Citi Trends Inc: Form 10-Q for the period ended Jul 30, 2011

Forward-Looking Statements

Except for specific historical information, many of the matters discussed in this Form 10-Q may express or imply projections of revenues or expenditures, statements of plans and objectives for future operations, growth or initiatives, statements of future economic performance, or statements regarding the outcome or impact of pending or threatened litigation. These, and similar statements, are forward-looking statements concerning matters that involve risks, uncertainties and other factors that may cause the actual performance of the Company to differ materially from those expressed or implied by these statements. All forward-looking information should be evaluated in the context of these risks, uncertainties and other factors. The words “believe,” “anticipate,” “project,” “plan,” “expect,” “estimate,” “objective,” “forecast,” “goal,” “intend,” “will likely result,” or “will continue” and similar words and expressions generally identify forward-looking statements. The Company believes the assumptions underlying these forward-looking statements are reasonable; however, any of the assumptions could be inaccurate, and therefore, actual results may differ materially from those projected in the forward-looking statements.

The factors that may result in actual results differing from such forward-looking information include, but are not limited to: transportation and distribution delays or interruptions; changes in freight rates; the Company’s ability to negotiate effectively the cost and purchase of merchandise; inventory risks due to shifts in market demand; the Company’s ability to gauge fashion trends and changing consumer preferences; changes in consumer spending on apparel; changes in product mix; interruptions in suppliers’ businesses; a deterioration in general economic conditions, including the possibility of a prolonged period of limited economic growth in the United States, and conditions caused by acts of war or terrorism or other factors; temporary changes in demand due to weather patterns; seasonality of the Company’s business; delays associated with building, opening and operating new stores; delays associated with building, opening, expanding or converting new or existing distribution centers; and other factors described in the section titled “Item 1A. Risk Factors” and elsewhere in the Company’s Annual Report on Form 10-K for the fiscal year ended January 29, 2011 and in Part II, “Item 1A. Risk Factors” and elsewhere in the Company’s Quarterly Reports on Form 10-Q and any amendments thereto and in the other documents the Company files with the SEC, including reports on Form 8-K.

Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this Form 10-Q. Except as may be required by law, the Company undertakes no obligation to update or revise publicly any forward-looking statements contained herein to reflect events or circumstances occurring after the date of this Form 10-Q or to reflect the occurrence of unanticipated events. Readers are advised, however, to read any further disclosures the Company may make on related subjects in its public disclosures or documents filed with the SEC, including reports on Form 8-K.

Overview

We are a value-priced retailer of urban fashion apparel and accessories for the entire family. Our merchandise offerings are designed to appeal to the preferences of fashion conscious consumers, particularly African-Americans. We operated 482 stores in both urban and rural markets in 27 states as of July 30, 2011.

We measure performance using key operating statistics. One of the main performance measures we use is comparable store sales growth. We define a comparable store as a store that has been opened for an entire fiscal year. Therefore, a store will not be considered a comparable store until its 13th month of operation at the earliest or until its 24th month at the latest. As an example, stores opened in fiscal 2010 and fiscal 2011 are not considered comparable stores in fiscal 2011. Relocated and expanded stores are included in the comparable store sales results. We also use other operating statistics, most notably average sales per store, to measure our performance. As we typically occupy existing space in established shopping centers rather than sites built specifically for our stores, store square footage (and therefore sales per square foot) varies by store. We focus on overall store sales volume as the critical driver of profitability. The average sales per store has increased over the years, as we have increased comparable store sales and opened new stores that are generally larger than our historical store base. Average sales per store increased from $0.8 million in fiscal 2000 to $1.4 million in fiscal 2010.

In addition to sales, we measure gross profit as a percentage of sales and store operating expenses, with a particular focus on labor, as a percentage of sales. These results translate into store level contribution, which we use to evaluate overall performance of each individual store. Finally, we monitor corporate expenses against budgeted amounts. All of the statistics discussed above are critical components of earnings before interest, taxes, depreciation and amortization (“EBITDA”), which is considered our most important operating statistic, and Adjusted EBITDA (comprised of EBITDA plus non-cash asset impairment expense). Although EBITDA and Adjusted EBITDA provide useful information on an operating cash flow basis, they are limited measures in that they exclude the impact of cash requirements for interest expense, income taxes and capital expenditures. Therefore, EBITDA and Adjusted EBITDA should be used as supplements to results of operations and cash flows as reported under GAAP and should not be used as a singular measure of operating performance or as a substitute for GAAP results. Provided below is a reconciliation of net income to EBITDA and to Adjusted EBITDA for the twenty-six and thirteen week periods ended July 30, 2011 and July 31, 2010:

Accounting Periods

The following discussion contains references to fiscal years 2011 and 2010, which represent fiscal years ending or ended on January 28, 2012 (fiscal 2011) and January 29, 2011 (fiscal 2010), respectively. Fiscal 2011 and fiscal 2010 both have 52-week accounting periods. This discussion and analysis should be read with the unaudited condensed consolidated financial statements and the notes thereto.

Results of Operations

The following discussion of the Company’s financial performance is based on the unaudited condensed consolidated financial statements set forth herein. The nature of the Company’s business is seasonal. Historically, sales in the first and fourth quarters have been higher than sales achieved in the second and third quarters of the fiscal year. Expenses and, to a greater extent, operating income, 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 the Company’s business may affect comparisons between periods.

Twenty-Six Weeks Ended July 30, 2011 and July 31, 2010

Net Sales. Net sales increased $9.0 million, or 2.9%, to $319.4 million in the twenty-six weeks ended July 30, 2011 from $310.4 million in the twenty-six weeks ended July 31, 2010. The increase in net sales was due primarily to the opening of 60 new stores since last year’s second quarter, partially offset by an 8.9% decrease in comparable store sales and the effect of closing three stores since last year’s second quarter. The decline in comparable store sales has resulted primarily from challenging economic conditions for our customer base, including high unemployment and a reduction in discretionary spending due to rising food and gasoline prices. Comparable stores include locations that have been relocated or expanded. There were fifteen stores relocated or expanded since last year’s second quarter, all of which impacted comparable store sales. Sales in comparable relocated and expanded stores increased 3.8% in the first half of 2011, while sales in all other comparable stores decreased 9.7%. The 8.9% overall decrease in comparable store sales was reflected in a 9.3% decline in customer transactions, partially offset by a slightly higher average ticket. Comparable store sales changes by major merchandise class were as follows in the first half of 2011: Accessories -1%; Home -3%; Children’s -8%; Women’s -9%; and Men’s -13%.

The new stores opened in 2010 and 2011, net of the closed stores, accounted for an increase of $35.5 million in total sales, while the 8.9% sales decrease in the 398 comparable stores totaled $26.5 million.

Gross Profit. Gross profit decreased $2.2 million, or 1.8%, to $118.5 million in the first half of 2011 from $120.7 million in last year’s first half. The decrease in gross profit is the result of a decline in the gross margin to 37.1% from 38.9% in last year’s first half, partially offset by the effect of the increase in total sales discussed above. The decrease in gross margin was due primarily to a decline in the core merchandise margin (initial mark-up, net of markdowns) of 170 basis points, resulting from the need for clearance markdowns in the declining sales environment.

Selling, General and Administrative Expenses. Selling, general and administrative expenses increased $8.9 million, or 9.6%, to $101.8 million in the first half of 2011 from $92.9 million in last year’s first half. The increase in these expenses was due primarily to additional store level, distribution and corporate costs arising from the opening of 60 new stores since last year’s second quarter. As a percentage of sales, selling, general and administrative expenses increased to 31.9% in the first half of fiscal 2011 from 29.9% in the first half of fiscal 2010, due primarily to the deleveraging effect on expenses as a percentage of sales when comparable store sales decline 8.9%. In particular, rent, utilities and other occupancy expenses, which tend to be highly fixed in nature, increased 110 basis points as a percentage of sales, and payroll expenses, which have a sizable fixed component associated with store management and corporate overhead, increased 50 basis points as a percentage of sales. The remaining 40 basis points of increase included 20 basis points ($0.6 million) related to expenses incurred in connection with closing the Savannah, Georgia distribution center and 20 basis points spread over numerous other categories of expense as a result of the comparable store sales deleverage described above.

Depreciation and Amortization. Depreciation and amortization expense increased $2.4 million, or 25.4%, to $11.9 million in the first half of 2011 from $9.5 million in the first half of 2010, as the result of capital expenditures incurred for new and relocated/expanded stores and a new distribution center in Roland, Oklahoma.

Asset Impairment. Impairment charges for property and equipment at certain underperforming stores totaled $1.6 million in the first half of 2011. There were no such charges in the first half of 2010.

Income Tax Expense. Income tax expense decreased $5.2 million, or 80.5%, to $1.3 million in this year’s first half from $6.5 million in the first half of 2010 due primarily to a decrease in pretax income, partially offset by an increase in the effective income tax rate to 38.0% from 35.3%. The increase in the effective income tax rate was the result of a charge to income tax expense of $0.7 million related to the establishment of a valuation allowance for certain state tax credits that are no longer more likely than not to be utilized. Excluding the impact of the valuation allowance, the effective income tax rate would have decreased in the first half of 2011 due to other tax credits being higher as a percentage of pretax income as a result of the decline in pretax income.

Net Income. Net income decreased $9.8 million, or 82.6%, to $2.1 million in the first half of 2011 from $11.9 million in the first half of 2010 due to the factors discussed above.

Thirteen Weeks Ended July 30, 2011 and July 31, 2010

Net Sales. Net sales increased $1.2 million, or 0.9%, to $130.2 million in the thirteen weeks ended July 30, 2011 from $129.0 million in the thirteen weeks ended July 31, 2010. The increase in net sales was due primarily to the opening of 60 new stores since last year’s second quarter, partially offset by an 11.9% decrease in comparable store sales and the effect of closing three stores since last year’s second quarter. The decline in comparable store sales has resulted primarily from challenging economic conditions for our customer base, including high unemployment and a reduction in discretionary spending due to rising food and gasoline prices. Comparable stores include locations that have been relocated or expanded. There were fifteen stores relocated or expanded since last year’s second quarter, all of which impacted comparable store sales. Sales in comparable relocated and expanded stores increased 5.6% in the second quarter of 2011, while sales in all other comparable stores decreased 13.0%. The 11.9% overall decrease in comparable store sales was due entirely to a decline in customer transactions, as the average ticket was flat with last year’s second quarter. Comparable store sales changes by major merchandise class were as follows in the second quarter of 2011: Home -2%; Accessories -5%; Children’s -11%; Women’s -11%; and Men’s -14%.

The new stores opened in 2010 and 2011, net of closed stores, accounted for an increase of $15.8 million in total sales, while the 11.9% sales decrease in the 398 comparable stores totaled $14.6 million.

Gross Profit. Gross profit decreased $4.8 million, or 10.0%, to $43.5 million in the second quarter of 2011 from $48.3 million in last year’s second quarter. The decrease in gross profit is the result of a decline in the gross margin to 33.4% from 37.4% in last year’s second quarter, partially offset by the effect of the increase in total sales discussed above. The decrease in gross margin was due to a decline in the core merchandise margin (initial mark-up, net of markdowns) of 350 basis points, resulting from the need for clearance markdowns in the declining sales environment, and a 50 basis point increase in freight costs as a percentage of sales.

Selling, General and Administrative Expenses. Selling, general and administrative expenses increased $6.3 million, or 14.1%, to $50.7 million in the second quarter of 2011 from $44.4 million in last year’s second quarter. The increase in these expenses was due primarily to additional store level, distribution and corporate costs arising from the opening of 60 new stores since last year’s second quarter. As a percentage of sales, selling, general and administrative expenses increased to 38.9% in the second quarter of fiscal 2011 from 34.4% in the second quarter of fiscal 2010, due primarily to the deleveraging effect on expenses as a percentage of sales when comparable store sales decline 11.9%. In particular, rent, utilities and other occupancy expenses, which tend to be highly fixed in nature, increased 150 basis points as a percentage of sales, and payroll expenses, which have a sizable fixed component associated with store management and corporate overhead, increased 150 basis points as a percentage of sales. The remaining 150 basis points of increase included 50 basis points ($0.6 million) related to expenses incurred in connection with closing the Savannah, Georgia distribution center and 100 basis points spread over numerous other categories of expense as a result of the comparable store sales deleverage described above.

Depreciation and Amortization. Depreciation and amortization expense increased $1.6 million, or 33.2%, to $6.4 million in the second quarter of 2011 from $4.8 million in the second quarter of 2010, as the result of capital expenditures incurred for new and relocated/expanded stores and a new distribution center in Roland, Oklahoma.

Asset Impairment. Impairment charges for property and equipment at certain underperforming stores totaled $1.6 million in the second quarter of 2011. There were no such charges in the second quarter of 2010.

Income Tax Benefit. Income tax benefit increased $4.8 million to $5.1 million in this year’s second quarter from $0.3 million in the second quarter of 2010 due to an increase in pretax loss, partially offset by a decrease in the effective income tax rate to 33.7% from 35.3%. The decrease in the effective income tax rate was the result of a reduction in income tax benefit of $0.7 million related to the establishment of a valuation allowance for certain state tax credits that are no longer more likely than not to be utilized. Excluding the impact of the valuation allowance, the effective income tax rate would have increased in the second quarter of 2011 due to other tax credits being higher as a percentage of pretax loss as a result of the increase in pretax loss.

Net Loss. Net loss increased to $10.0 million in the second quarter of 2011 from $0.6 million in the second quarter of 2010 due to the factors discussed above.

Liquidity and Capital Resources

Our cash requirements are primarily for working capital, expansion of our distribution infrastructure, opening of new stores, remodeling of our existing stores and the improvement of our information systems. In recent years, we have met these cash requirements from cash flow from operations and short-term trade credit. We expect to be able to meet future cash requirements with cash flow from operations, short-term trade credit, existing cash balances and, if necessary, borrowings under our revolving credit facility.

Current Financial Condition. As of July 30, 2011, we had total cash and cash equivalents of $49.5 million compared with $69.2 million as of January 29, 2011. Inventory represented 39.5% of our total assets as of July 30, 2011. Management’s ability to manage our inventory can have a significant impact on our cash flows from operations during a given interim period or fiscal year. In addition, inventory purchases can be seasonal in nature, such as the purchase of warm-weather or Christmas-related merchandise. Total inventories at the end of the second quarter of 2011 were up $14.8 million, or 13.7%, compared to the second quarter of fiscal 2010, while store selling square footage increased 15.2% year-over-year as of the end of the quarter.

Cash Flows From Operating Activities. Net cash provided by operating activities was $13.5 million in the first twenty-six weeks of fiscal 2011 compared to $9.1 million in the same period of fiscal 2010. The main source of cash provided during the first twenty-six weeks of fiscal 2011 was net income adjusted for noncash expenses such as depreciation and amortization, asset impairment, loss on disposal of property and equipment, deferred income taxes and stock-based compensation expense, totaling $17.5 million (compared to $22.6 million in the first twenty-six weeks of fiscal 2010). Other significant sources of cash in the first twenty-six weeks of fiscal 2011 were (i) a $3.1 million increase in accrued expenses and other long-term liabilities (compared to $0.8 million in the first twenty-six weeks of fiscal 2010) due to the Company’s store growth and the timing of payments for various accrued expenses; (ii) a $1.8 million decrease in prepaid and other current assets (compared to $1.1 million in the first twenty-six weeks of fiscal 2010) due primarily to credit card receivables being seasonally lower at the end of the second quarter than at year end, because sales near the end of January are higher than at the end of July; and (iii) a $1.2 million increase in layaway deposits (compared to $1.3 million in the first twenty-six weeks of fiscal 2010) due to the seasonality of layaway transactions which are low at the end of January, because all balances have to be redeemed by customers or they are cancelled by the middle of December each year. Significant uses of cash consisted primarily of a $6.4 million decrease in accounts payable (compared to $3.8 million in the first twenty-six weeks of fiscal 2010) due to a decline in inventory turns as evidenced by the 8.9% decrease in comparable store sales in the first half of fiscal 2011, and due to seasonality, as a larger portion of inventory is still included in accounts payable at the end of January than the end of July, because January inventory includes recent purchases for the upcoming spring season which are more significant than the recent purchases of merchandise in July for the upcoming back-to-school season. In addition, uses of cash included a $2.9 million change in income tax receivable/payable (compared to $4.3 million in the first twenty-six weeks of fiscal 2010) due to the timing of quarterly estimated payments.

Cash Flows From Investing Activities. Cash used in investing activities was $33.4 million in the first twenty-six weeks of fiscal 2011 compared to cash provided of $11.8 million in the first twenty-six weeks of fiscal 2010. Cash used for purchases of property and equipment totaled $23.2 million and $18.1 million in the first twenty-six weeks of fiscal 2011 and 2010, respectively. Capital expenditures in the first twenty-six weeks of 2011 included the equipping of the new distribution center in Roland, Oklahoma, while the first twenty-six weeks of 2010 included the acquisition of the distribution center. Other capital expenditures in the first twenty-six weeks of 2011 included 24 new stores, nine store relocations/expansions and ten store conversions to the new Citi Lights format. In the first twenty-six weeks of 2010, other capital expenditures included 24 new stores and seven store relocations/expansions. Investing activities in the first twenty-six weeks of 2011 and 2010, respectively, included $10.2 million of net purchases of investment securities and $29.9 million of net redemptions of investment securities.

Cash Flows From Financing Activities. Cash flows from financing activities were insignificant in the first twenty-six weeks of both fiscal 2011 and 2010.

Cash Requirements

Our principal sources of liquidity consist of: (i) cash and cash equivalents (which equaled $49.5 million as of July 30, 2011); (ii) short-term trade credit; (iii) cash generated from operations on an ongoing basis as we sell our merchandise inventory; and (iv) a $20 million revolving credit facility. Trade credit represents a significant source of financing for inventory purchases and arises from customary payment terms and trade practices with our vendors. Historically, our principal liquidity requirements have been for working capital and capital expenditure needs.

We believe that our existing sources of liquidity will be sufficient to fund our operations and anticipated capital expenditures for at least the next 12 months.

Critical Accounting Policies

The preparation of our condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. There have been no material changes to the Critical Accounting Policies outlined in the Company’s Annual Report on Form 10-K for the year ended January 29, 2011.

Goodwill

Goodwill represents the excess of the purchase price over the fair value of assets acquired. Goodwill acquired in a purchase business combination and determined to have an indefinite useful life is not amortized, but instead tested for impairment annually or more frequently if events occur or circumstances change which would, more likely than not, reduce the fair value of a reporting unit below its carrying value. In our case, there is only one reporting unit, therefore, fair value and carrying value used in the test are at the consolidated level. Goodwill impairment is determined using a two-step process. The first step is to identify if a potential impairment exists by comparing the Company’s fair value with its carrying amount, including goodwill. If such fair value exceeds the carrying amount, the goodwill is not considered to have a potential impairment and the second step of the impairment test is not necessary.

During the second quarter of 2011, there was a significant decline in our earnings and, therefore, the market price of our stock. These factors indicated potential impairment, thus requiring an interim impairment test. Based on the testing performed, we determined that the Company’s fair value, including a reasonable control premium, exceeded the carrying value of assets (including goodwill) by approximately 35% as of July 30, 2011. Accordingly, the second step of the impairment testing was not required and no impairment charges were recorded. Due to the uncertainty of the Company’s future results, it is possible that goodwill could be impaired in future periods; however, the potential impairment charges are limited to the carrying value of goodwill on the condensed consolidated balance sheet, which was $1.4 million as of July 30, 2011.

Impairment of Long-Lived Assets

If facts and circumstances indicate that a long-lived asset may be impaired, the carrying value is reviewed. If this review indicates that the carrying value of the asset will not be recovered as determined based on projected undiscounted cash flows related to the asset over its remaining life, the carrying value of the asset is reduced to its estimated fair value. Non-cash impairment losses related to leasehold improvements and fixtures and equipment at 21 underperforming stores totaled $1.6 million in the twenty-six and thirteen week periods ended July 30, 2011. There were no impairment losses in the twenty-six and thirteen week periods ended July 31, 2010. There are an additional 16 stores with asset carrying values totaling $1.6 million that will require close monitoring in future quarters due to having projected undiscounted cash flows that are just slightly above asset carrying values. Impairment losses in the future are dependent on a number of factors such as site selection and general economic trends on a localized, regional or national basis, and thus could be significantly different from historical results. To the extent our estimates for net sales, gross profit and store expenses are not realized, future assessments of recoverability could result in additional impairment charges.

Income Taxes

Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. In assessing the realizability of deferred tax assets, we consider whether it is more likely than not that some portion or all of our deferred tax assets will not be realized. Losses incurred during the second quarter of 2011 caused us to conclude that our ability to utilize certain tax credits in one state was no longer more likely than not, necessitating a charge to income tax expense and a reduction in deferred tax assets of $0.7 million in connection with the establishment of a valuation allowance. Deferred tax assets as of July 30, 2011 still include the portion of such tax credits that are expected to be utilized in the future. However, if operating results deteriorate in the future, these tax credits may also require a valuation allowance, which would result in a charge to income tax expense and a reduction in deferred tax assets of $0.5 million.

There have been no material changes in our market risk during the twenty-six weeks ended July 30, 2011 compared to the disclosures in Part II, Item 7A of our Annual Report on Form 10-K for the year ended January 29, 2011.

We have carried out an evaluation under the supervision and with the participation of management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of July 30, 2011 pursuant to Rules 13a-15 and 15d-15 of the Exchange Act. Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer each concluded that our disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information has been accumulated and communicated to our management, including the officers who certify our financial reports, as appropriate, to allow timely decisions regarding the required disclosures.

Our disclosure controls and procedures are designed to provide reasonable assurance that the controls and procedures will meet their objectives. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives.

There were no changes in our internal control over financial reporting that occurred during the fiscal quarter ended July 30, 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

There are no material changes to the Risk Factors described under the section “ITEM 1A. RISK FACTORS” in the Company’s Annual Report on Form 10-K for the fiscal year ended January 29, 2011.