances, receivables and payables. Fluctuations in foreign currency exchange rates result in transaction gains/(losses) being recorded in earnings as U.S. GAAP requires that monetary assets/liabilities be remeasured at the spot exchange rate at quarter-end or upon settlement. The Company has chosen not to apply hedge accounting to these instruments because there are no differences in the timing of gain or loss recognition on the hedging instruments and the hedged items.
Refer to Note 14, “DERIVATIVE INSTRUMENTS.”
Stockholders’ equity
As of February 3, 2018 and January 28, 2017, there were 150.0 million shares of A&F’s Class A Common Stock (the “Common Stock”), $0.01 par value, authorized, of which 68.2 million shares and 67.8 million shares were outstanding as of February 3, 2018 and January 28, 2017, respectively, and 106.4 million shares of Class B Common Stock, $0.01 par value, authorized, of which none were outstanding as of February 3, 2018 and January 28, 2017.
Holders of Class A Common Stock generally have identical rights to holders of Class B Common Stock, except holders of Class A Common Stock are entitled to one vote per share while holders of Class B Common Stock are entitled to three votes per share on all matters submitted to a vote of stockholders.
Revenue recognition
The Company recognizes sales at the time the customer takes possession of the merchandise. Amounts relating to shipping and handling billed to customers in a sale transaction are classified as net sales and the related direct shipping and handling costs are classified as stores and distribution expense on the Consolidated Statements of Operations and Comprehensive Income (Loss). Sales are recorded net of an allowance for estimated returns, associate discounts, and promotions and other similar customer incentives. The Company estimates reserves for sales returns based on historical experience. The sales return reserve is classified within accrued expenses on the Consolidated Balance Sheets.
The Company sells gift cards in its stores and through direct-to-consumer operations. The Company accounts for gift cards sold to customers by recognizing a liability at the time of sale. Gift cards sold to customers do not expire or lose value over periods of inactivity. The gift card liability remains until the Company recognizes income from gift cards. Income from gift cards is recognized at the earlier of redemption by the customer, as net sales, or when the Company determines that the likelihood of redemption is remote, referred to as gift card breakage, as other operating income on the Consolidated Statements of Operations and Comprehensive Income (Loss). The Company determines the probability of the gift card being redeemed to be remote based on historical redemption patterns and is not required by law to escheat the value of unredeemed gift cards to the jurisdictions in which it operates. The gift card liability is classified within accrued expenses on the Consolidated Balance Sheets.
The Company maintains loyalty programs for both Hollister and Abercrombie in which customers primarily have the opportunity to earn points toward future merchandise discount rewards based on qualifying purchases. Upon reaching certain point thresholds, customers are issued a reward, which they may redeem for future merchandise discounts both in-store or online. Generally, rewards expire after 90 days from the date of issuance. The Company will defer sales revenue equal to the relative selling price of the points earned in the qualifying transaction, taking into account expected future redemptions. This deferred revenue liability is classified within accrued expenses on the Consolidated Balance Sheets and is recognized at the earlier of redemption or expiration. All redemptions of rewards are treated as a reduction in the future transaction price within net sales on the Consolidated Statements of Operations and Comprehensive Income (Loss).
The Company’s revenue under wholesale arrangements is generally recognized at the time ownership passes to the partner. Under franchise and license arrangements, revenue generally consists of royalties earned upon sale of merchandise by franchise and license partners to retail customers.
The Company does not include tax amounts collected from customers in net sales.
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Cost of sales, exclusive of depreciation and amortization
Cost of sales, exclusive of depreciation and amortization on the Consolidated Statements of Operations and Comprehensive Income (Loss), primarily consists of cost incurred to ready inventory for sale, including product costs, freight, and import cost, as well as provisions for reserves for shrink and lower of cost and net realizable value. Gains and losses associated with the effective portion of designated foreign currency exchange forward contracts related to the hedging of inventory purchases are also recognized in cost of sales, exclusive of depreciation and amortization, on the Consolidated Statements of Operations and Comprehensive Income (Loss) when the inventory being hedged is sold.
Costs incurred to physically move product to stores is recorded in cost of sales, exclusive of depreciation and amortization, on the Consolidated Statements of Operations and Comprehensive Income (Loss).
The Company’s cost of sales, exclusive of depreciation and amortization, and consequently gross profit, may not be comparable to that of other retailers, as inclusion of certain costs vary across the industry. Some retailers include all costs related to buying, design and distribution operations in cost of sales, while others may include either all or a portion of these costs in selling, general and administrative expenses.
Stores and distribution expense
Stores and distribution expense on the Consolidated Statements of Operations and Comprehensive Income (Loss) includes: store payroll; store management, rent, utilities and other landlord expenses; depreciation and amortization, except for those amounts included in marketing, general and administrative expense; repairs and maintenance and other store support functions; direct-to-consumer expense; and distribution center (“DC”) expense.
Shipping and handling costs, including costs incurred to store, move and prepare product for shipment, and costs incurred to physically move product to customers, associated with direct-to-consumer operations, were $150.7 million, $125.4 million and $115.0 million for Fiscal 2017, Fiscal 2016 and Fiscal 2015, respectively. Handling costs, including costs incurred to store, move and prepare product for shipment to stores, were $38.6 million, $41.5 million and $44.5 million for Fiscal 2017, Fiscal 2016 and Fiscal 2015, respectively. These amounts are recorded in stores and distribution expense on the Consolidated Statements of Operations and Comprehensive Income (Loss).
Pre-opening expenses related to new store openings are expensed as incurred and are reflected as a component of stores and distribution expense on the Consolidated Statements of Operations and Comprehensive Income (Loss).
Marketing, general and administrative expense
Marketing, general and administrative expense on the Consolidated Statements of Operations and Comprehensive Income (Loss) includes: home office compensation, except for those departments included in stores and distribution expense; photography and social media; store marketing; information technology; outside services, such as legal and consulting; depreciation and amortization related to home office assets and trademark assets, respectively; relocation; recruiting; and travel expenses.
Costs to design and develop the Company’s merchandise are expensed as incurred and are reflected as a component of marketing, general and administrative expense on the Consolidated Statements of Operations and Comprehensive Income (Loss).
Other operating income, net
Other operating income, net on the Consolidated Statements of Operations and Comprehensive Income (Loss) primarily consists of gains and losses resulting from foreign currency denominated transactions and gift card breakage. Foreign currency denominated transactions resulted in a gain of $7.0 million for Fiscal 2017, a gain of $0.4 million for Fiscal 2016 and a loss of $1.5 million for Fiscal 2015. Gift card breakage was $6.4 million, $10.3 million and $4.7 million for Fiscal 2017, Fiscal 2016 and Fiscal 2015, respectively. For Fiscal 2016, other operating income, net included a $12.3 million gain, in connection with a settlement of certain economic loss claims associated with the April 2010 Deepwater Horizon oil spill. For Fiscal 2015, other operating income, net included income of $2.2 million related to insurance recoveries.
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Advertising costs
Advertising costs primarily consists of paid media advertising, direct digital advertising, including e-mail distribution, digital content and in-store photography and signage, and are reported on the Consolidated Statements of Operations and Comprehensive Income (Loss). Advertising costs related specifically to direct-to-consumer operations are expensed as incurred as a component of stores and distribution expense. The production of in-store photography and signage are expensed when the marketing campaign commences and all other advertising costs are expensed as incurred as components of marketing, general and administrative expense. The Company recognized $116.5 million, $110.1 million and $80.7 million in advertising expense in Fiscal 2017, Fiscal 2016 and Fiscal 2015, respectively.
Leased facilities
The Company leases property for its stores under operating leases. Lease agreements may contain construction allowances, rent escalation clauses and, in some instances, contingent rent provisions.
Annual store rent consists of a fixed minimum amount and, in some instances, contingent rent based on sales performance. For construction allowances, the Company records a deferred lease credit on the Consolidated Balance Sheets and amortizes the deferred lease credit as a reduction of rent expense on the Consolidated Statements of Operations and Comprehensive Income (Loss) over the term of the lease. For scheduled rent escalation clauses during the lease term, the Company records minimum rental expense on a straight-line basis over the term of the lease on the Consolidated Statements of Operations and Comprehensive Income (Loss). The difference between rent expense and the amounts paid under the lease, less amounts attributable to the repayment of construction allowances recorded as deferred rent, is included in accrued expenses and other liabilities on the Consolidated Balance Sheets. The term over which the Company amortizes construction allowances and minimum rental expenses on a straight-line basis begins on the date of initial possession, which is generally when the Company enters the space and begins construction.
For certain leases that provide for contingent rents, the Company records a contingent rent liability in accrued expenses on the Consolidated Balance Sheets, and the corresponding rent expense on the Consolidated Statements of Operations and Comprehensive Income (Loss) on a ratable basis over the measurement period when it is determined that achieving the specified levels during the fiscal year is probable. In addition, most leases require payment of real estate taxes, insurance and certain common area maintenance costs in addition to future minimum lease payments.
A summary of rent expense follows:
(1)
Includes lease termination fees of $2.0 million, $15.5 million and $3.3 million for Fiscal 2017, Fiscal 2016 and Fiscal 2015, respectively. Fiscal 2015 includes a benefit of $1.6 million related to better than expected lease exit terms associated with the closure of the Gilly Hicks stand-alone stores.
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
At February 3, 2018, the Company was committed to noncancelable leases with remaining terms of less than one year to 13 years. Excluded from the obligations below are portions of lease terms that are currently cancelable at the Company’s discretion without condition. While included in the obligations below, in many instances the Company has options to terminate certain leases if stated sales volume levels are not met or the Company ceases operations in a given country, which may be subject to lease termination policies. A summary of operating lease commitments, including leasehold financing obligations, under noncancelable leases follows:
Leasehold financing obligations
In certain lease arrangements, the Company is involved in the construction of a building and is deemed to be the owner of the construction project. In those instances, the Company records an asset for the amount of the total project costs, including the portion funded by the landlord, and an amount related to the value attributed to the pre-existing leased building in property and equipment, net, and a corresponding financing obligation in leasehold financing obligations, on the Consolidated Balance Sheets. Once construction is complete, if it is determined that the asset does not qualify for sale-leaseback accounting treatment, the Company continues to amortize the obligation over the lease term and depreciates the asset over its useful life. The Company allocates a portion of its rent obligation to the assets which are owned for accounting purposes as a reduction of the financing obligation and interest expense. As of February 3, 2018 and January 28, 2017, the Company had $50.7 million and $46.4 million, respectively, of long-term liabilities related to leasehold financing obligations. Total interest expense related to landlord financing obligations was $5.5 million, $5.7 million and $5.3 million for Fiscal 2017, Fiscal 2016 and Fiscal 2015, respectively.
Share-based compensation
The Company issues shares of Common Stock from treasury stock upon exercise of stock options and stock appreciation rights and vesting of restricted stock units, including those converted from performance share awards. As of February 3, 2018, the Company had sufficient treasury stock available to settle restricted stock units, stock appreciation rights and stock options outstanding. Settlement of stock awards in Common Stock also requires that the Company have sufficient shares available in stockholder-approved plans at the applicable time.
In the event, at each reporting date as of which share-based compensation awards remain outstanding, there are not sufficient shares of Common Stock available to be issued under the Abercrombie & Fitch Co. 2016 Long-Term Incentive Plan for Directors (as amended effective June 15, 2017, the “2016 Directors LTIP”) and the Abercrombie & Fitch Co. 2016 Long-Term Incentive Plan for Associates (as amended effective June 15, 2017, the “2016 Associates LTIP”), or under a successor or replacement plan, the Company may be required to designate some portion of the outstanding awards to be settled in cash, which would result in liability classification of such awards. The fair value of liability-classified awards would be re-measured each reporting date until such awards no longer remain outstanding or until sufficient shares of Common Stock become available to be issued under the existing plans or under a successor or replacement plan. As long as the awards are required to be classified as a liability, the change in fair value would be recognized in current period expense based on the requisite service period rendered.
Fair value of both service-based and performance-based restricted stock units is calculated using the market price of the underlying Common Stock on the date of grant reduced for anticipated dividend payments on unvested shares. In determining fair value, the Company does not take into account performance-based vesting requirements. Performance-based vesting requirements are taken into account in determining the number of awards expected to vest. For market-based restricted stock units, fair value is calculated using a Monte Carlo simulation with the number of shares that ultimately vest dependent on the Company’s total stockholder return measured against the total stockholder return of a select group of peer companies over a three-year period. For awards with performance-based or market-based vesting requirements, the number of shares that ultimately vest can vary from 0% to 200% of target depending on the level of achievement of performance criteria.
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Company estimates the fair value of stock appreciation rights using the Black-Scholes option-pricing model, which requires the Company to estimate the expected term of the stock appreciation rights and expected future stock price volatility over the expected term. Estimates of expected terms, which represent the expected periods of time the Company believes stock appreciation rights will be outstanding, are based on historical experience. Estimates of expected future stock price volatility are based on the volatility of the Company’s Common Stock price for the most recent historical period equal to the expected term of the stock appreciation right, as appropriate. The Company calculates the volatility as the annualized standard deviation of the differences in the natural logarithms of the weekly stock closing price, adjusted for stock splits and dividends.
Service-based restricted stock units are expensed on a straight-line basis over the total awards’ requisite service period, net of forfeitures. Performance-based restricted stock units subject to graded vesting are expensed on an accelerated attribution basis, net of forfeitures. Performance share award expense is primarily recognized in the performance period of the awards’ requisite service period. Market-based restricted stock units without graded vesting features are expensed on a straight-line basis over the requisite service period, net of forfeitures. Compensation expense for stock options and stock appreciation rights is recognized on a straight-line basis over the awards’ requisite service period, net of forfeitures. The Company adjusts share-based compensation expense on a quarterly basis for actual forfeitures.
For awards that are expected to result in a tax deduction, a deferred tax asset is recorded in the period in which share-based compensation expense is recognized. A current tax deduction arises upon the issuance of restricted stock units and performance share awards or the exercise of stock options and stock appreciation rights and is principally measured at the award’s intrinsic value. If the tax deduction differs from the recorded deferred tax asset, the excess tax benefit or deficit associated with the tax deduction is recognized within income tax expense.
Refer to Note 13, “SHARE-BASED COMPENSATION.”
Net income per share attributable to A&F
Net income per basic and diluted share attributable to A&F is computed based on the weighted-average number of outstanding shares of Common Stock.
Additional information pertaining to net income per share attributable to A&F is as follows:
(1)
Reflects the total number of shares related to outstanding share-based compensation awards that have been excluded from the computation of net income per diluted share attributable to A&F because the impact would have been anti-dilutive.
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Recent accounting pronouncements
The Company reviews recent accounting pronouncements on a quarterly basis and has excluded discussion of those not applicable to the Company and those not expected to have a material impact on the Company’s financial statements. The following table provides a brief description of recent accounting pronouncements the Company has adopted or that could affect the Company’s financial statements.
*
Early adoption is permitted.
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
3. FAIR VALUE
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The inputs used to measure fair value are prioritized based on a three-level hierarchy. The three levels of inputs to measure fair value are as follows:
•
Level 1-inputs are unadjusted quoted prices for identical assets or liabilities that are available in active markets that the Company can access at the measurement date.
•
Level 2-inputs are other than quoted market prices included within Level 1 that are observable for assets or liabilities, directly or indirectly.
•
Level 3-inputs to the valuation methodology are unobservable.
The lowest level of significant input determines the placement of the entire fair value measurement in the hierarchy. The three levels of the hierarchy and the distribution within it of the Company’s assets and liabilities, which are measured at fair value on a recurring basis, were as follows:
The Level 2 assets and liabilities consist of trust-owned life insurance policies and derivative financial instruments, primarily foreign currency exchange forward contracts. The fair value of foreign currency exchange forward contracts is determined by using quoted market prices of the same or similar instruments, adjusted for counterparty risk.
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Fair value of borrowings:
The Company’s borrowings under the Company’s credit facilities are carried at historical cost in the accompanying Consolidated Balance Sheets.
The carrying amount and fair value of the Company’s gross borrowings under the Term Loan Facility were as follows:
No borrowings were outstanding under the Company’s senior secured revolving credit facility as of February 3, 2018 or January 28, 2017. Refer to Note 11, “BORROWINGS,” for further discussion of the Company’s credit facilities.
4. INVENTORIES
Inventories consisted of:
Inventories included inventory in transit from vendors of $80.2 million and $79.2 million at February 3, 2018 and January 28, 2017, respectively. Inventory in transit is merchandise owned by the Company that has not yet been received at a Company distribution center.
Refer to Note 2, “SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Inventories,” for discussion regarding significant accounting policies related to the Company’s inventories.
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
5. PROPERTY AND EQUIPMENT, NET
Property and equipment, net consisted of:
For Fiscal 2017, the Company incurred store asset impairment charges of $14.4 million, primarily related to certain of the Company's international Abercrombie & Fitch stores in Germany, Spain, Italy and Hong Kong.
For Fiscal 2016, the Company incurred store asset impairment charges of $7.9 million, primarily related to the Company’s abercrombie kids flagship store in London.
For Fiscal 2015, the Company incurred store asset impairment charges of $18.2 million, primarily related to the Company’s Abercrombie & Fitch flagship store in Hong Kong and the removal of certain store fixtures in connection with changes to the Abercrombie and Hollister store experiences.
The Company had $38.7 million and $35.6 million of construction project assets in property and equipment, net at February 3, 2018 and January 28, 2017, respectively, related to the construction of buildings in certain lease arrangements where the Company is deemed to be the owner of the construction project.
Refer to Note 2, “SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Property and equipment, net,” for discussion regarding significant accounting policies related to the Company’s property and equipment, net.
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
6. RABBI TRUST ASSETS
Investments of Rabbi Trust assets consisted of the following:
The Rabbi Trust includes amounts, restricted in their use, to meet funding obligations to participants in the Abercrombie & Fitch Co. Nonqualified Savings and Supplemental Retirement Plan I, the Abercrombie & Fitch Co. Nonqualified Savings and Supplemental Retirement Plan II and the Supplemental Executive Retirement Plan. The Rabbi Trust assets primarily consist of trust-owned life insurance policies which are recorded at cash surrender value and are included in other assets on the Consolidated Balance Sheets. The change in cash surrender value of the trust-owned life insurance policies held in the Rabbi Trust resulted in realized gains of $3.1 million in each of Fiscal 2017, Fiscal 2016 and Fiscal 2015, recorded in interest expense, net on the Consolidated Statements of Operations and Comprehensive Income (Loss).
7. OTHER ASSETS
Other assets consisted of:
(1)
Refer to Note 6, “RABBI TRUST ASSETS.”
(2)
Intellectual property primarily includes trademark assets associated with the Company’s international operations, consisting of finite-lived and indefinite-lived intangible assets of approximately $12.5 million and $13.7 million, respectively, as of February 3, 2018, and approximately $13.4 million and $13.7 million, respectively, as of January 28, 2017. The Company’s finite-lived intangible assets are amortized over a useful life of 10 to 20 years.
(3)
Restricted cash includes various cash deposits with international banks that are used as collateral for customary nondebt banking commitments and deposits into trust accounts to conform to standard insurance security requirements.
(4)
Long-term supplies include, but are not limited to, hangers, frames, sign holders, security tags, back-room supplies and construction materials.
(5)
Other includes prepaid leases and various other assets.
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
8. ACCRUED EXPENSES
Accrued expenses consisted of:
(1)
Accrued payroll and related costs include salaries, incentive compensation, benefits, withholdings and other payroll related costs.
(2)
Other includes expenses incurred but not yet paid related to outside services associated with store and home office operations and deferred revenue related to loyalty programs.
9. DEFERRED LEASE CREDITS
Deferred lease credits are derived from payments received from landlords to wholly or partially offset store construction costs and are classified between current and long-term liabilities. The amounts, which are amortized over the respective terms of the related leases, consisted of the following:
10. INCOME TAXES
Tax Cuts and Jobs Act of 2017
On December 22, 2017, the Tax Cuts and Jobs Act of 2017 (the “Act”) was signed into law. The Act makes broad and significantly complex changes to the U.S. corporate income tax system by, among other things; reducing the U.S. federal corporate income tax rate from 35% to 21%, transitioning U.S. international taxation to a modified territorial tax system and imposing a mandatory one-time deemed repatriation tax, payable over eight years, on accumulated undistributed foreign subsidiary earnings and profits as of December 31, 2017. Given the significant changes resulting from and complexities associated with the Act, the estimated financial impacts for Fiscal 2017 are provisional and assessed as of March 1, 2018. The ultimate outcome may differ from these provisional amounts, possibly materially, due to, among other things, additional analysis, changes in interpretations and assumptions the Company has made, additional regulatory guidance that may be issued and actions the Company may take as a result of the Act. Provisional amounts are expected to be finalized after the Company's 2017 U.S. corporate income tax return is filed in the fourth quarter of Fiscal 2018, but no later than one year from the enactment of the Act.
As a result of the Company's initial analysis of the impact of the Act, the Company incurred discrete net income tax charges of $19.9 million in Fiscal 2017, which consisted of:
•
$21.7 million of provisional tax expense related to the mandatory one-time deemed repatriation tax on accumulated undistributed foreign subsidiary earnings and profits of approximately $363.5 million;
•
$3.8 million of provisional tax expense related to the remeasurement of the Company's ending deferred tax assets and liabilities at February 3, 2018, as a result of the U.S. federal corporate income tax rate reduction from 35% to 21%; and,
•
$5.6 million of tax benefit for the decrease in its federal deferred tax liability on unremitted foreign earnings.
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
As a result of the provisional, mandatory one-time deemed repatriation tax, the Company has incurred federal tax on its foreign earnings as of December 31, 2017 of $21.7 million. After the utilization of existing tax credits, the Company expects U.S. federal cash tax payments of approximately $10.6 million on the mandatory one-time deemed repatriation, payable over eight years. Under a modified territorial system, future earnings are generally not subject to additional federal tax, however as discussed below, the U.S. has adopted several new tax concepts. Additionally, if funds were to be legally repatriated to the U.S. it could have implications at the state and foreign levels. Accordingly, the Company has not fully concluded on its position with respect to reinvestment of foreign earnings and whether its existing international structure for the various jurisdictions is the optimal structure for the future, but expects to complete this assessment in Fiscal 2018.
The Act includes two new U.S. tax base erosion provisions, the global intangible low-taxed income (“GILTI”) provisions and the base-erosion and anti-abuse tax (“BEAT”) provisions. The GILTI provisions require the Company to include foreign subsidiary earnings in excess of an allowable return on certain of the foreign subsidiary’s tangible assets in its U.S. income tax return. The Company has elected to account for GILTI tax in the period in which it is incurred and is evaluating whether it will be subject to incremental U.S. tax on GILTI income beginning in Fiscal 2018. The BEAT provisions eliminate the deduction of certain base-erosion payments made to related foreign corporations, and impose a minimum tax if greater than regular tax. The Company does not currently expect it will be subject to this tax. Based on these expectations, the Company has not included any tax impacts of GILTI or BEAT in its consolidated financial statements as of February 3, 2018.
Components of Income Taxes
Income (loss) before taxes consisted of:
(1)
Includes intercompany charges to foreign affiliates for management fees, cost-sharing, royalties and interest and excludes a portion of foreign income that is currently includable on the U.S. federal income tax return.
Income tax expense (benefit) consisted of:
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Reconciliation between the statutory federal income tax rate and the effective tax rate is as follows:
(1)
On December 22, 2017, the Act was signed into law, which reduced the U.S. federal corporate income tax rate from 35% to 21% resulting in a blended U.S. federal income tax rate of 33.7% based on the applicable tax rates before and after January 1, 2018, and the number of days in Fiscal 2017.
(2)
Given the low level of income in absolute dollars in Fiscal 2016, effective tax rate reconciling items that may have been considered de minimis in prior years in terms of absolute dollars and on a percentage basis were amplified on a percentage basis in Fiscal 2016 even as the absolute dollar value of the reconciling items were similar to prior years. Accordingly, year over year comparability may be difficult as a result of the amplifying effect of the lower levels of income.
(3)
U.S. branch operations in Canada and Puerto Rico are subject to tax at the full U.S. tax rates. As a result, income from these operations do not create reconciling items.
(4)
In Fiscal 2017, the Company adopted new share-based compensation accounting standards and in accordance with this guidance, the Company recognized $10.6 million of discrete non-cash income tax charges in Fiscal 2017 in income tax expense (benefit) on the Consolidated Statements of Operations and Comprehensive Income (Loss). Refer to Note 2, “SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--Recent Accounting Pronouncements,” for further discussion.
Historically, jurisdictional location of pre-tax income (loss) represented a significant component of the Company’s effective tax rate as income tax rates outside the U.S. were generally lower than the U.S. statutory income tax rate. Furthermore, the impact of changes in the jurisdictional location of pre-tax income (loss) on the Company’s effective tax rate were amplified on a percentage basis at lower levels of consolidated pre-tax income (loss) in absolute dollars. As a result of the Act, the U.S. effective tax rate will be generally lower, but the effective tax rate remains dependent on jurisdictional mix. The taxation of non-U.S. operations line items in the table above excludes items related to the Company’s non-U.S. operations reported separately in the appropriate corresponding line items.
For Fiscal 2017, the impact of foreign taxation of non-U.S. operations on the Company’s effective income tax rate was primarily related to the Company’s Swiss and Hong Kong subsidiaries, along with the Company’s NCI. For Fiscal 2017, the Company’s Swiss subsidiary earned pre-tax income of $31.6 million with a jurisdictional effective tax rate of 1.2%. For Fiscal 2017, the Company’s Hong Kong subsidiary incurred pre-tax losses of $7.4 million with a jurisdictional effective tax rate of negative 3.1%. With respect to the NCI, the subsidiaries incurred pre-tax income of $3.4 million with no jurisdictional tax effect.
For Fiscal 2016, the impact of foreign taxation of non-U.S. operations on the Company’s effective income tax rate was primarily related to the Company’s Swiss and Hong Kong subsidiaries, along with the Company’s NCI. For Fiscal 2016, the Company’s Swiss subsidiary earned pre-tax income of $18.7 million with a jurisdictional effective tax rate of negative 11.0%. For Fiscal 2016, the Company’s Hong Kong subsidiary incurred pre-tax losses of $12.6 million with a jurisdictional effective tax rate of negative 4.5%. With respect to the NCI, the subsidiaries incurred pre-tax income of $3.8 million with no jurisdictional tax effect.
For Fiscal 2015, the impact of foreign taxation of non-U.S. operations on the Company’s effective income tax rate was primarily related to the Company’s subsidiaries in Australia, Switzerland and Hong Kong. For Fiscal 2015, the Company’s Australian subsidiary incurred pre-tax losses of $4.9 million, with no jurisdictional tax effect, related to the closure of the Company’s Australian operations. For Fiscal 2015, the Company’s Swiss subsidiary earned pre-tax income of $1.9 million with a jurisdictional effective tax rate of negative 745%. The Swiss jurisdictional effective tax rate included the impact of the Company’s omnichannel
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
restructuring as well as the release of a valuation allowance. For Fiscal 2015, the Company’s Hong Kong subsidiary incurred pre-tax losses of $6.8 million with a jurisdictional effective tax rate of 15.8%, slightly below the statutory tax rate of 16.5%.
Components of Deferred Income Tax Assets and Liabilities
The effect of temporary differences which gives rise to deferred income tax assets (liabilities) were as follows:
Accumulated other comprehensive loss is shown net of deferred tax assets and liabilities, resulting in a deferred tax liability of $1.2 million and $0.6 million as of February 3, 2018 and January 28, 2017, respectively. Accordingly, these deferred taxes are not reflected in the table above.
As of February 3, 2018, the Company had deferred tax assets related to foreign and state NOL and credit carryforwards of $3.0 million and $1.2 million, respectively, that could be utilized to reduce future years’ tax liabilities. If not utilized, a portion of the foreign NOL carryovers will begin to expire in 2020 and a portion of state NOL will begin to expire in 2021. Some foreign NOL have an indefinite carryforward period.
The Company believes it is more likely than not that NOLs and credit carryforwards will reduce future years’ tax liabilities in various states and certain foreign jurisdictions less any associated valuation allowance. All valuation allowances have been reflected through the Consolidated Statements of Operations and Comprehensive Income (Loss). No other valuation allowances have been provided for deferred tax assets because management believes that it is more likely than not that the full amount of the net deferred tax assets will be realized in the future. While the Company does not expect material adjustments to the total amount of valuation allowances within the next 12 months, changes in assumptions may occur based on the information then currently available. In such case, the Company will record an adjustment in the period in which a determination is made.
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Other
The amount of uncertain tax positions as of February 3, 2018, January 28, 2017 and January 30, 2016, which would impact the Company’s effective tax rate if recognized and a reconciliation of the beginning and ending amounts of uncertain tax positions are as follows:
The Internal Revenue Service (“IRS”) is currently conducting an examination of the Company’s U.S. federal income tax return for Fiscal 2017 as part of the IRS’ Compliance Assurance Process program. The IRS examinations for Fiscal 2016 and prior years have been completed. The Company has a $6.2 million carryback refund claim related to Fiscal 2016 which is pending a routine Joint Committee on Taxation review. State and foreign returns are generally subject to examination for a period of three to five years after the filing of the respective return. The Company has various state and foreign income tax returns in the process of examination, administrative appeals or litigation. The outcome of these examinations is not expected to have a material impact on the Company’s financial statements. The Company believes that some of these audits and negotiations will conclude within the next 12 months and that it is reasonably possible the amount of uncertain income tax positions, including interest, may change by an immaterial amount due to settlements of audits and expiration of statutes of limitations.
The Company does not expect material adjustments to the total amount of uncertain tax positions within the next 12 months, but the outcome of tax matters is uncertain and unforeseen results can occur.
During Fiscal 2017, the Company recognized a $0.1 million benefit related to net interest and penalties, compared to a $0.2 million benefit recognized during Fiscal 2016. Interest and penalties of $0.2 million were accrued at the end of Fiscal 2017, compared to $0.3 million accrued at the end of Fiscal 2016.
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
11. BORROWINGS
Asset-Based Revolving Credit Facility
On August 7, 2014, A&F, through its subsidiary Abercrombie & Fitch Management Co. (“A&F Management”) as the lead borrower (with A&F and certain other subsidiaries as borrowers or guarantors), entered into an asset-based revolving credit agreement.
As of October 19, 2017, the Company, through A&F Management, entered into a Second Amendment to Credit Agreement (the “ABL Second Amendment”), amending and extending the maturity date of the asset-based revolving credit agreement. As amended, the asset-based revolving credit agreement continues to provide for a senior secured revolving credit facility of up to $400 million (the “Amended ABL Facility.”) The Amended ABL Facility is subject to a borrowing base, consisting primarily of U.S. inventory, with a letter of credit sub-limit of $50 million and an accordion feature allowing A&F to increase the revolving commitment by up to $100 million subject to specified conditions. The Amended ABL Facility is available for working capital, capital expenditures and other general corporate purposes. The Amended ABL Facility will mature on October 19, 2022.
Obligations under the Amended ABL Facility are unconditionally guaranteed by A&F and certain of its subsidiaries. The Amended ABL Facility is secured by a first-priority security interest in certain working capital of the borrowers and guarantors consisting of inventory, accounts receivable and certain other assets. The Amended ABL Facility is also secured by a second-priority security interest in certain property and assets of the borrowers and guarantors, including certain fixed assets, intellectual property, stock of subsidiaries and certain after-acquired material real property.
At the Company’s option, borrowings under the Amended ABL Facility will bear interest at either (a) an adjusted LIBOR rate plus a margin of 1.25% to 1.50% per annum, or (b) an alternate base rate plus a margin of 0.25% to 0.50% per annum. The applicable margins with respect to LIBOR loans and base rate loans, including swing line loans, under the Amended ABL Facility are 1.25% and 0.25% per annum, respectively, and are subject to adjustment each fiscal quarter based on average historical availability during the preceding quarter. The Company is also required to pay a fee of 0.25% per annum on undrawn commitments under the Amended ABL Facility. Customary agency fees and letter of credit fees are also payable in respect of the Amended ABL Facility.
No borrowings were outstanding under the Amended ABL Facility as of February 3, 2018.
The Company had availability under the Amended ABL Facility of $259.3 million as of February 3, 2018.
Term Loan Facility
A&F, through its subsidiary A&F Management as the borrower (with A&F and certain other subsidiaries as guarantors), also entered into a term loan agreement on August 7, 2014, which, as amended, provides for a term loan facility of $300 million (the “Term Loan Facility” and, together with the Amended ABL Facility, the “Credit Facilities”). A portion of the proceeds of the Term Loan Facility was used to repay the outstanding balance of approximately $127.5 million under the Company’s 2012 Term Loan Agreement, to repay outstanding borrowings of approximately $60 million under the Company’s 2011 Credit Agreement and to pay fees and expenses associated with the transaction.
The Term Loan Facility was issued at a 1.0% discount. In addition, the Company recorded deferred financing fees associated with the issuance of the Credit Facilities in Fiscal 2014 of $5.8 million in aggregate, of which $3.2 million was paid to lenders. The Company also recorded deferred financing fees associated with the issuance of the ABL Second Amendment of $0.9 million.The debt discount and deferred financing fees are amortized over the respective contractual terms of the Credit Facilities.
The Company’s Term Loan debt is presented in the Consolidated Balance Sheets, net of the unamortized discount and fees. Net borrowings as of February 3, 2018 and January 28, 2017 were as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Term Loan Facility will mature on August 7, 2021 and amortizes at a rate equal to 0.25% of the original principal amount per quarter, beginning with the fourth quarter of Fiscal 2014. The Company made repayments of $15 million and $25 million in Fiscal 2017 and Fiscal 2016, respectively, in prepayment of its scheduled Fiscal 2017 through Fiscal 2021 amortization and a portion of the amount of principal due at maturity. The Term Loan Facility is subject to (a) beginning in 2016, an annual mandatory prepayment in an amount equal to 0% to 50% of the Company’s excess cash flows in the preceding fiscal year, depending on the Company’s leverage ratio and (b) certain other mandatory prepayments upon receipt by the Company of proceeds of certain debt issuances, asset sales and casualty events, subject to certain exceptions specified therein, including reinvestment rights, less any voluntary payments made. The final principal installment of $253.3 million on the Term Loan Facility will be due August 7, 2021.
All obligations under the Term Loan Facility are unconditionally guaranteed by A&F and certain of its subsidiaries. The Term Loan Facility is secured by a first-priority security interest in certain property and assets of the borrowers and guarantors, including certain fixed assets, intellectual property, stock of subsidiaries and certain after-acquired material real property. The Term Loan Facility is also secured by a second-priority security interest in certain working capital of the borrowers and guarantors consisting of inventory, accounts receivable and certain other assets, with certain exceptions.
At the Company’s option, borrowings under the Term Loan Facility will bear interest at either (a) an adjusted LIBOR rate no lower than 1.00% plus a margin of 3.75% per annum or (b) an alternate base rate plus a margin of 2.75% per annum. Customary agency fees are also payable in respect of the Term Loan Facility. The interest rate on borrowings under the Term Loan Facility was 5.32% as of February 3, 2018.
Representations, Warranties and Covenants
The Credit Facilities contain various representations, warranties and restrictive covenants that, among other things and subject to specified exceptions, restrict the ability of A&F and its subsidiaries to incur indebtedness (including guarantees), grant liens, make investments, pay dividends or distributions with respect to capital stock, make prepayments on other indebtedness, engage in mergers, dispose of certain assets or change the nature of their business. In addition, excess availability equal to the greater of 10% of the loan cap or $30 million must be maintained under the Amended ABL Facility. The Credit Facilities do not otherwise contain financial maintenance covenants.
Both Credit Facilities 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.
The Company was in compliance with the covenants under the Credit Facilities as of February 3, 2018.
12. OTHER LIABILITIES
Other liabilities consisted of:
(1)
Deferred compensation includes the Supplemental Executive Retirement Plan, the Abercrombie & Fitch Co. Savings and Retirement Plan and the Abercrombie & Fitch Nonqualified Savings and Supplemental Retirement Plan, all further discussed in Note 16, “SAVINGS AND RETIREMENT PLANS,” as well as deferred Board of Directors compensation and other accrued retirement benefits.
(2)
Other includes asset retirement obligations, the provisional, mandatory one-time deemed repatriation tax on accumulated foreign earnings, net and various other liabilities.
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
13. SHARE-BASED COMPENSATION
Financial Statement Impact
The Company recognized share-based compensation expense of $22.1 million, $22.1 million and $28.4 million for Fiscal 2017, Fiscal 2016 and Fiscal 2015, respectively. The Company recognized tax benefits associated with share-based compensation expense of $8.0 million, $8.3 million and $10.6 million for Fiscal 2017, Fiscal 2016 and Fiscal 2015, respectively.
The effect of adjustments for forfeitures was $2.9 million, $3.4 million and $5.6 million for Fiscal 2017, Fiscal 2016 and Fiscal 2015, respectively.
Plans
As of February 3, 2018, the Company had two primary share-based compensation plans: (i) the 2016 Directors LTIP, with 750,000 shares of the Company’s Common Stock authorized for issuance, under which the Company is authorized to grant restricted stock, restricted stock units, stock appreciation rights, stock options and deferred stock awards to non-associate members of the Company’s Board of Directors; and (ii) the 2016 Associates LTIP, with 4,700,000 shares of the Company’s Common Stock authorized for issuance, under which the Company is authorized to grant restricted stock, restricted stock units, performance share awards, stock appreciation rights and stock options to associates of the Company. The Company also has six other share-based compensation plans under which it granted restricted stock, restricted stock units, performance share awards, stock appreciation rights and stock options to associates of the Company and restricted stock units, stock options and deferred stock awards to non-associate members of the Company’s Board of Directors in prior years.
The 2016 Directors LTIP, a stockholder-approved plan, permits the Company to annually grant awards to non-associate directors, subject to the following limits:
•
For non-associate directors: awards with an aggregate fair market value on the date of the grant of no more than $300,000;
•
For the non-associate director occupying the role of Non-Executive Chairman of the Board (if any): additional awards with an aggregate fair market value on the date of grant of no more than $500,000; and
•
For the non-associate director occupying the role of Executive Chairman of the Board (if any): additional awards with an aggregate fair market value on the date of grant of no more than $2,500,000.
Under the 2016 Directors LTIP, restricted stock units are subject to a minimum vesting period ending no sooner than the earlier of (i) the first anniversary of the grant date or (ii) the date of the next regularly scheduled annual meeting of stockholders held after the grant date. Any stock appreciation rights or stock options granted under this plan have the same minimum vesting period requirements as restricted stock units and, in addition, must have a term that does not exceed a period of ten years from the grant date, subject to forfeiture under the terms of the 2016 Directors LTIP.
The 2016 Associates LTIP, a stockholder-approved plan, permits the Company to annually grant one or more types of awards covering up to an aggregate for all awards of 1.0 million of underlying shares of the Company’s Common Stock to any associate of the Company. Under the 2016 Associates LTIP, for restricted stock units that have performance-based vesting, performance must be measured over a period of at least one year and for restricted stock units that do not have performance-based vesting, vesting in full may not occur more quickly than in pro-rata installments over a period of three years from the date of the grant, with the first installment vesting no sooner than the first anniversary of the date of the grant. In addition, any stock options or stock appreciation rights granted under this plan must have a minimum vesting period of one year and a term that does not exceed a period of ten years from the grant date, subject to forfeiture under the terms of the2016 Associates LTIP.
Each of the 2016 Directors LTIP, and the 2016 Associates LTIP, provides for accelerated vesting of awards if there is a change of control and certain other conditions specified in each plan are met.
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Restricted Stock Units
The following table summarizes activity for restricted stock units for Fiscal 2017:
(1)
Includes 704,703 unvested service-based restricted stock units subject to vesting requirements related to the achievement of certain performance metrics, such as operating income and net income, for the fiscal year immediately preceding the vesting date. Holders of these restricted stock units have the opportunity to earn back one of more installments of the award if cumulative performance requirements are met in a subsequent year.
(2)
Unvested shares related to restricted stock units with performance-based vesting conditions can achieve up to 200% of their target vesting amount and are reflected at 100% of their target vesting amount in the table above.
As of February 3, 2018, there was $24.6 million, $5.2 million and $3.2 million of total unrecognized compensation cost, net of estimated forfeitures, related to service-based, performance-based and market-based restricted stock units, respectively. The unrecognized compensation cost is expected to be recognized over a weighted-average period of 14 months, 13 months and 11 months for service-based, performance-based and market-based restricted stock units, respectively.
The actual tax benefit realized for tax deductions related to the issuance of shares associated with restricted stock unit vesting was $2.8 million, $7.0 million and $5.9 million for Fiscal 2017, Fiscal 2016, and Fiscal 2015, respectively.
Additional information pertaining to restricted stock units for Fiscal 2017, Fiscal 2016 and Fiscal 2015 follows:
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The weighted-average assumptions used for market-based restricted stock units in the Monte Carlo simulation during Fiscal 2017, Fiscal 2016 and Fiscal 2015 were as follows:
Stock Appreciation Rights
The following table summarizes stock appreciation rights activity for Fiscal 2017:
No stock appreciation rights were granted during Fiscal 2017 and Fiscal 2016. The weighted-average assumptions used in the Black-Scholes option-pricing model for stock appreciation rights granted during Fiscal 2015 were as follows:
As of February 3, 2018, there was $1.0 million of total unrecognized compensation cost, net of estimated forfeitures, related to stock appreciation rights. The unrecognized compensation cost is expected to be recognized over a weighted-average period of 7 months.
No stock appreciation rights were exercised in Fiscal 2017 and the total intrinsic value of stock appreciation rights exercised was insignificant during Fiscal 2016 and $4.3 million during Fiscal 2015. The grant date fair value of stock appreciation rights that vested during Fiscal 2017, Fiscal 2016 and Fiscal 2015 was $2.4 million, $4.3 million and $4.9 million, respectively.
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Stock Options
The following table summarizes stock option activity for Fiscal 2017:
No stock options were granted during during Fiscal 2017, Fiscal 2016 and Fiscal 2015. The total intrinsic value of stock options exercised was insignificant during Fiscal 2016 and Fiscal 2015 and no stock options were exercised in Fiscal 2017. As of February 3, 2018, there was no unrecognized compensation cost related to currently outstanding stock options.
14. DERIVATIVE INSTRUMENTS
As of February 3, 2018, the Company had outstanding the following foreign currency exchange forward contracts that were entered into to hedge either a portion, or all, of forecasted foreign-currency-denominated intercompany inventory sales, the resulting settlement of the foreign-currency-denominated intercompany accounts receivable, or both:
(1)
Amounts reported are the U.S. Dollar notional amounts outstanding as of February 3, 2018.
As of February 3, 2018, the Company had outstanding the following foreign currency exchange forward contracts that were entered into to hedge foreign currency denominated net monetary assets/liabilities:
(1)
Amounts reported are the U.S. Dollar notional amounts outstanding as of February 3, 2018.
The location and amounts of derivative fair values on the Consolidated Balance Sheets as of February 3, 2018 and January 28, 2017 were as follows:
Refer to Note 3, “FAIR VALUE,” for further discussion of the determination of the fair value of derivative instruments.
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The location and amounts of derivative gains and losses for Fiscal 2017 and Fiscal 2016 on the Consolidated Statements of Operations and Comprehensive Income (Loss) were as follows:
(1)
The amount represents the change in fair value of derivative contracts due to changes in spot rates.
(2)
The amount represents the reclassification from AOCL into earnings when the hedged item affects earnings, which is when merchandise is sold to the Company’s customers.
(3)
The amount represents the change in fair value of derivative contracts due to changes in the difference between the spot price and forward price that is excluded from the assessment of hedge effectiveness and, therefore, recognized in earnings.
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
15. ACCUMULATED OTHER COMPREHENSIVE LOSS
For Fiscal 2017, the activity in accumulated other comprehensive loss was as follows:
(1)
For Fiscal 2017, a loss was reclassified from accumulated other comprehensive loss to cost of sales, exclusive of depreciation and amortization on the Consolidated Statement of Operations and Comprehensive Income (Loss).
For Fiscal 2016, the activity in accumulated other comprehensive loss was as follows:
(1)
For Fiscal 2016, a gain was reclassified from accumulated other comprehensive loss to cost of sales, exclusive of depreciation and amortization on the Consolidated Statement of Operations and Comprehensive Income (Loss). Additionally, a foreign currency translation loss related to the Company's dissolution of its Australian operations was reclassified to other operating income, net.
For Fiscal 2015, the activity in accumulated other comprehensive loss was as follows:
(1)
For Fiscal 2015, a gain was reclassified from accumulated other comprehensive loss to cost of sales, exclusive of depreciation and amortization on the Consolidated Statement of Operations and Comprehensive Income (Loss).
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
16. SAVINGS AND RETIREMENT PLANS
The Company maintains the Abercrombie & Fitch Co. Savings & Retirement Plan, a qualified plan. All U.S. associates are eligible to participate in this plan if they are at least 21 years of age. In addition, the Company maintains the Abercrombie & Fitch Co. Nonqualified Savings and Supplemental Retirement, composed of two sub-plans (Plan I and Plan II). Plan I contains contributions made through December 31, 2004, while Plan II contains contributions made on and after January 1, 2005. Participation in these plans is based on service and compensation. The Company’s contributions to these plans are based on a percentage of associates’ eligible annual compensation. The cost of the Company’s contributions to these plans was $14.4 million, $11.1 million and $15.4 million for Fiscal 2017, Fiscal 2016 and Fiscal 2015, respectively.
In addition, the Company maintains the Supplemental Executive Retirement Plan which provides retirement income to its former Chief Executive Officer for life, based on averaged compensation before retirement, including base salary and cash incentive compensation. The Company has recorded $9.7 million and $10.2 million, as of February 3, 2018 and January 28, 2017, respectively, in other liabilities on the Consolidated Balance Sheets related to future Supplemental Executive Retirement Plan distributions.
17. SEGMENT REPORTING
The Company's two operating segments are brand-based: Hollister and Abercrombie, the latter of which includes the Company’s Abercrombie & Fitch and abercrombie kids brands. These operating segments have similar economic characteristics, classes of consumers, products, production and distribution methods, operate in the same regulatory environments, and have been aggregated into one reportable segment.
The Company’s net sales by operating segment for Fiscal 2017, Fiscal 2016 and Fiscal 2015 were as follows:
The Company’s net sales by geographic area for Fiscal 2017, Fiscal 2016 and Fiscal 2015 were as follows:
The Company’s long-lived assets by geographic area as of February 3, 2018, January 28, 2017 and January 30, 2016 were as follows:
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
18. CONTINGENCIES
The Company is a defendant in lawsuits and other adversary proceedings arising in the ordinary course of business. Legal costs incurred in connection with the resolution of claims and lawsuits are generally expensed as incurred, and the Company establishes estimated liabilities for the outcome of litigation where losses are deemed probable and reasonably estimable. The Company’s assessment of the current exposure could change in the event of the discovery of additional facts. As of February 3, 2018, the Company had accrued charges for legal contingencies, including the certain legal matters detailed below, of approximately $18 million, which are classified within other current liabilities on the accompanying Consolidated Balance Sheet. The estimated liability represents what the Company believes to be reasonable estimates of the loss exposures related to its legal matters. Actual liabilities may differ from the amounts recorded, due to uncertainties regarding regarding final settlement agreement negotiations, actual claims rate experience, court approvals and the terms of any approval by the courts, and there can be no assurance that final resolution of legal matters will not have a material adverse effect on the Company’s financial condition, results of operations or cash flows. The Company may be subject to estimated incremental losses of as much as approximately $25 million. There are certain claims and legal proceedings pending against the Company for which accruals have not been established.
Certain Legal Matters
The Company is a defendant in two separate class action lawsuits filed by former associates of the Company who are represented by the same counsel. The first lawsuit, filed in 2013, alleges failure to indemnify business expenses and a series of derivative claims for compelled patronization, inaccurate wage statements, waiting time penalties, minimum wage violations and unfair competition under California state law on behalf of all non-exempt hourly associates at Abercrombie & Fitch, abercrombie kids, Hollister and Gilly Hicks stores in California. Four subclasses of associates have since been certified, and was before a U.S. District Court of California. The second lawsuit, filed in 2015, alleges that associates were required to purchase uniforms without reimbursement in violation of federal law, and laws of the states of New York, Florida and Massachusetts, as well as derivative putative state law claims and seeks to pursue such claims on a class and collective basis. On December 12, 2017, a U.S. District Court of California granted the parties’ stipulation to transfer the first lawsuit pending and combine it with the second lawsuit then pending before a U.S. District Court of Ohio.
Both matters were mediated and the parties signed a $25.0 million claims-made settlement agreement which, subject to final approval by a U.S. District Court of Ohio, is intended to result in a full and final settlement of all claims in both lawsuits on a class-wide basis. On February 16, 2018, a U.S. District Court of Ohio granted preliminary approval of the proposed settlement and ordered that notice of the proposed settlement be given to the absent members of the settlement class. The ultimate settlement amount is dependent upon the actual claims made by members of the class and is also subject to final approval by the U.S. District Court of Ohio. A final approval hearing is set to occur in the second quarter of Fiscal 2018.
In addition to the matters discussed above, the Company is a defendant in other class action lawsuits filed by former associates of the Company. These lawsuits allege non-exempt hourly associates of the Company were not properly compensated, in violation of federal and California law, for call-in practices requiring associates to engage in certain pre-shift activities in order to determine whether they should report to work and the Company's alleged failure to pay Reporting Time and all wages earned at termination. In addition, these lawsuits include derivative claims alleging inaccurate wage statements and unfair competition under California state law on behalf of non-exempt hourly associates. These lawsuits are currently assigned to the same judge and remain stayed in a U.S. District Court of California.
There can be no absolute assurance that settlements will be finalized or approved or of the ultimate outcomes of the litigations.
Other
For Fiscal 2016, the Company recognized a $12.3 million gain in other operating income, net in connection with a settlement of certain economic loss claims associated with the April 2010 Deepwater Horizon oil spill.
ABERCROMBIE & FITCH CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
19. QUARTERLY FINANCIAL DATA (UNAUDITED)
Summarized unaudited quarterly financial results for Fiscal 2017 and Fiscal 2016 are presented below. See “RESULTS OF OPERATIONS,” in “ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS,” of this Annual Report on Form 10-K for information regarding items included below that could affect comparability between quarterly results.
(1)
Gross profit is derived from cost of sales, exclusive of depreciation and amortization.
(2)
Net income (loss) attributable to A&F for Fiscal 2017 included certain items related to asset impairment, legal charges and discrete net tax charges related to the Act. These items adversely impacted net income (loss) attributable to A&F by $4.5 million, $10.4 million and $23.0 million for the second, third and fourth quarters of Fiscal 2017, respectively.
(3)
Net income (loss) per share for each of the quarters was computed using the weighted average number of shares outstanding during the quarter while the full year is computed using the average of the weighted average number of shares outstanding each quarter; therefore, the sum of the quarters may not equal the total for the year.
(4)
Net income (loss) attributable to A&F for Fiscal 2016 included certain items related to asset impairment, indemnification recoveries and claims settlement benefits. These items benefited net income (loss) attributable to A&F by $3.7 million and $6.5 million for the second and third quarters of Fiscal 2016, respectively, and adversely impacted net income (loss) attributable to A&F by $2.1 million for the fourth quarter of Fiscal 2016.
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of
Abercrombie & Fitch Co.
Opinions on the Financial Statements and Internal Control over Financial Reporting
We have audited the accompanying consolidated balance sheets of Abercrombie and Fitch Co. and its subsidiaries as of February 3, 2018 and January 28, 2017, and the related consolidated statements of operations and comprehensive income (loss), of stockholders’ equity and of cash flows for each of the three years in the period ended February 3, 2018, including the related notes appearing under Item 8 (collectively referred to as the “consolidated financial statements”). We also have audited the Company's internal control over financial reporting as of February 3, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of February 3, 2018 and January 28, 2017, and the results of their operations and their cash flows for each of the three years in the period ended February 3, 2018 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of February 3, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the COSO.
Change in Accounting Principle
As discussed in Note 2 to the consolidated financial statements, the Company changed the manner in which it accounts for certain elements of its share-based compensation during the fiscal year ended February 3, 2018.
Basis for Opinions
The Company's management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in Management's Annual Report on Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on the Company’s consolidated financial statements and on the Company's internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) ("PCAOB") and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.
Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
Definition and Limitations of Internal Control over Financial Reporting
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
/s/ PricewaterhouseCoopers LLP
Columbus, Ohio
April 2, 2018
We have served as the Company’s auditor since 1996.
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A.
CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
A&F maintains disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) that are designed to provide reasonable assurance that information required to be disclosed in the reports that A&F files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to A&F’s management, including the principal executive officer and the principal financial officer, as appropriate to allow timely decisions regarding required disclosures. Because of inherent limitations, disclosure controls and procedures, no matter how well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of disclosure controls and procedures are met.
A&F’s management, including the Chief Executive Officer of A&F (who serves as Principal Executive Officer of A&F) and the
Senior Vice President and Chief Financial Officer of A&F (who serves as Principal Financial Officer and Principal Accounting
Officer of A&F), evaluated the effectiveness of A&F’s design and operation of its disclosure controls and procedures as of February 3, 2018. The Chief Executive Officer of A&F (in such individual’s capacity as the Principal Executive Officer of A&F) and the Senior Vice President and Chief Financial Officer of A&F (in such individual’s capacity as the Principal Financial Officer of A&F) concluded that A&F’s disclosure controls and procedures were effective at a reasonable level of assurance as of February 3, 2018, the end of the period covered by this Annual Report on Form 10-K.
Management’s Annual Report on Internal Control Over Financial Reporting
The management of A&F is responsible for establishing and maintaining adequate internal control over financial reporting. A&F’s internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluations of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Accordingly, even an effective system of internal control over financial reporting will provide only reasonable assurance with respect to financial statement preparation.
With the participation of the Chief Executive Officer and the Senior Vice President and Chief Financial Officer of A&F, management evaluated the effectiveness of A&F’s internal control over financial reporting as of February 3, 2018 using criteria established in the Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on the assessment of A&F’s internal control over financial reporting, under the criteria described in the preceding sentence, management has concluded that, as of February 3, 2018, A&F’s internal control over financial reporting was effective.
A&F’s independent registered public accounting firm, PricewaterhouseCoopers LLP, has issued an audit report on the effectiveness of A&F’s internal control over financial reporting as of February 3, 2018 as stated in their report, which is included in “ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA” of this Annual Report on Form 10-K.
Changes in Internal Control Over Financial Reporting
There were no changes in A&F’s internal control over financial reporting during the fourth quarter ended February 3, 2018 that materially affected, or are reasonably likely to materially affect, A&F’s internal control over financial reporting.
ITEM 9B.
ITEM 9B.
OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Directors, Executive Officers and Persons Nominated or Chosen to Become Directors or Executive Officers
Information concerning directors and executive officers of A&F as well as persons nominated or chosen to become directors or executive officers is incorporated by reference from the text to be included under the caption “PROPOSAL 1 - ELECTION OF DIRECTORS” in A&F’s definitive Proxy Statement for the Annual Meeting of Stockholders to be held on June 14, 2018 and from the text under the caption “EXECUTIVE OFFICERS OF THE REGISTRANT” at the end of “ITEM 1. BUSINESS” in PART I of this Annual Report on Form 10-K.
Compliance with Section 16(a) of the Exchange Act
Information concerning beneficial ownership reporting compliance under Section 16(a) of the Securities Exchange Act of 1934, as amended, is incorporated by reference from the text to be included under the caption “SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - Section 16(a) Beneficial Ownership Reporting Compliance,” in A&F’s definitive Proxy Statement for the Annual Meeting of Stockholders to be held on June 14, 2018.
Code of Business Conduct and Ethics
The Board of Directors has adopted the Abercrombie & Fitch Co. Code of Business Conduct and Ethics, which is available on the “Corporate Governance” page of the Company’s website at www.abercrombie.com, accessible through the “Investors” page.
Audit and Finance Committee
Information concerning A&F’s Audit and Finance Committee, including the determination of A&F's Board of Directors that the Audit and Finance Committee has at least one “audit committee financial expert” (as defined under applicable SEC rules) serving on the Audit and Finance Committee, is incorporated by reference from the text to be included under the caption “PROPOSAL 1 - ELECTION OF DIRECTORS - Committees of the Board - Audit and Finance Committee,” in A&F’s definitive Proxy Statement for the Annual Meeting of Stockholders to be held on June 14, 2018.
Procedures by which Stockholders May Recommend Nominees to A&F’s Board of Directors
Information concerning the procedures by which stockholders of A&F may recommend nominees to A&F’s Board of Directors is incorporated by reference from the text to be included under the captions “PROPOSAL 1 - ELECTION OF DIRECTORS - Director Qualifications and Consideration of Director Candidates,” “PROPOSAL 1 - ELECTION OF DIRECTORS - Director Nominations,” “PROPOSAL 1 - ELECTION OF DIRECTORS - Nominations of Individuals for Election as Directors at the 2019 Annual meeting Using Proxy Access,” and in A&F’s definitive Proxy Statement for the Annual Meeting of Stockholders to be held on June 14, 2018. As previously disclosed, under “Item 5.03. Amendments to Articles of Incorporation or Bylaws; Change in Fiscal Year” in the Current Report on A&F's Form 8-K filed on February 27, 2018, on February 23, 2018, A&F's Board of Directors unanimously adopted amendments to Section 2.04 of A&F's Amended and Restated Bylaws to implement “proxy access.” Other than the implementation by A&F of “proxy access,” the procedures by which shareholders may recommend nominees to A&F's Board of Directors have not materially changed from those described in A&F’s definitive Proxy Statement for the Annual Meeting of Stockholders held on June 15, 2017.
ITEM 11.
ITEM 11.
EXECUTIVE COMPENSATION
Information regarding executive compensation is incorporated by reference from the text to be included under the captions “PROPOSAL 1 - ELECTION OF DIRECTORS - Compensation of Directors,” “PROPOSAL 1 - ELECTION OF DIRECTORS - Board Role in Risk Oversight,” “PROPOSAL 1 - ELECTION OF DIRECTORS - Compensation and Organization Committee Interlocks and Insider Participation,” “COMPENSATION DISCUSSION AND ANALYSIS,” “REPORT OF THE COMPENSATION AND ORGANIZATION COMMITTEE ON EXECUTIVE COMPENSATION” and “EXECUTIVE OFFICER COMPENSATION,” in A&F’s definitive Proxy Statement for the Annual Meeting of Stockholders to be held on June 14, 2018.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Information concerning the security ownership of certain beneficial owners and management is incorporated by reference from the text to be included under the caption “SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT” in A&F’s definitive Proxy Statement for the Annual Meeting of Stockholders to be held on June 14, 2018.
Information regarding the number of shares of Common Stock of A&F to be issued and remaining available under equity compensation plans of A&F as of February 3, 2018 is incorporated by reference from the text to be included under the caption “EQUITY COMPENSATION PLANS” in A&F’s definitive Proxy Statement for the Annual Meeting of Stockholders to be held on June 14, 2018.
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Information concerning certain relationships and transactions involving the Company and certain related persons within the meaning of Item 404(a) of SEC Regulation S-K as well as information concerning A&F’s policies and procedures for the review, approval or ratification of transactions with related persons is incorporated by reference from the text to be included under the caption “PROPOSAL 1 - ELECTION OF DIRECTORS - Certain Relationships and Related Person Transactions” in A&F’s definitive Proxy Statement for the Annual Meeting of Stockholders to be held on June 14, 2018.
Information concerning the independence of the directors of A&F is incorporated by reference from the text to be included under the captions “PROPOSAL 1 - ELECTION OF DIRECTORS - Director Independence”, “PROPOSAL 1 - ELECTION OF DIRECTORS - Board Leadership Structure”and “PROPOSAL 1 - ELECTION OF DIRECTORS - Committees of the Board” in A&F’s definitive Proxy Statement for the Annual Meeting of Stockholders to be held on June 14, 2018.
ITEM 14.
ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES
Information concerning the pre-approval policies and procedures of A&F’s Audit and Finance Committee and the fees for services rendered by the Company’s principal independent registered public accounting firm is incorporated by reference from the text to be included under captions “AUDIT AND FINANCE COMMITTEE MATTERS - Pre-Approval Policy” and “AUDIT AND FINANCE COMMITTEE MATTERS - Fees of Independent Registered Public Accounting Firm” in A&F’s definitive Proxy Statement for the Annual Meeting of Stockholders to be held on June 14, 2018.
PART IV
ITEM 15.
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) The following documents are filed as a part of this Annual Report on Form 10-K:
(1) Consolidated Financial Statements:
Consolidated Statements of Operations and Comprehensive Income (Loss) for the fiscal years ended February 3, 2018, January 28, 2017 and January 30, 2016.
Consolidated Balance Sheets at February 3, 2018 and January 28, 2017.
Consolidated Statements of Stockholders’ Equity for the fiscal years ended February 3, 2018, January 28, 2017 and January 30, 2016.
Consolidated Statements of Cash Flows for the fiscal years ended February 3, 2018, January 28, 2017 and January 30, 2016.
Notes to Consolidated Financial Statements.
Report of Independent Registered Public Accounting Firm - PricewaterhouseCoopers LLP.
(2) Consolidated Financial Statement Schedules:
All financial statement schedules for which provision is made in the applicable accounting regulations of the SEC are omitted because the required information is either not applicable or not material.
(3) Exhibits:
The documents listed below are filed or furnished with this Annual Report on Form 10-K as exhibits or incorporated into this Annual Report on Form 10-K by reference as noted:
*
Management contract or compensatory plan or arrangement required to be filed as an exhibit to this Annual Report on Form 10-K pursuant to Item 15(a)(3) of Annual Report on Form 10-K.
**
These certifications are furnished.
†
Certain portions of this exhibit have been omitted based upon a request for confidential treatment filed with the Securities and Exchange Commission (the “SEC”). The non-public information has been separately filed with the SEC in connection with that request.
(b) The documents listed in Item 15(a)(3) are filed or furnished with this Annual Report on Form 10-K as exhibits or incorporated into this Annual Report on Form 10-K by reference.
(c) Financial Statement Schedules
None
ITEM 16.
FORM 10-K SUMMARY
None.
SIGNATURES
Pursuant to the requirements of Section 13 or l5(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
ABERCROMBIE & FITCH CO.
Date: April 2, 2018
By
/s/ Scott Lipesky
Scott Lipesky
Senior Vice President and Chief Financial Officer
(Principal Financial Officer, Principal Accounting Officer and Authorized Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on April 2, 2018.
*
Terry L. Burman
Non-Executive Chairman of the Board and Director
/s/ Fran Horowitz
Fran Horowitz
Chief Executive Officer and Director (Principal Executive Officer)
*
Kerrii B. Anderson
Director
*
James B. Bachmann
Director
*
Bonnie R. Brooks
Director
*
Sarah M. Gallagher
Director
*
Michael E. Greenlees
Director
*
Archie M. Griffin
Director
/s/ Scott Lipesky
Scott Lipesky
Senior Vice President and Chief Financial Officer (Principal Financial Officer, Principal Accounting Officer and Authorized Officer)
*
Arthur C. Martinez
Director
*
Charles R. Perrin
Director
*
The undersigned, by signing his name hereto, does hereby sign this Annual Report on Form 10-K on behalf of each of the above-named directors of the Registrant pursuant to powers of attorney executed by such directors, which powers of attorney are filed with this Annual Report on Form 10-K as Exhibit 24.1, in the capacities as indicated and on April 2, 2018.
By
/s/ Scott Lipesky
Scott Lipesky
Attorney-in-fact