GAP INC (GAP) FY 2024 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.
Our Business
We are a collection of lifestyle brands offering apparel, accessories, and personal care products for men, women, and children under the Old Navy, Gap, Banana Republic, and Athleta brands. As of February 3, 2024, we had Company-operated stores in the United States, Canada, Japan, and Taiwan. Our products are available to customers online through Company-owned websites and through third-party arrangements. We also have franchise agreements to operate Old Navy, Gap, Banana Republic, and Athleta throughout Asia, Europe, Latin America, the Middle East, and Africa. Under these agreements, third parties operate, or will operate, stores and websites that sell apparel and related products under our brand names. In addition to operating in the specialty, outlet, online, and franchise channels, we use our omni-channel capabilities to bridge the digital world and physical stores to further enhance our shopping experience for our customers. Our omni-channel services, including buy online pick-up in store, order-in-store, find-in-store, and ship-from-store, as well as enhanced mobile-enabled experiences, are tailored uniquely across our collection of brands. Most of the products sold under our brand names are designed by us and manufactured by independent sources.
Overview
Financial results for fiscal 2023 are as follows:
•Net sales for fiscal 2023 decreased 5 percent to $14.9 billion compared with $15.6 billion for fiscal 2022.
•Store and franchise sales for fiscal 2023 decreased 3 percent compared with fiscal 2022 and online sales for fiscal 2023 decreased 7 percent compared with fiscal 2022.
•Gross profit for fiscal 2023 was $5.8 billion compared with $5.4 billion for fiscal 2022. Gross margin for fiscal 2023 was 38.8 percent compared with 34.3 percent for fiscal 2022.
•Operating income for fiscal 2023 was $560 million compared with operating loss of $(69) million for fiscal 2022.
•Effective tax rate for fiscal 2023 was 9.7 percent compared with negative 45.3 percent for fiscal 2022.
•Net income for fiscal 2023 was $502 million compared with net loss of $(202) million for fiscal 2022.
•Diluted earnings per share was $1.34 for fiscal 2023 compared with diluted loss per share of $(0.55) for fiscal 2022.
•Merchandise inventory as of the fourth quarter of fiscal 2023 decreased 16 percent compared with the fourth quarter of fiscal 2022.
Fiscal 2023 consisted of 53 weeks versus 52 weeks in fiscal 2022. Net sales and operating results, as well as other metrics derived from the Consolidated Statement of Operations, include the impact of the additional week; however, the comparable sales calculation excludes the 53rd week.
Effective August 22, 2023, Richard Dickson became the Company's President and Chief Executive Officer. Bob L. Martin, who had been serving as the Company's Chief Executive Officer on an interim basis, remained as the Executive Board Chair until October 28, 2023, when he transitioned to a non-employee Board Chair role.
On April 25, 2023, the Company's management committed to a restructuring plan (the "Plan") as part of the Company's previously announced efforts to simplify and optimize its operating model and structure. The Plan included a reduction in workforce of approximately 1,800 employees, primarily in headquarters locations. The actions associated with the reduction of the Company's workforce under the Plan were substantially completed in the first half of fiscal 2023. In connection with the Plan, the Company incurred $93 million in pre-tax restructuring costs during fiscal 2023, which included employee-related costs of $64 million and consulting and other associated costs of $29 million. These restructuring costs were primarily recorded within operating expenses on the Consolidated Statement of Operations.
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The Company has also completed its initiative of rationalizing the Gap and Banana Republic store fleet by closing, net of openings, 344 Gap and Banana Republic stores in North America from the beginning of fiscal 2020 to the end of fiscal 2023. The majority of the selected stores had leases that expired between these fiscal years, which allowed us to exit stores with a minimal net impact to our Consolidated Statements of Operations.
On November 7, 2022, we signed agreements to transition our Gap Greater China operations to a third party, Baozun, to operate Gap Greater China stores and the in-market website as a franchise partner, subject to regulatory approvals and closing conditions. On January 31, 2023, the Gap China transaction closed with Baozun. The impact upon divestiture was not material to our results of operations for fiscal 2023. The Gap Taiwan operations will continue to operate as usual until regulatory approvals and closing conditions are met.
During the first quarter of fiscal 2023, the Company also sold a building for $76 million and recorded a pre-tax gain on sale of $47 million within operating expenses on the Consolidated Statement of Operations.
We are focused on the following strategic priorities in the near term:
•maintaining and building upon the financial and operational rigor, through an optimized cost structure and disciplined inventory management;
•reinvigorating our brands to drive relevance and an engaging omni-channel experience;
•strengthening our platform and evolving with a digital first mindset;
•energizing our culture by attracting and retaining strong talent; and
•continuing to integrate social and environmental sustainability into business practices to support long-term growth.
We identify our operating segments according to how our business activities are managed and evaluated. As of February 3, 2024, our operating segments included Old Navy Global, Gap Global, Banana Republic Global, and Athleta Global. We have determined that each of our operating segments share similar economic and other qualitative characteristics, and, therefore, the results of our operating segments are aggregated into one reportable segment.
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Results of Operations
A discussion regarding our results of operations for fiscal year 2023 compared with fiscal year 2022 is presented below. A discussion regarding our results of operations for fiscal year 2022 compared with fiscal year 2021 can be found under Part II, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, in our Annual Report on the Form 10-K for the year ended January 28, 2023, filed with the SEC on March 14, 2023.
Net Sales
See Note 3 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K for net sales disaggregation.
Comparable Sales ("Comp Sales")
Comp Sales include the results of Company-operated stores and sales through our online channel. The calculation of Comp Sales excludes the results of the franchise and licensing business. Comp Sales included the results of certain foreign operations until their respective transitions to third-party franchise partners. See Note 17 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K for further details.
A store is included in the Comp Sales calculations when it has been open and operated by the Company for at least one year and the selling square footage has not changed by 15 percent or more within the past year. A store is included in the Comp Sales calculations on the first day it has comparable prior year sales. Stores in which the selling square footage has changed by 15 percent or more as a result of a remodel, expansion, or reduction are excluded from the Comp Sales calculations until the first day they have comparable prior year sales.
A store is considered non-comparable (“Non-comp”) when it has been open and operated by the Company for less than one year or has changed its selling square footage by 15 percent or more within the past year.
A store is considered “Closed” if it is temporarily closed for three or more full consecutive days or it is permanently closed. When a temporarily closed store reopens, the store will be placed in the Comp/Non-comp status it was in prior to its closure. If a store was in Closed status for three or more days in the prior year, the store will be in Non-comp status for the same days the following year.
Current year foreign exchange rates are applied to both current year and prior year Comp Sales to achieve a consistent basis for comparison.
The percentage change in Comp Sales by global brand and for The Gap, Inc., as compared with the preceding year, is as follows:
| Fiscal Year | |||||
|---|---|---|---|---|---|
| 2023 | 2022 | ||||
| Old Navy Global | (1) | % | (12) | % | |
| Gap Global | 1 | % | (4) | % | |
| Banana Republic Global | (7) | % | 9 | % | |
| Athleta Global | (12) | % | (5) | % | |
| The Gap, Inc. | (2) | % | (7) | % |
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Store count, openings, closings, and square footage for our stores are as follows:
| January 28, 2023 | Fiscal 2023 | February 3, 2024 | ||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Number of Store Locations | Number of Stores Opened | Number of Stores Closed | Number of Store Locations | Square Footage (in millions) | ||||||||||
| Old Navy North America | 1,238 | 25 | 20 | 1,243 | 19.8 | |||||||||
| Gap North America | 493 | 1 | 22 | 472 | 5.0 | |||||||||
| Gap Asia (1) | 232 | 2 | 11 | 134 | 1.2 | |||||||||
| Banana Republic North America | 419 | 2 | 21 | 400 | 3.3 | |||||||||
| Banana Republic Asia | 46 | 4 | 7 | 43 | 0.2 | |||||||||
| Athleta North America | 257 | 25 | 12 | 270 | 1.1 | |||||||||
| Company-operated stores total | 2,685 | 59 | 93 | 2,562 | 30.6 | |||||||||
| Franchise (1) | 667 | 293 | 96 | 998 | N/A | |||||||||
| Total | 3,352 | 352 | 189 | 3,560 | 30.6 | |||||||||
| Increase (decrease) over prior year | 6.2 | % | (3.8) | % | ||||||||||
| January 29, 2022 | Fiscal 2022 | January 28, 2023 | ||||||||||||
| Number of Store Locations | Number of Stores Opened | Number of Stores Closed | Number of Store Locations | Square Footage (in millions) | ||||||||||
| Old Navy North America (2) | 1,252 | 30 | 20 | 1,238 | 19.8 | |||||||||
| Gap North America | 520 | 10 | 37 | 493 | 5.2 | |||||||||
| Gap Asia | 329 | 5 | 102 | 232 | 2.0 | |||||||||
| Gap Europe (3) | 11 | — | — | — | — | |||||||||
| Banana Republic North America | 446 | 2 | 29 | 419 | 3.5 | |||||||||
| Banana Republic Asia | 50 | 3 | 7 | 46 | 0.2 | |||||||||
| Athleta North America | 227 | 40 | 10 | 257 | 1.1 | |||||||||
| Company-operated stores total | 2,835 | 90 | 205 | 2,685 | 31.8 | |||||||||
| Franchise (2)(3) | 564 | 138 | 70 | 667 | N/A | |||||||||
| Total | 3,399 | 228 | 275 | 3,352 | 31.8 | |||||||||
| Decrease over prior year | (1.4) | % | (4.5) | % |
__________
(1)The 89 Gap China stores that were transitioned to Baozun during the period are not included as store closures or openings for Company-operated and Franchise store activity. The ending balance for Gap Asia excludes Gap China stores and the ending balance for Franchise includes Gap China locations transitioned during the period.
(2)The 24 Old Navy Mexico stores that were transitioned to Grupo Axo during the period are not included as store closures or openings for Company-operated and Franchise store activity. The ending balance for Old Navy North America excludes Old Navy Mexico stores and the ending balance for Franchise includes Old Navy Mexico stores.
(3)The 11 Gap Italy stores that were transitioned to OVS S.p.A. ("OVS") during the period are not included as store closures or openings for Company-operated and Franchise store activity. The ending balance for Gap Europe excludes Gap Italy stores and the ending balance for Franchise includes Gap Italy stores.
Outlet and factory stores are reflected in each of the respective brands.
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Net Sales Discussion
Our net sales for fiscal 2023 decreased $727 million, or 5 percent, compared with fiscal 2022, driven primarily by a decrease in Comp Sales, the transition of our Gap China business to a partnership model, and other strategic store closures. Fiscal 2023 also includes incremental sales attributable to the 53rd week. Additionally, there was an unfavorable impact of foreign exchange of $74 million. The foreign exchange impact is the translation impact if net sales for fiscal 2022 were translated at exchange rates applicable during fiscal 2023.
Cost of Goods Sold and Occupancy Expenses
| ($ in millions) | Fiscal Year | ||||||
|---|---|---|---|---|---|---|---|
| 2023 | 2022 | ||||||
| Cost of goods sold and occupancy expenses | $ | 9,114 | $ | 10,257 | |||
| Gross profit | $ | 5,775 | $ | 5,359 | |||
| Cost of goods sold and occupancy expenses as a percentage of net sales | 61.2 | % | 65.7 | % | |||
| Gross margin | 38.8 | % | 34.3 | % |
Cost of goods sold and occupancy expenses decreased 4.5 percentage points as a percentage of net sales in fiscal 2023 compared with fiscal 2022.
•Cost of goods sold decreased 4.9 percentage points as a percentage of net sales in fiscal 2023 compared with fiscal 2022, primarily driven by a decrease in air freight expenses and improved promotional activity. Additionally, there was a decrease in inventory impairment charges compared with fiscal 2022. The impact of commodity costs was relatively flat for fiscal 2023 compared with fiscal 2022.
•Occupancy expenses increased 0.4 percentage points as a percentage of net sales in fiscal 2023 compared with fiscal 2022, primarily driven by a decrease in Comp Sales without a corresponding decrease in fixed occupancy expenses.
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Operating Expenses and Operating Margin
| ($ in millions) | Fiscal Year | ||||||
|---|---|---|---|---|---|---|---|
| 2023 | 2022 | ||||||
| Operating expenses | $ | 5,215 | $ | 5,428 | |||
| Operating expenses as a percentage of net sales | 35.0 | % | 34.8 | % | |||
| Operating margin | 3.8 | % | (0.4) | % |
Operating expenses decreased $213 million, but increased 0.2 percentage points as a percentage of net sales during fiscal 2023 compared with fiscal 2022, due to a decrease in net sales as well as the following:
•a decrease in advertising expenses;
•a decrease in payroll expenses related to our operating model and structure changes;
•a decrease due to the transition of our China business to a partnership model;
•a decrease in technology-related investments;
•a gain on sale of building of $47 million that occurred during fiscal 2023; and
•a loss on divestiture activity of $35 million that occurred during fiscal 2022 related to the transition of the Old Navy Mexico business; partially offset by
•an increase in performance-based compensation; and
•restructuring expenses of $89 million incurred during fiscal 2023 as a result of actions taken to simplify and optimize our operating model and structure.
Interest Expense
| ($ in millions) | Fiscal Year | ||||||
|---|---|---|---|---|---|---|---|
| 2023 | 2022 | ||||||
| Interest expense | $ | 90 | $ | 88 |
Interest expense primarily includes interest on outstanding borrowings and obligations mainly related to our Senior Notes.
Interest Income
| ($ in millions) | Fiscal Year | ||||||
|---|---|---|---|---|---|---|---|
| 2023 | 2022 | ||||||
| Interest income | $ | (86) | $ | (18) |
Interest income increased $68 million during fiscal 2023 compared with fiscal 2022 primarily due to higher cash balances and higher interest rates, as well as tax-related interest income.
Income Taxes
| ($ in millions) | Fiscal Year | ||||||
|---|---|---|---|---|---|---|---|
| 2023 | 2022 | ||||||
| Income tax expense | $ | 54 | $ | 63 | |||
| Effective tax rate | 9.7 | % | (45.3) | % |
The change in the effective tax rate for fiscal 2023 compared with fiscal 2022 was primarily due to changes in the amount and jurisdictional mix of pre-tax earnings, partially offset by prior year divestiture activity, the current year benefit from the impact of changes in valuation allowances, and current year benefit from a U.S. transfer pricing settlement related to our sourcing activities.
See Note 5 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K for further details.
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Liquidity and Capital Resources
We consider the following to be measures of our liquidity and capital resources:
| ($ in millions) | February 3, 2024 | January 28, 2023 | |||||
|---|---|---|---|---|---|---|---|
| Cash and cash equivalents | $ | 1,873 | $ | 1,215 | |||
| Debt | |||||||
| 3.625 percent Senior Notes due 2029 | 750 | 750 | |||||
| 3.875 percent Senior Notes due 2031 | 750 | 750 | |||||
| Working capital | 1,299 | 1,361 | |||||
| Current ratio | 1.42:1 | 1.42:1 |
As of February 3, 2024, the majority of our cash and cash equivalents were held in the United States and are generally accessible without any limitations.
We are also able to supplement near-term liquidity, if necessary, with our senior secured asset-based revolving credit agreement (the "ABL Facility") or other available market instruments. During fiscal 2023, the Company repaid an aggregate of $350 million to reduce the outstanding borrowing under the ABL Facility to zero. There were no borrowings under the ABL Facility as of February 3, 2024. See Note 7 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K for disclosures on the ABL Facility.
Our largest source of operating cash flows is cash collections from the sale of our merchandise. Our primary uses of cash include merchandise inventory purchases, lease and occupancy costs, personnel-related expenses, purchases of property and equipment, shipping costs, and payment of taxes. As our business typically follows a seasonal pattern, with sales peaking during the end-of-year holiday period, we fund inventory expenditures during normal and peak periods through cash flows from operating activities and available cash. The seasonality of our operations, in addition to the impact of global economic conditions such as the uncertainty surrounding global inflationary pressures, acts of terrorism or war, global credit and banking markets, and new legislation, may lead to significant fluctuations in certain asset and liability accounts as well as cash inflows and outflows between fiscal year-end and subsequent interim periods.
Our voluntary supply chain finance ("SCF") program provides certain suppliers with the opportunity to sell their receivables due from us to participating financial institutions at the sole discretion of both the suppliers and the financial institutions. We are not a party to the agreements between our suppliers and the financial institutions and our payment terms are not impacted by whether a supplier participates in the SCF program. See Note 18 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K, for disclosures on the Company's SCF program.
We are party to many contractual obligations involving commitments to make payments to third parties. These obligations impact our short-term and long-term liquidity and capital resource needs. Certain contractual obligations are reflected on the Consolidated Balance Sheet as of February 3, 2024, while others are considered future obligations. Our contractual obligations primarily consist of operating leases, purchase obligations and commitments, long-term debt and related interest payments, and income taxes. See Notes 7 and 12 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K for information related to our debt and operating leases, respectively.
Purchase obligations and commitments consist of open purchase orders to purchase inventory as well as commitments for products and services used in the normal course of business. As of February 3, 2024, our purchase obligations and commitments were approximately $4 billion. We expect that the majority of these purchase obligations and commitments will be settled within one year.
Our contractual obligations related to income taxes are primarily related to unrecognized tax benefits. See Note 5 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K for information related to income taxes.
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We believe our existing balances of cash and cash equivalents, along with our cash flows from operations, and instruments mentioned above, provide sufficient funds for our business operations as well as capital expenditures, dividends, and other liquidity requirements associated with our business operations over the next 12 months and beyond.
Cash Flows from Operating Activities
Net cash provided by operating activities increased $925 million during fiscal 2023 compared with fiscal 2022, primarily due to the following:
Net income (loss)
•Net income compared with net loss in the prior year;
Changes in operating assets and liabilities
•an increase of $582 million related to accounts payable primarily due to the timing of payments for inventory during fiscal 2023 compared with fiscal 2022; and
•an increase of $255 million related to accrued expenses and other current liabilities primarily due to an increase in performance-based compensation during fiscal 2023 compared with fiscal 2022; partially offset by
•a decrease of $342 million related to income taxes payable, net of receivables and other tax-related items, primarily due to receipt of tax refunds during fiscal 2022 related to fiscal 2020 net operating loss carryback claims; and
•a decrease of $171 million related to merchandise inventory primarily due to a continued reduction of inventory during fiscal 2023 that was less than the reduction of inventory during fiscal 2022.
Cash Flows from Investing Activities
Net cash used for investing activities increased $107 million during fiscal 2023 compared with fiscal 2022, primarily due to the following:
•$76 million in net proceeds from the sale of a building during fiscal 2023 compared with $458 million in net proceeds from the sale of buildings during fiscal 2022; partially offset by
•$265 million less purchases of property and equipment during fiscal 2023 compared with fiscal 2022, largely due to rationalizing our technology investments and a decrease in new store and supply chain spend.
In fiscal 2023, cash used for purchases of property and equipment was $420 million primarily related to information technology, store investments, and supply chain to support our omni and digital strategies.
Cash Flows from Financing Activities
Net cash used for financing activities was $567 million during fiscal 2023 compared with $6 million of net cash provided by financing activities during fiscal 2022, primarily due to the following:
•$350 million from the ABL Facility that was borrowed during fiscal 2022 and repaid during fiscal 2023; partially offset by
•$123 million in repurchases of common stock during fiscal 2022 compared with no repurchases during fiscal 2023.
Free Cash Flow
Free cash flow is a non-GAAP financial measure. We believe free cash flow is an important metric because it represents a measure of how much cash a company has available for discretionary and non-discretionary items after the deduction of capital expenditures. We require regular capital expenditures including technology improvements as well as building and maintaining our stores and distribution centers. We use this metric internally, as we believe our sustained ability to generate free cash flow is an important driver of value creation. However, this non-GAAP financial measure is not intended to supersede or replace our GAAP results.
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The following table reconciles free cash flow, a non-GAAP financial measure, from net cash provided by operating activities, a GAAP financial measure.
| Fiscal Year | |||||||
|---|---|---|---|---|---|---|---|
| ($ in millions) | 2023 | 2022 | |||||
| Net cash provided by operating activities | $ | 1,532 | $ | 607 | |||
| Less: Purchases of property and equipment | (420) | (685) | |||||
| Free cash flow | $ | 1,112 | $ | (78) |
Debt and Credit Facilities
Certain financial information about the Company's debt and credit facilities is set forth under the headings "Debt and Credit Facilities" in Note 7 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K.
Dividend Policy
In determining whether and at what level to declare a dividend, we consider a number of factors including sustainability, operating performance, liquidity, and market conditions.
We paid an annual dividend of $0.60 per share in fiscal 2023 and fiscal 2022. In February 2024, the Board authorized a dividend of $0.15 per share for the first quarter of fiscal 2024.
Share Repurchases
Certain financial information about the Company's share repurchases is set forth under the heading "Share Repurchases" in Note 10 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K.
Critical Accounting Policies and Estimates
The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") requires management to adopt accounting policies and make significant judgments and estimates to develop amounts reflected and disclosed in the financial statements.
Our significant accounting policies can be found under the heading "Organization and Summary of Significant Accounting Policies" in Note 1 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K. The policies and estimates discussed below include the financial statement elements that are either judgmental or involve the selection or application of alternative accounting policies and are material to our financial statements.
Inventory Valuation
We value inventory at the lower of cost or net realizable value (“LCNRV”), with cost determined using the weighted-average cost method. We review our inventory levels in order to identify slow-moving merchandise and broken assortments (items no longer in stock in a sufficient range of sizes or colors), and we primarily use promotions and markdowns to clear merchandise. We record an adjustment to inventory when future estimated selling price is less than cost. Our LCNRV adjustment calculation requires management to make assumptions to estimate the selling price and amount of slow-moving merchandise and broken assortments subject to markdowns, which is dependent upon factors such as historical trends with similar merchandise, inventory aging, forecasted consumer demand, and the promotional environment.
We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our LCNRV. However, if estimates regarding consumer demand are inaccurate, or if economic conditions including global inflationary pressures change beyond what is currently estimated by management, our operating results could be affected.
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Impairment of Long-Lived Assets
Long-lived assets, which primarily consist of property and equipment and operating lease assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. Events that result in an impairment review include a significant decrease in the operating performance of the long-lived asset or the decision to close a store, corporate facility, or distribution center.
Long-lived assets are considered impaired if the carrying amount exceeds the estimated undiscounted future cash flows of the asset or asset group over the estimated remaining useful life. The asset group is defined as the lowest level for which identifiable cash flows are available and largely independent of the cash flows of other groups of assets. For our Company-operated stores, the individual store generally represents the lowest level of independent identifiable cash flows and the asset group is comprised of both property and equipment and operating lease assets.
For impaired assets, we recognize a loss equal to the difference between the carrying amount of the asset or asset group and its estimated fair value. The estimated fair value of the asset or asset group is based on discounted future cash flows of the asset or asset group using a discount rate commensurate with the related risk. For operating lease assets, the Company determines the estimated fair value of the assets by comparing the discounted contractual rent payments to estimated market rental rates using available valuation techniques.
Our estimate of future cash flows requires management to make assumptions and to apply judgment, including forecasting future sales and gross profits and estimating useful lives of the assets. These estimates can be affected by factors such as future sales results, real estate market conditions, store closure plans, economic conditions, business interruptions, interest rates and government regulations that can be difficult to predict. If actual results and conditions are not consistent with the estimates and assumptions used in our calculations, we may be exposed to additional impairments of long-lived assets.
See Note 8 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K for additional information and disclosures about impairment of long-lived assets.
Income Taxes
We are a multinational company operating in multiple domestic and foreign locations with different tax laws and regulations. The Company's management is required to interpret and apply these tax laws and regulations in determining the amount of its income tax liability for financial statement purposes. We record valuation allowances against our deferred tax assets when it is more likely than not that some portion or all of such deferred tax assets will not be realized. In determining the need for valuation allowances, management is required to make assumptions and to apply judgment, including tax planning strategies, forecasting future income, taxable income, and the geographic mix of income or losses in the jurisdictions in which we operate. Our effective tax rate in a given financial statement period may also be materially impacted by changes in the geographic mix and level of income or losses, changes in the expected or actual outcome of audits, and changes in the deferred tax valuation allowances or new tax legislation.
On a recurring basis, we assess the need for valuation allowances related to our deferred income tax assets, which includes consideration of both positive and negative evidence to determine, based on the weight of the available evidence, whether it is more likely than not that some or all of our deferred tax assets will not be realized. In our assessment, we consider recent financial operating results, the scheduled expiration of our net operating losses, potential sources of taxable income, the reversal of existing taxable differences, taxable income in prior carryback years (if permitted under tax law), and tax planning strategies.
It is possible that there will be changes in our business structure, our performance, our industry or otherwise that cause results to differ materially in future periods. If the changes result in significant and sustained reductions in our pre-tax income or utilization of existing tax carryforwards in future periods, additional valuation allowances may be required with corresponding adverse impacts on results of operations. Such adverse impacts may be material.
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At any point in time, many tax years are subject to or in the process of being audited by various U.S. and foreign tax jurisdictions. These audits include reviews of our tax filing positions, including the timing and amount of deductions taken and the allocation of income between tax jurisdictions. When an uncertain tax position is identified, we recognize a benefit only if we believe it is more likely than not that the tax position based on its technical merits will be sustained upon examination by the relevant tax authorities. We recognize a benefit for tax positions using the highest cumulative tax benefit that is more likely than not to be realized. We establish a liability for tax positions that do not meet this threshold. The evaluation of uncertain tax positions requires management to apply specialized skill and knowledge related to tax laws and regulations and to make assumptions that are subject to factors such as possible assessments by tax authorities, changes in facts and circumstances, issuance of new regulations, and resolutions of tax audits. To the extent we prevail in matters for which a liability has been established or are required to pay amounts in excess of our established liability, our effective income tax rate in a given financial statement period could be materially affected.
See Note 5 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K for additional information on income taxes.
Revenue Recognition
The Company’s revenues primarily include merchandise sales at stores, online, and through franchise and licensing agreements. We also receive revenue sharing from our credit card agreement for private label and co-branded credit cards, and breakage revenue related to our gift cards, merchandise return cards, and outstanding loyalty points, which are realized based upon historical redemption patterns. For online sales, the Company has elected to treat shipping and handling as fulfillment activities and not a separate performance obligation. Accordingly, we recognize revenue for our single performance obligation related to online sales at the time control of the merchandise passes to the customer, which is generally at the time of shipment. Revenues are presented net of any taxes collected from customers and remitted to governmental authorities.
We record sales return allowances and a right of returns asset on a gross basis for expected future merchandise returns, based on historical return patterns, merchandise mix, and recent trends. The actual amount of customer returns, which are inherently uncertain, may differ from our estimates. Sales return allowances are recorded within accrued expenses and other current liabilities and the right of returns asset is recorded within other current assets on our Consolidated Balance Sheets.
We also defer revenue when cash payments are received in advance of performance for unsatisfied obligations related to our gift cards, licensing agreements, outstanding loyalty points, and reimbursements of loyalty program discounts associated with our credit card agreement.
See Note 3 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K for related revenue disclosures.
Recent Accounting Pronouncements
See "Organization and Summary of Significant Accounting Policies" in Note 1 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K for recent accounting pronouncements, including the expected dates of adoption and estimated effects on our Consolidated Financial Statements.