1. Nature of Business and Summary of Significant Accounting Policies
(a) Basis of Presentation
J.Crew Group, Inc. and its wholly owned subsidiaries (the “Company” or “Group”) was acquired (the “Acquisition”) on March 7, 2011 through a merger with Chinos Acquisition Corporation (“Merger Sub”), a wholly-owned subsidiary of Chinos Holdings, Inc. (the “Parent”). The Parent was formed by investment funds affiliated with TPG Capital, L.P. (“TPG”) and Leonard Green & Partners, L.P. (“LGP” and together with TPG, the “Sponsors”). Subsequent to the Acquisition, Group became an indirect, wholly owned subsidiary of Parent, which is owned by affiliates of the Sponsors, co-investors and members of management. Prior to March 7, 2011, the Company operated as a public company with its common stock traded on the New York Stock Exchange.
Although the Company continued as the same legal entity after the Acquisition, the accompanying consolidated statements of operations and comprehensive income (loss), stockholders’ equity and cash flows are presented for two periods: Predecessor and Successor, which relate to the period before and after the Acquisition. The period March 8, 2011 to January 28, 2012 is referred to as the “Successor period” and the period January 30, 2011 to March 7, 2011 is referred to as the “Predecessor period.” The Acquisition and the allocation of the purchase price were recorded as of March 7, 2011.
All significant intercompany balances and transactions are eliminated in consolidation.
(b) Business
The Company designs, contracts for the manufacture of, markets and distributes women’s, men’s and children’s apparel, shoes and accessories under the J.Crew, crewcuts and Madewell brand names. The Company’s products are marketed primarily in the United States and Canada through two primary sales channels: (i) Stores, which consists of retail, factory and Madewell stores, and (ii) Direct, which consists of websites and catalogs.
The Company is subject to seasonal fluctuations in its merchandise sales and results of operations. The Company expects its revenues generally to be lower in the first and second quarters than in the third and fourth quarters (which includes the holiday season) of each fiscal year.
A significant amount of the Company’s products are produced in Asia through arrangements with independent contractors. As a result, the Company’s operations could be adversely affected by political instability resulting in the disruption of trade from the countries in which these contractors are located or by the imposition of additional duties or regulations relating to imports or by the contractor’s inability to meet the Company’s production requirements.
(c) Fiscal Year
The Company’s fiscal year ends on the Saturday closest to January 31. The fiscal years 2012, 2011 (which reflects the Predecessor and Successor periods), and 2010 ended on February 2, 2013, January 28, 2012 and January 29, 2011, respectively. Fiscal year 2012 consisted of 53 weeks and fiscal years 2011 and 2010 consisted of 52 weeks.
(d) Use of Estimates in the Preparation of Financial Statements
Management of the Company is required to make estimates and assumptions about future events in preparing financial statements in conformity with generally accepted accounting principles (“GAAP”). These estimates and assumptions affect the amounts of assets, liabilities, revenues and expenses and the disclosure of loss contingencies at the date of the consolidated financial statements. While management believes that past estimates and assumptions have been materially accurate, current estimates are subject to change if different assumptions as to the outcome of future events are made. Management evaluates estimates and judgments on an ongoing basis and predicates those estimates and judgments on historical experience and on reasonable factors. Since future events and their effects cannot be determined with absolute certainty, actual results may differ from the estimates used in preparing the accompanying consolidated financial statements.
(e) Revenue Recognition
Revenue is recognized at the point of sale in the Stores channel, and at an estimated date of receipt by the customer in the Direct channel. Prices for all merchandise are listed in the Company’s catalogs and website and are confirmed with the customer upon order. The customer has no cancellation privileges other than customary rights of return. The Company accrues a sales return allowance for estimated returns of merchandise that will occur subsequent to the balance sheet date, but relate to sales prior to the balance sheet date. The Company presents taxes collected from customers and remitted to governmental authorities on a net basis on the consolidated statements of operations and comprehensive income (loss).
A liability is recognized at the time a gift card is sold, and revenue is recognized at the time the gift card is redeemed for merchandise. Revenue is deferred and a liability is recognized for gift cards issued in connection with the Company’s customer loyalty program. Any unredeemed loyalty gift cards are recognized as income in the period in which they expire.
Amounts billed to customers for shipping and handling fees related to Direct sales are recorded in other revenues. Other revenues also includes income from unredeemed gift cards, estimated based on Company specific historical trends, which amounted to $2,508 in fiscal 2012, $476 in the Successor period, $244 in the Predecessor period and $3,130 in fiscal 2010.
(f) Merchandise Inventories
Merchandise inventories are stated at the lower of average cost or market. The Company capitalizes certain design, purchasing and warehousing costs in inventory and these costs are included in cost of goods sold as the inventories are sold.
(g) Advertising and Catalog Costs
Direct response advertising, which consists primarily of catalog production and mailing costs, are capitalized and amortized over the expected future revenue stream. Amortization of capitalized advertising costs is computed using the ratio of current period revenues for the catalog cost pool to the total of current and estimated future period revenues for that catalog cost pool. The capitalized costs of direct response advertising are amortized, commencing with the date catalogs are mailed, over the duration of the expected revenue stream, which is approximately two months. Deferred catalog costs, included in prepaid expenses and other current assets, as of February 2, 2013 and January 28, 2012 were $9,643 and $7,620 respectively. Catalog costs, which are reflected in selling, general and administrative expenses, were $44,525 in fiscal 2012, $43,533 in the Successor period, $4,201 in the Predecessor period and $41,859 fiscal 2010.
All other advertising costs, which are expensed as incurred, were $39,093 in fiscal 2012, $25,704 in the Successor period, $1,998 in the Predecessor period and $18,802 in fiscal 2010.
(h) Deferred Rent and Lease Incentives
Rental payments under operating leases are charged to expense on a straight-line basis after consideration of rent holidays, step rent provisions and escalation clauses. Differences between rental expense (recognized from the date of possession) and actual rental payments are recorded as deferred rent and included in deferred credits.
The Company receives construction allowances upon entering into certain store leases. These construction allowances are recorded as deferred credits and are amortized as a reduction of rent expense over the term of the related lease. Deferred construction allowances were $34,088 and $15,016 at February 2, 2013 and January 28, 2012, respectively.
Deferred credits were eliminated in the allocation of purchase price on March 7, 2011. Deferred credits as of February 2, 2013 reflect deferred rent and lease incentives for properties which the Company took possession subsequent to the Acquisition. Additionally, in the allocation of purchase price, the Company recorded assets and liabilities for favorable and unfavorable lease commitments, which are amortized on a straight-line basis over the remaining lease life. See note 3 for more information regarding the allocation of the purchase price.
(i) Share-Based Compensation
The fair value of employee share-based awards is recognized as compensation expense on a straight line basis over the requisite service period of the award. Determining the fair value of options at the grant date requires judgment, including estimating the expected term that stock options will be outstanding prior to exercise, the associated volatility and the expected dividend yield. Upon grant of awards, the Company also estimates an amount of forfeitures that will occur prior to vesting. See note 6 for a complete description of the accounting for share-based awards.
(j) Property and Equipment
Property and equipment are stated at cost and are depreciated over the estimated useful lives using the straight-line method. Buildings and improvements are depreciated over estimated useful lives of twenty years. Furniture, fixtures and equipment are depreciated over estimated useful lives, ranging from three to ten years. Leasehold improvements are depreciated over the shorter of their useful lives or related lease terms (without consideration of optional renewal periods).
The Company capitalizes certain costs (included in fixtures and equipment) related to the acquisition and development of software and amortizes these costs using the straight line method over the estimated useful life of the software, which is three to five years. Certain development costs not meeting the criteria for capitalization are expensed as incurred.
Property and equipment was increased to its fair market value in the allocation of purchase price on March 7, 2011. The revised carrying values of the property and equipment are depreciated over their remaining useful lives. See note 3 for more information regarding the allocation of purchase price.
(k) Impairment of Long-Lived Assets
The Company reviews long-lived assets and certain identifiable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The Company assesses the recoverability of such assets based upon estimated cash flow forecasts. Charges for impairment were $631 in fiscal 2012, $1,908 in the Successor period, none in the Predecessor period and $535 in fiscal 2010. See note 11 for more information regarding impairment of long-lived assets.
(l) Income Taxes
The Company accounts for income taxes using an asset and liability method. Deferred tax assets and deferred tax liabilities are recognized based on the difference between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred taxes are measured using current enacted tax rates in effect in the years in which those temporary differences are expected to reverse. The provision for income taxes includes taxes currently payable and deferred taxes resulting from the tax effects of temporary differences between the financial statement and tax bases of assets and liabilities.
The Company maintains valuation allowances where it is more likely than not that all or a portion of a deferred tax asset will not be realized. Changes in the valuation allowances are included in the Company’s tax provision in the period of change. In determining whether a valuation allowance is warranted, the Company evaluates factors such as prior earnings history, expected future earnings, carry-back and carry-forward periods and tax strategies that could potentially enhance the likelihood of the realization of a deferred tax asset.
With respect to uncertain tax positions taken or expected to be taken on a tax return, the Company recognizes in its financial statements the impact of tax positions that meet a “more likely than not” threshold, based on the technical merits of the position. The tax benefits recognized from uncertain positions are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon effective settlement.
The Company recognizes interest expense and income related to income taxes as a component of interest expense, and penalties as a component of selling, general and administrative expenses.
(m) Segment Information
The Company has two operating segments, Stores and Direct, which are aggregated into one reportable segment. The Company’s identifiable assets are located primarily in the United States. Export sales are not significant.
(n) Cash and Cash Equivalents
The Company considers all highly liquid marketable securities, with maturities of 90 days or less when purchased, to be cash equivalents. Cash equivalents, which were $41,613 and $201,933 at February 2, 2013 and January 28, 2012, respectively, are stated at cost, which approximates market value.
(o) Operating Expenses
Cost of goods sold (including buying and occupancy costs) includes the direct cost of purchased merchandise, freight, design, buying and production costs, occupancy costs related to store operations, and all shipping and handling and delivery costs associated with the Direct channel.
Selling, general and administrative expenses include all operating expenses not included in cost of goods sold, primarily catalog production and mailing costs, administrative payroll, store expenses other than occupancy costs, depreciation and amortization, certain warehousing expenses (aggregating to $29,673 in fiscal 2012, $24,888 in the Successor period, $1,494 in the Predecessor period and $26,932 in fiscal 2010), and credit card fees.
(p) Deferred Financing Costs
Deferred financing costs are amortized over the term of the related debt agreements. The amortization is included in interest expense, net.
(q) Store Pre-opening Costs
Costs associated with the opening of new stores are expensed as incurred.
(r) Goodwill and Intangible Assets
The Acquisition of the Company was accounted for as a purchase business combination, whereby the purchase price paid was allocated to recognize the acquired assets and liabilities at fair value. In connection with the purchase price allocation, intangible assets were established for the J.Crew and Madewell trade names, loyalty program, customer lists and favorable lease commitments. The purchase price in excess of the fair value of assets and liabilities was recorded as goodwill, which consists primarily of intangible assets related to the knowhow, design and merchandising of the Company’s brands that do not qualify for separate recognition.
Indefinite-lived intangible assets, such as the J.Crew trade name and goodwill, are not subject to amortization. The Company assesses the recoverability of indefinite-lived intangibles whenever there are indicators of impairment, or at least annually in the fourth quarter. If the recorded carrying value of an intangible asset exceeds its estimated fair value, the Company records a charge to write the intangible asset down to its fair value. Definite-lived intangibles, such as the Madewell trade name, loyalty program, customer lists and favorable lease commitments, are amortized on a straight line basis over their useful life or remaining lease term. See note 5 for more information regarding goodwill and intangible assets of the Company.
The Company assesses the recoverability of goodwill at the reporting unit level, which consists of its operating segments, Stores and Direct. In this assessment, the Company first compares the estimated enterprise fair value of each of the reporting units to its recorded carrying value. The Company estimates the enterprise fair value based on discounted cash flow techniques. If the recorded carrying value of a reporting unit exceeds its estimated enterprise fair value in the first step, a second step is performed in which the Company allocates the enterprise fair value to the fair value of the reporting unit’s net assets. The second step of the impairment testing process requires, among other things, estimates of fair values of substantially all of the Company’s tangible and intangible assets. Any enterprise fair value in excess of amounts allocated to such net assets represents the implied fair value of goodwill for that reporting unit. If the recorded goodwill balance for a reporting unit exceeds the implied fair value of goodwill, an impairment charge is recorded to write goodwill down to its fair value.
(s) Dividends
Dividends are recorded at the declaration date as a reduction of retained earnings included in stockholders’ equity. If the amount of the dividend exceeds retained earnings, the dividend is recorded as a reduction of additional paid-in capital. On December 21, 2012, the Company paid a dividend of $197,450 to stockholders of record of the Parent on December 17, 2012, and reduced additional paid-in capital. No dividends were declared or paid in the Successor and Predecessor periods, or in fiscal 2010.
(t) Reclassification
Certain prior year amounts have been reclassified to conform to the current year’s presentation.