Tilly'S, Inc.: Form 10-Q for the period ended Oct 28, 2023

The following discussion and analysis of the financial condition and results of our operations should be read together with the financial statements and related notes of Tilly’s, Inc. included in Part I Item 1 of this Quarterly Report on Form 10-Q (this "Report") and with our audited consolidated financial statements and the related notes included in our Annual Report on Form 10-K for the fiscal year ended January 28, 2023. As used in this Report, except where the context otherwise requires or where otherwise indicated, the terms “the Company”, “World of Jeans & Tops”, “we”, “our”, “us”, "Tillys" and “Tilly’s” refer to Tilly’s, Inc. and its subsidiary.

Overview

Tillys is a destination specialty retailer of casual apparel, footwear, accessories and hardgoods for men, women, boys and girls. We believe we bring together an unparalleled selection of iconic global, emerging, and proprietary brands rooted in an active and outdoor lifestyle. The Tillys concept began in 1982, when our co-founders, Hezy Shaked and Tilly Levine, opened our first store in Orange County, California. As of October 28, 2023, we operated 249 stores in 33 states, averaging approximately 7,270 square feet per store, compared to 247 total stores at the same time last year. We also sell our products through our e-commerce website, www.tillys.com (http://www.tillys.com).

Known or Anticipated Trends

Economic Trends

We believe the uncertain and inflationary economic environment has had, and is likely to continue to have, a significant, adverse impact on our consumer's confidence and spending and, by extension, our operating results. Persistent inflation has also resulted in increased costs for many products and services that are necessary for the operation of our business, such as product costs, labor costs, shipping costs, and digital marketing costs, among others. For example, store payroll and payroll related expenses represented approximately 47% of our total selling, general and administrative expenses for the first nine months of fiscal 2023. Our average hourly rate for store payroll in the first nine months of fiscal 2023 was 26% higher than in the pre-pandemic first nine months of fiscal 2019 and 7% higher than in the first nine months of last year. Minimum wage increases are estimated to cost us approximately $3 million more during fiscal 2023 than in fiscal 2022 and are estimated to add another approximately $2 million in costs during fiscal 2024 compared to fiscal 2023. These and other cost increases may continue to have a material adverse impact on our results of operations and financial condition in fiscal 2023 and into fiscal 2024, particularly if the broader economy is negatively impacted by recessionary impacts for an extended period of time. We currently expect that our total capital expenditures for fiscal 2023 will be approximately $13 million, inclusive of 7 total new stores and upgrades to certain distribution and information technology systems.

Fiscal 2024 New Store Openings and Capital Expenditure Plans

During fiscal 2024, we currently expect to open four new stores. We currently expect that our total capital expenditures for fiscal 2024 will not exceed $15 million, inclusive of our new store plans and upgrades to certain distribution and information technology infrastructure systems.

How We Assess the Performance of Our Business

In assessing the performance of our business, we consider a variety of performance and financial measures. The key indicators of the financial condition and operating performance of our business are net sales, comparable store sales, gross profit, selling, general and administrative ("SG&A") expenses and operating (loss) income.

Net Sales

Net sales reflect revenue from the sale of our merchandise at store locations and through e-commerce, net of sales taxes. Store sales are reflected in sales when the merchandise is received by the customer. For e-commerce sales, we recognize revenue, and the related cost of goods sold at the time the merchandise is shipped to the customer. Net sales also include shipping and handling fees for e-commerce shipments that have been shipped to the customer. Net sales are net of returns on sales during the period as well as an estimate of returns expected in the future stemming from current period sales. We recognize revenue from gift cards as they are redeemed for merchandise. Prior to redemption, we maintain a current liability for unredeemed gift card balances. Our gift cards do not have expiration dates and in most cases there is no legal obligation to remit unredeemed gift cards to relevant jurisdictions. Based on actual historical redemption patterns, we determined that a small percentage of gift cards are unlikely to be redeemed (which we refer to as gift card “breakage”). Based on our historical gift card breakage rate, we recognize breakage revenue over the redemption period in proportion to actual gift card redemptions.

Our business is seasonal and as a result our revenues fluctuate from quarter to quarter. In addition, our revenues in any given quarter can be affected by a number of factors including the timing of holidays and weather patterns. The third and fourth quarters of the fiscal year, which include the back-to-school and holiday sales seasons, have historically produced stronger sales and disproportionately stronger operating results than have the first two quarters of the fiscal year.

Comparable Store Net Sales

Comparable store net sales is a measure that indicates the change in year-over-year comparable store net sales, which allows us to evaluate how our store base is performing. Numerous factors affect our comparable store net sales, including:

• overall economic trends;
• our ability to attract traffic to our stores and online platform;
• our ability to identify and respond effectively to consumer preferences and fashion trends;
• competition;
• the timing of our releases of new and seasonal styles;
• changes in our product mix;
• pricing;
• the level of customer service that we provide in stores;
• our ability to source and distribute products efficiently;
• calendar shifts of holiday or seasonal periods;
• the number and timing of store openings and the relative proportion of new stores to mature stores; and
• the timing and success of promotional and advertising efforts.

Our comparable store net sales are defined as sales from our e-commerce platform and stores open on a daily basis compared to the same respective fiscal dates of the prior year. A remodeled, relocated or refreshed store is included in comparable store net sales, both during and after construction, if the square footage of the store used to sell merchandise was not changed by more than 20% in any fiscal month. We include sales from our e-commerce platform as part of comparable store net sales as we manage and analyze our business on a single omni-channel basis and have substantially integrated our investments and operations for our stores and e-commerce platform to give our customers seamless access and increased ease of shopping. Comparable store net sales exclude gift card breakage income and e-commerce shipping and handling fee revenue. Some of our competitors and other retailers may calculate comparable or “same store” net sales differently than we do. As a result, data in this Report regarding our comparable store net sales may not be comparable to similar data made available by other retailers.

Gross Profit

Gross profit is equal to our net sales less our cost of goods sold. Cost of goods sold reflects the direct cost of purchased merchandise as well as buying, distribution and occupancy costs. Buying costs include compensation and benefit expense for our internal buying organization. Distribution costs include costs for receiving, processing and warehousing our store merchandise, and shipping of merchandise to or from our distribution and e-commerce fulfillment centers, and to our e-commerce customers and between store locations. Occupancy costs include the rent, common area maintenance, utilities, property taxes, security and depreciation costs of all store locations. These costs are significant and can be expected to continue to increase as our company grows. The components of our reported cost of goods sold may not be comparable to those of other retail companies.

We regularly analyze the components of gross profit as well as gross profit as a percentage of net sales. Specifically we look at the initial markup on purchases, markdowns and reserves, shrinkage, buying costs, distribution costs and occupancy costs. Any inability to obtain acceptable levels of initial markups, a significant increase in our use of markdowns or a significant increase in inventory shrinkage or inability to generate sufficient sales leverage on the buying, distribution and occupancy components of cost of goods sold could have an adverse impact on our gross profit and results of operations.

Gross profit is also impacted by shifts in the proportion of sales of proprietary branded products compared to third-party branded products, as well as by sales mix shifts within and between brands and between major product departments such as young men's and women's apparel, footwear or accessories. A substantial shift in the mix of products could have a material impact on our results of operations. In addition, gross profit and gross profit as a percent of sales have historically been higher in the third and fourth quarters of the fiscal year, as these periods include the back-to-school and winter holiday selling seasons. This reflects that various costs, including occupancy costs, generally do not increase in proportion to the seasonal sales increase.

Selling, General and Administrative Expenses

Our selling, general and administrative, or SG&A, expenses are comprised of store selling expenses and corporate-level general and administrative expenses. Store selling expenses include store and regional support costs, including personnel, advertising and debit and credit card processing costs, e-commerce receiving and processing costs and store supplies costs. General and administrative expenses include the payroll and support costs of corporate functions such as executive management, legal, accounting, information systems, human resources, impairment charges and other centralized services. Store selling expenses generally vary proportionately with net sales and store growth. In contrast, general and administrative expenses are generally not directly proportional to net sales and store growth, but will be expected to increase over time to support the needs of our growing company. SG&A expenses as a percentage of net sales are usually higher in lower volume periods and lower in higher volume periods.

Operating (Loss) Income

Operating (loss) income equals gross profit less SG&A expenses. Operating (loss) income excludes interest income, interest expense and income taxes. Operating (loss) income percentage measures operating (loss) income as a percentage of our net sales.

Results of Operations

The following tables summarize key components of our unaudited results of operations for the periods indicated, both in dollars (in thousands) and as a percentage of our net sales:

The following table presents store operating data for the periods indicated:

(1) Our comparable store net sales are defined as sales from our e-commerce platform and stores open on a daily basis compared to the same respective fiscal dates of the prior year. A remodeled or relocated store is included in comparable store net sales, both during and after construction, if the square footage of the store used to sell merchandise was not changed by more than 20% in any fiscal month. We include sales from our e-commerce platform as part of our comparable store net sales as we manage and analyze our business on an omni-channel basis and have substantially integrated our investments and operations for our stores and e-commerce platform to give our customers seamless access and increased ease of shopping. Comparable store net sales exclude gift card breakage income, and e-commerce shipping and handling fee revenue.

(2) The number of stores and the amount of square footage reflect the number of days during the period that stores were open. E-commerce sales, e-commerce shipping and handling fee revenue and gift card breakage income are excluded from net sales in deriving average net sales per retail store and average net sales per square foot.

(3) E-commerce net sales include e-commerce sales and e-commerce shipping and handling fee revenue.

Third Quarter (13 Weeks) Ended October 28, 2023 Compared to Third Quarter (13 Weeks) Ended October 29, 2022

Net Sales

Total net sales were $166.5 million, a decrease of $11.4 million, or 6.4%, compared to $177.8 million last year. Total comparable net sales, including both physical stores and e-commerce, decreased by 9.0%. We believe persistent inflation continues to have an adverse impact on spending by our customers, and, in particular, our younger customer demographic.

• Net sales from physical stores were $132.4 million, a decrease of $9.1 million or 6.4%, compared to $141.5 million last year, with a comparable store net sales decrease of 9.1%. In comparable stores, customer traffic decreased by 9%, total transaction volume decreased by 9%, and the average transaction value was flat. Net sales from physical stores represented 79.6% of total net sales both this year and last year. We ended the third quarter with 249 total stores compared to 247 total stores at the end of the third quarter last year.
• Net sales from e-commerce were $34.0 million, a decrease of $2.3 million or 6.2%, compared to $36.3 million last year. E-commerce net sales represented 20.4% of total net sales both this year and last year.

Gross Profit

Gross profit was $48.7 million, or 29.3% of net sales, compared to $54.6 million, or 30.7% of net sales, last year. Buying, distribution, and occupancy costs deleveraged by 90 basis points, despite being $1.0 million lower than last year primarily due to a decrease in distribution costs resulting from reduced freight costs, partially offset by higher occupancy costs as a result of two net additional stores compared to last year. Product margins declined by 50 basis points primarily due to increased markdowns and estimated inventory valuation reserves.

Selling, General and Administrative Expenses

SG&A expenses were $51.2 million or 30.8% of net sales, compared to $48.3 million, or 27.1% of net sales, last year. The primary components of the SG&A variances, both in terms of percentage of net sales and total dollars, were as follows:

Operating (Loss) Income

Operating loss was $(2.5) million, or (1.5)% of net sales, compared to operating income of $6.3 million, or 3.6% of net sales, last year as a result of the combination of factors noted above.

Other Income, Net

Other income was $1.3 million compared to $0.7 million last year, primarily attributable to earning significantly higher rates of return on our marketable securities.

Income Tax (Benefit) Expense

Income tax benefit was $(0.3) million, or 28.0% of pre-tax loss, compared to income tax expense of $1.8 million, or 26.3% of pre-tax income, last year. The increase in the effective income tax rate was primarily attributable to a decrease in pre-tax income and discrete income tax items associated with stock-based compensation.

Net (Loss) Income and (Loss) Income Per Diluted Share

Net loss was $(0.8) million, or $(0.03) per share, compared to net income of $5.1 million, or $0.17 per diluted share, last year as a result of the combination of factors noted above.

Thirty-Nine Weeks Ended October 28, 2023 Compared to Thirty-Nine Weeks Ended October 29, 2022

Net Sales

Total net sales were $450.1 million, a decrease of $41.9 million or 8.5%, compared to $491.9 million last year. Total comparable net sales, including both physical stores and e-commerce, decreased by 11.3%. We believe persistent inflation continues to have an adverse impact on spending by our younger customer demographic.

• Net sales from physical stores were $360.0 million, a decrease of $36.1 million or 9.1%, compared to $396.1 million last year with a comparable store net sales decrease of 12.3%. In comparable stores, customer traffic decreased by 10%, total transaction volume decreased by 12%, and the average transaction value was flat. Net sales from physical stores represented 80.0% of total net sales compared to 80.5% of total net sales last year.
• Net sales from e-commerce were $90.0 million, a decrease of $5.8 million or 6.1%, compared to $95.8 million last year. E-commerce net sales represented 20.0% of total net sales compared to 19.5% of total net sales last year.

Gross Profit

Gross profit was $119.0 million, or 26.4% of net sales, compared to $150.4 million, or 30.6% of net sales, last year. Buying, distribution, and occupancy costs deleveraged by 260 basis points and increased by $2.3 million collectively, predominantly due to occupancy costs, as a result of operating two net additional stores and carrying these costs against a lower level of net sales, partially offset by a decrease in distribution costs resulting from reduced freight costs. Product margins declined by 150 basis points primarily due to increased markdowns and estimated inventory valuation reserves.

Selling, General and Administrative Expenses

SG&A expenses were $141.4 million, or 31.4% of net sales, compared to $137.8 million, or 28.0% of net sales, last year. The primary components of the SG&A variances, both in terms of percentage of net sales and total dollars, were as follows:

Operating (Loss) Income

Operating loss was $(22.5) million, or (5.0)% of net sales, compared to operating income of $12.6 million, or 2.6% of net sales, last year as a result of the combination of factors noted above.

Other Income, Net

Other income was $3.6 million compared to $0.9 million last year, primarily attributable to earning significantly higher rates of return on our marketable securities.

Income Tax (Benefit) Expense

Income tax benefit was $(4.9) million, or 26.0% of pre-tax loss, compared to income tax expense of $3.7 million, or 27.2% of pre-tax income, last year. The decrease in the effective income tax rate was primarily attributable to a decrease in pre-tax income and discrete income tax items associated with stock-based compensation.

Net (Loss) Income and (Loss) Income Per Diluted Share

Net loss was $(13.9) million, or $(0.47) per share, compared to net income of $9.8 million, or $0.32 per diluted share, last year as a result of the combination of factors noted above.

Liquidity and Capital Resources

Our business relies on cash flows from operating activities as well as cash on hand as our primary sources of liquidity. We currently expect to finance company operations, store growth and remodels and all of our planned capital expenditures with existing cash on hand, marketable securities and cash flows from operations.

In addition to cash and cash equivalents and marketable securities, the most significant components of our working capital are merchandise inventories, accounts payable and accrued expenses. We believe that cash flows from operating activities, our cash and marketable securities on hand, and credit facility availability will be sufficient to cover our working capital requirements and anticipated capital expenditures for the next 12 months from the filing of this Report. If cash flows from operations are not sufficient or available to meet our capital requirements, then we will be required to obtain additional equity or debt financing in the future. There can be no assurance that equity or debt financing will be available to us when we need it or, if available, that the terms will be satisfactory to us and not dilutive to our stockholders.

Working Capital

Working capital at October 28, 2023, was $76.4 million compared to $94.1 million at January 28, 2023, a decrease of $17.7 million. The primary changes in our working capital during the first three quarters of fiscal 2023 were as follows:

Cash Flow Analysis

A summary of operating, investing and financing activities for the thirty-nine weeks ended October 28, 2023 compared to the thirty-nine weeks ended October 29, 2022 is shown in the following table (in thousands):

Net Cash Used in Operating Activities

Operating activities consist primarily of net (loss) income adjusted for non-cash items that include depreciation, asset impairment write-downs, deferred income taxes, (gain) interest on maturities of marketable securities and share-based compensation expense, plus the effect on cash of changes during the year in our assets and liabilities.

Net cash used in operating activities was $10.5 million this year compared to $11.1 million last year. The $0.6 million decrease in net cash used in operating activities compared to last year was due to a variety of largely offsetting increases and decreases of similar amounts within current assets and current liabilities.

Net Cash (Used in) Provided by Investing Activities

Cash flows from investing activities consist primarily of capital expenditures and maturities and purchases of marketable securities.

Net cash used in investing activities was $18.7 million this year compared to net cash provided of $55.5 million last year. Net cash used in investing activities in the first three quarters of fiscal 2023 consisted of purchases of marketable securities of $88.1 million and capital expenditures totaling $10.5 million, partially offset by maturities of marketable securities of $80.0 million. Net cash provided by investing activities in the first three quarters of fiscal 2022 consisted of maturities of marketable securities of $117.2 million, partially offset by the purchases of marketable securities of $49.8 million and capital expenditures totaling $11.9 million.

Net Cash Provided by (Used in) Financing Activities

Financing activities primarily consist of share repurchases and proceeds from employee exercises of stock options.

Net cash provided by financing activities was $37 thousand this year resulting from the proceeds of employee exercises of stock options of $0.2 million, partially offset by taxes paid on a short-swing profits disgorgement payment to us of $0.2 million. Net cash used in financing activities of $10.8 million last year was attributable to the repurchase of shares of our common stock of $10.9 million partially offset by proceeds from the exercise of stock options of 56 thousand.

Asset-Backed Credit Agreement

On April 27, 2023 (the “Closing Date”), we entered into an asset-backed credit agreement and revolving line of credit note (the "Note" and, collectively, the “Credit Agreement”) with Wells Fargo Bank, National Association, as lender (the “Bank”). The Credit Agreement provides for an asset-based, senior secured revolving credit facility (“Revolving Facility”) of up to $65.0 million (“Revolving Commitment”) consisting of revolving loans, letters of credit and swing line loans, with a sub-limit on letters of credit outstanding at any time of $10.0 million and a sub-limit for swing line loans of $7.5 million, which replaced our previous senior unsecured credit agreement. The Credit Agreement also includes an uncommitted accordion feature whereby we may increase the Revolving Commitment by an aggregate amount not to exceed $12.5 million, subject to certain conditions. The Revolving Facility matures on April 27, 2026. The payment and performance in full of the secured obligations under the Revolving Facility are secured by a lien on and security interest in all of our assets.

The maximum borrowings permitted under the Revolving Facility is equal to the lesser of (x) the Revolving Commitment and (y) the applicable borrowing base, which is equal to (i) 90% of our eligible credit card receivables, plus (ii) 90% of the cost of certain adjusted eligible inventory, less certain inventory reserves, plus (iii) 90% of the cost of certain adjusted eligible in-transit inventory, less certain inventory reserves, less (iv) certain other reserves established by the Bank.

The unused portion of the Revolving Commitment accrues a commitment fee of 0.375% per annum. Borrowings under the Revolving Facility bear interest at a rate per annum that ranges from the Secured Overnight Financing Rate (“SOFR”) plus a credit spread adjustment (equal to 10 basis points for one- and three-month term SOFR) plus 1.50% to 2.00%, or a base rate (as calculated in accordance with the Credit Agreement) (the “Base Rate”) plus 0.50% to 1.00%, based on the average daily borrowing capacity under the Revolving Facility over the applicable fiscal quarter. We are allowed to elect to apply either SOFR or Base Rate interest to borrowings at its discretion, other than in the case of swing line loans, to which the Base Rate shall apply.

Under the Credit Agreement, we are subject to a variety of affirmative and negative covenants customary in an asset-based lending facility, including a financial covenant relating to availability (which is required to remain above the greater of: (i) ten percent (10%) of the Loan Cap (as defined in the Credit Agreement) and (ii) $6.0 million). Prior to the first anniversary of the Closing Date, we are prohibited from declaring or paying any cash dividends to our stockholders or repurchasing our common stock. Thereafter, we are permitted to declare or pay cash dividends and/or repurchase our common stock provided, among other things, no default or event of default exists as of the date of any such payment and after giving effect thereto and certain minimum availability and minimum projected availability tests are satisfied.

Events of default under the Credit Agreement include, among other things, failure to pay principal, interest, fees or other amounts; covenant defaults; material inaccuracy of representations and warranties; bankruptcy events; actual or asserted invalidity of any the Credit Agreement or related loan documents; or a change of control.

As of October 28, 2023, we were in compliance with all of our covenants, were eligible to borrow up to a total of $63.0 million, and had no outstanding borrowings under the Credit Agreement. The only utilization of the letters of credit sub-limit under the Credit Agreement was a $2.025 million irrevocable standby letter of credit.

Contractual Obligations

As of October 28, 2023, there were no material changes to our contractual obligations as described in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section of our Annual Report on Form 10-K for the fiscal year ended January 28, 2023.

Critical Accounting Policies and Estimates

The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires the appropriate application of certain accounting policies, some of which require us to make estimates and assumptions about future events and their impact on amounts reported in our consolidated financial statements. Since future events and their impact cannot be determined with absolute certainty, the actual results will inevitably differ from our estimates. A summary of our significant accounting policies is included in Note 2 to the consolidated financial statements in our Annual Report on Form 10-K for the fiscal year ended January 28, 2023.

As of October 28, 2023, there were no material changes in the market risks described in the “Quantitative and Qualitative Disclosure About Market Risks” section of our Annual Report on Form 10-K for the fiscal year ended January 28, 2023.

Evaluation of Disclosure Controls and Procedures

Our management, including our Chief Executive Officer and our Chief Financial Officer, with the participation of our Disclosure Committee, evaluated the effectiveness of our disclosure controls and procedures as of October 28, 2023. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to our management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Based on the evaluation of our disclosure controls and procedures as of October 28, 2023, our Chief Executive Officer and Chief Financial Officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.

Changes in Internal Control Over Financial Reporting

There was no change in our internal control over financial reporting identified in connection with the evaluation required by Rule 13a-15(d) and 15d-15(d) of the Exchange Act that occurred during the thirteen weeks ended October 28, 2023 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Inherent Limitations on Effectiveness of Controls

Our management, including our Chief Executive Officer and Chief Financial Officer, believes that our disclosure controls and procedures and internal control over financial reporting are designed to provide reasonable assurance of achieving their objectives and are effective at the reasonable assurance level. However, our management does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected.

These inherent limitations include the realities that judgments in decision making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the controls. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

We operate in a rapidly changing environment that involves a number of risks that could materially and adversely affect our business, financial condition, prospects, operating results or cash flows. In addition to the other information set forth in this Report, please refer to the section titled “Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended January 28, 2023 for a detailed discussion of the risks that affect our business.