DOLLAR GENERAL CORP (DG) FY 2023 MD&A
This page reproduces the company's own Item 7 MD&A text from the linked SEC filing. It is filer text, not grepcent analysis, scoring, or investment advice.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This discussion and analysis should be read with, and is qualified in its entirety by, the Consolidated Financial Statements and the notes thereto. It also should be read in conjunction with the Cautionary Disclosure Regarding Forward-Looking Statements and the Risk Factors disclosures set forth in the Introduction and in Item 1A of this report, respectively.
Executive Overview
We are the largest discount retailer in the United States by number of stores, with 19,147 stores located in 47 U.S. states and Mexico as of March 3, 2023, with the greatest concentration of stores in the southern, southwestern, midwestern and eastern United States. Our first store in Mexico opened in February of 2023. We offer a broad selection of merchandise, including consumable products such as food, paper and cleaning products, health and beauty products and pet supplies, and non-consumable products such as seasonal merchandise, home decor and domestics, and basic apparel. Our merchandise includes national brands from leading manufacturers, as well as our own private brand selections with prices at substantial discounts to national brands. We offer our customers these national brand and private brand products at everyday low prices (typically $10 or less) in our convenient small-box locations.
We believe our convenient store formats, locations, and broad selection of high-quality products at compelling values have driven our substantial growth and financial success over the years and through a variety of economic cycles. We are mindful that the majority of our customers are value-conscious, and many have low and/or fixed incomes. As a result, we are intensely focused on helping our customers make the most of their spending dollars. Our core customers are often among the first to be affected by negative or uncertain economic conditions and among the last to feel the effects of improving economic conditions, particularly when trends are inconsistent and of an uncertain duration. The primary macroeconomic factors that affect our core customers include unemployment and underemployment rates, wage growth, changes in U.S. and global trade policy, and changes to certain government assistance programs (including cost of living adjustments), such as the Supplemental Nutrition Assistance Program (“SNAP”), unemployment benefits, and economic stimulus payments. Additionally, our customers are impacted by increases in those expenses that generally comprise a large portion of their household budgets, such as rent, healthcare, energy and fuel prices, as well as cost inflation in frequently purchased household products (including food), such as that which we have continued to experience as further discussed below. Finally, significant unseasonable or unusual weather patterns or extreme weather, such as that discussed below, can impact customer shopping behaviors.
We remain committed to our long-term operating priorities as we consistently strive to improve our performance while retaining our customer-centric focus. These priorities include: 1) driving profitable sales growth, 2) capturing growth opportunities, 3) enhancing our position as a low-cost operator, and 4) investing in our diverse teams through development, empowerment and inclusion.
We seek to drive profitable sales growth through initiatives aimed at increasing customer traffic and average transaction amount. As we work to provide everyday low prices and meet our customers’ affordability needs, we remain focused on enhancing our margins through pricing and markdown optimization, effective category management, distribution and transportation efficiencies, private brands penetration, global sourcing, and inventory shrink and damage reduction initiatives. Several of our strategic and other sales-driving initiatives are also designed to capture growth opportunities and are discussed in more detail below.
During the second half of 2022, we experienced higher inventory damages and shrink than we anticipated. We believe these increases are due to multiple factors, including the challenging macroeconomic environment, materially higher inventory levels, and, as to damages, Winter Storm Elliott in December. In addition, we believe some portion of the increase in damages is a residual impact of the warehouse capacity constraints and associated store and supply chain inefficiencies we faced, which are discussed in more detail below. While we anticipate shrink and damages may continue to pressure our results through the first half of 2023, we believe we are taking actions that we believe will reduce the impact of these challenges to our business as we move throughout the year.
26
Table of Contents
Historically, sales in our consumables category, which tend to have lower gross margins, have been the key drivers of net sales and customer traffic, while sales in our non-consumables categories, which tend to have higher gross margins, have contributed to more profitable sales growth and an increase in average transaction amount. Prior to 2020, our sales mix had continued to shift toward consumables, and, within consumables, toward lower margin departments such as perishables. This trend did not occur in 2020 or the first quarter of 2021, as we saw a significant increase in demand in many non-consumable products, including home, seasonal and apparel, resulting in an overall significant mix shift into non-consumable categories during those periods. Beginning in the second quarter of 2021 and continuing thereafter, we began to see reversion toward the historical mix trends. We continue to expect sales mix challenges to persist as the mix trend reversion toward consumables returned to pre-pandemic levels in the fourth quarter of 2021 and has exceeded pre-pandemic levels since the first quarter of 2022. Several of our initiatives, including certain of those discussed below, are intended to address these mix challenges; however, there can be no assurances that these efforts will be successful.
In 2022, we saw continued growth in average transaction amount, which was driven primarily by inflation, and we believe, to a lesser degree, our merchandising efforts. In the second and third quarters of 2022, we experienced a slight to modest increase in customer traffic, respectively. In addition, although we believe our sales growth in the first half of 2022 was negatively impacted by the global and domestic supply chain challenges and disruptions discussed further below, primarily in the form of lower merchandise in-stock levels in our stores, we have seen some improvement in our in-stock levels and in the global supply chain environment. However, in the second half of 2022, we experienced what we believe to be temporary warehouse capacity constraints and inefficiencies within our internal supply chain, including unanticipated temporary delays in opening or securing additional storage facilities, all of which is discussed further below.
We continue to implement and invest in certain strategic initiatives that we believe will help drive profitable sales growth with both new and existing customers and capture long-term growth opportunities. Such opportunities include providing our customers with additional shopping access points and even greater convenience by leveraging and developing digital tools and technology, such as our Dollar General app, which contains a variety of tools to enhance the in-store shopping experience. Additionally, we launched a partnership with a third party delivery service during 2021, which is now available in the majority of our stores, and we continue to grow our DG Media Network, which is our platform for connecting brand partners with our customers to drive even greater value for each.
Further, our non-consumables initiative, which offers a new, differentiated and limited assortment that will change throughout the year, continues to contribute to improved overall sales and gross margin performance in stores where it has been deployed. We have completed the rollout in the vast majority of our Dollar General stores.
Additionally, we are continuing to grow the footprint of pOpshelf, a unique retail concept that incorporates certain of the lessons learned from the non-consumables initiative in a differentiated format that is focused on categories such as seasonal and home décor, health and beauty, home cleaning supplies, and party and entertainment goods. At the end of fiscal 2022, we operated 140 standalone pOpshelf locations and 40 pOpshelf store-within-a-store concepts within existing Dollar General Market stores. We believe this concept represents a significant growth opportunity and are targeting nearly 300 standalone pOpshelf stores by the end of fiscal 2023, and approximately 1,000 stores by the end of fiscal 2025.
Our “DG Fresh” initiative, a self-distribution model for frozen and refrigerated products that is designed to reduce product costs, enhance item assortment, improve our in-stock position, and enhance sales, has positively contributed to our sales performance since we completed the initial rollout in the second quarter of 2021, driven by higher in-stock levels and the introduction of new products in select stores. DG Fresh now wholly or partially serves essentially all stores across the chain and has benefitted gross profit through improved initial markups on inventory purchases, which were partially offset by increased distribution and transportation costs. Moving forward, we plan to focus on additional optimization of the distribution footprint and product assortment within DG Fresh to further drive profitable sales growth.
27
Table of Contents
We also have a health initiative, branded as “DG Well Being”, with the goal of increasing access to basic healthcare products, and ultimately services over time, particularly in rural communities. The initial focus of this initiative is a significantly expanded health product assortment in certain stores, primarily those in our larger formats.
To support our other operating priorities, we remain focused on capturing growth opportunities. In fiscal 2022, we opened a total of 1,039 new stores, remodeled 1,795 stores, and relocated 127 stores. In fiscal 2023, we plan to open approximately 1,050 new stores in the United States (including any pOpshelf stores), remodel approximately 2,000 stores, and relocate approximately 120 stores, for a total of 3,170 real estate projects. We opened our first store in Mexico in the first quarter of fiscal 2023. Our goal is to operate approximately 20 stores in Mexico by the end of 2023, all of which would be incremental to our planned 1,050 new store openings.
We continue to innovate within our channel and utilize the most productive of our various Dollar General store formats based on the specific market opportunity. We expect store format innovation to allow us to capture additional growth opportunities within our existing markets. We are now using two larger format stores (approximately 8,500 square feet and 9,500 square feet, respectively), and expect the 8,500 square foot format, along with our existing Dollar General Plus format of a similar size, to continue as our base prototypes for the majority of new stores, replacing our traditional 7,300 square foot format and higher-cooler count Dollar General Traditional Plus format. The larger formats allow for expanded high-capacity-cooler counts; an extended queue line; and a broader product assortment, including the non-consumable initiative, a larger health and beauty section, and produce in select stores. We continue to incorporate lessons learned from our various store formats and layouts into our existing store base. These lessons contribute to innovation in developing new formats, with a goal of driving increased customer traffic, average transaction amount, same-store sales and overall store productivity.
We have established a position as a low-cost operator, always seeking ways to reduce or control costs that do not affect our customers’ shopping experiences. We plan to continue enhancing this position over time while employing ongoing cost discipline to reduce certain expenses as a percentage of sales. Nonetheless, we seek to maintain flexibility to invest in the business as necessary to enhance our long-term competitiveness and profitability.
We are continuing to deploy “Fast Track,” an initiative aimed at further enhancing our convenience proposition and in-stock position as well as creating labor efficiencies within our stores. The completed portion of the first phase of Fast Track involved sorting process optimization within our non-refrigerated distribution centers, as well as increased shelf-ready packaging, to allow for greater store-level stocking efficiencies, while the current focus involves adding a self-checkout option, which we now have in the majority of our stores. These and the other strategic initiatives discussed above have required and will require us to incur upfront expenses for which there may not be an immediate return in terms of sales or enhanced profitability.
To further optimize our cost structure and facilitate greater operational control within our supply chain, we more-than-doubled the size of our private tractor fleet in 2022 to more than 1,600 tractors. We plan to continue expanding the size of our fleet to drive additional savings, and our goal is to have more than 2,000 tractors in the fleet by the end of fiscal 2023.
Certain of our operating expenses, such as wage rates and occupancy costs, have continued to increase in recent years, due primarily to market forces, including labor availability, increases in minimum wage rates and increases in property rents. Further federal, state and/or local minimum wage increases could have a material negative impact on our operating expenses, although the magnitude and timing of such impact is uncertain. In 2023, we plan to make an investment of approximately $100 million to further enhance our store standards and compliance efforts as well as the customer and associate experience in our stores, primarily through incremental labor hours. We believe these investments will also elevate consistency of experience in our stores, and amplify the potential of our strategic initiatives, while driving greater on-shelf availability and market share gains.
In addition, we have experienced challenges such as increased costs and disruptions in our business as a result of various global events, including the COVID-19 pandemic and its associated impacts. Such challenges include incremental transportation, distribution, and payroll costs, as well as supply chain disruptions. While we have begun to see some improvement in the overall global supply chain environment, we experienced some
28
Table of Contents
unanticipated delays in acquiring additional temporary warehouse space sufficient for our inventory needs, which caused delays and inefficiencies within our internal supply chain in the second half of fiscal 2022. These challenges resulted in materially higher than anticipated supply chain costs, including detention fees incurred for delays in returning shipping containers and higher temporary storage and transportation costs and labor. We have made significant progress in acquiring additional temporary and permanent warehouse capacity and plan to add a significant amount of additional warehouse capacity in fiscal 2023. We believe these additional facilities will support greater efficiencies throughout our supply chain.
In addition, while we believe the growth rate of inflation is beginning to moderate, we expect continued inflationary pressures in the near term due to higher input costs and that higher energy and fuel prices will continue to affect us as well as our vendors and customers, resulting in higher commodity, transportation and other costs, including product costs, all of which may result in continued pressure to our operating results. To the extent that these inflationary pressures result in a recessionary environment, we may experience adverse effects on our business, results of operations and cash flows. Certain of our initiatives and plans are intended to help offset these inflation-driven challenges; however, they are somewhat dependent on the scale and timing of any increased costs, among other factors. There can be no assurance that our mitigation efforts will be successful. Moreover, recent increases in market interest rates have had a negative impact on our interest expense, both with respect to issuances of commercial paper notes and other indebtedness.
Our diverse teams are a competitive advantage, and we proactively seek ways to continue investing in their development. Our goal is to create an environment that attracts, develops, and retains talented personnel, particularly at the store manager level, because employees who are promoted from within our company generally have longer tenures and are greater contributors to improvements in our financial performance.
To further enhance shareholder returns, we repurchased shares of our common stock and paid quarterly cash dividends in 2022, and our Board of Directors recently increased the quarterly cash dividend, beginning with the dividend to be paid on or before April 25, 2023. We expect to continue our share repurchase activity and to pay quarterly cash dividends for the foreseeable future, subject to Board discretion and approval.
During the fourth quarter of 2022, Winter Storm Elliott significantly impacted our operations during the month of December, resulting in negative impacts to customer traffic, sales growth and associated gross margin, as well as incremental damages and repairs and maintenance expense.
We utilize key performance indicators (“KPIs”) in the management of our business. Our KPIs include same-store sales, average sales per square foot, and inventory turnover. Same-store sales are calculated based upon our stores that were open at least 13 full fiscal months and remain open at the end of the reporting period. We include stores that have been remodeled, expanded or relocated in our same-store sales calculation. Changes in same-store sales are calculated based on the comparable 52 calendar weeks in the current and prior years. The method of calculating same-store sales varies across the retail industry. As a result, our calculation of same-store sales is not necessarily comparable to similarly titled measures reported by other companies. Average sales per square foot is calculated based on total sales for the preceding 12 months as of the ending date of the reporting period divided by the average selling square footage during the period, including the end of the fiscal year, the beginning of the fiscal year, and the end of each of our three interim fiscal quarters. Inventory turnover is calculated based on total cost of goods sold for the preceding four quarters divided by the average inventory balance as of the ending date of the reporting period, including the end of the fiscal year, the beginning of the fiscal year, and the end of each of our three interim fiscal quarters. Each of these measures is commonly used by investors in retail companies to measure the health of the business. We use these measures to maximize profitability and for decisions about the allocation of resources.
29
Table of Contents
A continued focus on our four operating priorities as discussed above, and other impacts as discussed below, resulted in the following overall operating and financial performance in 2022 as compared to 2021. Basis points, as referred to below, are equal to 0.01% as a percentage of net sales.
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | Net sales in 2022 increased 10.6% over 2021. Sales in same-stores increased 4.3%, primarily due to an increase in average transaction amount. Average sales per square foot in 2022 were $273, including a $5 contribution from the 53rd week. |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | The gross profit rate decreased by 37 basis points due primarily to an increased LIFO provision and a greater proportion of lower margin consumables sales. |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | SG&A as a percentage of sales increased by 25 basis points primarily due to increases in utilities, retail labor, and repairs and maintenance. |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | Operating profit increased 3.3% to $3.33 billion in 2022 compared to $3.22 billion in 2021. |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | Interest expense increased by $53.7 million in 2022 primarily due to higher average borrowings and higher interest rates. |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | The change in the effective income tax rate to 22.5% in 2022 from 21.7% in 2021 was primarily due to decreased income tax benefits associated with stock-based compensation compared to 2021. |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | We reported net income of $2.42 billion, or $10.68 per diluted share, for 2022 compared to net income of $2.40 billion, or $10.17 per diluted share, for 2021. |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | We generated approximately $1.98 billion of cash flows from operating activities in 2022, a decrease of 30.8% compared to 2021. |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | Inventory turnover was 4.0 times, and inventories increased 14.3% on a per store basis compared to 2021. |
| Column 1 | Column 2 | Column 3 |
|---|---|---|
| ● | We repurchased approximately 11.6 million shares of our outstanding common stock for $2.7 billion. |
Readers should refer to the detailed discussion of our operating results below for additional comments on financial performance in the current year as compared with the prior years presented.
Results of Operations
Accounting Periods. The following text contains references to years 2022, 2021, and 2020, which represent fiscal years ended February 3, 2023, January 28, 2022, and January 29, 2021, respectively. Our fiscal year ends on the Friday closest to January 31. Fiscal year 2022 was a 53-week accounting period and fiscal years 2021 and 2020 were 52-week accounting periods.
Seasonality. The nature of our business is somewhat seasonal. Primarily because of sales of Christmas-related merchandise, operating profit in our fourth quarter (November, December and January) has historically been higher than operating profit achieved in each of the first three quarters of the fiscal year. Expenses, and to a greater extent operating profit, vary by quarter. Results of a period shorter than a full year may not be indicative of results expected for the entire year. Furthermore, the seasonal nature of our business may affect comparisons between periods.
30
Table of Contents
The following table contains results of operations data for fiscal years 2022, 2021 and 2020, and the dollar and percentage variances among those years.
| | | | | | | | | | | | | | | | | | | | | |
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| | | | | | | | | | | | 2022 vs. 2021 | 2021 vs. 2020 | | |||||||
| (amounts in millions, except | | | | | | | Amount | % | Amount | % | | |||||||||
| per share amounts) | | 2022 | | 2021 | | 2020 | | Change | | Change | Change | | Change | | ||||||
| Net sales by category: | | | | | | | | | | | | | | | | | | | | |
| Consumables | | $ | 30,155.2 | | $ | 26,258.6 | | $ | 25,906.7 | | $ | 3,896.6 | | 14.8 | % | $ | 351.9 | | 1.4 | % |
| % of net sales | | 79.68 | % | 76.73 | % | 76.77 | % | | | | | | | | | | ||||
| Seasonal | | 4,182.8 | | 4,182.2 | | 4,083.7 | | 0.6 | | 0.0 | | 98.5 | | 2.4 | | |||||
| % of net sales | | 11.05 | % | 12.22 | % | 12.10 | % | | | | | | | | | | ||||
| Home products | | 2,332.4 | | 2,322.4 | | 2,210.0 | | 10.0 | | 0.4 | | 112.4 | | 5.1 | | |||||
| % of net sales | | 6.16 | % | 6.79 | % | 6.55 | % | | | | | | | | | | ||||
| Apparel | | 1,174.4 | | 1,457.3 | | 1,546.6 | | (282.9) | | (19.4) | | (89.2) | | (5.8) | | |||||
| % of net sales | | 3.10 | % | 4.26 | % | 4.58 | % | | | | | | | | | | ||||
| Net sales | | $ | 37,844.9 | | $ | 34,220.4 | | $ | 33,746.8 | | $ | 3,624.4 | | 10.6 | % | $ | 473.6 | | 1.4 | % |
| Cost of goods sold | | 26,024.8 | | 23,407.4 | | 23,028.0 | | 2,617.3 | | 11.2 | | 379.5 | | 1.6 | | |||||
| % of net sales | | 68.77 | % | 68.40 | % | 68.24 | % | | | | | | | | | | ||||
| Gross profit | | 11,820.1 | | 10,813.0 | | 10,718.9 | | 1,007.1 | | 9.3 | | 94.1 | | 0.9 | | |||||
| % of net sales | | 31.23 | % | 31.60 | % | 31.76 | % | | | | | | | | | | ||||
| Selling, general and administrative expenses | | 8,491.8 | | 7,592.3 | | 7,164.1 | | 899.5 | | 11.8 | | 428.2 | | 6.0 | | |||||
| % of net sales | | 22.44 | % | 22.19 | % | 21.23 | % | | | | | | | | | | ||||
| Operating profit | | 3,328.3 | | 3,220.7 | | 3,554.8 | | 107.6 | | 3.3 | | (334.1) | | (9.4) | | |||||
| % of net sales | | 8.79 | % | 9.41 | % | 10.53 | % | | | | | | | | | | ||||
| Interest expense | | 211.3 | | 157.5 | | 150.4 | | 53.7 | | 34.1 | | 7.1 | | 4.7 | | |||||
| % of net sales | | 0.56 | % | 0.46 | % | 0.45 | % | | | | | | | | | | ||||
| Other (income) expense | | 0.4 | | — | | — | | 0.4 | | — | | — | | — | | |||||
| % of net sales | | 0.00 | % | 0.00 | % | 0.00 | % | | | | | | | | | | ||||
| Income before income taxes | | 3,116.6 | | 3,063.1 | | 3,404.4 | | 53.5 | | 1.7 | | (341.2) | | (10.0) | | |||||
| % of net sales | | 8.24 | % | 8.95 | % | 10.09 | % | | | | | | | | | | ||||
| Income tax expense | | 700.6 | | 663.9 | | 749.3 | | 36.7 | | 5.5 | | (85.4) | | (11.4) | | |||||
| % of net sales | | 1.85 | % | 1.94 | % | 2.22 | % | | | | | | | | | | ||||
| Net income | | $ | 2,416.0 | | $ | 2,399.2 | | $ | 2,655.1 | | $ | 16.8 | | 0.7 | % | $ | (255.8) | | (9.6) | % |
| % of net sales | | 6.38 | % | 7.01 | % | 7.87 | % | | | | | | | | | | ||||
| Diluted earnings per share | | $ | 10.68 | | $ | 10.17 | | $ | 10.62 | | $ | 0.51 | | 5.0 | % | $ | (0.45) | | (4.2) | % |
Net Sales. The net sales increase in 2022 was primarily due to sales from new stores, and an increase in same-store sales of 4.3% compared to 2021, partially offset by the impact of store closures. In 2022, our 17,886 same-stores accounted for sales of $35.3 billion. The increase in same-store sales reflects an increase in average transaction amount which was driven by higher average item retail prices as a result of higher inflation, partially offset by a decline in customer traffic. Same-store sales decreased in each of our product categories except consumables, with the largest percentage decrease in the apparel category. Net sales for the 53rd week of 2022 totaled $678.1 million.
The net sales increase in 2021 was primarily due to sales from new stores, partially offset by a decrease in same-store sales of 2.8% compared to 2020 as well as the impact of store closures. In 2021, our 16,954 same-stores accounted for sales of $32.4 billion. The decrease in same-store sales reflects a decline in customer traffic partially offset by an increase in average transaction amount which was driven by higher average item retail prices. Same-store sales decreased in each of our product categories, with the largest percentage decrease in the apparel category.
Gross Profit. In 2022, gross profit increased by 9.3%, and as a percentage of net sales decreased by 37 basis points to 31.2% compared to 2021. A greater LIFO provision which was driven by higher product costs, a higher proportion of lower margin consumables sales, and increases in inventory markdowns, damages and shrink each contributed to the decrease in the gross profit rate. These factors were partially offset by higher inventory markups and improvements in transportation costs.
31
Table of Contents
In 2021, gross profit increased by 0.9%, and as a percentage of net sales decreased by 16 basis points to 31.6% compared to 2020. Increased transportation costs, a greater LIFO provision which was driven by higher product costs, increased inventory damages and higher distribution costs each contributed to the decrease in the gross profit rate. These factors were partially offset by higher inventory markups, a reduction in markdowns as a percentage of net sales, and a lower inventory shrink rate. In 2021, consumables and non-consumables sales increased at approximately the same rate when compared to 2020.
SG&A. SG&A as a percentage of net sales was 22.4% in 2022 compared to 22.2% in 2021, an increase of 25 basis points. The primary expenses that were higher as a percentage of net sales in 2022 were utilities, retail labor, and repairs and maintenance, partially offset by incentive compensation expenses and store occupancy costs.
SG&A as a percentage of net sales was 22.2% in 2021 compared to 21.2% in 2020, an increase of 96 basis points. The primary expenses that were higher as a percentage of net sales in 2021 were retail labor, store occupancy costs, depreciation and amortization, employee benefits, utilities, and workers’ compensation and general liability expenses, partially offset by reductions in discretionary employee bonus and other miscellaneous COVID-related expenses and incentive compensation expenses.
Interest Expense. Interest expense increased $53.7 million to $211.3 million in 2022 compared to 2021 and increased $7.1 million to $157.5 million in 2021 compared to 2020 primarily due to higher outstanding borrowings and higher interest rates. See the detailed discussion under “Liquidity and Capital Resources” regarding the financing of various long-term obligations.
Income Taxes. The effective income tax rate for 2022 was 22.5% compared to a rate of 21.7% for 2021 which represents a net increase of 0.8 percentage points. The effective income tax rate was higher in 2022 primarily due to decreased income tax benefits associated with stock-based compensation compared to 2021.
The effective income tax rate for 2021 was 21.7% compared to a rate of 22.0% for 2020 which represents a net decrease of 0.3 percentage points. The effective income tax rate was lower in 2021 primarily due to increased income tax benefits associated with federal tax credits partially offset by a higher state effective tax rate compared to 2020.
Effects of Inflation
In 2022 and 2021, we experienced increases in product costs due in part to higher rates of inflation, particularly to the global supply chain as well as our own internal supply chain. In 2022, higher rates of inflation affected the costs of building materials and certain of our other capital costs.
Liquidity and Capital Resources
Current Financial Condition and Recent Developments
During the past three years, we have generated an aggregate of approximately $8.7 billion in cash flows from operating activities and incurred approximately $3.7 billion in capital expenditures. During that period, we expanded the number of stores we operate by 2,826, representing growth of approximately 17%, and we remodeled or relocated 5,554 stores, or approximately 34% of the stores we operated as of the beginning of the three-year period. In 2023, we intend to continue our current strategy of pursuing store growth, remodels and relocations.
At February 3, 2023, we had a $2.0 billion unsecured revolving credit agreement (the “Revolving Facility”), $750.0 million 364-day unsecured revolving credit facility (the “364-Day Revolving Facility”), $5.4 billion aggregate principal amount of senior notes, and a commercial paper program that may provide borrowing availability of up to $2.0 billion. At February 3, 2023, we had total consolidated outstanding debt (including the current portion of long-term obligations) of $7.0 billion, most of which was in the form of senior notes. All of our material borrowing arrangements are described in greater detail below. Our borrowing availability under the Revolving Facility may be effectively limited by our commercial paper notes (“CP Notes”) as further described
32
Table of Contents
below. The information contained in Note 5 to the consolidated financial statements contained in Part II, Item 8 of this report is incorporated herein by reference.
We believe our cash flow from operations, and our existing cash balances, combined with availability under the Revolving Facility, 364-Day Revolving Facility, CP Notes and access to the debt markets, will provide sufficient liquidity to fund our current obligations, projected working capital requirements, capital spending and anticipated dividend payments for a period that includes the next twelve months as well as the next several years. However, our ability to maintain sufficient liquidity may be affected by numerous factors, many of which are outside of our control. Depending on our liquidity levels, conditions in the capital markets and other factors, we may from time to time consider the issuance of debt, equity or other securities, the proceeds of which could provide additional liquidity for our operations.
For fiscal 2023, we anticipate potential combined borrowings under the Revolving Facility, 364-Day Revolving Facility, and CP Notes to be a maximum of approximately $2.0 billion outstanding at any one time, including any anticipated borrowings to fund repurchases of common stock.
Revolving Credit Facilities
Our Revolving Facility consists of a $2.0 billion senior unsecured revolving credit facility of which up to $100.0 million is available for the issuance of letters of credit and which is scheduled to mature on December 2, 2026.
Borrowings under the Revolving Facility bear interest at a rate equal to an applicable interest rate margin plus, at our option, either (a) Adjusted Term SOFR (which is Term SOFR (as published by CME Group Benchmark Administration Limited) plus a credit spread adjustment of 0.10%) or (b) a base rate (which is usually equal to the prime rate). The applicable interest rate margin for borrowings as of February 3, 2023 was 1.015% for Adjusted Term SOFR borrowings and 0.015% for base-rate borrowings. We must also pay a facility fee, payable on any used and unused commitment amounts of the Revolving Facility, and customary fees on letters of credit issued under the Revolving Facility. As of February 3, 2023, the facility fee rate was 0.11%. The applicable interest rate margins for borrowings, the facility fees and the letter of credit fees under the Revolving Facility are subject to adjustment from time to time based on our long-term senior unsecured debt ratings.
We entered into the 364-Day Revolving Facility on January 31, 2023, which will expire on January 30, 2024. At February 3, 2023, the 364-Day Revolving Facility had no outstanding borrowings.
Borrowings under the 364-Day Revolving Facility bear interest at a rate equal to an applicable interest rate margin plus, at our option, either (a) Adjusted Term SOFR (which is Term SOFR (as published by CME Group Benchmark Administration Limited) plus a credit spread adjustment of 0.10%) or (b) a base rate (which is usually equal to the prime rate). We are also required to pay a facility fee to the lenders under the 364-Day Revolving Facility for any used and unused commitments. As of February 3, 2023, the applicable interest rate margin for Adjusted Term SOFR loans was 1.035% and the facility fee rate was 0.09% per annum. The applicable interest rate margins for borrowings and the facility fees under the 364-Day Revolving Facility are subject to adjustment from time to time based on our long-term senior unsecured debt ratings.
The Revolving Facility and the 364-Day Revolving Facility contain a number of customary affirmative and negative covenants that, among other things, restrict, subject to certain exceptions, our (and our subsidiaries’) ability to: incur additional liens; sell all or substantially all of the our assets; consummate certain fundamental changes or change in the our lines of business; and incur additional subsidiary indebtedness. The Revolving Facility and the 364-Day Revolving Facility also contain financial covenants which require the maintenance of a minimum fixed charge coverage ratio and a maximum leverage ratio. As of February 3, 2023, we were in compliance with all such covenants. Both facilities also contain customary events of default.
As of February 3, 2023, we had no outstanding borrowings, no outstanding letters of credit, and borrowing availability of $2.0 billion under the Revolving Facility that, due to our intention to maintain borrowing availability related to the commercial paper program described below, could contribute liquidity of $0.3 billion. As of February
33
Table of Contents
3, 2023, under the 364-Day Revolving Facility, we had no outstanding borrowings and borrowing availability of $750 million. At February 3, 2023 we had combined availability under the credit facilities of $1.0 billion. In addition, we had outstanding letters of credit of $39.7 million which were issued pursuant to separate agreements.
Commercial Paper
We may issue the CP Notes from time to time in an aggregate amount not to exceed $2.0 billion outstanding at any time. The CP Notes may have maturities of up to 364 days from the date of issue and rank equal in right of payment with all of our other unsecured and unsubordinated indebtedness. We intend to maintain available commitments under the Revolving Facility in an amount at least equal to the amount of CP Notes outstanding at any time. As of February 3, 2023, our consolidated balance sheet reflected outstanding unsecured CP Notes of $1.5 billion. CP Notes totaling $230.8 million were held by a wholly-owned subsidiary and therefore are not reflected in the consolidated balance sheets.
Senior Notes
In October 2015 we issued $500.0 million aggregate principal amount of 4.150% senior notes due 2025 (the “2025 Senior Notes”) at a discount of $0.8 million, which are scheduled to mature on November 1, 2025. In April 2017 we issued $600.0 million aggregate principal amount of 3.875% senior notes due 2027 (the “2027 Senior Notes”) at a discount of $0.4 million, which are scheduled to mature on April 15, 2027. In April 2018 we issued $500.0 million aggregate principal amount of 4.125% senior notes due 2028 (the “2028 Senior Notes”) at a discount of $0.5 million, which are scheduled to mature on May 1, 2028. In April 2020 we issued $1.0 billion aggregate principal amount of 3.5% senior notes due 2030 (the “2030 Senior Notes”) at a discount of $0.7 million, which are scheduled to mature on April 3, 2030, and $500.0 million aggregate principal amount of 4.125% senior notes due 2050 (the “2050 Senior Notes”) at a discount of $5.0 million, which are scheduled to mature on April 3, 2050. In September 2022, we issued $750.0 million aggregate principal amount of 4.25% senior notes due 2024 (the “2024 Senior Notes”), net of discount of $0.7 million, which are scheduled to mature on September 20, 2024, $550.0 million aggregate principal amount of 4.625% senior notes due 2027 (the “November 2027 Senior Notes”), net of discount of $0.5 million, which are scheduled to mature on November 1, 2027, $700.0 million aggregate principal amount of 5.0% senior notes due 2032 (the “2032 Senior Notes”), net of discount of $2.4 million which are scheduled to mature on November 1, 2032, and $300.0 million aggregate principal amount of 5.50% senior notes due 2052 (the “2052 Senior Notes”), net of discount of $0.3 million, which are scheduled to mature on November 1, 2052. Collectively, the 2024 Senior Notes, 2025 Senior Notes, 2027 Senior Notes, November 2027 Senior Notes, 2028 Senior Notes, 2030 Senior Notes, 2032 Senior Notes, 2050 Senior Notes, and 2052 Senior Notes, comprise the “Senior Notes”, each of which were issued pursuant to an indenture as supplemented and amended by supplemental indentures relating to each series of Senior Notes (as so supplemented and amended, the “Senior Indenture”). Interest on the 2027 Senior Notes is payable in cash on April 15 and October 15 of each year. Interest on the 2025 Senior Notes and the 2028 Senior Notes is payable in cash on May 1 and November 1 of each year. Interest on the 2030 Senior Notes and the 2050 Senior Notes is payable in cash on April 3 and October 3 of each year. Interest on the 2024 Senior Notes is payable in cash on March 20 and September 20 of each year, commencing on March 20, 2023. Interest on the November 2027 Senior Notes, the 2032 Senior Notes and the 2052 Senior Notes is payable in cash on May 1 and November 1 of each year, commencing on May 1, 2023.
We may redeem some or all of the Senior Notes at any time at redemption prices set forth in the Senior Indenture. Upon the occurrence of a change of control triggering event, which is defined in the Senior Indenture, each holder of our Senior Notes has the right to require us to repurchase some or all of such holder’s Senior Notes at a purchase price in cash equal to 101% of the principal amount thereof, plus accrued and unpaid interest, if any, to, but excluding, the repurchase date. In October 2022 we redeemed $900.0 million aggregate principal amount of 3.25% senior notes due 2023 and incurred a loss on redemption of $0.4 million.
The Senior Indenture contains covenants limiting, among other things, our ability (subject to certain exceptions) to consolidate, merge, or sell or otherwise dispose of all or substantially all of our assets; and our ability and the ability of our subsidiaries to incur or guarantee indebtedness secured by liens on any shares of voting stock of significant subsidiaries.
34
Table of Contents
The Senior Indenture also provides for events of default which, if any of them occurs, would permit or require the principal of and accrued interest on our Senior Notes to become or to be declared due and payable, as applicable.
Rating Agencies
Our senior unsecured debt is rated “Baa2,” by Moody’s with a stable outlook and “BBB” by Standard & Poor’s with a stable outlook, and our commercial paper program is rated “P-2” by Moody’s and “A-2” by Standard and Poor’s. Our current credit ratings, as well as future rating agency actions, could (i) impact our ability to finance our operations on satisfactory terms; (ii) affect our financing costs; and (iii) affect our insurance premiums and collateral requirements necessary for our self-insured programs. There can be no assurance that we will maintain or improve our current credit ratings.
Future Cash Requirements
The following table summarizes significant estimated future cash requirements under our various contractual obligations and other commitments at February 3, 2023, in total and disaggregated into current (1 year) and long-term (1 or more years) obligations (in thousands):
| | | | | | | | | | | | | | | | | |
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| | | Payments Due by Period | ||||||||||||||
| Contractual obligations | Total | 1 year | 1 - 3 years | 3 - 5 years | 5+ years | |||||||||||
| Long-term debt obligations | | $ | 7,102,596 | | $ | 1,516,478 | | $ | 1,278,878 | | $ | 1,178,910 | | $ | 3,128,329 | |
| Interest(a) | | 2,385,726 | | 317,474 | | 443,478 | | 359,908 | | 1,264,866 | | |||||
| Self-insurance liabilities(b) | | 274,160 | | 136,611 | | | 94,560 | | | 34,630 | | | 8,359 | | ||
| Operating lease obligations | | 12,737,264 | | 1,675,193 | | | 3,138,929 | | | 2,651,776 | | | 5,271,366 | | ||
| Subtotal | | $ | 22,499,745 | | $ | 3,645,756 | | $ | 4,955,845 | | $ | 4,225,224 | | $ | 9,672,920 | |
| | | | | | | | | | | | | | | | | |
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| | | Commitments Expiring by Period | ||||||||||||||
| Commercial commitments(c) | Total | 1 year | 1 - 3 years | 3 - 5 years | 5+ years | |||||||||||
| Letters of credit | | $ | 39,838 | | $ | 39,838 | | $ | — | | $ | — | | $ | — | |
| Purchase obligations(d) | | 2,465,087 | | 2,409,635 | | 55,452 | | — | | — | | |||||
| Subtotal | | $ | 2,504,925 | | $ | 2,449,473 | | $ | 55,452 | | $ | — | | $ | — | |
| Total contractual obligations and commercial commitments | | $ | 25,004,670 | | $ | 6,095,229 | | $ | 5,011,297 | | $ | 4,225,224 | | $ | 9,672,920 | |
| Column 1 | Column 2 |
|---|---|
| (a) | Represents obligations for interest payments on long-term debt and includes projected interest on variable rate long-term debt using 2022 yearend rates and balances. Variable rate long-term debt includes the Revolving Facility (although such facility had a balance of zero as of February 3, 2023), the 364-Day Revolving Facility (although such facility had a balance of zero as of February 3, 2023), the CP Notes (which had a balance of $1.5 billion as of February 3, 2023, and which amount is net of $230.8 million held by a wholly-owned subsidiary), and interest rate swaps being accounted for as fair value hedges. |
| Column 1 | Column 2 |
|---|---|
| (b) | We retain a significant portion of the risk for our workers’ compensation, employee health, general liability, property loss, automobile, and certain third-party landlord claims exposures. As these obligations do not have scheduled maturities, these amounts represent undiscounted estimates based upon actuarial assumptions. Substantially all amounts are reflected on an undiscounted basis in our consolidated balance sheets. |
| Column 1 | Column 2 |
|---|---|
| (c) | Commercial commitments include information technology license and support agreements, supplies, fixtures, letters of credit for import merchandise, and other inventory purchase obligations. |
| Column 1 | Column 2 |
|---|---|
| (d) | Purchase obligations include legally binding agreements for software licenses and support, supplies, fixtures, and merchandise purchases (excluding such purchases subject to letters of credit). |
35
Table of Contents
Share Repurchase Program
Our common stock repurchase program had a total remaining authorization of approximately $1.38 billion at February 3, 2023. The authorization allows repurchases from time to time in open market transactions, including pursuant to trading plans adopted in accordance with Rule 10b5-1 of the Securities Exchange Act of 1934, as amended, or in privately negotiated transactions. The timing, manner and number of shares repurchased will depend on a variety of factors, including price, market conditions, compliance with the covenants and restrictions under our debt agreements and other factors. The repurchase program has no expiration date and may be modified or terminated from time to time at the discretion of our Board of Directors. For more detail about our share repurchase program, see Part II, Item 5 of this report and Note 11 to the consolidated financial statements contained in Part II, Item 8 of this report.
Other Considerations
In March 2023, the Board of Directors declared a quarterly cash dividend of $0.59 per share which is payable on or before April 25, 2023 to shareholders of record of our common stock on April 11, 2023. We paid quarterly cash dividends of $0.55 per share in 2022. Although the Board currently expects to continue regular quarterly cash dividends, the declaration and amount of future cash dividends are subject to the Board’s sole discretion and will depend upon, among other factors, our results of operations, cash requirements, financial condition, contractual restrictions and other factors that our Board may deem relevant in its sole discretion.
Our inventory balance represented approximately 53% of our total assets exclusive of operating lease assets, goodwill, and other intangible assets as of February 3, 2023. Our ability to effectively manage our inventory balances can have a significant impact on our cash flows from operations during a given fiscal year as discussed further below. Inventory purchases are often somewhat seasonal in nature, such as the purchase of warm-weather or Christmas-related merchandise. Efficient management of our inventory has been and continues to be an area of focus for us.
We utilize supply chain finance programs whereby qualifying suppliers may elect at their sole discretion to sell our payment obligations to designated third party financial institutions. While the terms of these agreements are between the supplier and the financial institution, the supply chain finance financial institutions allow the participating suppliers to utilize our creditworthiness in establishing credit spreads and associated costs. As of February 3, 2023, the amount due to suppliers participating in these supply chain finance programs was $300.9 million.
As described in Note 7 to the consolidated financial statements, we are involved in a number of legal actions and claims, some of which could potentially result in material cash payments. Adverse developments in those actions could materially and adversely affect our liquidity.
Cash Flows
Cash flows from operating activities. Cash flows from operating activities were $1.98 billion in 2022, which represents a $881.3 million decrease compared to 2021. Changes in merchandise inventories resulted in a $1.7 billion decrease in our working capital in 2022 compared to the decrease of $550.1 million in 2021 as described in greater detail below. Changes in other noncash losses resulted in a $530.5 million increase as compared to a $191.0 million increase in 2021 primarily due to an increase in the LIFO provision. Changes in accounts payable resulted in a $194.7 million decrease in our working capital in 2022 compared to a $98.7 million increase in 2021, due primarily to the timing of inventory receipts and related payments. Changes in accrued expenses resulted in a $25.4 million decrease in our working capital in 2022 compared to a $37.3 million decrease in 2021, due primarily to the timing of accruals and payments for freight, payroll taxes and incentive compensation. Changes in income taxes in 2022 compared to 2021 are primarily due to the timing of payments for income taxes.
Cash flows from operating activities were $2.87 billion in 2021, which represents a $1.01 billion decrease compared to 2020. The COVID-19 pandemic resulted in significantly increased sales, gross profit, and operating income in 2020, and our net income decreased $255.8 million in 2021 compared to 2020. Changes in accounts
36
Table of Contents
payable resulted in a $98.7 million increase in our working capital in 2021 compared to a $745.6 million increase in 2020, due primarily to the timing of receipts and payments. Changes in accrued expenses resulted in a $37.3 million decrease in our working capital in 2021 compared to a $388.6 million increase in 2020, due primarily to the timing of accruals and payments for payroll taxes and incentive compensation. Changes in merchandise inventories resulted in a $550.1 million decrease in our working capital in 2021 which was similar to the decrease of $575.8 million in 2020 as described in greater detail below. Changes in income taxes in 2021 compared to 2020 are primarily due to the timing of payments for income taxes.
On an ongoing basis, we closely monitor and manage our inventory balances, and they may fluctuate from period to period based on new store openings, the timing of purchases, and other factors. Merchandise inventories increased by 20% in 2022, by 7% in 2021 and by 12% in 2020. The increase in the 2022 period primarily reflects the impact of product cost inflation, as well as a greater mix of higher-value products, particularly in the home products and seasonal categories, primarily due to the continued rollout of our non-consumables initiative. Inventory levels in the consumables category increased by $367.8 million, or 11%, in 2022, decreased by $1.8 million, or 0%, in 2021, and increased by $455.6 million, or 15% in 2020. The seasonal category increased by $455.5 million, or 42%, in 2022, by $177.8 million, or 20%, in 2021, and by $35.7 million, or 4%, in 2020. The home products category increased by $315.4 million, or 43%, in 2022, by $230.0 million, or 45%, in 2021, and by $66.3 million, or 15%, in 2020. The apparel category increased by $7.8 million, or 2%, in 2022, decreased by $39.2 million, or 10%, in 2021, and increased by $12.9 million, or 3%, in 2020.
Cash flows from investing activities. Significant components of property and equipment purchases in 2022 included the following approximate amounts: $589 million for improvements, upgrades, remodels and relocations of existing stores; $443 million for distribution and transportation-related capital expenditures; $373 million related to store facilities, primarily for leasehold improvements, fixtures and equipment in new stores; and $62 million for information systems upgrades and technology-related projects. The timing of new, remodeled and relocated store openings along with other factors may affect the relationship between such openings and the related property and equipment purchases in any given period. During 2022, we opened 1,039 new stores and remodeled or relocated 1,922 stores.
Significant components of property and equipment purchases in 2021 included the following approximate amounts: $510 million for improvements, upgrades, remodels and relocations of existing stores; $268 million for distribution and transportation-related capital expenditures; $244 million related to store facilities, primarily for leasehold improvements, fixtures and equipment in new stores; and $44 million for information systems upgrades and technology-related projects. During 2021, we opened 1,050 new stores and remodeled or relocated 1,852 stores.
Significant components of property and equipment purchases in 2020 included the following approximate amounts: $447 million for improvements, upgrades, remodels and relocations of existing stores; $271 million for distribution and transportation-related capital expenditures; $250 million related to store facilities, primarily for leasehold improvements, fixtures and equipment in new stores; and $50 million for information systems upgrades and technology-related projects. During 2020, we opened 1,000 new stores and remodeled or relocated 1,780 stores.
Capital expenditures during 2023 are projected to be in the range of $1.8 billion to $1.9 billion. We anticipate funding 2023 capital requirements with a combination of some or all of the following: existing cash balances, cash flows from operations, availability under our Revolving Facility and 364-Day Revolving Facility and/or the issuance of additional senior notes and CP Notes. We plan to continue to invest in store growth and development of approximately 1,050 new stores and approximately 2,120 stores to be remodeled or relocated. Capital expenditures in 2023 are anticipated to support our store growth as well as our remodel and relocation initiatives, including capital outlays for leasehold improvements, fixtures and equipment; the construction of new stores; costs to support and enhance our supply chain initiatives including new and existing distribution center facilities and our private fleet; technology initiatives; as well as routine and ongoing capital requirements.
Cash flows from financing activities. During the 2022 period we had proceeds from the issuance of long-term debt of $2.3 billion, and our repayments of long-term debt totaled $911.3 million. Net commercial paper borrowings increased by $1.4 billion and we had no borrowings or repayments under the Revolving Facility or the
37
Table of Contents
364-Day Revolving Facility. We repurchased 11.6 million shares of our common stock at a total cost of $2.7 billion and paid cash dividends of $493.7 million.
In 2021, net commercial paper borrowings increased by $54.3 million. and we had no borrowings or repayments under the Revolving Facility. We repurchased 12.1 million shares of our common stock at a total cost of $2.5 billion and paid cash dividends of $392.2 million.
In 2020, net proceeds from the issuance of long-term debt totaled $1.5 billion, net commercial paper borrowings decreased by $425.2 million, and borrowings and repayments under the Revolving Facility were $300.0 million each. We repurchased 12.3 million shares of our common stock at a total cost of $2.5 billion and paid cash dividends of $355.9 million.
Critical Accounting Policies and Estimates
The preparation of financial statements in accordance with generally accepted accounting principles in the United States (“U.S. GAAP”) requires management to make estimates and assumptions that affect reported amounts and related disclosures. In addition to the estimates presented below, there are other items within our financial statements that require estimation but are not deemed critical as defined below. We believe these estimates are reasonable and appropriate. However, if actual experience differs from the assumptions and other considerations used, the resulting changes could have a material effect on the financial statements taken as a whole.
Management believes the following policies and estimates are critical because they involve significant judgments, assumptions, and estimates. Management has discussed the development and selection of the critical accounting estimates with the Audit Committee of our Board of Directors, and the Audit Committee has reviewed the disclosures presented below relating to those policies and estimates. See Note 1 to the consolidated financial statements for a detailed discussion of our principal accounting policies.
Merchandise Inventories. Merchandise inventories are stated at the lower of cost or market (“LCM”) with cost determined using the retail last in, first out (“LIFO”) method. We use the retail inventory method (“RIM”) to calculate gross profit and the resulting valuation of inventories at cost, which are computed utilizing a calculated cost-to-retail inventory ratio to the retail value of sales at an inventory department level. We apply the RIM to these departments, which are groups of products that are fairly uniform in terms of cost, selling price relationship and turnover. The RIM will result in valuing inventories at LCM if permanent markdowns are currently taken as a reduction of the retail value of inventories. Inherent in the RIM calculation are certain management judgments and estimates that may impact the ending inventory valuation at cost, as well as the gross profit recognized. These judgments include ensuring departments consist of similar products, recording estimated shrinkage between physical inventories, and timely recording of markdowns needed to sell inventory.
We perform an annual LIFO analysis whereby all merchandise units are considered for inclusion in the index formulation. An actual valuation of inventory under the LIFO method is made at the end of each year based on the inventory levels and costs at that time. In contrast, interim LIFO calculations are based on management’s annual estimates of sales, the rate of inflation or deflation, and year-end inventory levels. We also perform analyses for determining obsolete inventory, adjusting inventory on a quarterly basis to an LCM value based on various management assumptions including estimated below cost markdowns not yet recorded, but required to liquidate such inventory in future periods.
Factors considered in the determination of markdowns include current and anticipated demand based on changes in competitors’ practices, consumer preferences, consumer spending, significant weather events and unseasonable weather patterns. Certain of these factors are outside of our control and may result in greater than estimated markdowns to entice consumer purchases of excess inventory. The amount and timing of markdowns may vary significantly from year to year.
We perform physical inventories in a significant majority of our stores on an annual basis. We calculate our shrink provision based on actual physical inventory results during the fiscal period and an accrual for estimated shrink occurring subsequent to a physical inventory through the end of the fiscal reporting period. This accrual is
38
Table of Contents
calculated as a percentage of sales at each retail store, at a department level, based on the store’s most recent historical shrink rate. To the extent that subsequent physical inventories yield different results than the estimated accrual, our effective shrink rate for a given reporting period will include the impact of adjusting to the actual results.
We believe our estimates and assumptions related to the application of the RIM results in a merchandise inventory valuation that reasonably approximates cost on a consistent basis.
Impairment of Long-lived Assets. Impairment of long-lived assets results when the carrying value of the assets exceeds the estimated undiscounted future cash flows generated by the assets. Our estimate of undiscounted future store cash flows is based upon historical operations of the stores and estimates of future profitability which encompasses many factors that are subject to variability and are difficult to predict. If our estimates of future cash flows are not materially accurate, our impairment analysis could be impacted accordingly. If a long-lived asset is found to be impaired, the amount recognized for impairment is equal to the difference between the carrying value and the asset’s estimated fair value. The fair value is estimated based primarily upon projected future cash flows (discounted at our credit adjusted risk-free rate) or other reasonable estimates of fair market value. Although not currently anticipated, changes in these estimates, assumptions or projections could materially affect the determination of fair value or impairment.
Insurance Liabilities. We retain a significant portion of the risk for our workers’ compensation, employee health, general liability, property loss, automobile and certain third-party landlord claim exposures. These represent significant costs primarily due to our large employee base and number of stores. Provisions are made for these liabilities on an undiscounted basis. Certain of these liabilities are based on actual claim data and estimates of incurred but not reported claims developed using actuarial methodologies based on historical claim trends, which have been and are anticipated to continue to be materially accurate. If future claim trends deviate from recent historical patterns, or other unanticipated events affect the number and significance of future claims, we may be required to record additional expenses or expense reductions, which could be material to our future financial results.
Contingent Liabilities – Income Taxes. Income tax reserves are determined using the methodology established by accounting standards relating to uncertainty in income taxes. These standards require companies to assess each income tax position taken using a two-step process. A determination is first made as to whether it is more likely than not that the position will be sustained, based upon the technical merits, upon examination by the taxing authorities. If the tax position is expected to meet the more likely than not criteria, the benefit recorded for the tax position equals the largest amount that is greater than 50% likely to be realized upon ultimate settlement of the respective tax position. Uncertain tax positions require determinations and liabilities to be estimated based on provisions of the tax law which may be subject to change or varying interpretation. If our determinations and estimates prove to be inaccurate, the resulting adjustments could be material to our future financial results.
Lease Accounting. Lease liabilities are recorded at a discount based upon our estimated collateralized incremental borrowing rate which involves significant judgments and estimates. Factors incorporated into the calculation of lease discount rates include the valuations and yields of our senior notes, their credit spread over comparable U.S. Treasury rates, and an index of the credit spreads for all North American investment grade companies by rating. To determine an indicative secured rate, we use the estimated credit spread improvement that would result from an upgrade of one ratings classification by tenor. Many of our stores are subject to build-to-suit arrangements with landlords, which typically carry a primary lease term of up to 15 years with multiple renewal options. We also have stores subject to shorter-term leases and many of these leases have renewal options. We record single lease expense on a straight-line basis over the lease term including any option periods that are reasonably certain to be renewed, commencing on the date that we take physical possession of the property from the landlord. Tenant allowances, to the extent received, are recorded as a reduction of the right of use asset. Improvements of leased properties are amortized over the shorter of the life of the applicable lease term or the estimated useful life of the asset.
Share-Based Payments. Our stock option awards are valued on an individual grant basis using the Black-Scholes-Merton closed form option pricing model. We believe that this model fairly estimates the value of our stock option awards. The application of this valuation model involves assumptions that are judgmental in the valuation of stock options, which affects compensation expense related to these options. These assumptions include the term that
39
Table of Contents
the options are expected to be outstanding, the historical volatility of our stock price, applicable interest rates and the dividend yield of our stock. Other factors involving judgments that affect the expensing of share-based payments include estimated forfeiture rates of share-based awards. Historically, these estimates have been materially accurate; however, if our estimates differ materially from actual experience, we may be required to record additional expense or reductions of expense, which could be material to our future financial results.
40
Table of Contents