10-K 1 d10k.htm FORM 10-K (FOR THE FISCAL YEAR ENDED FEBRUARY 2, 2008) Form 10-K (For the fiscal year ended February 2, 2008)
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-K

 

 

(Mark One)

 

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended February 2, 2008

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number 0-18632

THE WET SEAL, INC.

(Exact name of registrant as specified in its charter)

 

Delaware   33-0415940
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification No.)
26972 Burbank, Foothill Ranch, CA   92610
(Address of principal executive offices)   (Zip Code)

(949) 699-3900

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

 

Title of Each Class

 

Name of Each Exchange on Which Registered

Class A Common Stock, $0.10 par value per share   NASDAQ Global Market

Securities registered pursuant to Section 12(g) of the Act: None

 

 

Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  þ

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  þ

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  þ    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    þ

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act:

Large accelerated filer:  ¨        Accelerated filer:  þ        Non-accelerated filer:  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  þ

The aggregate market value of voting stock held by non-affiliates of the registrant as of August 4, 2007, was approximately $401,880,000 based on the closing sale price of $4.61 per share as reported on the NASDAQ Global Market on August 3, 2007.

The number of shares outstanding of the registrant’s Class A common stock, par value $0.10 per share, at April 7, 2008, was 92,205,051. There were no shares outstanding of the registrant’s Class B common stock, par value $0.10 per share, at April 7, 2008.

DOCUMENTS INCORPORATED BY REFERENCE

PART III of this Annual Report incorporates information by reference from the registrant’s definitive Proxy Statement for its Annual Meeting of Stockholders to be filed with the SEC within 120 days of February 2, 2008.

 

 

 


Table of Contents

THE WET SEAL, INC.

Annual Report on Form 10-K

For the Fiscal Year Ended February 2, 2008

TABLE OF CONTENTS

 

          Page
   Part I   

Item 1.

  

Business

   1

Item 1A.

  

Risk Factors

   10

Item 1B.

  

Unresolved Staff Comments

   18

Item 2.

  

Properties

   18

Item 3.

  

Legal Proceedings

   19

Item 4.

  

Submission of Matters to a Vote of Security Holders

   21
   Part II   

Item 5.

  

Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   22

Item 6.

  

Selected Financial Data

   24

Item 7.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   25

Item 7A.

  

Quantitative and Qualitative Disclosures About Market Risk

   50

Item 8.

  

Financial Statements and Supplementary Data

   51

Item 9.

  

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

   51

Item 9A.

  

Controls and Procedures

   51

Item 9B.

  

Other Information

   52
   Part III   

Item 10.

  

Directors, Executive Officers and Corporate Governance of the Registrant

   53

Item 11.

  

Executive Compensation

   53

Item 12.

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

   53

Item 13.

  

Certain Relationships and Related Transactions, and Director Independence

   54

Item 14.

  

Principal Accounting Fees and Services

   54
   Part IV   

Item 15.

  

Exhibits and Financial Statement Schedules

   55

Signatures

   56


Table of Contents

PART I

 

Item 1. Business

Statement Regarding Forward Looking Disclosure and Risk Factors

Certain sections of this Annual Report on Form 10-K, including “Item 1. Business” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contain various forward-looking statements within the meaning of Section 27A of the Securities Act, as amended, and Section 21E of the Exchange Act, which represent our expectations or beliefs concerning future events.

Forward-looking statements include statements that are predictive in nature, which depend upon or refer to future events or conditions, and/or which include words such as “believes,” “plans,” “anticipates,” “estimates,” “expects,” “may,” “will,” or similar expressions. In addition, any statements concerning future financial performance, ongoing divisional strategies or prospects, and possible future actions, which may be provided by our management, are also forward-looking statements. Forward-looking statements are based on current expectations and projections about future events and are subject to risks, uncertainties, and assumptions about our company, economic and market factors and the industry in which we do business, among other things. These statements are not guarantees of future performance and we undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise.

Actual events and results may differ materially from those expressed or forecasted in forward-looking statements due to a number of factors. Factors that could cause our actual performance, future results and actions to differ materially from any forward-looking statements include, but are not limited to, those discussed in “Risk Factors” below and discussed elsewhere in this Annual Report.

General

We are a national specialty retailer operating stores selling fashionable and contemporary apparel and accessory items designed for female customers aged 13 to 35. As of February 2, 2008, we operated 494 retail stores in 47 states, Puerto Rico and Washington D.C. Our products can also be purchased online.

All references to “we,” “our,” “us,” and “our company” in this Annual Report mean The Wet Seal, Inc. and its wholly owned subsidiaries. All references in this Annual Report to “fiscal 2008,” “fiscal 2007,” “fiscal 2006,” “fiscal 2005,” and “fiscal 2004” mean the fiscal year ending January 31, 2009 and the fiscal years ended February 2, 2008, February 3, 2007, January 28, 2006 and January 29, 2005, respectively. Our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all amendments to those reports and the proxy statement for our annual meeting of stockholders are made available, free of charge, on our corporate web site, www.wetsealinc.com, as soon as reasonably practicable after such reports have been filed with or furnished to the Securities and Exchange Commission (“SEC”). Our Business Ethics Policy and Code of Conduct is also located within the Corporate Information section of our corporate website. These documents are also available in print to any stockholder who requests a copy from our Investor Relations department. The public may also read and copy any materials that we have filed with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. In addition, these materials may be obtained at the website maintained by the SEC at www.sec.gov. The content of our websites (www.wetsealinc.com, www.wetseal.com, and www.ardenb.com) is not intended to be incorporated by reference in this Annual Report.

The names “Wet Seal” and “Arden B” (which are registered in the retail store services and other classes) are trademarks and servicemarks of our company. Each trademark, tradename, or servicemark of any other company appearing in this Annual Report belongs to its respective owner.

 

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Business Segments

We operate two nationwide, primarily mall-based, chains of retail stores under the names “Wet Seal” and “Arden B”. Although the two operating segments are similar in their products, production processes, distribution methods and regulatory environment, they are distinct in their economic characteristics. As a result, we consider these segments as two distinct reportable segments.

Wet Seal. Wet Seal is the junior apparel brand for teenage girls that seek trend-focused and value competitive clothing with a target customer age of 13 to 19 years old. Wet Seal seeks to provide its customer base with a balance of affordably priced fashionable apparel and accessories.

Arden B. Arden B is a fashion brand for the feminine contemporary woman with sex appeal. Arden B targets customers aged 25 to 35 and seeks to deliver contemporary collections of fashion separates and accessories for various aspects of the customers’ lifestyles.

We maintain a web-based store located at www.wetseal.com, offering Wet Seal merchandise to customers over the internet. We also maintain a web-based store located at www.ardenb.com, offering Arden B apparel and accessories comparable to those carried in the stores. Our online stores are designed to serve as an extension of the in-store experience, and offer a wide selection of merchandise, which helps expand in-store sales. Internet operations for both Wet Seal and Arden B are included in their respective operating segments. In fiscal 2007 and 2006, we experienced rapid growth in both visitor traffic and our online sales and we will continue to develop our Wet Seal and Arden B websites to increase their effectiveness in marketing our brands.

See Note 16 of the Notes to Consolidated Financial Statements for financial information regarding segment reporting, which information is incorporated herein by reference.

Our Stores

Wet Seal stores average approximately 3,900 square feet in size and in fiscal 2007 had average sales per square foot of $314. As of February 2, 2008, we operated 399 Wet Seal stores. Arden B stores average approximately 3,100 square feet in size and in fiscal 2007 had average sales per square foot of $420. As of February 2, 2008, we operated 95 Arden B stores.

In December 2004, we announced the closing of approximately 150 Wet Seal stores as part of our turnaround strategy. We completed our inventory liquidation sales and the closing of 153 Wet Seal stores in March 2005. During fiscal 2005, we scaled back plans to open new stores in an effort to limit capital expenditures and concentrate our efforts on restoring the core business.

During fiscal 2006, we opened 34 and closed four Wet Seal stores and opened four and closed four Arden B stores.

During fiscal 2007, we opened 71 and closed ten Wet Seal stores and opened seven and closed four Arden B stores. We believe future closures for at least the next 12 months following the date of this Annual Report will primarily result from lease expirations where we decide not to extend, or are unable to extend, a store lease.

We expect our store count to remain relatively flat, or increase nominally, in fiscal 2008 to allow time to re-assess our real estate strategy, build our backlog of store opening opportunities, and maintain focus on managing our existing store base through a challenging retail environment we expect will persist through fiscal 2008. We have approximately 80 existing store leases scheduled to expire in fiscal 2008. We expect to negotiate new leases that will allow us to remain in a substantial majority of these locations. Our ability to increase the number of Wet Seal and Arden B stores in the future will depend, in part, on satisfactory cash flows from existing operations, the demand for our merchandise, our ability to find suitable mall or other locations with

 

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acceptable sites and satisfactory terms, and general business conditions. Our management does not believe there are significant geographic constraints on the locations of future stores.

Competitive Strengths

Experienced Management Team is in Place. Although we have recently had changes among our senior management team, the current members of our senior management have extensive knowledge of our business and operations which will be instrumental in driving our company into the next phase of its growth cycle. Mr. Edmond S. Thomas, our new president and chief executive officer, formerly served as the president and chief operating officer of our company from 1992 to 2000. Our new chief financial officer, Steven H. Benrubi, served as our controller for over two years prior to his appointment as chief financial officer. Dyan Jozwick has served as chief merchandise officer for our Wet Seal division for nearly two years. Sharon Hughes, the consultant that we have hired to lead the Arden B merchandising efforts on an interim basis, was an employee of our company from 1990 through 2002. During this period Ms. Hughes was involved in the formation of the Arden B division and held several different merchant roles, including senior vice president of merchandising.

Merchandising Model at Wet Seal is Focused on Fast Fashion at Affordable Prices. At Wet Seal, we have developed considerable expertise in identifying, stocking and selling a broad assortment of fresh, fashionable apparel and accessories at competitive prices. Our buyers work closely with senior management to determine the optimal product selection, promotion and pricing strategy. A significant portion of our merchandise is sourced domestically. This sourcing strategy enables us to ship new merchandise to the stores with high frequency. We also take regular markdowns to effect the rapid sale of slow-moving inventory.

Improved Financial Condition. Since the completion of a recapitalization of our company in May 2005, our financial condition has improved materially. During fiscal 2005, 2006 and 2007, we experienced positive comparable store sales growth, on a consolidated basis, in eight out of twelve fiscal quarters and had positive cash flow from operations in each of those fiscal years.

Due to the improvement in our financial performance since the end of fiscal 2004, we have been able to reduce our outstanding indebtedness. Through fiscal 2007, $47.9 million in principal amount of our convertible notes had been converted into shares of our Class A common stock. We used the proceeds from a May 2005 financing transaction to repay a bridge loan that we received from investors in a January 2005 recapitalization of our company. In addition, in March 2006, we repaid the $8.0 million outstanding balance of a junior secured term loan under our then existing credit facility, and in fiscal 2007 and 2006, we repurchased 3.6 million shares and 2.4 million shares, respectively, of our Class A common stock for $20.1 million and $15.1 million, respectively. As of February 2, 2008, our total debt, net of discount, is $3.6 million, stockholders’ equity is $127.8 million and cash and cash equivalents is $100.6 million.

The improvement in our financial condition gives us the ability to invest in opening new Wet Seal and Arden B stores.

Strategic Review of Business Operations

Since his appointment in October 2007, our new chief executive officer has identified areas in which our company’s business and operations can be improved. Our chief executive officer has focused on increasing comparable store sales for our retail divisions, improving our company’s gross margin, enhancing new store productivity, reviving the Arden B business and expanding our online business. As a result, we have implemented cost-cutting initiatives and identified strategic opportunities regarding merchandise margin, store operations, real estate, marketing, information systems, and physical distribution and transportation. As part of our cost-cutting initiatives, in January 2008, we eliminated 49 positions in our corporate offices, and two positions in field operations, across numerous functional areas.

 

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As part of a strategic review of business operations, we believe we have significant opportunities to improve our business trends and drive sales improvement. The key elements of our opportunities are to:

Improve Merchandise Margin In our Wet Seal division, we have identified opportunities to improve our planning and allocation function, merchandise mix and markdown cadence. During fiscal 2008, we will complete merchandising profiles of each Wet Seal store and integrate them into our planning and allocation function. We plan to improve our assortment planning and size optimization, increase our focus on key merchandise item categories, expand our bottoms offering and add denim brands to the merchandise mix. In our Arden B division, we have identified opportunities to improve inventory management, merchandise mix, and sourcing and to modify price points, where appropriate. We plan to better align our merchandise mix with customer needs through improving the balance of wear-to-work, everyday and occasion apparel, and adding fashion basics across key merchandise item categories. Additionally, we will reassess our sourcing process and employ more consistent pricing practices and improved promotional disciplines.

Improve Store Operations Our store operation opportunities include an improved alignment of incentive compensation with selling performance, better utilization of customer feedback and improved performance in under-producing new stores. We plan to establish stronger accountability by developing incentive plans aligned with store sales growth and store profitability. We will evaluate store tasks to determine if excess tasks can be eliminated to facilitate greater focus on sales. We will realign operations management of both the Wet Seal and Arden B divisions to reduce costs. Finally, we plan to employ more detailed analysis and monitoring of new store performance.

Improve Real Estate We will seek to improve our new store economics and address pressure from rising occupancy and store construction costs. Additionally, we plan to test off-mall locations by opening a small number of stores in regional “power centers” during fiscal 2008. We plan to rebuild the pipeline for store growth and rationalize current deals in the pipeline, which we estimate will reduce fiscal 2008 store openings to approximately 20 to 25 stores.

Improve Marketing We believe we have opportunity to improve our marketing planning and alignment of our messages to the divisional merchandising strategies. We are developing specific plans for each division for fiscal 2008. We intend to place more emphasis on visual merchandising, direct marketing and grass roots marketing, while reducing our magazine advertising, as we believe there is a much better return on investment in the grass roots approach. We also intend to increase emphasis on direct mail and heighten our focus on customer acquisition. Additionally, we intend to increase our use of internet marketing to drive increased store traffic.

Improve Information Systems We believe we have opportunity to reduce costs and improve the efficiency of our information systems. We will conduct an independent review of our information systems infrastructure to determine immediate cost savings. Additionally, we will develop short term and long term information systems strategies and install improved project management and cost controls.

Improve Physical Distribution and Transport Our physical distribution and transport opportunities include facilitating more efficient store operations by resuming daily shipping to stores and, eventually, delivering merchandise to stores that is “floor-ready.”

Resume Our Positive Comparable Store Sales Trend From fiscal 2005 through 2006, we experienced seven out of eight quarters of positive comparable store sales results, on a consolidated basis, versus the negative comparable store sales trends of fiscal 2004. These improvements resulted primarily from increased transaction counts and the number of items purchased per customer, partially offset by a decrease in average retail price per item sold due to a change in pricing strategy. After positive comparable store sales results in the first quarter of fiscal 2007, we have experienced three consecutive quarters of comparable store sales declines, on a consolidated basis, in the low single digits. In fiscal 2007, we experienced a 1.1% decrease in comparable store sales principally due to decreases in the number of transactions generated per store and the number of items purchased per customer.

 

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LOGO

 

 
TOTAL COMPANY MONTHLY COMPARABLE STORE SALES

Jan-04

   -21.5%    Jan-05    8.2%    Jan-06    51.4%    Jan-07    3.6%    Jan-08    -5.7%

Feb-04

   -12.5%    Feb-05    16.4%    Feb-06    29.3%    Feb-07    5.0%        

Mar-04

   -21.1%    Mar-05    36.3%    Mar-06    16.2%    Mar-07    10.9%        

Apr-04

   -16.8%    Apr-05    35.7%    Apr-06    17.0%    Apr-07    -9.6%        

May-04

   -7.8%    May-05    56.9%    May-06    -8.3%    May-07    1.9%        

Jun-04

   -10.1%    Jun-05    59.3%    Jun-06    -4.0%    Jun-07    0.7%        

Jul-04

   -14.7%    Jul-05    50.9%    Jul-06    6.4%    Jul-07    -7.2%        

Aug-04

   -14.8%    Aug-05    48.3%    Aug-06    8.7%    Aug-07    1.7%        

Sep-04

   -8.0%    Sep-05    44.9%    Sep-06    5.8%    Sep-07    -7.0%        

Oct-04

   -15.5%    Oct-05    46.6%    Oct-06    7.5%    Oct-07    -5.4%        

Nov-04

   -19.5%    Nov-05    51.5%    Nov-06    5.5%    Nov-07    -1.7%        

Dec-04

   -11.8%    Dec-05    38.5%    Dec-06    1.3%    Dec-07    0.6%          

LOGO

 

 
WET SEAL MONTHLY COMPARABLE STORE SALES

Jan-04

   -35.7%    Jan-05    18.9%    Jan-06    83.7%    Jan-07    5.8%    Jan-08    -1.1%

Feb-04

   -25.5%    Feb-05    27.1%    Feb-06    47.9%    Feb-07    5.2%        

Mar-04

   -32.2%    Mar-05    51.9%    Mar-06    26.0%    Mar-07    14.0%        

Apr-04

   -27.0%    Apr-05    55.7%    Apr-06    20.1%    Apr-07    -10.0%        

May-04

   -17.5%    May-05    79.2%    May-06    -5.0%    May-07    3.1%        

Jun-04

   -21.7%    Jun-05    95.4%    Jun-06    -4.0%    Jun-07    2.8%        

Jul-04

   -26.0%    Jul-05    89.9%    Jul-06    8.1%    Jul-07    -6.0%        

Aug-04

   -22.5%    Aug-05    74.8%    Aug-06    8.6%    Aug-07    5.4%        

Sep-04

   -16.5%    Sep-05    81.0%    Sep-06    8.3%    Sep-07    -4.7%        

Oct-04

   -24.3%    Oct-05    91.3%    Oct-06    8.7%    Oct-07    -3.7%        

Nov-04

   -24.5%    Nov-05    89.0%    Nov-06    7.3%    Nov-07    0.0%        

Dec-04

   -21.0%    Dec-05    69.4%    Dec-06    2.1%    Dec-07    4.8%          

 

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LOGO

 

 
ARDEN B MONTHLY COMPARABLE STORE SALES

Jan-04

   29.2%    Jan-05    -4.5%    Jan-06    5.2%    Jan-07    -2.7%    Jan-08    -21.2%

Feb-04

   37.2%    Feb-05    0.6%    Feb-06    -4.6%    Feb-07    4.2%        

Mar-04

   23.1%    Mar-05    11.0%    Mar-06    -4.8%    Mar-07    1.8%        

Apr-04

   19.7%    Apr-05    -0.1%    Apr-06    8.7%    Apr-07    -8.3%        

May-04

   25.0%    May-05    17.8%    May-06    -16.9%    May-07    -1.7%        

Jun-04

   29.8%    Jun-05    1.9%    Jun-06    -4.1%    Jun-07    -6.0%        

Jul-04

   23.0%    Jul-05    -8.2%    Jul-06    0.8%    Jul-07    -11.4%        

Aug-04

   13.3%    Aug-05    -2.4%    Aug-06    9.1%    Aug-07    -12.0%        

Sep-04

   12.9%    Sep-05    -4.3%    Sep-06    -0.7%    Sep-07    -13.6%        

Oct-04

   5.5%    Oct-05    -8.2%    Oct-06    4.5%    Oct-07    -10.3%        

Nov-04

   -8.2%    Nov-05    2.0%    Nov-06    0.8%    Nov-07    -6.7%        

Dec-04

   5.7%    Dec-05    -5.0%    Dec-06    -0.7%    Dec-07    -12.7%          

Note: The numbers in the foregoing charts do not include sales from discontinued operations.

For fiscal 2006, we experienced moderate growth in comparable store sales results versus the dramatically improved results we had in fiscal 2005. The decrease in growth was principally due to a merchandising misstep and delays in inventory receipts, which caused our Wet Seal stores to lack fashion tops and dresses in May and June 2006. Our merchandising team identified the issue and adjusted purchasing levels, thus restoring our positive comparable store sales momentum in each month from July through the end of fiscal 2006.

In fiscal 2008, we plan on improving comparable store sales with the implementation of identified strategic initiatives noted above, which includes better alignment of our merchandise mix with customer needs, efficiencies in our planning and allocation functions, and the alignment of store incentive compensation with selling performance.

Revive Arden B In February 2008, we engaged Sharon Hughes as a consultant to serve as the chief merchandise officer for Arden B under the direction and supervision of Mr. Thomas. We believe our primary opportunity for the Arden B division is in the adjustment of our merchandise mix. We are adjusting our assortments at Arden B to include more fashion basic and wear-to-work merchandise. We believe Arden B has yet to achieve its full potential with its core young contemporary customer. We aim to drive sales and profitability at Arden B through distinctive, quality merchandise, unified apparel and accessory assortments and an improved in-store customer experience.

Expand our Online Business We plan to continue to grow our internet business through several initiatives, including a focus on integrated branding, targeted marketing programs utilizing our customer database and our customer loyalty programs. Although our internet sales are modest compared to consolidated net sales, we are experiencing substantial growth. A combination of several changes contributed to the improvement, including hiring the right staff with internet marketing experience, changing processes to make them scalable, aligning the

 

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online sites to the look of the stores and implementing appropriate targeted marketing. We are optimizing inventory allocated to the internet business to better meet demand and have strengthened our buying and planning staff to meet the anticipated sales growth in this area. We plan to continue to grow our internet business through continued improvements to inventory planning, fulfillment, and customer service. The growth in website traffic continues to be substantial and the internet is a key component for driving store traffic. Prior to the 2007 holiday season, we launched a new website platform for both divisions. The new websites support advanced merchandising capabilities, personalization based on browsing behavior and past purchase history, and testing tools to measure and determine the most effective content and promotion strategies.

Design, Buying and Product Development

Our design and buying teams are responsible for identifying evolving fashion trends and developing themes to guide our merchandising strategy. Each retail division has a separate buying team. The merchandising teams for each retail division develop fashion themes and strategies through assessing customer responses to current trends, shopping international and appropriate domestic markets, and using fashion services and gathering references from industry publications. After selecting fashion themes, the design and buying teams work closely with vendors to use colors, materials and designs that create images consistent with the themes for our product offerings.

Since fiscal 2004 for our Wet Seal division, and beginning in fiscal 2008 for our Arden B division, we have decreased our dependency on internally-designed merchandise. This allows us more flexibility to respond to the changing fashion trends of our target customers, to buy in smaller lots and to reduce product development lead times. See also “Allocation and Distribution” below.

Marketing, Advertising and Promotion

We believe that our brands are among our most important assets. Our ability to successfully increase brand awareness is dependent upon our ability to address the changing needs and priorities of each brand’s target customers. We will place more emphasis on visual merchandising, direct marketing and grass roots marketing, while reducing our magazine advertising as we believe there is a much better return on investment in these marketing approaches. We will also increase emphasis on direct mail, heighten our focus on customer acquisition, and increase our use of internet marketing to drive increased store traffic.

During fiscal 2007, 2006, and 2005, we spent 1.1%, 1.1%, and 0.8%, respectively, of net sales on advertising. In fiscal 2007, our primary marketing focus was on in-store promotion programs for the Wet Seal stores and print media for the Arden B stores, which included publications in various magazines throughout the year.

As discussed further in Note 1 of Notes to Consolidated Financial Statements contained elsewhere within this Annual Report, we offer a frequent buyer program in our Wet Seal stores in order to build loyalty to the brand, increase the frequency of visits, promote multiple item purchases and gain direct access to the customer. As part of this program we send e-mails to participants to notify them of special in-store promotions. Our Arden B division also offers a loyalty program, “B Rewarded,” designed for the same purposes as that of our Wet Seal division.

Sourcing and Vendor Relationships

We purchase our merchandise from both domestic and foreign vendors. For fiscal 2007, approximately 16% of our retail merchandising receipts were directly imported from foreign vendors. Although in fiscal 2007 no single vendor provided more than 10% of our merchandise, management believes we are the largest customer of many of our smaller vendors. Quality control is monitored at the distribution points of our largest vendors and manufacturers, and merchandise is inspected upon arrival at our Foothill Ranch, California facility.

 

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We do not maintain any long-term or exclusive commitments or arrangements to purchase merchandise from any single supplier, and there are many vendors who could supply our merchandise.

Allocation and Distribution

Our merchandising effort primarily focuses on maintaining a regular flow of fresh, fashionable merchandise into our stores. Successful execution depends in large part on our integrated planning, allocation and distribution functions. By working closely with store operations management and merchandise buyers, our teams of planners and allocators manage inventory levels and coordinate the allocation of merchandise to each of our stores based on sales volume and store size, demographics, climate and other factors that may influence an individual store’s product mix.

All merchandise for retail stores is received from vendors at our Foothill Ranch, California distribution center, where items are inspected and prepared for shipping to our stores. We ship all of our merchandise to our stores by common carrier. Consistent with our goal of maintaining the freshness of our product offerings, we frequently ship new merchandise to stores, and markdowns are taken regularly to effect the rapid sale of slow-moving inventory. Marked-down merchandise that remains unsold is either sent to clearance centers for deep discounting and rapid movement, sold to an outside clearance company or given to charity. The fulfillment process and distribution of merchandise for our online business is performed at our Foothill Ranch distribution center.

Information and Control Systems

Our merchandise, financial and store computer systems are integrated and operate using primarily Oracle® technology. We have invested in a large data warehouse that provides management, buyers and planners comprehensive data that helps us identify emerging trends and manage inventories. The core merchandise system is provided by a leading retail enterprise resource planning, or “ERP,” software provider, and is frequently enhanced to support strategic business initiatives.

All of our stores have a point-of-sale system operating on software provided by a leading provider of specialty retailing point-of-sale systems. This system facilitates bar-coded ticket scanning, automatic price look-ups and centralized credit authorizations. All stores are networked to the corporate office via a centrally managed virtual private network. We utilize a store portal that is integrated with the corporate merchandise ERP system to provide the stores and corporate staff with current information regarding sales, promotions, inventory and shipments, and enables more efficient communications with the corporate office. In fiscal 2007, we installed new wide area networking hardware at all stores which incorporate security upgrades to guard against security breaches to our stores point-of-sale system, completed our merchandise allocation system, upgraded our financial system, and launched a new website platform for the online business. In fiscal 2008, we anticipate implementing a new time and attendance labor system as well as providing more applications for inventory management at the store level using in-store radio frequency systems.

Seasonality

Our business is seasonal by nature, with the Christmas season, beginning the week of Thanksgiving and ending the first Saturday after Christmas, and the back-to-school season, beginning the last week of July and ending during September, historically accounting for a large percentage of sales volume. For the past three fiscal years, the Christmas and back-to-school seasons together accounted for an average of slightly more than 30% of our annual sales. Our profitability depends, to a significant degree, on the sales generated during these peak periods. Any decrease in sales or margins during these periods, whether as a result of economic conditions, poor weather or other factors, could have a material adverse effect on our company.

 

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Trademarks

Our primary trademarks and service marks are WET SEAL® and ARDEN B®, which are registered in the U.S. Patent and Trademark Office. We also use and have registered, or have applications pending for, a number of other U.S. trademarks, including, but not limited to, ACCOMPLICE®, ARDEN B SPORT™, B. FIRST™, B. IN™, B. REWARDED® , ENR EVOLUTION NOT REVOLUTION®, FIT IN. STAND OUT.™, FORMULA X®, GET IT. WEAR IT. FLAUNT IT.®, SEAL STASH®, STUDIO ARDEN B™, STYLIZER®, and TREND SPOT™. In general, the registrations for these trademarks and service marks are renewable indefinitely, as long as we continue to use the marks as required by applicable trademark laws. We are not aware of any adverse claims or infringement actions relating to our trademarks or service marks.

Competition

The women’s retail apparel industry is highly competitive, with fashion, quality, price, location and service being the principal competitive factors. Our Wet Seal and Arden B stores compete with specialty apparel retailers, department stores and certain other apparel retailers, including Aeropostale, Anthropologie, Abercrombie & Fitch, Charlotte Russe, Gap, Banana Republic, H&M, Old Navy, Pacific Sunwear, American Eagle, Target, Urban Outfitters, Forever 21, Express, J.C. Penney, bebe, Zara, Guess? and BCBG. Many of our competitors are large national chains that have substantially greater financial, marketing and other resources than we do. While we believe we compete effectively for favorable site locations and lease terms, competition for prime locations within malls is intense, and we cannot ensure that we will be able to obtain new locations on terms favorable to us, if at all.

Customers

Our company’s business is not dependent upon a single customer or small group of customers.

Environmental Matters

We are not aware of any federal, state or local environmental laws or regulations that will materially affect our earnings or competitive position, or result in material capital expenditures. However, we cannot predict the effect on our operations of possible future environmental legislation or regulations. During fiscal 2007, there were no material capital expenditures for environmental control facilities and no such material expenditures are anticipated for fiscal 2008.

Government Regulation

Our company is subject to various federal, state and local laws affecting our business. Each of our company’s stores must comply with licensing and regulation by a number of governmental authorities in jurisdictions in which the store is located. To date, our company has not been significantly affected by any difficulty, delay or failure to obtain required licenses or approvals.

Our company is also subject to federal and state laws governing such matters as employment and pay practices, overtime and working conditions. The bulk of our company’s employees are paid on an hourly basis at rates related to the federal and state minimum wages. In the past, we have been assessed penalties or paid settlements to gain dismissal of lawsuits for non-compliance with certain of these laws, and future non-compliance could result in a material adverse effect on our company’s operations. In July 2006 and May 2007, we were served with class action complaints alleging violations under certain state of California labor laws. In November 2006, we reached an agreement to settle the July 2006 class action complaint for approximately $0.3 million, and as of February 2, 2008, we had accrued within accrued liabilities in our consolidated balance sheet an amount that approximates this settlement amount. On February 29, 2008, the court issued its order granting final approval of the class action settlement. We are vigorously defending the May 2007

 

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complaint and are unable to predict the likely outcome and whether such outcome may have a material adverse effect on our results of operations or financial condition. Accordingly, no provision for a loss contingency for the May 2007 complaint has been accrued at February 2, 2008.

Our company is also subject to the Fair Credit Reporting Act (the “Act”) under federal law, as well as to state laws with similar requirements, with respect to the protection our customers’ credit and debit card and other personal data. The Act provides in part that expiration dates may not be printed together with certain parts of the customer’s account number on credit or debit card receipts given to customers. The Act imposes significant penalties upon violators of these rules and regulations if the lack of compliance is deemed to have been willful. Otherwise, damages are limited to actual losses incurred. In January and February 2007, we were served with two class action complaints alleging violations of the Act. The plaintiffs in the February 2007 complaint dismissed the complaint with prejudice in August 2007. On December 11, 2007, we reached a tentative agreement to settle the January 2007 complaint for less than $0.1 million. However, prior to the receipt of the executed settlement agreement, on February 8, 2008, we were named in another action, alleging the same violation, in the U.S. District Court, Western District of Pennsylvania. As a result, we withdrew our offer to settle the January 2007 action noted above. Our company does not believe that it has any liability for the violations alleged in the complaints and will vigorously contest these allegations. However, in the event we are found to have liability under the Act for these allegations, significant damages could be assessed against our company, and this could have a material adverse effect on our results of operations and financial condition. In addition, any future non-compliance with federal or state laws pertaining to the protection of customers’ personal data could result in a material adverse effect on our results of operations.

We continue to monitor our facilities for compliance with the Americans with Disabilities Act, or the ADA, in order to conform to its requirements. Under the ADA, we could be required to expend funds to modify stores to better provide service to, or make reasonable accommodation for the employment of, disabled persons. We believe that expenditures, if required, would not have a material adverse effect on our company’s operations.

Employees

As of February 2, 2008, our operations had 7,745 employees, consisting of 2,157 full-time employees and 5,588 part-time employees. Full-time personnel consisted of 671 salaried employees and 1,486 hourly employees. All part-time personnel are hourly employees. Of all employees, 7,371 were sales personnel and 374 were administrative and distribution center personnel. Personnel at all levels of store operations are provided various opportunities for cash and/or other incentives based upon various individual store sales targets. All of our employees are non-union, and, in management’s opinion, are paid competitively at current industry standards. We believe that our relationship with our employees is good.

 

Item  1A. Risk Factors

Risks Related to our Business

The financial performance of our Arden B division has been poor for several quarters and our ability to improve the financial performance of this division may not be successful.

We have experienced deterioration in the financial performance of our Arden B division over the past five fiscal quarters.

The success of our Arden B division is largely dependent upon our ability to offer fashion to our target customers that satisfies current fashion tastes at appropriate price points. With the deterioration of our comparable store sales over the past several quarters we recognize that we have not met this challenge. We have recently engaged Sharon Hughes as a consultant to serve as the chief merchandise officer for our Arden B division and to focus on providing fashion appropriate merchandise to Arden B’s target customer in an attractive shopping environment. However, to the extent that there are design and/or merchandising misjudgments or a lack

 

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of customer traffic in Arden B stores, the financial condition, results of operations and/or cash flows for our Arden B division will not improve and/or could further worsen.

Our Board of Directors and senior management team are continually reviewing the financial performance and the turnaround efforts involving our Arden B division. In the future, we could decide to close stores that are producing continuing financial losses or cease operations. If we do so, we would be required to write down the carrying value of these impaired assets to realizable value, a non-cash event that would negatively impact our earnings and earnings per share. If we decide to close any stores before the expiration of the lease term, we may incur payments to landlords to terminate or “buy out” the remaining term of the lease. We also may incur employee termination and inventory liquidation costs at such stores. These costs would negatively impact our financial results and cash position.

In the last two fiscal years, we have grown our business through opening new stores. However, in the near term we will not increase our store count and this decision may have a negative impact on our financial condition, results of operations and/or cash flows.

In 2006, we announced our desire to grow the number of stores in our chain significantly. We noted that there was a potential to have 600 to 700 Wet Seal stores and 200 to 250 Arden B stores. Due to difficult economic conditions generally, a need to rebuild our pipeline of potential real estate opportunities, and the weak performance of our Arden B division, we do not anticipate opening any new Arden B stores in fiscal 2008 and expect to open only a few new Wet Seal stores, net of closures during the same period. We have redirected our focus to improving the financial performance of our existing stores and finding the correct mix of merchandise for our customers. To the extent we are unable to improve the sales and profitability and reduce the selling expenses of our existing stores, our financial position, results of operations and/or cash flows may suffer.

Our ability to use net operating loss carryforwards to offset future taxable income for U.S. federal income tax purposes is subject to limitation.

In general, Section 382 of the Internal Revenue Code, or Section 382, contains provisions that may limit the availability of federal net operating loss carryforwards, or NOLs, to be used to offset taxable income in any given year upon the occurrence of certain events, including significant changes in ownership interests. Under Section 382, potential limitations on NOLs are triggered when there has been an “ownership change” (generally defined as a greater than 50% change (by value) in our stock ownership over a three-year period).

Our ownership changes on April 1, 2005 and December 28, 2006 resulted in Section 382 limitations applying to NOLs generated prior to those dates, which were approximately $172.1 million. As a result of these ownership changes, of our $138.2 million NOLs as of February 2, 2008, we may utilize up to $66.6 million of our NOLs to offset taxable income in fiscal 2008. Future transactions involving the sale or other transfer of our stock and any changes in the value of our stock may result in additional ownership changes for purposes of Section 382. The occurrence of such additional ownership changes could limit our ability to utilize our remaining NOLs and possibly other tax attributes. Limitations imposed on our ability to use NOLs and other tax attributes to offset future taxable income could cause us to pay U.S. federal income taxes earlier than we otherwise would if such limitations were not in effect. Any further ownership change could cause such NOLs and other tax attributes to expire unused, thereby reducing or eliminating the benefit of such NOLs and other tax attributes to us and adversely affecting our future cash flow.

In recent months we have had significant changes in our senior management and these changes may impact our ability to execute our business strategy in the near term.

In the third quarter of fiscal 2007, we appointed Edmond S. Thomas as our new president and chief executive officer and promoted Steven H. Benrubi, our former corporate controller, to be our new chief financial

 

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officer. In addition to these changes, in February 2008, our chief operating officer and our president of Arden B merchandise resigned. Mr. Thomas, Mr. Benrubi and others within management will assume the duties of our former chief operating officer, while Sharon Hughes will serve as chief merchandise officer for Arden B under the direct supervision of Mr. Thomas.

Although Mr. Thomas previously served as our president and chief operating officer, Mr. Benrubi previously served as our vice president and corporate controller and Ms. Hughes previously was an employee of our company for over a decade, we anticipate that we will experience a transition period before these individuals are fully integrated in their new roles, which could impact our ability to address the business challenges that confront our company.

We may not be successful in achieving improvements in the business and operations of our company that have been identified by our new president and chief executive officer.

Since his appointment, Mr. Thomas has identified several areas in which our company’s business and operations can be improved. Mr. Thomas has focused on increasing comparable store sales for our retail divisions, improving our company’s gross margin, enhancing in-store productivity, reviving the Arden B business and expanding our online business. Although Mr. Thomas is highly qualified and has extensive experience in the retail industry, including with our company, we may not be able to implement our strategy in the desired time frame and/or achieve the intended results and level of improvement desired by our senior management team and Board of Directors.

If we are unable to anticipate and react to new fashion trends, our financial condition and results of operations could be adversely affected.

We rely on a limited demographic customer base for a large percentage of our sales. Our brand image is dependent upon our ability to anticipate, identify and provide fresh inventory reflecting current fashion trends. If we fail to anticipate, identify or react appropriately or in a timely manner to these fashion trends, we could experience reduced consumer acceptance of our products, a diminished brand image and higher markdowns. These factors could result in lower selling prices and sales volumes for our products, which could adversely affect our financial condition and results of operations.

Our company’s ability to attract customers to its stores depends heavily on the success of the shopping centers in which many of our stores are located.

Substantially all of our stores are located in shopping centers. Factors beyond our control impact shopping center traffic, such as general economic conditions and consumer spending levels. Accordingly the slowdown in the U.S. economy may negatively affect consumer spending and reduce shopping center traffic. Moreover, the inability of mall “anchor” tenants and other area attractions to generate consumer traffic around our stores, or the decline in the popularity of malls as shopping destinations, would reduce our sales volume and, consequently, adversely affect our financial condition, results of operations and/or cash flows.

We depend upon a single center for our corporate offices and distribution activities, and any significant disruption in the operation of this center could harm our business, financial condition, results of operations and/or cash flows.

Our corporate offices and the distribution functions for all of our stores and internet business are handled from a single, leased facility in Foothill Ranch, California. In general, this area of California is subject to earthquakes and wildfires. Any significant interruption in the operation of this facility due to a natural disaster, arson, accident, system failure or other unforeseen event could delay or impair our ability to distribute merchandise to our stores and, consequently, lead to a decrease in sales. The financial losses incurred may exceed our insurance for earthquake damages and business interruption costs related to any such disruption. As a

 

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result, our business, financial condition, results of operations and/or cash flows could be adversely affected. Furthermore, we have little experience operating essential functions away from our main corporate offices and are uncertain what effect operating satellite facilities might have on our business, personnel and results of operations.

Fluctuations in our results of operations for the third fiscal quarter and the fourth fiscal quarter have a disproportionate effect on our overall financial condition, results of operations and/or cash flows.

We experience seasonal fluctuations in revenues and operating income, with a disproportionate amount of our revenues and a majority of our income being generated in the third fiscal quarter “back to school” season, which begins the last week of July and ends during September, and the fourth fiscal quarter “holiday” season. Our revenues and income are generally lower during the first and second fiscal quarters. In addition, any factors that harm our third and fourth fiscal quarter operating results, including adverse weather or unfavorable economic conditions, could have a disproportionate effect on our results of operations for the entire fiscal year.

In order to prepare for our peak shopping seasons, we must order and keep in stock significantly more merchandise than we would carry at other times of the year. An unanticipated decrease in demand for our products during our peak shopping seasons could require us to sell excess inventory at a substantial markdown, which could reduce our net sales and gross profit. Alternatively, an unanticipated increase in demand for certain of our products could leave us unable to fulfill customer demand and result in lost sales and customer dissatisfaction.

Our quarterly results of operations may also fluctuate significantly as a result of a variety of other factors, including the merchandise mix and the timing and level of inventory markdowns. As a result, historical period-to-period comparisons of our revenues and operating results are not necessarily indicative of future period-to-period results. You should not rely on the results of a single fiscal quarter, particularly the third fiscal quarter “back to school” season or fourth fiscal quarter “holiday” season, as an indication of our annual results or our future performance.

Our failure to effectively compete with other retailers for sales and locations could have a material adverse effect on our financial condition, results of operations and/or cash flows.

The women’s retail apparel industry is highly competitive, with fashion, quality, price, location and service being the principal competitive factors. Our Wet Seal and Arden B stores compete with specialty apparel retailers, department stores and certain other apparel retailers, including Aeropostale, Anthropologie, Abercrombie & Fitch, Charlotte Russe, Gap, Banana Republic, H&M, Old Navy, Pacific Sunwear, American Eagle, Target, Urban Outfitters, Forever 21, Express, J.C. Penney, bebe, Zara, Guess? and BCBG. Many of our competitors are large national chains that have substantially greater financial, marketing and other resources than we do. We face a variety of competitive challenges, including:

 

   

anticipating and quickly responding to changing consumer demands;

 

   

maintaining favorable brand recognition and effectively marketing our products to consumers in narrowly-defined market segments;

 

   

developing innovative, high-quality products in sizes, colors and styles that appeal to consumers in our target markets and maintaining a sufficient quantity of these items for which there is the greatest demand;

 

   

obtaining favorable site locations within malls on reasonable terms;

 

   

sourcing merchandise efficiently; and

 

   

pricing our products competitively and achieving customer perception of value.

 

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Our industry has low barriers to entry that allow the introduction of new products or new competitors at a fast pace. Any of these factors could result in reductions in sales or the prices of our products which, in turn, could have a material adverse effect on our financial condition, results of operations and/or cash flows.

Further, competition for prime locations and lease terms within shopping malls, in particular, is intense, and we may not be able to obtain new locations or maintain our existing locations on terms favorable to us.

The upcoming expiration of leases for approximately 80 of our existing stores could lead to increased costs associated with renegotiating our leases and/or relocating our stores.

We have approximately 80 existing store leases scheduled to expire in fiscal 2008. In connection with the expiration of these leases, we will have to renegotiate new leases which could result in higher rental amounts for each store and landlord requirements to remodel existing locations as a condition for renewal. Although we expect to negotiate new leases with acceptable terms that will allow us to remain in a substantial majority of these locations, we may not be able to obtain new terms that are favorable to us. In addition, as a result of renewal negotiations, we may be required by the landlord to remodel, which could result in significant capital expenditures. In addition, some landlords may refuse to renew our leases due to our lower sales per square foot as compared with other prospective tenants. If we are unable to agree to new terms with our landlords, we will have to relocate these stores, which could result in a significant expenditure and could lead to an interruption in the operation of our business at the affected stores, and we could be required to relocate to less desirable locations.

Because of the importance of our brand names, we may lose market share to our competitors if we fail to adequately protect our intellectual property rights.

We believe that our trademarks and other proprietary rights are important to our success and our competitive position. We have registered trademarks for Wet Seal and Arden B (which are registered in the retail store services and other classes). We take actions to establish and protect our intellectual property. However, others may infringe on our intellectual property rights or seek to block the sale of our products as violative of their intellectual property rights. If we are required to stop using any of our registered or non-registered trademarks, our sales could decline and, consequently, our business and results of operations could be adversely affected.

Covenants contained in agreements governing our existing indebtedness restrict the manner in which we conduct our business, and our failure to comply with these covenants could result in a default under these agreements, which would have a material adverse effect on our business, financial condition, growth prospects and ability to procure merchandise for our stores.

Our senior revolving credit facility and the indenture, as amended, governing our secured convertible notes contain covenants that restrict the manner in which we conduct our business. Subject to certain exceptions (including an exception to permit limited stock repurchases), these covenants restrict our ability to, among other things:

 

   

incur or guarantee additional indebtedness or refinance our existing indebtedness;

 

   

make investments or acquisitions;

 

   

merge, consolidate, dissolve or liquidate;

 

   

engage in certain asset sales (including the sale of stock);

 

   

repurchase stock;

 

   

grant liens on assets;

 

   

pay dividends; and

 

   

close stores.

 

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A breach of any of these covenants could result in a default under the agreements governing our existing indebtedness, acceleration of any amounts then outstanding, the foreclosure upon collateral securing the debt obligations, or the unavailability of the lines of credit.

We do not authenticate the license rights of our suppliers.

We purchase merchandise from a number of vendors who purport to hold manufacturing and distribution rights under the terms of license agreements or that assert their products are not subject to any restrictions as to distribution. We generally rely upon each vendor’s representation concerning those manufacturing and distribution rights and do not independently verify whether each vendor legally holds adequate rights to the licensed properties they are manufacturing or distributing. If we acquire unlicensed merchandise or merchandise violating a registered trademark, we could be obligated to remove it from our stores, incur costs associated with destruction of the merchandise if the vendor is unwilling or unable to reimburse us and be subject to civil and criminal liability. The occurrence of any of these events could adversely affect our financial condition, results of operations and/or cash flows.

We are subject to risks associated with our procurement of products from non-U.S. based vendors and U.S. vendors that purchase products internationally, any of which could have a material adverse effect on our business, financial condition, results of operations and/or cash flows.

A portion of our products is manufactured outside the United States. As a result, we are susceptible to greater losses as a result of a number of risks inherent in doing business in international markets and from a number of factors beyond our control, any of which could have a material adverse effect on our business, financial condition, results of operations and/or cash flows.

These factors include:

 

   

import or trade restrictions (including increased tariffs, customs duties, taxes or quotas) imposed by the United States government in respect of the foreign countries in which our products are currently manufactured or any of the countries in which our products may be manufactured in the future;

 

   

political instability or acts of terrorism, significant fluctuations in the value of the United States dollar against foreign currencies, restrictions on the transfer of funds between the United States and foreign jurisdictions, and/or potential disruption of imports due to labor disputes at U.S. ports, any of which could adversely affect our merchandise flow and, consequently, cause our sales to decline; and

 

   

local business practices that do not conform to our legal or ethical guidelines.

Our imports are limited by textile agreements between the United States and a number of foreign jurisdictions, including Hong Kong, China, Taiwan and South Korea. These agreements impose quotas on the amounts and types of merchandise that may be imported into the United States from these countries. These agreements also allow the United States to limit the importation of categories of merchandise that are not now subject to specified limits. The United States and the countries in which our products are produced or sold may also, from time to time, impose new quotas, duties, tariffs or other restrictions, or adversely adjust prevailing quota, duty or tariff levels. In addition, none of our international suppliers or international manufacturers supplies or manufactures our products exclusively. As a result, we compete with other companies for the production capacity of independent manufacturers and import quota capacity. If we were unable to obtain our raw materials and finished apparel from the countries where we wish to purchase them, either because room under the necessary quotas was unavailable or for any other reason, or if the cost of doing so should increase, it could have a material adverse effect on our business, financial condition, results of operations and/or cash flows.

Violation of labor laws and practices by our suppliers could harm our business and results of operations.

Our company’s policy is to use only those sourcing agents and independent manufacturers who operate in material compliance with applicable laws and regulations. The violation of laws, particularly labor laws, by an

 

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independent manufacturer, or by one of the sourcing agents, or the divergence of an independent manufacturer’s or sourcing agent’s labor practices from those generally accepted as ethical in the United States or in the country in which the manufacturing facility is located, and the public revelation of those illegal or unethical practices, could cause significant damage to our company’s reputation. Although our manufacturer operating guidelines promote ethical business practices, we do not control the business and operations of the manufacturers and cannot guarantee their legal and regulatory compliance.

We are exposed to business risks as a result of our internet operations.

We operate online stores at www.wetseal.com and www.ardenb.com. Our internet operations are subject to numerous risks, including:

 

   

online security breaches and/or credit card fraud;

 

   

reliance on third-party software providers; and

 

   

diversion of sales from our retail stores.

In addition, increased internet sales by our competitors could result in increased price competition and decreased margins. Our inability to effectively address these risks and any other risks that we face in connection with our internet operations could adversely affect the profitability of our internet operations.

Three lawsuits have been filed against us alleging violations of the Fair Credit Reporting Act.

In fiscal 2007 and fiscal 2008, we were served with a total of three class action complaints alleging violations of The Fair Credit Reporting Act (one of the complaints was dismissed in August 2007). The Act provides in part that portions of the credit card number may not be printed together with expiration dates on credit or debit card receipts given to customers. The Act currently imposes significant penalties upon violators of these rules and regulations where the violation is deemed to have been willful. Otherwise damages are limited to actual losses incurred by the card holder. We do not believe that we have any liability for the violations alleged in the complaints and will vigorously contest these allegations. Moreover, there is pending legislation in Congress that would modify the definition of a “willful” violation in a manner favorable to our company. However, in the event we are found to have liability under the Act for these allegations, significant damages could be assessed against our company, which could have a material adverse effect on our financial condition and results of operations as well as consumer perception of our company.

Our retail store operations are affected by local, regional and national economic conditions.

Our business is sensitive to consumer spending patterns and preferences. Various economic conditions affect the level of spending on the merchandise we offer, including general business conditions, interest rates, taxation, the availability of consumer credit and consumer confidence in future economic conditions. Our sales and profitability may be adversely affected by unfavorable economic conditions on a local, regional or national level.

Risks Related to our Common Stock

Our stockholders may experience dilution due to conversions and exercises of outstanding convertible securities and/or the anti-dilution protection of the securities.

Since May 2004, we have completed private placements of Class A common stock and warrants, convertible notes and shares of preferred stock that are convertible into or exercisable for shares of Class A common stock. Through February 2, 2008, we have issued 57,319,486 shares of our Class A common stock as a result of these private placements and exercises and conversions of these securities. An additional 18,749,624 shares of Class A common stock may be issued under the convertible notes, preferred stock and warrants that remain outstanding,

 

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and this number of shares of Class A common stock is subject to anti-dilution adjustments based upon the anti-dilution provisions contained in these instruments. The issuance of the additional shares of Class A common stock upon conversion and exercise could cause the market price of our Class A common stock to decline.

The price of our Class A Common Stock has fluctuated significantly during the past few years and may fluctuate significantly in the future.

Our Class A common stock, which is traded on the NASDAQ Global Market, has experienced and may continue to experience significant price and volume fluctuations that could adversely affect the market price of our Class A common stock. The market price of our Class A common stock is likely to fluctuate, both because of actual and perceived changes in our operating results and prospects and because of general volatility in the stock market. The market price of our Class A common stock could continue to fluctuate widely in response to factors such as:

 

   

actual or anticipated variations in our results of operations, including comparable store sales;

 

   

the addition or loss of suppliers, customers and other business relationships;

 

   

changes in financial estimates of, and recommendations by, securities analysts;

 

   

conditions or trends in the apparel and consumer products industries;

 

   

additions or departures of key personnel;

 

   

sales of our Class A common stock;

 

   

general market and economic conditions; and

 

   

other events or factors, including the realization of any of the risks described in this risk factors section, many of which are beyond our control.

Fluctuations in the price and trading volume of our Class A common stock in response to factors such as those set forth above could be unrelated or disproportionate to our actual operating performance.

We have never paid dividends on our Class A common stock and do not plan to do so in the future.

Holders of shares of our Class A common stock are entitled to receive any dividends that may be declared by our Board of Directors. However, we have not paid any cash dividends on our Class A common stock and we do not expect to for the foreseeable future. Also, our agreements with our senior lenders and the indenture governing our notes restrict the payment of dividends to our stockholders.

Our charter provisions and Delaware law may have anti-takeover effects.

Our certificate of incorporation permits our Board of Directors to designate and issue, without stockholder approval, up to 2,000,000 shares of preferred stock with voting, conversion and other rights and preferences that could differentially and adversely affect the voting power or other rights of the holders of our Class A common stock, which could be used to discourage an unsolicited acquisition proposal. Furthermore, certain provisions of Delaware law applicable to our company could also delay or make more difficult a merger, tender offer or proxy contest involving our company, including Section 203 of the Delaware General Corporation Law, which prohibits a Delaware corporation from engaging in any business combination with any interested stockholder for a period of three years unless certain conditions are met.

The possible issuance of preferred stock and the application of anti-takeover provisions of Delaware law could each have the effect of delaying, deferring or preventing a change in control of our company, including, without limitation, discouraging a proxy contest, making the acquisition of a substantial block of Class A common stock more difficult and limiting the price that investors might in the future be willing to pay for shares of our Class A common stock.

 

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Item  1B. Unresolved Staff Comments

None.

 

Item  2. Properties

Our principal executive offices are located at 26972 Burbank, Foothill Ranch, California, with 301,408 square feet of leased office and distribution facility space. Our principal executive offices contain 215,192 square feet of merchandise handling and storage space in the distribution facility and 86,216 square feet of office space. Our lease for this space runs through December 4, 2017, with the option for us to terminate on December 4, 2014 upon payment by us of an early termination fee of $0.7 million.

We lease all of our stores. Lease terms for our stores typically are 10 years. The leases generally provide for a fixed minimum rental and, on occasion, additional rental based on a percentage of sales once a minimum sales level has been reached. Certain leases include cash reimbursements received from landlords for leasehold improvements and other cash payments received from landlords as lease incentives. When a lease expires, we generally renew that lease at current market terms. However, each renewal is based upon an analysis of the individual store’s profitability and sales potential. At the end of fiscal 2007, we had 1,863,123 square feet of leased space under retail store leases.

The following table sets forth our 494 stores by state or territory as of February 2, 2008:

 

State

   Wet Seal    Arden B   

State

   Wet Seal    Arden B

Alabama

   8    1    Nebraska    3    —  

Alaska

   1    —      Nevada    4    1

Arizona

   9    1    New Hampshire    2    1

Arkansas

   4    —      New Jersey    10    6

California

   49    15    New Mexico    3    —  

Colorado

   3    3    New York    14    5

Connecticut

   3    —      North Carolina    8    3

Delaware

   1    —      North Dakota    4    —  

Florida

   26    8    Ohio    19    2

Georgia

   10    2    Oklahoma    3    —  

Hawaii

   5    1    Oregon    4    —  

Idaho

   2    —      Pennsylvania    21    5

Illinois

   19    6    Rhode Island    1    1

Indiana

   10    1    South Carolina    6    1

Iowa

   3    1    South Dakota    1    —  

Kansas

   6    1    Tennessee    8    1

Kentucky

   4    1    Texas    24    7

Louisiana

   6    —      Utah    6    1

Massachusetts

   11    4    Virginia    10    4

Maryland

   8    2    Washington    11    1

Michigan

   14    2    West Virginia    3    —  

Minnesota

   11    3    Wisconsin    9    —  

Mississippi

   2    —      Washington D.C.    —      1

Missouri

   6    2    Puerto Rico    1    1

Montana

   3    —           

 

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The following table sets forth information with respect to store openings and closings since fiscal 2003:

Total Company

 

     Fiscal Years
     2007    2006    2005    2004    2003

Stores open at beginning of year

   430    400    502    604    606

Stores opened during the year

   78    38    11    8    31

Stores closed during the year

   14    8    113    110    33
                        

Stores open at end of year

   494    430    400    502    604
                        

Wet Seal

 

     Fiscal Years
     2007    2006    2005    2004    2003

Stores open at beginning of year

   338    308    408    474    476

Stores opened during the year

   71    34    8    6    22

Stores closed during the year

   10    4    108    72    24
                        

Stores open at end of year

   399    338    308    408    474
                        

Arden B

 

     Fiscal Years
     2007    2006    2005    2004    2003

Stores open at beginning of year

   92    92    94    99    100

Stores opened during the year

   7    4    3    2    8

Stores closed during the year

   4    4    5    7    9
                        

Stores open at end of year

   95    92    92    94    99
                        

Zutopia (discontinued in fiscal 2004)

 

     Fiscal Years
     2007    2006    2005    2004    2003

Stores open at beginning of year

   —      —      —      31    30

Stores opened during the year

   —      —      —      —      1

Stores closed during the year

   —      —      —      31    —  
                        

Stores open at end of year

   —      —      —      —      31
                        

 

Item  3. Legal Proceedings

Active Legal Proceedings

In January 2007, a class action complaint was filed against us in the Central District of the United States District Court of California, Southern Division alleging violations of The Fair Credit Reporting Act (or the “Act”), and in February 2007, a class action complaint was filed against us alleging similar violations in United States District Court, Central District of California, Western Division. The plaintiffs in the February 2007 complaint dismissed the complaint with prejudice in August 2007. The Act provides in part that expiration dates

 

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may not be printed on credit or debit card receipts given to customers. The Act imposes significant penalties upon violators of these rules and regulations where the violation is deemed to have been willful. Otherwise damages are limited to actual losses incurred by the card holder. On December 11, 2007, we reached a tentative agreement to settle the January 2007 complaint for less than $0.1 million. However, prior to the receipt of the executed settlement agreement, on February 8, 2008, we were named in another action, alleging the same violation, in the U.S. District Court, Western District of Pennsylvania. As a result, we withdrew our offer to settle the January 2007 action noted above. As of February 2, 2008, we had accrued an amount that approximates the anticipated settlement amount within accrued liabilities on our consolidated balance sheet.

On July 19, 2006, a complaint was filed in the Superior Court of the State of California for the County of Los Angeles, or the Superior Court, on behalf of certain of our current and former employees that were employed and paid by us on an hourly basis during the four-year period from July 19, 2002, through July 19, 2006. We were named as defendants. The complaint alleged various violations under the State of California Labor Code, the State of California Business and Professions Code, and orders issued by the Industrial Welfare Commission. On November 30, 2006, we reached an agreement to pay approximately $0.3 million to settle this matter, subject to Superior Court approval. On May 18, 2007, the Superior Court entered an order granting preliminary approval of the class action settlement. On February 29, 2008, the court issued its order granting final approval of the class action settlement. As of February 2, 2008, we had accrued an amount that approximates this settlement amount within accrued liabilities on our consolidated balance sheet.

On May 22, 2007, a complaint was filed in the Superior Court of the State of California for the County of Orange on behalf of certain of our current and former employees that were employed and paid by us during the four-year period from May 21, 2003 through May 21, 2007. We were named as a defendant. The complaint alleged various violations under the State of California Labor Code, the State of California Business and Professions Code, and orders issued by the Industrial Welfare Commission. We are vigorously defending this litigation and are unable to predict the likely outcome and whether such outcome may have a material adverse effect on our results of operations or financial condition. Accordingly, no provision for a loss contingency has been accrued at February 2, 2008.

Legal Proceedings Settled after February 2, 2008

Between August 26, 2004, and October 12, 2004, six securities class action lawsuits were filed in the United States District Court for the Central District of California, or the Court, on behalf of persons who purchased our Class A common stock between January 7, 2003, and August 19, 2004. We and certain of our former directors and former executives were named as defendants. The complaints alleged violations of Sections 10(b) and 20(a) of the Exchange Act, and Rule 10b-5 of the Exchange Act, on the grounds that, among other things, we failed to disclose and misrepresented material adverse facts that were known and disregarded by us. On November 17, 2004, the Court consolidated the actions and appointed lead plaintiffs and counsel. On January 29, 2005, the lead plaintiffs filed their consolidated class action complaint with the Court, which consolidated all of the previously reported class actions. The consolidated complaint alleged that we violated the federal securities laws by making material misstatements of fact or failing to disclose material facts during the class period, from March 2003 to August 2004, concerning our prospects to stem ongoing losses in our Wet Seal division and return that business to profitability. The consolidated complaint also alleged that our former directors and La Senza Corporation, a Canadian company controlled by them, unlawfully utilized material non-public information in connection with the sale of our common stock by La Senza. The consolidated complaint sought class certification, compensatory damages, interest, costs, attorney’s fees and injunctive relief. We filed a motion to dismiss the consolidated complaint in April 2005. On September 15, 2005, the consolidated class action was dismissed against us in the lawsuit. However, plaintiffs were granted leave to file an amended complaint, which they did file on November 23, 2005. We filed a motion to dismiss the amended complaint on January 25, 2006. A court hearing on this motion was held on October 23, 2006. On August 28, 2007, the consolidated class action complaint was dismissed without leave to amend in the United States District Court. On September 28, 2007, the plaintiff appealed the decision to the Ninth Circuit Court of Appeals. On March 18, 2008, a stipulated voluntary dismissal

 

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was filed by the plaintiffs and us in the United States Court of Appeals for the Ninth Circuit. All parties agreed that the appeal will be dismissed with prejudice and that each party shall bear all of its own costs and attorneys fees, whether they were incurred on the appeal or in the district court.

From time to time, we are involved in other litigation matters relating to claims arising out of our operations in the normal course of business. We believe that, in the event of a settlement or an adverse judgment on certain of our pending litigation, we are adequately covered by insurance; however, certain other matters may exist or arise for which we do not have insurance coverage. As of February 2, 2008, we were not engaged in any such other legal proceedings that are expected, individually or in the aggregate, to have a material adverse effect on our results of operations or financial condition.

 

Item  4. Submission of Matters to a Vote of Security Holders

None.

 

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PART II

 

Item  5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

We have two classes of common stock: Class A and Class B. Our Class A common stock is listed on The NASDAQ Global Stock Market under the symbol “WTSLA”. As of April 7, 2008, there were 606 stockholders of record of our Class A common stock. The closing price of our Class A common stock on April 7, 2008, was $3.50 per share. As of April 7, 2008, there were no shares of our Class B common stock outstanding.

Price Range of Stock

The following table reflects the high and low closing sale prices of our Class A common stock as reported by NASDAQ for the last two fiscal years:

 

Quarter

   Fiscal 2007    Fiscal 2006
   High    Low    High    Low

First Quarter

   $ 6.64    $ 5.68    $ 6.77    $ 5.02

Second Quarter

   $ 6.31    $ 4.30    $ 5.75    $ 4.22

Third Quarter

   $ 4.59    $ 2.33    $ 6.23    $ 4.30

Fourth Quarter

   $ 3.11    $ 1.92    $ 7.48    $ 5.73

Dividend Policy

We have reinvested earnings in the business and have never paid any cash dividends to holders of our common stock. The declaration and payment of future dividends, which are subject to the terms and covenants contained in the agreements governing our existing indebtedness, are at the sole discretion of the Board of Directors and will depend upon our profitability, financial condition, cash requirements, future prospects and other factors deemed relevant by our Board of Directors. Our senior revolving credit facility and the indenture associated with our notes restrict our ability to declare or pay dividends on any of our shares without consent from the lenders.

Securities Authorized for Issuance Under Equity Compensation Plans

The following table provides information as of February 2, 2008, about our common stock that may be issued upon the exercise of options, warrants and rights granted to employees, consultants or members of our Board of Directors under all of our existing equity compensation plans, including our 1996 Long-Term Incentive Plan, as amended, the 2000 Stock Incentive Plan and the 2005 Stock Incentive Plan, as amended:

 

     (a)     (b)    (c)

Plan category

   Equity Compensation Plan Information
   Number of securities
to be issued
upon exercise of
outstanding options,
warrants and rights
    Weighted-average
exercise price of
outstanding options,
warrants and rights
   Number of securities
remaining available for
future issuance under
equity compensation plans
(excluding securities
reflected in column (a))

Equity compensation plans approved by security holders

   2,926,553     $ 7.46    2,299,164

Equity compensation plans not approved by security holders

   500,000 *     —      —  
                 

Total

   3,426,553     $ 7.46    2,299,164
                 

 

* On October 8, 2007, Mr. Edmond Thomas, our president and chief executive officer, was issued 500,000 restricted shares of our company’s Class A common stock. The restricted shares were not issued pursuant to one of our company’s equity compensation plans. The restricted shares were issued pursuant to Section 4350(l)(1)(A)(iv) of the Nasdaq Marketplace Rules which permits equity incentive compensation to be issued to new employees of a company outside of a shareholder approved plan. The restricted shares vest in three substantially equal tranches on the next three anniversary dates of the original grant.

 

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Stock Price Performance Graph

The following graph compares the cumulative stockholder return on our Class A common stock with the return on the Total Return Index for the NASDAQ Stock Market (US) and the NASDAQ Retail Trade Stocks. The graph assumes $100 invested on January 31, 2003 in the stock of The Wet Seal, Inc., the NASDAQ Global Stock Market (US) and the NASDAQ Retail Trade Stocks. It also assumes that all dividends are reinvested.

Comparison of Cumulative Total Return for the Class A Common Stock

of The Wet Seal, Inc., January 31, 2003 through February 1, 2008 (1)

LOGO

 

     January 30,
2004*
   January 28,
2005*
   January 27,
2006*
   February 2,
2007*
   February 1,
2008*

The Wet Seal, Inc.

   $ 98    $ 25    $ 62    $ 73    $ 35

NASDAQ Stock Market (US)

   $ 156    $ 154    $ 175    $ 188    $ 181

NASDAQ Retail Trade Stocks

   $ 147    $ 176    $ 190    $ 207    $ 184

 

* Closest preceding trading date to the beginning of our fiscal year.

(1) Returns are based upon the premise that $100 is invested in each of (a) Wet Seal Class A common stock, (b) NASDAQ Stock Market and (c) the index of NASDAQ Retail Trade Stocks on January 31, 2003 and that all dividends (if any) were reinvested. Over a five year period, and based on the actual price movement of these investments, the original $100 would have turned into the amounts shown as of the end of each Wet Seal fiscal year. Stockholder returns over the indicated period should not be considered indicative of future shareholder returns.

The historical stock performance shown on the graph is not necessarily indicative of future price performance.

Unregistered Sales of Equity Securities

(a) None.

(b) None.

(c) None.

 

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Item  6. Selected Financial Data

The following table sets forth selected consolidated financial and other data as of and for the 2003 through 2007 fiscal years. The following selected financial data has been derived from our consolidated financial statements. The data set forth below should be read in conjunction with the consolidated financial statements and notes thereto, which are included elsewhere in this Annual Report on Form 10-K.

Five-Year Financial Summary

(In thousands, except per share and per square foot amounts, ratios, share data, store data and square footage data)

 

Fiscal Year   2007     2006     2005     2004     2003  

Fiscal Year Ended

  February 2,
2008
    February 3,
2007
    January 28,
2006
    January 29,
2005
    January 31,
2004
 

Operating Results

         

Net sales

  $ 611,163     $ 564,324     $ 500,807     $ 435,582     $ 517,870  

Cost of sales

  $ 408,892     $ 370,888     $ 339,483     $ 377,664     $ 420,520  

Gross margin

  $ 202,271     $ 193,436     $ 161,324     $ 57,918     $ 97,350  

Selling, general and administrative expenses

  $ 177,468     $ 178,703     $ 171,988     $ 162,047     $ 160,224  

Store closure (adjustments) costs

  $ —       $ (730 )   $ 4,517     $ 16,398     $ —    

Asset impairment

  $ 5,546     $ 425     $ 989     $ 41,378     $ —    

Operating income (loss)

  $ 19,257     $ 15,038     $ (16,170 )   $ (161,905 )   $ (62,874 )

Income (loss) before provision (benefit) for income taxes

  $ 23,610     $ (12,530 )   $ (29,032 )   $ (164,080 )   $ (61,287 )

Income (loss) from continuing operations

  $ 23,232     $ (12,838 )   $ (29,362 )   $ (194,762 )   $ (40,014 )

Loss from discontinued operations, net of income taxes(1)

  $ —       $ —       $ —       $ (6,967 )   $ (8,300 )

Net income (loss)

  $ 23,232     $ (12,838 )   $ (29,362 )   $ (201,729 )   $ (48,314 )

Accretion of non-cash dividends on convertible preferred stock

  $ —       $ —       $ (23,317 )   $ —       $ —    

Net income (loss) attributable to common stockholders

  $ 23,232     $ (12,838 )   $ (52,679 )   $ (201,729 )   $ (48,314 )

Per Share Data

         

Net income (loss) attributable to common stockholders, basic

  $ 0.24     $ (0.18 )   $ (1.19 )   $ (5.99 )   $ (1.62 )

Net income (loss) attributable to common stockholders, diluted

  $ 0.23     $ (0.18 )   $ (1.19 )   $ (5.99 )   $ (1.62 )

Weighted-average shares outstanding, basic

    91,154,133       72,577,398       44,340,894       33,698,912       29,748,888  

Weighted-average shares outstanding, diluted

    100,938,542       72,577,398       44,340,894       33,698,912       29,748,888  

Other Financial Information

         

Cash, cash equivalents and investments

  $ 100,618     $ 105,254     $ 96,806     $ 71,702     $ 63,457  

Working capital

  $ 90,236     $ 89,954     $ 65,203     $ 26,886     $ 38,567  

Ratio of current assets to current liabilities

    2.5       2.5       2.0       1.4       1.8  

Total assets

  $ 224,076     $ 208,167     $ 181,055     $ 161,492     $ 262,452  

Long-term debt, including current portion(2)

  $ 3,583     $ 2,739     $ 19,824     $ 30,388     $ —    

Total stockholders’ equity

  $ 127,839     $ 116,797     $ 64,470     $ 37,053     $ 166,728  

Other Operating Information

         

Number of stores open at year end

    494       430       400       502       604  

Number of stores opened during the year

    78       38       11       8       31  

Number of stores closed during the year

    14       8       113       110       33  

Square footage of leased store space at year end

    1,863,123       1,612,807       1,498,638       1,920,460       2,273,349  

Average sales per square foot of leased store space(3)

  $ 332     $ 348     $ 330     $ 203     $ 228  

Average sales per store(3)

  $ 1,248     $ 1,301     $ 1,236     $ 768     $ 861  

Comparable store sales—continuing operations (decrease) increase (1)(4)

    (1.1 )%     6.1 %     44.7 %     (13.0 )%     (16.4 )%

 

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(1) The Zutopia concept was designated as a discontinued operation, which had an insignificant impact on the comparable store sales.
(2) Long-term debt is presented net of unamortized discount of $5.5 million, $6.0 million, $35.6 million, and $44.3 million for fiscal 2007, fiscal 2006, fiscal 2005 and fiscal 2004, respectively.

(3)

Sales during the 53rd week of fiscal 2006 were excluded from “Sales” for purposes of calculating “Average sales per square foot of leased store space” and “Average sales per store” in order to make fiscal 2006 comparable to fiscal 2003 through fiscal 2005 and fiscal 2007.

(4)

“Comparable store sales” for fiscal 2006 (a 53-week fiscal year) includes a comparison of the 53rd week of comparable store sales in fiscal 2006 to the 1st week of comparable store sales in fiscal 2006. Stores are deemed comparable stores on the first day of the month following the one-year anniversary of their opening or significant remodel/relocation.

 

Item  7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with our audited consolidated financial statements and notes thereto included elsewhere in this Annual Report on Form 10-K. The following discussion and analysis contains forward-looking statements which involve risks and uncertainties, and our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth under the heading “Statement Regarding Forward Looking Disclosure and Risk Factors” included elsewhere in this Annual Report on Form 10-K.

Executive Overview

We are a national specialty retailer operating stores selling fashionable and contemporary apparel and accessory items designed for female customers aged 13 to 35. We operate two nationwide, primarily mall-based, chains of retail stores under the names “Wet Seal” and “Arden B”. At February 2, 2008, we had 494 retail stores in 47 states, Puerto Rico and Washington D.C. Of the 494 stores, there were 399 Wet Seal stores and 95 Arden B stores.

We report our results of operations as two reportable segments representing our two retail divisions (“Wet Seal” and “Arden B”). Internet operations for Wet Seal and Arden B are included in their respective operating segments. Although the two operating segments are similar in their products, production processes, distribution methods and regulatory environment, in fiscal 2007, due to the poor profit performance of the Arden B division and the disparity in financial performance between the two segments, we concluded that we no longer consider these operating segments to be economically similar.

Our fiscal year ends on the Saturday closest to the end of January. Fiscal 2006 includes 53 weeks of operations and fiscal 2007 and fiscal 2005 each include 52 weeks of operations.

We consider the following to be key performance indicators in evaluating our performance:

Comparable store sales—For purposes of measuring comparable store sales, sales include merchandise sales as well as membership fee revenues recognized under our Wet Seal division’s frequent buyer program during the applicable period. Stores are deemed comparable stores on the first day of the month following the one-year anniversary of their opening or significant remodel/relocation, which we define to be a square footage increase or decrease of at least 20%. Stores that are remodeled or relocated with a resulting square footage change of less than 20% are maintained in the comparable store base with no interruption. However, stores that are closed for four or more days in a fiscal month, due to remodel, relocation or other reasons, are removed from the comparable store base that fiscal month as well as for the comparable fiscal month in the following fiscal year. Comparable store sales results are important in achieving operating leverage on certain expenses such as store payroll, occupancy, depreciation and amortization, general and administrative expenses, and other costs that are at least partially fixed. Positive comparable store sales results generate greater operating leverage on expenses

 

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while negative comparable store sales results negatively affect operating leverage. Comparable store sales results also have a direct impact on our total net sales, cash, and working capital.

Average transaction counts—We consider the trend in the average number of sales transactions occurring in our stores to be a key performance metric. To the extent we are able to increase transaction counts in our stores that more than offset any decrease in the average dollar sale per transaction, we will generate increases in our comparable store sales.

Gross margins—We analyze the components of gross margin, specifically cumulative mark-on, markups, markdowns, shrink, buying costs, distribution costs, and store occupancy costs. Any inability to obtain acceptable levels of initial markups, a significant increase in our use of markdowns or in inventory shrink, or an inability to generate sufficient sales leverage on other components of cost of sales could have an adverse impact on our gross margin results and results of operations.

Operating income (loss)—We view operating income (loss) as a key indicator of our financial success. The key drivers of operating income (loss) are comparable store sales, gross margins, and the changes we experience in operating costs.

Cash flow and liquidity (working capital)—We evaluate cash flow from operations, liquidity and working capital to determine our short-term operational financing needs.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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.

We believe the application of our accounting policies, and the estimates inherently required therein, are reasonable. Our accounting policies and estimates are reevaluated on an ongoing basis, and adjustments are made when facts and circumstances dictate a change. Our accounting policies are more fully described in Note 1 of Notes to Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K. The policies and estimates discussed below involve the selection or application of alternative accounting policies that are material to our consolidated financial statements. Management has discussed the development and selection of these critical accounting policies and estimates with the Audit Committee of our Board of Directors.

We have certain accounting policies that require more significant management judgment and estimates than others. These include our accounting policies with respect to revenue recognition, merchandise inventories, long-lived assets, impairment of goodwill, stock-based compensation, income taxes, insurance reserves and derivative financial instruments.

Revenue Recognition

Sales are recognized upon purchases by customers at our retail store locations. Taxes collected from our customers are and have been recorded on a net basis. For online sales, revenue is recognized at the estimated time goods are received by customers. Based upon an analysis completed by us during the first fiscal quarter of 2007, customers typically receive goods within four days of being shipped versus a previously estimated five to seven days. This change in estimate did not have a significant effect on the amount of revenue recognized for online sales during fiscal 2007. Shipping and handling fees billed to customers for online sales are included in net sales. We have recorded accruals to estimate sales returns by customers based on historical sales return results. A customer generally may return merchandise within 30 days of the original purchase date. Actual return

 

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rates have historically been within management’s estimates and the accruals established. As the accrual for merchandise returns is based on estimates, the actual returns could differ from the accrual, which could impact net sales. The accrual for merchandise returns is recorded in accrued liabilities on the consolidated balance sheets and was $0.7 million and $0.8 million at February 2, 2008, and February 3, 2007, respectively. For fiscal 2007, 2006 and 2005, shipping and handling fee revenues were $1.9 million, $1.5 million, and $0.7 million, respectively.

We recognize the sales from gift cards, gift certificates and store credits as they are redeemed for merchandise. Prior to redemption, we maintain an unearned revenue liability for gift cards, gift certificates and store credits until we are released from such liability, which includes consideration of potential obligations arising from state escheatment laws. Our gift cards, gift certificates and store credits do not have expiration dates; however, over time, a percentage of gift cards, gift certificates and store credits are not redeemed or recovered (“breakage”). Historically, due to the lack of sufficient historical redemption trend data, we had not recognized breakage on gift cards, gift certificates and store credits. In the fourth quarter of fiscal 2007, we analyzed company-specific historical redemption patterns and determined that the likelihood of redemption of unredeemed gift cards, gift certificates and store credits three years after their issuance is remote. Beginning in the fourth quarter of fiscal 2007, we adjusted our unearned revenue liability to recognize estimated unredeemed amounts and recorded breakage as additional sales for gift cards, gift certificates and store credits that remained unredeemed three years after their issuance. Our net sales in the fourth quarter of fiscal 2007 included a benefit for an adjustment of $3.7 million to reduce our unearned revenue liability for estimated unredeemed amounts. The unearned revenue for gift cards, gift certificates and store credits is recorded in accrued liabilities on the consolidated balance sheets and was $6.3 million and $8.9 million at February 2, 2008 and February 3, 2007, respectively. If actual redemptions ultimately differ from the assumptions underlying our breakage adjustments, or our future experience indicates the likelihood of redemption of gift cards, gift certificates and store credits becomes remote at a different point in time after issuance, we may recognize further significant adjustments to our accruals for such unearned revenue, which could have a significant effect on our net sales and results of operations.

We maintain a frequent buyer program through our Wet Seal division. Under the program, customers receive a 10% to 20% discount on all purchases made during a twelve-month period and are provided $5-off coupons that may be used on purchases during such period. The annual membership fee of $20 is non-refundable.

We have historically recognized membership fee revenue under the frequent buyer program on a straight-line basis over the twelve-month membership period due to a lack of sufficient program history to determine customer usage patterns. During November 2007, we changed from in-store delivery to e-mail delivery of the program’s $5-off coupons, which eliminated the customer’s ability to use such coupons at the time of initial purchases. We believe this change will affect customer usage patterns. We also continue to test alternative program structures, and promotions tied to the program, and may decide to further modify the program in ways that could also affect customer usage patterns. As a result of the recent program change and potential further modifications, we believe it is appropriate to maintain straight-line recognition of membership fee revenue. We may, in the future, determine that recognition of membership fee revenue on a different basis is appropriate, which would affect net sales.

Discounts received by customers on purchases using the frequent buyer program are recognized at the time of such purchases. The unearned revenue for this program is recorded in accrued liabilities on the consolidated balance sheets and was $9.6 million and $10.1 million at February 2, 2008 and February 3, 2007, respectively.

We maintain a customer loyalty program through our Arden B division. Under the program, customers accumulate points based on purchase activity. Once a loyalty program member achieves a certain point level, the member earns awards that may be redeemed for merchandise. Merchandise redemptions are accrued as unearned revenue and recorded as a reduction of net sales as points are accumulated by the member.

 

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During fiscal 2006, we modified the terms of the Arden B loyalty program with respect to the number of points required to earn an award and the value of awards when earned. At the time of the program change, we also established expiration terms (i) for prospectively earned awards of two months from the date the award is earned and (ii) for pre-existing awards of either two or twelve months from the program change date. This resulted in a reduction to our estimate of ultimate award redemptions under the program. Additionally, during fiscal 2006, we further reduced our estimate of ultimate redemptions based upon lower than anticipated redemption levels under the program’s revised terms. As a result, in fiscal 2006, we recorded a benefit of $3.7 million, which was recorded as an increase to net sales and a decrease to accrued liabilities.

During fiscal 2007, we further modified the terms of the Arden B loyalty program whereby, quarterly, we convert into fractional awards the points accumulated by customers who have not made purchases within the preceding 18 months. Similar to all other awards currently being granted under the program, such fractional awards expire if unredeemed after 60 days.

The unearned revenue for this program is recorded in accrued liabilities on the consolidated balance sheets and was $2.0 million and $1.9 million at February 2, 2008 and February 3, 2007, respectively. If actual redemptions ultimately differ from accrued redemption levels, or if we further modify the terms of the program in a way that affects expected redemption value and levels, we could record adjustments to the unearned revenue accrual, which would affect net sales.

Merchandise Inventories

Merchandise inventories are stated at the lower of cost or market. Market is determined based on the estimated net realizable value, which generally is the merchandise selling price. Cost is calculated using the retail inventory method. Under the retail inventory method, inventory is stated at its current retail selling value and then is converted to a cost basis by applying a cost-to-retail ratio based on beginning inventory and the fiscal year purchase activity. The retail inventory method inherently requires management judgments and estimates, such as the amount and timing of permanent markdowns to clear unproductive or slow-moving inventory, which may impact the ending inventory valuation as well as gross margins.

Markdowns are recorded when the sales value of the inventory has diminished. Factors considered in the determination of permanent markdowns include current and anticipated demand, customer preferences, age of the merchandise and fashion trends. When a decision is made to permanently mark down merchandise, the resulting gross margin reduction is recognized in the period the markdown is recorded. Total markdowns on a cost basis in fiscal 2007, 2006 and 2005 were $84.5 million, $72.2 million and $60.6 million, respectively, and represented 13.8%, 12.8%, and 12.1% of net sales, respectively. We accrued $3.5 million and $4.7 million for planned but unexecuted markdowns as of February 2, 2008, and February 3, 2007, respectively.

To the extent that management’s estimates differ from actual results, additional markdowns may be required that could reduce our gross margin, operating income and the carrying value of inventories. Our success is largely dependent upon our ability to anticipate the changing fashion tastes of our customers and to respond to those changing tastes in a timely manner. If we fail to anticipate, identify or react appropriately to changing styles, trends or brand preferences of our customers, we may experience lower sales, excess inventories and more frequent and extensive markdowns, which would adversely affect our operating results.

Long-Lived Assets

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we evaluate the carrying value of long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Factors that are considered important that could trigger an impairment review include a current-period operating or cash flow loss combined with a history of operating or cash flow losses and a projection or

 

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forecast that demonstrates continuing losses or insufficient income associated with the use of a long-lived asset or asset group. Other factors include a significant change in the manner of the use of the asset or a significant negative industry or economic trend. This evaluation is performed based on undiscounted estimated future cash flows from operating activities compared with the carrying value of the related assets. If the undiscounted estimated future cash flows are less than the carrying value, an impairment loss is recognized, measured by the difference between the carrying value and the estimated fair value of the assets, with such estimated fair values determined using the best information available, generally the discounted estimated future cash flows of the assets using a rate that approximates our weighted-average cost of capital. Quarterly, we assess whether events or changes in circumstances have occurred that potentially indicate the carrying value of long-lived assets may not be recoverable.

During fiscal 2007, 2006 and 2005, we determined such events or changes in circumstances had occurred with respect to certain of our retail stores, and that operating losses or insufficient operating income would likely continue. As such, we recorded non-cash charges of $2.0 million, $0.4 million and $1.0 million, respectively, in our consolidated statements of operations for fiscal 2007, 2006 and 2005 to write down the carrying value of these stores’ long-lived assets to their estimated fair value.

The estimation of future cash flows from operating activities requires significant estimates of factors that include future sales growth and gross margin performance. If our sales growth, gross margin performance or other estimated operating results are not achieved at or above our forecasted level, or inflation exceeds our forecast and we are unable to recover such costs through price increases, the carrying value of certain of our retail stores may prove to be unrecoverable and we may incur additional impairment charges in the future.

Impairment of Goodwill

In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” we test goodwill for impairment no less frequently than annually, and also may test on an interim basis if an event or circumstance indicates that it is more likely than not impairment may have occurred. The impairment, if any, is measured based on the estimated fair value of a reporting unit. Fair value can be determined based on discounted cash flows, comparable sales or valuations of other retail businesses. Impairment occurs when the carrying amount of the goodwill exceeds its estimated fair value.

The most significant assumptions we use in this analysis are those made in estimating future cash flows. In estimating future cash flows, we use assumptions for items such as comparable store sales, store count growth rates, the rate of inflation and the discount rate we consider to represent our weighted-average cost of capital and/or the market discount rate for acquisitions of retail businesses.

If our assumptions used in performing the impairment test prove inaccurate, the fair value of our goodwill may ultimately prove to be significantly lower, thereby causing the carrying value to exceed the fair value and indicating impairment has occurred. Based on our analysis performed in the fourth quarter of fiscal 2007, which considered the deteriorating operating performance of the Arden B division and our resulting outlook for that business, we wrote off the entire $3.5 million carrying value of our goodwill, which was directly associated with the Arden B division. This charge is included in asset impairment in our consolidated statements of operations. As a result, no goodwill remains on our consolidated balance sheet as of February 2, 2008. Based on analyses performed in fiscal 2006 and 2005, we determined that no impairments of goodwill had occurred.

Stock-Based Compensation

Effective January 29, 2006, we adopted the provisions of SFAS No. 123(R), “Shared-Based Payment,” which requires the measurement and recognition of compensation expense for all share-based payment awards to employees and directors based on estimated fair values. SFAS No. 123(R) supersedes our previous accounting methodology using the intrinsic value method under Accounting Principles Board Opinion No. 25 (“APB 25”),

 

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“Accounting for Stock Issued to Employees.” Under the intrinsic value method, stock-based compensation associated with stock options and awards was determined as the difference, if any, between the fair market value of the related common stock on the measurement date and the price an employee must pay to exercise the award. Accordingly, stock-based compensation expense had been recognized for restricted stock grants as well as for stock options that were granted at prices that were below the fair market value of the related stock at the measurement date.

We adopted SFAS No. 123(R) using the modified prospective application method. Under this method, compensation expense recognized includes (a) compensation expense for all share-based awards granted prior to, but not yet vested, as of January 28, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” and (b) compensation expense for all share-based awards granted subsequent to January 28, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R). In accordance with the modified prospective application method, our consolidated financial statements for prior periods have not been restated to reflect the impact of SFAS No. 123(R).

On November 10, 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position (“FSP”) No. FAS 123R-3, “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards.” We have elected to adopt the alternative transition method provided in FSP No. FAS 123R-3 for calculating the tax effects of share-based compensation pursuant to SFAS No. 123(R). The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in capital pool (the “APIC Pool”) related to the tax effects of employee share-based compensation, and to determine the subsequent impact on the APIC Pool and consolidated statements of cash flows of the tax effects of employee and director share-based awards that are outstanding upon adoption of SFAS No. 123(R).

We also apply the provisions of Emerging Issues Task Force (“EITF”) Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Connection with Selling, Goods and Services,” and EITF Issue No. 00-18, “Accounting Recognition for Certain Transactions Involving Equity Instruments Granted to Other Than Employees” for stock-based compensation to other than employees.

We currently use the Black-Scholes option-pricing model to value stock options granted to employees. We use these values to recognize stock compensation expense for stock options in accordance with SFAS No. 123(R). The Black-Scholes model is complex and requires significant exercise of judgment to estimate future common stock dividend yield, common stock expected volatility, and the expected life of the stock options. These assumptions significantly affect our stock option valuations, and future changes in these assumptions could significantly change valuations of future stock option grants and, thus, affect future stock compensation expense. In addition, if circumstances were to change such that we determined stock options values were better represented by an alternative valuation method, such change could also significantly affect future stock compensation expense.

We also apply the Black-Scholes and Monte-Carlo simulation models to value performance shares granted to employees and consultants. Use of the Black-Scholes model for this purpose requires the same exercise of judgment noted above. The Monte-Carlo simulation model is also complex and requires significant exercise of judgment to estimate expected returns on our common stock, expected common stock volatility and our maximum expected share value during applicable vesting periods. This valuation approach also requires us to estimate a marketability discount in consideration of trading restrictions on performance share grants.

We currently believe Monte-Carlo simulation provides the most relevant value of performance share grants as the simulation allows for vesting throughout the vesting period and includes an assumption for equity returns over time, while the Black-Scholes method does not. As the Monte-Carlo simulation provides a more precise estimate of fair value, we have used that approach to value our performance shares for accounting purposes.

 

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The assumptions we use to value our performance shares significantly affect the resulting values used for accounting purposes. Accordingly, changes in these assumptions could significantly change valuations and, thus, affect future stock compensation expense. In addition, if circumstances were to change such that we determined performance share values were better represented by the Black-Scholes model or an alternative valuation method, and such changes resulted in a significant change in the value of performance shares, such changes could also significantly affect future stock compensation.

The following table summarizes stock-based compensation recorded in the consolidated statements of operations, including charges of $9.8 million and $22.2 million during fiscal 2006 and 2005, respectively, associated with merchandising consultant performance shares granted to the merchandising consultant as discussed further below under the heading “Merchandising Consultant”:

 

     February 2,
2008
   February 3,
2007
   January 28,
2006
     (in thousands)

Cost of sales

   $ 1,120    $ 986    $ —  

Selling, general and administrative expenses

     4,087      14,030      24,601
                    

Stock-based compensation

   $ 5,207    $ 15,016    $ 24,601
                    

Accounting for Income Taxes

We account for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes.” SFAS No. 109 requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the net deferred tax asset will not be realized. As a result of disappointing sales results during the 2004 back-to-school season and our historical operating losses, management concluded during fiscal 2004 that it was more likely than not that we would not realize our net deferred tax assets. As a result of this conclusion, we reduced to zero our net deferred tax assets by establishing a tax valuation allowance of $100.4 million in fiscal 2004. In addition, we have discontinued recognizing income tax benefits in the consolidated statements of operations until it is determined that it is more likely than not that we will generate sufficient taxable income to realize our deferred tax assets.

As of February 2, 2008, we had federal net operating loss carryforwards of $138.2 million, of which $12.9 million relates to benefits from the exercise of stock options for which the associated valuation allowance reversal will be recorded to paid-in capital on the consolidated balance sheets if and when reversed. Our federal net operating loss carryforwards begin to expire in 2023. The entire net operating loss carryforward of $138.2 million is subject to annual utilization limitations as of February 3, 2008. As of February 2, 2008, we also had federal charitable contribution carryforwards of $24.7 million, which begin to expire in 2008, alternative minimum tax credits of $1.3 million, which do not expire, and state net operating loss carryforwards of $137.6 million, which begin to expire in 2009 and are also subject to annual utilization limitations.

Section 382 of the Internal Revenue Code (“Section 382”) contains provisions that may limit the availability of federal net operating loss carryforwards to be used to offset taxable income in any given year upon the occurrence of certain events, including significant changes in ownership interests. Under Section 382, an ownership change that triggers potential limitations on net operating loss carryforwards occurs when there has been a greater than 50% change in ownership interest by shareholders owning 5% or more of a company over a period of three years or less. Based on our analysis, we had ownership changes on April 1, 2005 and December 28, 2006, which resulted in Section 382 limitations applying to federal net operating loss carryforwards generated prior to that date, which were approximately $172.1 million.

As a result of these ownership changes, of our $138.2 million of remaining federal net operating loss carryforwards, we may utilize up to approximately $66.6 million of federal net operating loss carryforwards to

 

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offset taxable income in fiscal 2008. We may also experience additional ownership changes, as defined by Section 382, in the future which could further limit the amount of federal net operating loss carryforwards annually available.

We may also generate income in future periods on a federal alternative minimum tax basis, which would result in alternative minimum taxes payable on a portion of such income. In addition, we may determine that varying state laws with respect to net operating loss carryforward utilization may result in lower limits, or an inability to utilize loss carryforwards in some states altogether, which could result in our incurring additional state income taxes.

In July 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (“FIN 48”), which clarifies the accounting and disclosure for uncertainty in tax positions, as defined. FIN 48 seeks to reduce the diversity in practice associated with the recognition and measurement related to accounting for income taxes. We were subject to the provisions of FIN 48 as of February 4, 2007. The adoption of FIN 48 had no effect on our consolidated financial statements. At February 2, 2008, we had less than $0.1 million in unrecognized tax benefits that, if recognized, would affect our effective income tax rate in future periods. We are currently unaware of any issues under review that could result in significant payments, accruals or material deviations from our recognized tax positions. However, if we later identify other income tax issues that result in significant additional payments or necessary accruals, this could have a material adverse effect on our reported results.

Insurance Reserves

We are partially self-insured for our workers’ compensation and group health plans. Under the workers’ compensation insurance program, we are liable for a deductible of $0.25 million for each individual claim and an aggregate annual liability of $1.6 million. Under our group health plan, we are liable for a deductible of $0.15 million for each claim and an aggregate monthly liability of $0.5 million. The monthly aggregate liability is subject to adjustment based on the number of participants in the plan each month. For both of the insurance plans, we record a liability for the costs associated with reported claims and a projected estimate for unreported claims considering historical experience and industry standards. We will continue to adjust the estimates as the actual experience dictates. A significant change in the number or dollar amount of claims could cause us to revise our estimate of potential losses and affect our reported results.

Derivative Financial Instruments

We account for derivative financial instruments in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended by SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 133 requires that all derivative financial instruments be recorded on the consolidated balance sheets at fair value.

As of February 2, 2008, our only derivative financial instrument was an embedded derivative associated with our secured convertible notes. The gain or loss as a result of the change in fair value of this embedded derivative is recognized in interest expense in the consolidated statements of operations each period. During fiscal 2005 and 2006, there were decreases of $0.1 million and $0.4 million, respectively, in the fair value of our embedded derivative. In fiscal 2007, the fair value of our embedded derivative increased $0.1 million.

We apply the Black-Scholes and Monte-Carlo simulation models to value this embedded derivative. In applying the Black-Scholes and Monte-Carlo simulation models, changes and volatility in our common stock price, and changes in risk-free interest rates, our expected dividend yield and expected returns on our common stock could significantly affect the fair value of this derivative instrument, which could then result in significant charges or credits to interest expense in our consolidated statements of operations.

 

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We have determined that value is best represented by a blend of valuation outcomes under Black-Scholes modeling and Monte-Carlo simulation. In addition to the estimate changes noted above, if circumstances were to change such that we determined that the embedded derivative value was better represented by an alternative valuation method, and such changes resulted in a significant change in the value of the embedded derivative, such changes could also significantly affect future interest expense.

Current Trends and Outlook

Our consolidated comparable store sales decreased 1.1% for fiscal 2007, driven by a 1.2% increase in comparable store sales in our Wet Seal division offset by an 8.2% decrease in comparable store sales in our Arden B division. This decline was due primarily to the continued softness in average store transaction counts and lower than anticipated full-priced selling at our Arden B division. We believe these overall trends may continue through at least the first half of fiscal 2008 and are planning our merchandise inventories and managing our costs with this expectation entering the spring season. We anticipate a high single digit comparable store sales percentage decline for the fiscal first quarter of 2008, driven primarily by a significantly greater comparable store sales decline in our Arden B division as we continue efforts to improve merchandise content in that division, partially offset by a lesser comparable store sales decline in our Wet Seal division. During the four weeks ended March 1, 2008 and the five weeks ended April 5, 2008, we experienced comparable store sales declines, on a consolidated basis, of 8.2% and 10.8%, respectively.

Our long term strategy is to expand our existing retail store base, return to positive comparable store sales growth, revive the Arden B business and expand our online business. We are also taking several steps to drive higher sales productivity in our retail stores, including improved store layout and visual displays, and have embarked on several initiatives to improve gross margins, including efforts to optimize sourcing of merchandise, enhance our inventory planning and allocation functions, better align merchandise mix with customer wants, rationalize our vendor base and improve supply chain efficiency through better coordination among and within our vendor, internal distribution and store operations organizations.

Our operating performance since fiscal 2005 has resulted in increased liquidity and improved credit standing with suppliers. However, we may experience continued declines in comparable store sales or may be unsuccessful in executing some or all of our business strategy. If our comparable store sales drop significantly for an extended period of time, or we falter in execution of our business strategy, we may not achieve our financial performance goals, which could impact our results of operations and operating cash flow, and we may be forced to seek alternatives to address cash constraints, including seeking debt and/or equity financing.

Store Openings and Closures

During fiscal 2007, we opened 71 and closed ten Wet Seal stores and opened seven and closed four Arden B stores. We believe future closures for at least the next 12 months will primarily result from lease expirations where we decide not to extend, or are unable to extend, a store lease.

We expect net store growth to remain flat, or grow nominally, net of closings, during fiscal 2008.

Credit Extensions

Prior to our recapitalization and financing transactions in fiscal 2004 and 2005, we experienced a tight credit environment. Credit extended to us by vendors, factors, and others for merchandise and services was extremely limited. This credit tightening required us to issue letters of credit outside of the ordinary course of business, or, in many instances, shorten vendor credit terms. The lack of credit created a considerable need for working capital. Our improving sales trend, the completion of financing transactions in fiscal 2004 and 2005, and our improved operating results in fiscal 2005, 2006 and 2007 have significantly improved our cash position and liquidity profile. As a result, we achieved improvements in credit terms with several vendors in fiscal 2006, and

 

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we believe, but cannot provide assurance, that we could now obtain longer credit terms with additional vendors. However, we continue to maintain shorter credit terms in order to take advantage of favorable purchase discounts.

Merchandising Consultant

From late 2004 through the end of fiscal 2006, we used the assistance of a consultant with our merchandising initiatives for our Wet Seal division. On July 6, 2005, we entered into a related consulting agreement that expired on January 31, 2007, and an associated stock award agreement that expired on January 1, 2008.

Under the terms of the consulting agreement and stock award agreement, we recorded charges of $9.8 million and $22.2 million in non-cash stock compensation, and $1.2 million and $2.8 million in cash charges, within general and administrative expenses in our consolidated statements of operations during fiscal 2006 and 2005, respectively. We incurred no stock compensation or cash charges associated with this agreement during fiscal 2007.

Results of Operations

The following table sets forth selected statements of operations data as a percentage of net sales for the fiscal year indicated. The discussion that follows should be read in conjunction with the table below:

 

     As a Percentage of Sales  
Fiscal Year    2007     2006     2005  
Fiscal Year Ended    February 2,
2008
    February 3,
2007
    January 28,
2006
 

Net sales

   100.0 %   100.0 %   100.0 %

Cost of sales

   66.9     65.7     67.8  
                  

Gross margin

   33.1     34.3     32.2  

Selling, general and administrative expenses

   29.0     31.7     34.3  

Store closure (adjustments) costs

   —       (0.1 )   0.9  

Asset impairment

   0.9     0.1     0.2  
                  

Operating income (loss)

   3.2     2.6     (3.2 )

Interest income (expense), net

   0.7     (4.9 )   (2.6 )
                  

Income (loss) before provision for income taxes

   3.9     (2.3 )   (5.8 )

Provision for income taxes

   0.1     —       0.1  
                  

Net income (loss)

   3.8     (2.3 )   (5.9 )

Accretion of non-cash dividends on convertible preferred stock

   —       —       (4.6 )
                  

Net income (loss) attributable to common stockholders

   3.8 %   (2.3 )%   (10.5 )%
                  

 

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Fiscal 2007 compared to Fiscal 2006

The following summarizes the consolidated operating results of our company. This discussion is followed by an overview of operating results by reportable segment.

Net Sales

 

     2007    Change From
Prior Fiscal Year
    2006
     ($ in millions)

Net sales

   $ 611.2    $ 46.8    8.3 %   $ 564.3

Comparable store sales

         (1.1 )%  

Net sales in fiscal 2007 increased as a result of the following:

 

   

An increase in the number of stores open, from 430 stores as of February 3, 2007, to 494 stores as of February 2, 2008;

 

   

An increase of $9.0 million in net sales for our internet business compared to the prior year, which is not a factor in calculating our comparable store sales; and

 

   

An increase of $3.7 million in net sales for the recording of breakage on unredeemed gift cards, gift certificates and store credits in the fourth quarter of fiscal 2007.

However, these factors were partially offset by:

 

   

A decrease of 1.1% in comparable store sales, which resulted from a 4.8% decrease in the number of transactions per store, partially offset by a 3.0% increase in the average dollar sale resulting from a 5.3% increase in our average unit retail prices, and a 1.7% decline in units purchased per customer;

 

   

Recognition of a $3.7 million benefit from the modification of the terms of our Arden B customer loyalty program in fiscal 2006; and

 

   

The inclusion of 53 weeks of operations in fiscal 2006 versus 52 weeks in fiscal 2007, which added $9.4 million in net sales to fiscal 2006.

Cost of Sales

 

     2007     Change From
Prior Fiscal Year
    2006  
     ($ in millions)  

Cost of sales

   $ 408.9     $ 38.0    10.2 %   $ 370.9  

Percentage of net sales

     66.9 %      1.2 %     65.7 %

Cost of sales includes the cost of merchandise, markdowns, inventory shortages, inventory valuation adjustments, inbound freight, payroll expenses associated with design, buying, planning and allocation, processing, receiving and other warehouse costs, rent, and depreciation and amortization expense associated with our stores and distribution center.

Cost of sales increased, in dollars, due primarily to the 8.3% increase in net sales and an increase in occupancy costs due to our increase in store count. Cost of sales increased as a percentage of net sales due primarily to:

 

   

A decrease in merchandise margin as a percentage of sales. The merchandise margin decreased due to an increase in markdown rates, which resulted from additional promotional activity and permanent markdowns in the third and fourth fiscal quarters in response to the competitive retail environment, partially offset by higher initial markup rates compared to the prior year;

 

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A deleveraging effect from our comparable store sales decrease; and

 

   

$1.4 million of pre-opening costs for our new stores incurred during fiscal 2007, associated with stores under construction and/or opened during the period, versus $0.6 million of such costs incurred in the prior year.

Selling, General and Administrative Expenses (SG&A)

 

     2007     Change From
Prior Fiscal Year
    2006  
     ($ in millions)  

Selling, general and administrative expenses

   $ 177.5     $ (1.2 )   (0.7 )%   $ 178.7  

Percentage of net sales

     29.0 %     (2.7 )%     31.7 %

Our SG&A expenses are comprised of two components. Selling expenses include store and field support costs, including personnel, advertising, and merchandise delivery costs as well as internet processing costs. General and administrative expenses include the cost of corporate functions such as executives, legal, finance and accounting, information systems, human resources, real estate and construction, loss prevention, and other centralized services.

Selling expenses increased approximately $10.0 million over the prior year. As a percentage of net sales, selling expense was 23.1% of net sales, or 20 basis points lower as a percentage of net sales, than a year ago.

The following contributed to the current year increase, in dollars, in selling expenses:

 

   

A $6.8 million increase in payroll and benefits costs as a result of the increase in the number of stores, the impact of store labor during pre-opening periods for stores under construction and/or opened during the current year, and an increase in claim costs in our employee health care plan, primarily associated with two cases;

 

   

A $1.9 million increase in credit card and other banking fees;

 

   

A $0.9 million increase in internet production and ordering costs due to higher internet sales compared to the prior year;

 

   

A $0.7 million increase in merchandise delivery costs due to the increased store growth; and

 

   

A $0.4 million increase in advertising and marketing expenditures.

However, these increases, in dollars, were partially offset by the following decreases:

 

   

A $0.3 million decrease in store and field travel costs;

 

   

A $0.2 million decrease in store supply costs; and

 

   

A $0.2 million decrease in field support bonuses based upon our financial performance relative to bonus targets.

General and administrative expenses decreased approximately $11.1 million from the prior year to $36.4 million. As a percentage of net sales, general and administrative expenses were 6.0%, or 240 basis points lower, than a year ago.

The following contributed to the current year decrease in general and administrative expenses:

 

   

A decrease in charges associated with the expiration at the end of fiscal 2006 of the July 2005 merchandising consultant agreement of $11.0 million, which resulted in prior year stock and cash compensation charges of $9.8 million and $1.2 million, respectively, versus no expense in fiscal 2007;

 

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A $0.7 million severance charge in the prior year related to a former executive;

 

   

A decrease of $1.7 million in legal fees due primarily to a $0.7 million insurance reimbursement and settlement, and a general decrease in the level of legal services; and

 

   

A $0.6 million decrease in corporate bonus based on our financial performance relative to bonus targets.

However, the decrease in general and administrative expenses was partially offset by the following increases:

 

   

A $0.7 million charge associated with a separation agreement upon departure of our former chief executive officer;

 

   

A $0.7 million increase in recruiting fees, primarily associated with our search for a new chief executive officer; and

 

   

A $1.5 million increase in corporate payroll due to achievement of full staffing in several corporate support functions.

Store Closure (Adjustments) Costs

 

     2007     Change From
Prior Fiscal Year
    2006  
     ($ in millions)  

Store closure (adjustments) costs

   $ —       $ (0.7 )   (100.0 )%   $ (0.7 )

Percentage of net sales

     0.0 %     (0.1 )%     (0.1 )%

As a result of decreases in estimated costs for lease terminations, due primarily to settlement agreements and a decrease in estimated legal and other costs, during fiscal 2006, we recognized a $0.7 million credit to store closure costs.

We incurred no store closure adjustments or costs during fiscal 2007.

Asset Impairment

 

     2007     Change From
Prior Fiscal Year
    2006  
     ($ in millions)  

Asset impairment

   $ 5.5     $ 5.1    1204.9 %   $ 0.4  

Percentage of net sales

     0.9 %      0.8 %     0.1 %

Based on our quarterly assessments of the carrying value of long-lived assets, in fiscal 2007 we identified certain stores with carrying values of their assets, including leasehold improvements, furniture, fixtures and equipment, in excess of such stores’ respective forecasted undiscounted cash flows. Accordingly, we reduced their respective carrying values to their estimated fair market values, as well as wrote down the value of certain capital additions made to previously impaired stores. We incurred non-cash charges of $2.0 million to write down these stores to their respective fair values.

Additionally, based on our annual goodwill analysis, which considered the deteriorating operating performance of our Arden B division and our resulting outlook for that business, we wrote off the entire $3.5 million carrying value of our goodwill, which was directly associated with the Arden B division.

During fiscal 2006, we recorded impairment charges of $0.4 million to write down certain stores’ assets to their respective fair values.

 

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Interest Income (Expense), Net

 

     2007     Change From
Prior Fiscal Year
    2006  
     ($ in millions)  

Interest income (expense), net

   $ 4.4     $ 31.9    115.8 %   $ (27.6 )

Percentage of net sales

     0.7 %      5.6 %     (4.9 )%

We generated interest income, net, of $4.4 million in fiscal 2007 comprised of:

 

   

Interest income of $5.3 million from investments in cash and marketable securities;

 

   

Non-cash interest expense of $0.8 million with respect to our secured convertible notes comprised primarily of discount amortization, with the nominal residual comprised of annual interest at 3.76%, which we have elected to add to principal;

 

   

Non-cash credits of $0.1 million from capitalized interest during the construction period on new store openings;

 

   

Amortization of deferred financing costs of $0.1 million associated with our revolving credit facility and secured convertible notes; and

 

   

Non-cash interest expense of $0.1 million to recognize the increase in market value of a derivative liability.

In fiscal 2006, we incurred interest expense, net, of $27.6 million, comprised of $29.1 million of net accelerated interest charges upon investor conversions into Class A common stock of $37.5 million of our secured convertible notes, $0.2 million to write off unamortized deferred financing costs and cash interest expense of $0.1 million for a prepayment penalty upon repayment of the $8.0 million term loan, $2.1 million of interest expense on our secured convertible notes for annual interest at 3.76% and discount amortization, amortization of $0.5 million of deferred financing cost, and $0.4 million interest expense on the term loan, plus related revolving credit facility, appraisal and amendment fees, partially offset by $4.4 million of interest income from investment of cash and a non-cash credit of $0.4 million to recognize the decrease in market value of derivative liabilities.

Provision for Income Taxes

 

     2007    Change From
Prior Fiscal Year
    2006
     ($ in millions)

Provision for income taxes

   $ 0.4    $ 0.1    22.7 %   $ 0.3

In fiscal 2007, we had net operating loss carryforwards available, subject to certain limitation, to offset our regular taxable income. We recognized a provision for income taxes that resulted in effective tax rates of 1.5% for federal income taxes and 0.1% for state income taxes. These effective rates are based on the portion of our estimated alternative minimum taxable income for fiscal 2007 that cannot be offset by net operating loss carryforwards.

We ceased recognizing tax benefits related to our net operating losses and other deferred tax assets beginning with our second quarter of fiscal 2004, and we currently recognize the tax benefits associated with our deferred tax assets only when they are realized.

In fiscal 2007 and fiscal 2006, we had sufficient net operating loss carryforwards available to fully offset taxable income generated in both fiscal years. In fiscal 2006, despite our loss before provision for income taxes, due primarily to the non-deductibility for tax purposes of the interest expense associated with our secured convertible notes, we generated taxable income. However, under federal tax law, we are permitted to use net

 

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operating loss carryforwards to offset only 90% of our taxable income, as calculated on the alternative minimum tax basis. As such, our remaining 10% of income, as calculated on the alternative minimum tax basis, is subject to federal income taxes payable at a rate of 20%. Our fiscal 2007 and fiscal 2006 provisions for income taxes are primarily comprised of this alternative minimum tax.

Segment Information

The following is a discussion of the operating results of our business segments. We consider each of our operating divisions to be a segment. In the tables below, Wet Seal and Arden B reportable segments include data from their respective stores and internet operations. Operating segment results include net sales, cost of sales, asset impairment and store closure costs, and other direct store and field management expenses, with no allocation of corporate overhead, interest income or expense.

 

Wet Seal:

    

(In thousands, except sales per square foot and store count data)

   Fiscal
2007
    Fiscal
2006
 

Net sales

   $ 478,405     $ 417,098  

% of consolidated net sales

     78 %     74 %

Comparable store sales % increase compared to the prior fiscal year

     1.2 %     8.8 %

Operating income

   $ 69,188     $ 47,194  

Sales per square foot

   $ 314     $ 321  

Number of stores as of year-end

     399       338  

Square footage as of year-end

     1,568       1,316  

Wet Seal comparable stores sales increased 1.2% in fiscal 2007, compared to a prior year increase of 8.8%. The increase in fiscal 2007 was due primarily to a 5.1% increase in the average dollar sale, partially offset by a 4.9% decrease in the number of transaction counts per store. The increase in the average dollar sale resulted from a 7.6% increase in our average unit retail prices, somewhat offset by a 1.6% decrease in units purchased per customer. The overall net sales increase was attributable to the increase in number of stores open, from 338 stores as February 3, 2007 to 399 stores as of February 2, 2008, a $6.5 million increase in net sales in our internet business, and a $2.9 million benefit of recording breakage for unredeemed gift cards, gift certificates and store credits in fiscal 2007, which are not factors in calculating our comparable store sales.

Wet Seal’s operating income increased to 14.5% of net sales in fiscal 2007, from 11.3% in fiscal 2006. The increase in operating income was due primarily to improved merchandise margins as a result of higher initial markup rates compared to prior year, partially offset by increase in markdown rates, as a result of the additional promotional activity and permanent markdowns in the third and fourth quarters of fiscal 2007 in response to the competitive retail environment. This favorable impact from merchandise margins was partially offset by an increase in occupancy costs resulting from the deleveraging effect from having only a slight increase in comparable store sales, and $1.4 million of pre-opening costs for our new stores opened in fiscal 2007, associated with stores under construction and/or opened during the period, versus $0.6 million of such costs incurred in the prior year. In addition, cash and non-cash stock compensation charges of $1.2 million and $9.8 million, respectively, were recorded in fiscal 2006 associated with the merchandising consultant engaged to assist with our merchandising initiatives versus no such charges being incurred in fiscal 2007.

 

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Arden B:

    

(In thousands, except sales per square foot and store count data )

   Fiscal
2007
    Fiscal
2006
 

Net sales

   $ 132,758     $ 147,226  

% of consolidated net sales

     22 %     26 %

Comparable store sales % decrease compared to the prior fiscal year

     (8.2 )%     (1.1 )%

Operating income (loss)

   $ (14,953 )   $ 2,878  

Sales per square foot

   $ 420     $ 459  

Number of stores as of year-end

     95       92  

Square footage as of year-end

     295       297  

Arden B comparable stores sales decreased 8.2% in fiscal 2007, compared to a prior year decrease of 1.1%. The decrease in fiscal 2007 was due primarily to a 4.3% decrease in the number of transaction counts per store and a 4.1% decrease in the average dollar sale. The decrease in the average dollar sale resulted from a 1.5% decline in our average unit retail prices and a 2.7% decline in units purchased per customer. In addition, Arden B’s net sales in fiscal 2006 included the modification of the terms of our Arden B customer loyalty program, which resulted in recognition of sales previously deferred of $3.7 million. These decreases were partially offset by a current year increase of $2.5 million in net sales in our internet business and a $0.8 million benefit of recording breakage of unredeemed gift cards, gift certificates and store credits in fiscal 2007, which are not factors in calculating our comparable store sales.

Arden B incurred an operating loss of 11.3% of net sales in fiscal 2007, compared to operating income of 2.0% of net sales in fiscal 2006. The decrease in operating results was due primarily to a decrease in merchandise margins resulting from a significant increase in markdown rates, and slightly lower initial markup rates, compared to prior year, and the deleveraging effect on occupancy and other operating costs resulting from the decrease in comparable store sales. Additionally, this segment’s operating results were impacted by an asset impairment charge of $1.9 million to write down the carrying value of long-lived assets that were identified during our quarterly evaluations of the carrying value of long-lived assets in excess of forecasted undiscounted cash flows, and the $3.5 million write off of the carrying value of the goodwill associated with the Arden B division.

Fiscal 2006 compared to Fiscal 2005

Net Sales

 

     2006    Change From
Prior Fiscal Year
    2005
     ($ in millions)

Net sales

   $ 564.3    $ 63.5    12.7 %   $ 500.8

Comparable store sales

         6.1 %  

Net sales in fiscal 2006 increased as a result of the following:

 

   

Our comparable store sales increase of 6.1% was a result of a 10.2% increase in transaction counts per store, partially offset by a 4.5% decrease in average dollar sale. The decrease in average dollar sale resulted from a 14.6% decrease in our average unit retail, driven by the continuation of our new merchandising strategy in our Wet Seal stores, partially offset by a 10.5% increase in units per customer;

 

   

Modification of the terms of our Arden B customer loyalty program to expire unredeemed awards after specified periods of time, which resulted in recognition of sales previously deferred of $3.7 million and which is not a factor in calculating our comparable store sales;

 

   

An increase of $10.1 million in net sales for our internet business compared to the prior year, which is also not a factor in calculating our comparable store sales;

 

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The inclusion of 53 weeks of operations in fiscal 2006 versus 52 weeks in fiscal 2005, which added $9.4 million in net sales to fiscal 2006; and

 

   

An increase in the number of stores open, from 400 Wet Seal and Arden B stores as of January 28, 2006, to 430 Wet Seal and Arden B stores as of February 3, 2007.

Cost of Sales

 

     2006     Change From
Prior Fiscal Year
    2005  
     ($ in millions)  

Cost of sales

   $ 370.9     $ 31.4    9.3 %   $ 339.5  

Percentage of net sales

     65.7 %      (2.1 )%     67.8 %

Cost of sales increased in dollars primarily due to the 12.7% increase in net sales. Cost of sales decreased as a percentage to net sales, due to:

 

   

Modification of the terms of our Arden B customer loyalty program to expire unredeemed awards after a specified period of time, resulting in recognition of sales previously deferred of $3.7 million with no corresponding charge to cost of sales;

 

   

Improvement in merchandise margin due to increases in cumulative markup rates and increased amortization of frequent buyer program revenues, partially offset by increased markdowns for discounts associated with the frequent buyer program, increased markdowns in connection with the transition of merchandise leadership within the Arden B division, and additional markdowns at Wet Seal stores due to relatively weak sales performance in the fourth quarter; and

 

   

The positive effect of sales leverage on occupancy costs.

However, the decrease was partially offset by the following:

 

   

An increase in buying, planning and allocation payroll and related costs due to higher staffing levels and $0.9 million in stock compensation expense resulting from our adoption of SFAS No. 123(R) as of the beginning of fiscal 2006; and

 

   

An increase in distribution costs associated with transferring security-tagging activity from our stores to our distribution center, an increase in inventory receipts and $0.1 million in stock compensation expense resulting from our adoption of SFAS No. 123(R) as of the beginning of fiscal 2006.

Selling, General and Administrative Expenses (SG&A)

 

     2006     Change From
Prior Fiscal Year
    2005  
     ($ in millions)  

Selling, general and administrative expenses

   $ 178.7     $ 6.7    3.9 %   $ 172.0  

Percentage of net sales

     31.7 %      (2.6 )%     34.3 %

Selling expenses increased approximately $17.3 million over the prior year. As a percentage of net sales, selling expenses were 23.3% of net sales, or 60 basis points higher as a percentage of net sales, than a year ago. The increase in selling expenses from last year, in dollars, was primarily due to a $9.2 million increase in payroll and benefits costs as a result of increased sales, labor-intensive store promotion set-ups, heavy inventory receipts and our increase in store count, partially offset by transfer of security-tagging activity from our stores to our distribution center during fiscal 2006; a $2.8 million increase in internet production and ordering costs due to higher internet sales compared to the prior year; a $2.2 million increase in spending for advertising associated with visual presentation, in-store signage, promotional contests and publication placements; a $1.0 million increase in store supply costs; a $0.4 million increase in credit card and other banking fees; a $0.5 million

 

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increase in security costs due to increased purchases of inventory sensor tags; a $1.0 million increase in store-related travel and field support costs; and a $0.2 million increase in inventory services due to our increased number of stores and higher inventory levels.

General and administrative expenses decreased approximately $10.6 million from the prior year to $47.5 million. As a percentage of net sales, general and administrative expenses were 8.4%, or 320 basis points lower, than a year ago.

The following contributed to the current year decrease in general and administrative expenses:

 

   

A decrease in charges associated with the July 2005 merchandise consultant agreement of $14.0 million, which resulted from prior year stock and cash compensation charges of $22.2 million and $2.8 million, respectively, versus only $9.8 million and $1.2 million of such charges, respectively, in the current year; and

 

   

A $2.0 million decrease in legal fees, due primarily to a decrease in the amount of legal charges associated with shareholder class action litigation initiated in mid-fiscal 2004 and an SEC investigation initiated in early fiscal 2005.

However, the decrease in general and administrative expenses was partially offset by the following increases:

 

   

$1.6 million in non-cash stock compensation expense for employee stock options and performance shares primarily as a result of our adoption of SFAS No. 123(R), as of the beginning of fiscal 2006;

 

   

A $2.6 million increase in corporate payroll due to increased staff levels in real estate and store construction functions in order to accommodate store growth plans as well as achievement of full staffing in several other corporate support functions;

 

   

A $1.0 million increase in payroll taxes and benefit costs due to increased corporate payroll and an increase in claims in our group health plan; and

 

   

A $0.2 million increase in other miscellaneous charges.

Store Closure (Adjustments) Costs

 

     2006     Change From
Prior Fiscal Year
    2005  
     ($ in millions)  

Store closure (adjustments) costs

   $ (0.7 )   $ (5.2 )   (115.6 )%   $ 4.5  

Percentage of net sales

     (0.1 )%     (1.0 )%     0.9 %

As a result of decreases in estimated costs for lease terminations, primarily due to settlement agreements and a decrease in estimated legal and other costs, during fiscal 2006, we recognized a $0.7 million credit to store closure costs.

Fiscal 2005 included store closure costs of $4.5 million primarily related to the estimated lease termination costs for 150 Wet Seal store closures as part of our turnaround strategy.

Asset Impairment

 

     2006     Change From
Prior Fiscal Year
    2005  
     ($ in millions)  

Asset impairment

   $ 0.4     $ (0.6 )   (57.0 )%   $ 1.0  

Percentage of net sales

     0.1 %     (0.1 )%     0.2 %

 

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Based on our quarterly assessments of the carrying value of long-lived assets, in fiscal 2006 we identified certain stores with carrying values of their assets, including leasehold improvements, furniture, fixtures and equipment, in excess of such stores’ respective forecasted undiscounted cash flows. Accordingly, we reduced their respective carrying values to their estimated fair market values. We incurred non-cash charges of $0.4 million to write down these stores to their respective fair values.

During fiscal 2005, we recorded impairment charges of $1.0 million to write down certain stores’ assets to their respective fair values, as well as to write down the value of certain capital additions made to previously impaired stores.

Interest Expense, Net

 

     2006     Change From
Prior Fiscal Year
    2005  
     ($ in millions)  

Interest expense, net

   $ (27.6 )   $ (14.7 )   114.3 %   $ (12.9 )

Percent of net sales

     (4.9 )%     (2.3 )%     (2.6 )%

We incurred interest expense, net, of $27.6 million in fiscal 2006 comprised of:

 

   

A net write off of $29.1 million of unamortized debt discount, deferred financing costs and accrued interest upon investor conversions into Class A common stock of $37.5 million of our secured convertible notes;

 

   

Non-cash interest expense of $2.1 million with respect to our secured convertible notes comprised of annual interest at 3.76% and discount amortization;

 

   

Amortization of deferred financing costs of $0.5 million associated with our senior credit facility, term loan and secured convertible notes;

 

   

A non-cash credit of $0.4 million to interest expense to recognize the decrease in market value during the period of a derivative liability resulting from a “change in control” put option held by the investors in our secured convertible notes;

 

   

Non-cash interest expense of $0.2 million to write off unamortized deferred financing costs and cash interest expense of $0.1 million for a prepayment penalty upon our repayment of the $8.0 million term loan in March 2006;

 

   

Interest expense of $0.4 million under our senior credit facility, for an $8.0 million term loan, plus related senior credit facility, appraisal and amendment fees; and

 

   

Interest income of $4.4 million from investment of cash.

In fiscal 2005, we incurred interest expense, net, of $12.9 million, comprised of $8.8 million of net accelerated interest charges upon investor conversions into Class A common stock of $10.4 million in principal amount of our $56.0 million of secured convertible notes, $1.2 million associated with our senior credit facility and the term loan thereunder, $1.2 million of interest expense on a $10.0 million bridge loan, $3.0 million of interest on our secured convertible notes and discount amortization, and amortization of $1.0 million of deferred financing cost, partially offset by $2.1 million of interest income from investment of cash and a non-cash credit of $0.2 million to recognize the decrease in market value of derivative liabilities.

Provision for Income Taxes

 

     2006    Change From
Prior Fiscal Year
    2005
     ($ in millions)

Provision for income taxes

   $ 0.3    $ (0.0 )   (0.0 )%   $ 0.3

 

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We ceased recognizing tax benefits related to our net operating losses and other deferred tax assets beginning with our second quarter of fiscal 2004, and we currently recognize the tax benefits associated with our deferred tax assets only when they are realized.

Due primarily to the non-deductibility for tax purposes of the interest expense associated with our secured convertible notes, we generated taxable income in fiscal 2006 despite our loss before provision for income taxes. We had sufficient net operating loss carryforwards available to fully offset our taxable income for fiscal 2006; however, under federal tax law, we are permitted to use net operating loss carryforwards to offset only 90% of our taxable income, as calculated on the alternative minimum tax basis. As such, our remaining 10% of income, as calculated on the alternative minimum tax basis, is subject to federal income taxes payable at a rate of 20%. Our fiscal 2006 provision for income taxes is primarily comprised of this alternative minimum tax.

During fiscal 2005, we incurred a provision for income taxes of $0.3 million to write off certain state tax receivables we no longer believe to be realizable.

Accretion of Non-Cash Dividends on Convertible Preferred Stock

During fiscal 2005, we issued 24,600 shares of our Series C Convertible Preferred Stock, with a stated value of $24.6 million. We initially recorded this preferred stock at a discount of $23.3 million. During fiscal 2005, we immediately accreted this discount in its entirety in the form of a deemed non-cash preferred stock dividend since the preferred stock is immediately convertible and has no stated redemption date.

Segment Information

The following is a discussion of the operating results of our business segments. We consider each of our operating divisions to be a segment. In the tables below, Wet Seal and Arden B reportable segments include data from their respective stores and internet operations. Operating segment results include net sales, cost of sales, asset impairment and store closure costs, and other direct store and field management expenses, with no allocation of corporate overhead, interest income or expense.

 

Wet Seal:

    

(In thousands, except sales per square foot and store count data)

   Fiscal
2006
    Fiscal
2005
 

Net sales

   $ 417,098     $ 363,064  

% of consolidated net sales

     74 %     72 %

Comparable store sales % increase compared to the prior fiscal year

     8.8 %     74.1 %

Operating income

   $ 47,194     $ 18,512  

Sales per square foot

   $ 321     $ 297  

Number of stores as of year-end

     338       308  

Square footage as of year-end

     1,316       1,206  

Wet Seal comparable stores sales increased 8.8% in fiscal 2006, compared to a fiscal 2005 increase of 74.1%. Wet Seal transaction counts per store increased 11.9%, partially offset by a 3.9% decrease in average dollar sale. The decrease in average dollar sale resulted from a 15.0% decrease in our average unit retail, driven by the continuation of our new merchandising strategy in our Wet Seal stores, partially offset by an 11.7% increase in units per customer. Wet Seal’s increase in net sales included an $8.3 million increase in net sales in the internet business, which is not a factor in calculating our comparable store sales. Additionally, the inclusion of 53 weeks of operations in fiscal 2006 versus 52 weeks in fiscal 2005 and the increase in the number of stores open, from 308 stores as January 28, 2006 to 338 stores as of February 3, 2007, contributed to the increase in net sales.

Wet Seal’s operating income increased to 11.3% of net sales in fiscal 2006, from 5.1% in fiscal 2005. The increase in operating income was due primarily to fiscal 2005 including $22.2 million of non-cash stock

 

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compensation charges and $2.8 million of cash compensation charges versus fiscal 2006 including $9.8 million of non-cash stock compensation charges and $1.2 million of cash compensation charges, associated with a consultant engaged to assist with our merchandising initiatives. Additionally, fiscal 2005 included a store closure costs of $4.5 million primarily related to the estimated lease termination costs for 150 Wet Seal store closures as part of our turnaround strategy, versus a favorable impact of $0.7 million in fiscal 2006 due to decreases in estimated costs for lease terminations to these same Wet Seal store closures. Cost of sales decreased as a percent to net sales due to the positive effect of the increased comparable store sales leverage on occupancy costs, and an improvement in merchandise margin due to increases in cumulative markup rates and increased amortization of frequent buyer program revenues, partially offset by increased markdowns for discounts associated with the frequent buyer program as well as additional markdowns due to relatively weak sales performance, primarily in the fourth quarter.

 

Arden B:

    

(In thousands, except sales per square foot and store count data)

   Fiscal
2006
    Fiscal
2005
 

Net sales

   $ 147,226     $ 137,743  

% of consolidated net sales

     26 %     28 %

Comparable store sales % (decrease) increase compared to the prior fiscal year

     (1.1 )%     0.1 %

Operating income (loss)

   $ 2,878     $ (2,770 )

Sales per square foot

   $ 459     $ 464  

Number of stores as of year-end

     92       92  

Square footage as of year-end

     297       293  

Arden B comparable stores sales decreased 1.1% in fiscal 2006, compared to a fiscal 2005 increase of 0.1%. Arden B transaction counts per store decreased 5.9%, partially offset by a 5.6% increase in average dollar sale. The increase in average dollar sale resulted from a 9.7% increase in our average unit retail, partially offset by a 3.1% decrease in units per customer. Additionally, Arden B’s net sales increase was attributable to a fiscal 2006 modification of the terms of our Arden B customer loyalty program, which resulted in recognition of sales previously deferred of $3.7 million and a $1.8 million increase in net sales in our internet business compared to fiscal 2005, which are not factors in calculating our comparable store sales. Additionally, the inclusion of 53 weeks of operations in fiscal 2006 versus 52 weeks in fiscal 2005 contributed to the increase in net sales.

Arden B generated operating income of 2.0% of net sales in fiscal 2006, compared to an operating loss of 2.0% of net sales in fiscal 2005. The increase in operating results was due primarily to the recognition of a $3.7 million benefit from the modification of the terms our Arden B customer loyalty program included in fiscal 2006 sales. Our merchandise margin increased due to a significant increase in initial markup rates, partially offset by higher markdown rates, compared to fiscal 2005. Additionally, this segment’s operating results were favorably impacted by non-cash charges of $0.3 million to write down the carrying value of long-lived assets that were identified during our quarterly assessments of the carrying value of long-lived assets in excess of forecasted undiscounted cash flows, compared to $1.0 million to write down the carrying value of long-lived assets in fiscal 2005.

Liquidity and Capital Resources

Net cash provided by operating activities was $51.5 million for fiscal 2007, compared to $28.8 million for the same period last year. For fiscal 2007, operating cash flows were directly impacted by our net income of $23.2 million, net non-cash charges (primarily depreciation and amortization, asset impairment charges, and stock-based compensation) of $26.3 million, a decrease in merchandise inventories, net of merchandise accounts payable, of $1.0 million, a net source of cash from changes in other operating assets and liabilities of $4.7 million, partially offset by gift card, gift certificate and store credit breakage of $3.7 million. For fiscal 2007, net cash used in investing activities of $38.5 million was used entirely for capital expenditures. Capital expenditures

 

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for the period were primarily for new stores, store relocations and remodeling for our Wet Seal division, and for various information technology projects. Capital expenditures do not include a $0.1 million increase since the end of fiscal 2006 in capital assets purchased on account for which we have not yet made payment. We expect to pay nearly all of the total balance of such amounts payable, $3.3 million, during the first quarter of fiscal 2008.

We estimate that, in fiscal 2008, capital expenditures will be between $28 million and $30 million, primarily for the construction of approximately 20 to 25 new stores, remodeling or relocation of existing stores and various other store-related and information technology capital projects. We anticipate receiving between $4 million and $5 million in landlord tenant improvement allowances in connection with certain of our new store lease agreements. We anticipate closing approximately 15 to 25 stores upon lease expirations during the course of the year, which would result in relatively flat, or nominally increased, net store count growth for fiscal 2008.

For fiscal 2007, net cash used in financing activities was $17.6 million, comprised primarily of $20.1 million used to repurchase 3.6 million shares of our Class A common stock pursuant to a 4.0 million share repurchase authorization granted by our Board of Directors on March 28, 2007, partially offset by $2.3 million in proceeds from investor exercises of common stock warrants. Our Board of Directors has suspended our authority to make further share repurchases under the March 28, 2007, authorization.

Total cash and cash equivalents at February 2, 2008, was $100.6 million, compared to $105.3 million at February 3, 2007.

We maintain a $35.0 million senior revolving credit facility, which can be increased up to $50.0 million in the absence of any default and upon the satisfaction of certain conditions precedent specified in the agreement. Under our senior revolving credit facility, we are subject to borrowing base limitations on the amount that can be borrowed and certain customary covenants, including covenants limiting our ability to incur additional indebtedness, make investments and acquisitions, grant liens, pay dividends, close stores and dispose of assets, subject to certain exceptions. Our ability to borrow and request the issuance of letters of credit is subject to the requirement that we maintain an excess of the borrowing base over the outstanding credit extensions of not less than $5.0 million. The interest rate on our line of credit under the senior revolving credit facility is the prime rate or, if we elect, the London Interbank Offered Rate (“LIBOR”) plus a margin ranging from 1.0% to 1.5%. The applicable LIBOR margin is based on the level of average Excess Availability, as defined under our senior revolving credit facility, at the time of election, as adjusted quarterly. The applicable LIBOR margin was 1.0% as of February 2, 2008. We also incur fees on outstanding letters of credit under the senior revolving credit facility in effect at a rate equal to the applicable LIBOR margin for standby letters of credit and 33.3% of the applicable LIBOR margin for commercial letters of credit.

The senior revolving credit facility ranks senior in right of payment to our secured convertible notes. Borrowings under the senior revolving credit facility are secured by all of our presently owned and hereafter acquired assets. Our obligations thereunder are guaranteed by one of our wholly owned subsidiaries, Wet Seal GC, LLC.

At February 2, 2008, the amount outstanding under the senior revolving credit facility consisted of $3.0 million in open documentary letters of credit related to merchandise purchases and $1.7 million in standby letters of credit. At February 2, 2008, we had $30.3 million available for cash advances and/or for the issuance of additional letters of credit. At February 2, 2008, we were in compliance with all covenant requirements in the senior revolving credit facility.

We believe we will have sufficient cash and credit availability to meet our operating and capital requirements for at least the next 12 months. However, we may experience continued declines in consolidated comparable store sales or experience other events that negatively affect our operating results. If our consolidated comparable store sales drop significantly for an extended period of time, or we falter in execution of our business strategy, we may not achieve our financial performance goals, which could impact our results of operations and

 

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operating cash flow. This could also cause a decrease in or elimination of excess availability under the Facility, which could force us to seek alternatives to address cash constraints, including seeking additional debt and/or equity financing.

Seasonality and Inflation

Our business is seasonal in nature, with the Christmas season, beginning the week of Thanksgiving and ending the first Saturday after Christmas, and the back-to-school season, beginning the last week of July and ending during September, historically accounting for a large percentage of our sales volume. For the past three fiscal years, the Christmas and back-to-school seasons together accounted for an average of slightly more than 30% of our annual sales. We do not believe that inflation has had a material effect on our results of operations during the past three years. However, we cannot be certain that our business will not be affected by inflation in the future.

Commitments and Contingencies

At February 2, 2008, our contractual obligations consisted of:

 

    Payments Due By Period

Contractual Obligations

(in thousands)

  Total   Less Than
1 Year
  1–3
Years
  4–5
Years
  Over 5
Years

Lease commitments:

         

Operating leases

  $ 312,400   $ 56,000   $ 92,600   $ 73,300   $ 90,500

Fixed common area maintenance

    55,700     7,100     13,600     13,300     21,700

Convertible notes, including accrued interest

    9,041     —       —       —       9,041

Supplemental Employee Retirement Plan

    2,076     220     440     440     976

Merchandise on order with suppliers

    45,558     45,558     —       —       —  

Projected interest on contractual obligations

    1,410     —       —       —       1,410
                             

Total

  $ 426,185   $ 108,878   $ 106,640   $ 87,040   $ 122,217
                             

Lease commitments include operating leases for our retail stores, principal executive offices, warehouse facilities and computers under operating lease agreements expiring at various times through 2019. Certain leases for our retail stores include fixed common area maintenance obligations.

We have a defined benefit Supplemental Employee Retirement Plan (the “SERP”) for one former director. The SERP provides for retirement death benefits through life insurance. We funded a portion of the SERP obligation in prior years through contributions to a trust arrangement known as a “Rabbi” trust.

We place merchandise orders approximately 45 to 60 days in advance for domestic merchandise and 120 days in advance for imported merchandise. Occasionally, we have “promotional events” for which we purchase larger quantities at discounted prices. We have markdown risk to the extent we do not ultimately achieve adequate sell-through on such merchandise.

The projected interest component on our company’s contractual obligations was estimated based on the prevailing or contractual interest rates for the respective obligations over the period of the agreements (see Note 6 of Notes to Consolidated Financial Statements). This projected interest pertains to the 3.76% interest, compounded annually, on our secured convertible notes. Upon investor conversions of our secured convertible notes, we no longer become obligated to pay a ratable portion of such interest.

 

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Our other commercial commitments consist of letters of credit primarily for the procurement of domestic and imported merchandise and to secure obligations to certain insurance providers, and are secured through our senior revolving credit facility. At February 2, 2008, our contractual commercial commitments under these letter of credit arrangements were as follows:

 

Other Commercial Commitments

(in thousands)

   Total
Amounts
Committed
   Amount of Commitment Expiration Per Period
      Less Than
1 Year
   1–3
Years
   4–5
Years
   Over 5
Years

Letters of credit

   $ 4,657    $ 4,657    —      —      —  

We do not maintain any long-term or exclusive commitments or arrangements to purchase merchandise from any single supplier.

Recently Adopted Accounting Pronouncements

Effective February 4, 2007, we adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 requires that a position taken or expected to be taken in a tax return be recognized in the financial statements when it is more likely than not that the position would be sustained upon examination by tax authorities. A recognized tax position is then measured at the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. The cumulative effect, if any, of applying FIN 48 is to be reported as an adjustment to the opening balance of accumulated deficit in the year of adoption. FIN 48 also requires that, subsequent to initial adoption, a change in judgment that results in subsequent recognition, derecognition or change in a measurement of a tax position taken in a prior annual period (including any related interest and penalties) be recognized as a discrete item in the period in which the change occurs. FIN 48 also requires expanded disclosures, including identification of tax positions for which it is reasonably possible that total amounts of unrecognized tax benefits will significantly change in the next twelve months, a description of tax years that remain subject to examination by major tax jurisdiction, a tabular reconciliation of the total amount of unrecognized tax benefits at the beginning and end of each annual reporting period, the total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate and the total amounts of interest and penalties recognized in the statements of operations and financial position. The adoption of FIN 48 had no effect on our consolidated financial statements.

At February 2, 2008, we had less than $0.1 million in unrecognized tax benefits that, if recognized, would affect our effective income tax rate in future periods. We are currently unaware of any issues under review that could result in significant payments, accruals or material deviations from our recognized tax positions.

Effective upon adoption of FIN 48, we recognize interest and penalties accrued related to unrecognized tax benefits and penalties within our provision for income taxes. We had no such interest and penalties accrued at February 2, 2008. Prior to our adoption of FIN 48, we recognized such interest and penalties, which were immaterial in prior periods, within general and administrative expenses.

The major jurisdictions in which we file income tax returns include the United States federal jurisdiction as well as various state jurisdictions within the United States. Our fiscal year 2004 and thereafter are subject to examination by the United States federal jurisdiction, and, generally, fiscal year 2002 and thereafter are subject to examination by various state tax authorities.

In May 2007, the FASB issued FSP No. FIN 48-1 (“FSP 48-1”), “Definition of Settlement in FASB Interpretation No. 48.” FSP 48-1 amended FIN 48 to provide guidance on how an enterprise should determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. FSP 48-1 required application upon the initial adoption of FIN 48. The adoption of FSP 48-1 did not affect our consolidated financial statements.

 

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In June 2006, the FASB ratified the consensus reached in EITF Issue No. 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (that is, Gross versus Net Presentation).” The EITF reached a consensus that the presentation of taxes on either a gross or net basis is an accounting policy decision that requires disclosure. EITF Issue No. 06-3 was effective for the first interim or annual reporting period beginning after December 15, 2006. Taxes collected from our customers are and have been recorded on a net basis. We did not modify this accounting policy. As such, the adoption of EITF Issue No. 06-3 did not have an effect on our consolidated financial position or results of operations.

New Accounting Pronouncements Not Yet Adopted

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 provides a new single authoritative definition of fair value and provides enhanced guidance for measuring the fair value of assets and liabilities and requires additional disclosures related to the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. Adoption of SFAS No. 157 is required as of the beginning of fiscal years beginning after November 15, 2007. In February 2008, the FASB issued FSP Nos. 157-1 and 157-2 which partially deferred the effective date of SFAS No. 157 for one year for certain nonfinancial assets and liabilities and removed certain leasing transactions from its scope. We have not yet determined the impact that the adoption of SFAS No. 157 will have on our consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115” (“SFAS No. 159”). SFAS No. 159 provides companies with an option to report many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. The objective of SFAS No. 159 is to reduce both complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently. The FASB believes that SFAS No. 159 helps to mitigate accounting-induced volatility by enabling companies to report related assets and liabilities at fair value, which would likely reduce the need for companies to comply with detailed rules for hedge accounting. SFAS No. 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities, and would require entities to display the fair value of those assets and liabilities for which the company has chosen to use fair value on the face of the balance sheet. The new statement does not eliminate disclosure requirements included in other accounting standards, including requirements for disclosures about fair value measurements included in SFAS No. 157, “Fair Value Measurements.” Adoption of SFAS No. 159 is required as of the beginning of fiscal years beginning after November 15, 2007. We do not intend to apply the fair value option to any of our assets or liabilities upon adoption of SFAS No. 159 and, accordingly, do not believe adoption of SFAS No. 159 will have any effect on our consolidated financial statements.

In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (“SFAS No. 141R”). The objective of SFAS No. 141R is to improve the relevance, representational faithfulness, and comparability of the information that a company provides in its financial reports about a business combination and its effects. Under SFAS No. 141R, a company is required to recognize the assets acquired, liabilities assumed, contractual contingencies, and contingent consideration measured at their fair value at the acquisition date. It further required research and development assets acquired in a business combination that have no alternative future use to be measured at their acquisition-date fair value and then immediately charged to expense, and that acquisition-related costs are to be recognized separately from the acquisition and expensed as incurred. Among other changes, this statement also required that “negative goodwill” be recognized in earnings as a gain attributable to the acquisition, and any deferred tax benefits resulting from a business combination be recognized in income from continuing operations in the period of the combination. SFAS No. 141R is effective for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Currently, we do not believe adoption of SFAS No. 141R will have any effect on our consolidated financial statements. However, SFAS No. 141R could affect how we account for business acquisitions occurring after its adoption date.

 

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In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements—an amendment of ARB No. 51” (“SFAS No. 160”). The objective of this statement is to improve the relevance, comparability, and transparency of the financial information that a company provides in its consolidated financial statements. SFAS No. 160 requires a company to clearly identify and present ownership interests in subsidiaries held by parties other than the company in the consolidated financial statements within the equity section but separate from the company’s equity. It also requires the amount of consolidated net income attributable to the parent and to the noncontrolling interest to be clearly identified and presented on the face of the consolidated statement of income; changes in ownership interest to be accounted for similarly, as equity transactions; and when a subsidiary is deconsolidated, any retained noncontrolling equity investment in the former subsidiary and the gain or loss on the deconsolidation of the subsidiary to be measured at fair value. SFAS No. 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. We do not believe adoption of SFAS No. 160 will have any effect on our consolidated financial statements.

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities—An Amendment of FASB Statement No. 133” (“SFAS No. 161”). The objective of SFAS No. 161 is to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. It is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. We have not yet determined the impact that the adoption of SFAS No. 161 will have on our consolidated financial statements.

Additional information regarding new accounting pronouncements is contained in Note 1 of Notes to Consolidated Financial Statements herein.

 

Item  7A. Quantitative and Qualitative Disclosures About Market Risk

To the extent that we borrow under our senior revolving credit facility, we are exposed to market risk related to changes in interest rates. At February 2, 2008, no borrowings were outstanding under the senior revolving credit facility. As of February 2, 2008, we are not a party to any derivative financial instruments, except as discussed in “Market Risk—Change in Value of our common stock” immediately below.

We contract for and settle all purchases in U.S. dollars, and in fiscal 2007 we directly imported only approximately 16% of our merchandise inventories. Thus, we consider the effect of currency rate changes to be indirect and, given the small amount of imported product, we believe the effect of a major shift in currency exchange rates would be insignificant to our results.

Market Risk—Change in Value of our Common Stock

Our secured convertible notes (see Note 6 of the Notes to Consolidated Financial Statements) contain an embedded derivative, which upon the occurrence of a change of control, as defined, allows each note holder the option to require us to redeem all or a portion of the notes at a price equal to the greater of (i) the product of (x) the conversion amount being redeemed and (y) the quotient determined by dividing (A) the closing sale price of our Class A common stock on the business day on which the first public announcement of such proposed change of control is made by (B) the conversion price and (ii) 125% of the conversion amount being redeemed. We account for this derivative at fair value on the consolidated balance sheets within other long-term liabilities in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” We determine the fair value of the derivative instrument each period using a combination of the Black-Scholes model and the Monte-Carlo simulation model. Such models are complex and require significant judgments in the estimation of fair values in the absence of quoted market prices. Changes in the fair market value of the derivative liability are recognized in earnings.

 

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In applying the Black-Scholes and Monte-Carlo simulation models, changes and volatility in our common stock price, and changes in risk-free interest rates, our expected dividend yield and expected returns on our common stock could significantly affect the fair value of this derivative instrument, which could then result in significant charges or credits to interest expense in our consolidated statements of operations. During fiscal 2007, there was a $0.1 million increase in the fair value of this derivative, which we recognized as an increase to the carrying value of the derivative liability and a reduction of interest expense in the consolidated statements of operations.

 

Item  8. Financial Statements and Supplementary Data

Information with respect to this item is set forth under Item 15.

 

Item  9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

None.

 

Item  9A. Controls and Procedures

Disclosure Controls and Procedures

We conducted an evaluation, under the supervision and with the participation of our chief executive officer and chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on such evaluation, our chief executive officer and chief financial officer have concluded that, as of the end of such period, our disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by us in the reports that we file or submit under the Exchange Act and are effective in ensuring that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Control Over Financial Reporting

During the fiscal quarter ended February 2, 2008, no changes occurred with respect to our internal control over financial reporting that materially affected, or are reasonably likely to materially affect, internal control over financial reporting.

Management’s Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, our management conducted an evaluation of the effectiveness of our internal control over financial reporting as of February 2, 2008, based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our management’s evaluation under the framework in Internal Control—Integrated Framework, our management concluded that our internal control over financial reporting was effective as of February 2, 2008.

Our internal control over financial reporting as of February 2, 2008, has been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their report which is included herein.

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of

The Wet Seal, Inc.

We have audited the internal control over financial reporting of The Wet Seal, Inc. and subsidiaries (the “Company”) as of February 2, 2008, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of February 2, 2008, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended February 2, 2008, of the Company and our report dated April 10, 2008, expressed an unqualified opinion on those financial statements.

Costa Mesa, CA

April 10, 2008

 

Item  9B. Other Information

None.

 

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PART III

 

Item  10. Directors, Executive Officers and Corporate Governance of the Registrant

The following is a list, as of April 10, 2008, of the names and ages of the executive officers of The Wet Seal, Inc.

 

Name

  

Officers and Other Positions Held With Our Company

   Age

Edmond S. Thomas

   President and Chief Executive Officer    54

Steven H. Benrubi

   Executive Vice President, Chief Financial Officer and Corporate Secretary    41

Dyan Jozwick

   Chief Merchandise Officer, Wet Seal Division    50

Edmond S. Thomas. Mr. Edmond Thomas was appointed president and chief executive officer effective October 2007. Mr. Thomas previously served as President and Chief Operating Officer of our Company from 1992 through 2000. Immediately prior to joining us, Mr. Thomas served as president and co-chief executive officer of Tilly’s Inc., a privately owned company that sells action sports related apparel, footwear and accessories. Mr. Thomas had served in this position since 2005. Mr. Thomas is currently the managing partner of The Evans Thomas Company, LLC, which is the general partner of AXIS Capital Fund I, LP, which provides advisory services for retail, catalog, and consumer goods companies along with investment in emerging growth retail companies. Mr. Thomas serves on the Board of Directors of Directed Electronics Inc., a designer and marketer of electronic products, and Trans-World Entertainment Corporation, a specialty music video retailer.

Steven H. Benrubi. Mr. Steve Benrubi was appointed our executive vice president and chief financial officer in September 2007. Since June 2005, Mr. Benrubi had previously served as our vice president and corporate controller. Immediately prior to that, from August 2003, he served as vice president and corporate controller of CKE Restaurants, Inc., the parent company of several fast food restaurant chains including Carl’s Jr. and Hardee’s. Prior to his employment with CKE Restaurants, Inc., Mr. Benrubi served as treasurer of Champion Enterprises, Inc., a manufacturer and retailer of manufactured homes.

Dyan Jozwick. Ms. Dyan Jozwick has served as chief merchandise officer for the Wet Seal division since May 2, 2006. Prior to joining the Company, from 1975 to 1995 and from July 1998 to April 2006, Ms. Jozwick served in various capacities, most recently as the retail senior vice president and general merchandise manager at Robinsons-May Department Stores, a subsidiary of Federated Department Stores. From October 1995 to July 1998, Ms. Jozwick was the executive vice president of sales, merchandising and production for Carole Little, Inc.

Additional information with respect to this item is incorporated by reference from the Registrant’s definitive Proxy Statement to be filed with the Commission not later than 120 days after the end of the Registrant’s fiscal year covered by this Annual Report on Form 10-K.

 

Item  11. Executive Compensation

Information with respect to this item is incorporated by reference from the Registrant’s definitive Proxy Statement to be filed with the SEC not later than 120 days after the end of the Registrant’s fiscal year covered by this Annual Report on Form 10-K.

 

Item  12. Security Ownership and Certain Beneficial Owners and Management and Related Stockholder Matters

Information with respect to this item is incorporated by reference from the Registrant’s definitive Proxy Statement to be filed with the SEC not later than 120 days after the end of the Registrant’s fiscal year covered by this Annual Report on Form 10-K.

 

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Item  13. Certain Relationships and Related Transactions, and Director Independence

Information with respect to this item is incorporated by reference from the Registrant’s definitive Proxy Statement to be filed with the SEC not later than 120 days after the end of the Registrant’s fiscal year covered by this Annual Report on Form 10-K.

 

Item  14. Principal Accountant Fees and Services

Information with respect to this item is incorporated by reference from the Registrant’s definitive Proxy Statement to be filed with the SEC not later than 120 days after the end of the Registrant’s fiscal year covered by this Annual Report on Form 10-K.

 

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PART IV

 

Item  15. Exhibits and Financial Statement Schedules

 

(a) The following documents are filed as part of this report:

 

  1. Financial Statements: The financial statements listed in the “Index to Consolidated Financial Statements and Financial Statement Schedules” at F-1 are filed as part of this report.

 

  2. Financial Statement Schedules: All schedules are omitted as they are not required, or the required information is shown in the consolidated financial statements or notes thereto.

 

  3. Exhibits: See “Exhibit Index.”

 

(b) See (a) 3 above.

 

(c) See (a) 1 and 2 above.

 

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

THE WET SEAL, INC.

(Registrant)

By:   /s/    EDMOND S. THOMAS        
  Edmond S. Thomas
  President and
  Chief Executive Officer
By:   /s/    STEVEN H. BENRUBI        
  Steven H. Benrubi
  Executive Vice President and
  Chief Financial Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated and on the dates indicated.

 

Signatures

  

Title

 

Date Signed

/s/    EDMOND S. THOMAS        

Edmond S. Thomas

   President and Chief Executive Officer (Principal Executive Officer) and Member of the Board of Directors   April 10, 2008

/s/    STEVEN H. BENRUBI        

Steven H. Benrubi

   Executive Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)   April 10, 2008

/s/    ALAN SIEGEL        

Alan Siegel

   Chairman of the Board of Directors   April 10, 2008

/s/    JONATHAN DUSKIN        

Jonathan Duskin

   Director   April 10, 2008

/s/    SIDNEY M. HORN        

Sidney M. Horn

   Director   April 10, 2008

/s/    HAROLD D. KAHN        

Harold D. Kahn

   Director   April 10, 2008

/s/    KENNETH M. REISS        

Kenneth M. Reiss

   Director   April 10, 2008

/s/    HENRY D. WINTERSTERN        

Henry D. Winterstern

   Director   April 10, 2008

/s/    MICHAEL ZIMMERMAN        

Michael Zimmerman

   Director   April 10, 2008

 

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THE WET SEAL, INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

AND FINANCIAL STATEMENT SCHEDULES

 

     Page

Report of Independent Registered Public Accounting Firm

   F-2

FINANCIAL STATEMENTS:

  

Consolidated balance sheets as of February 2, 2008 and February 3, 2007

   F-3

Consolidated statements of operations for the fiscal years ended February 2, 2008, February 3, 2007, and January 28, 2006

   F-4

Consolidated statements of stockholders’ equity for the fiscal years ended February 2, 2008, February 3, 2007, and January 28, 2006

   F-5

Consolidated statements of cash flows for the fiscal years ended February 2, 2008, February 3, 2007, and January 28, 2006

   F-7

Notes to consolidated financial statements

   F-9

FINANCIAL STATEMENT SCHEDULES:

  

All schedules are omitted as they are not required, or the required information is shown in the consolidated financial statements or the notes thereto.

  

 

F-1


Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of

The Wet Seal, Inc.

We have audited the accompanying consolidated balance sheets of The Wet Seal, Inc. and subsidiaries (the “Company”) as of February 2, 2008 and February 3, 2007, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended February 2, 2008. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of The Wet Seal, Inc. and subsidiaries as of February 2, 2008 and February 3, 2007, and the results of their operations and their cash flows for each of the three years in the period ended February 2, 2008, in conformity with accounting principles generally accepted in the United States of America.

As discussed in Notes 1 and 2 to the consolidated financial statements, the Company changed its method of accounting for share-based compensation upon adoption of Financial Accounting Standards Board Statement No. 123(R), “Shared-Based Payment,” in 2006.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of February 2, 2008, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated April 10, 2008, expressed an unqualified opinion on the Company’s internal control over financial reporting.

/s/ DELOITTE & TOUCHE LLP

Costa Mesa, CA

April 10, 2008

 

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Table of Contents

THE WET SEAL, INC.

CONSOLIDATED BALANCE SHEETS

 

     February 2,
2008
    February 3,
2007
 
    

(In thousands, except

share data)

 

ASSETS

    

CURRENT ASSETS:

    

Cash and cash equivalents

   $ 100,618     $ 105,254  

Income taxes receivable

     167       56  

Other receivables

     5,715       3,604  

Merchandise inventories

     31,590       34,231  

Prepaid expenses and other current assets

     10,991       8,795  
                

Total current assets

     149,081       151,940  
                

EQUIPMENT AND LEASEHOLD IMPROVEMENTS:

    

Leasehold improvements

     100,018       84,758  

Furniture, fixtures and equipment

     65,393       55,698  
                
     165,411       140,456  

Less accumulated depreciation and amortization

     (92,530 )     (89,931 )
                

Net equipment and leasehold improvements

     72,881       50,525  
                

OTHER ASSETS:

    

Deferred financing costs, net of accumulated amortization of $5,302 and $5,159 at February 2, 2008, and February 3, 2007, respectively

     412       555  

Other assets

     1,702       1,651  

Goodwill

     —         3,496  
                

Total other assets

     2,114       5,702  
                

TOTAL ASSETS

   $ 224,076     $ 208,167  
                

LIABILITIES AND STOCKHOLDERS’ EQUITY

    

CURRENT LIABILITIES:

    

Accounts payable—merchandise

   $ 9,474     $ 11,143  

Accounts payable—other

     10,197       10,078  

Income taxes payable

     —         128  

Accrued liabilities

     34,445       37,256  

Current portion of deferred rent

     4,729       3,381  
                

Total current liabilities

     58,845       61,986  
                

LONG-TERM LIABILITIES:

    

Secured convertible notes, including accrued interest of $962 and $634 at February 2, 2008 and February 3, 2007, respectively, and net of unamortized discount of $5,458 and $5,974 at February 2, 2008 and February 3, 2007, respectively

     3,583       2,739  

Deferred rent

     29,686       22,501  

Other long-term liabilities

     1,956       1,977  
                

Total long-term liabilities

     35,225       27,217  
                

Total liabilities

     94,070       89,203  
                

COMMITMENTS AND CONTINGENCIES (Note 8)

    

CONVERTIBLE PREFERRED STOCK, $0.01 par value, authorized 2,000,000 shares; 2,167 and 2,167 shares issued and outstanding at February 2, 2008 and February 3, 2007, respectively

     2,167       2,167  
                

STOCKHOLDERS’ EQUITY:

    

Common stock, Class A, $0.10 par value, authorized 300,000,000 shares; 98,377,559 shares issued and 92,006,359 shares outstanding at February 2, 2008 and 96,218,013 shares issued and 95,818,013 outstanding at February 3, 2007

     9,838       9,622  

Common stock, Class B convertible, $0.10 par value, authorized 10,000,000 shares; no shares issued and outstanding at February 2, 2008, and February 3, 2007, respectively

     —         —    

Paid-in capital

     287,848       280,163  

Accumulated deficit

     (147,982 )     (171,214 )

Treasury stock, 6,371,200 shares and 400,000 shares, at cost, at February 2, 2008 and February 3, 2007, respectively (Note 9)

     (22,461 )     (2,400 )

Accumulated other comprehensive income

     596       626  
                

Total stockholders’ equity

     127,839       116,797  
                

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

   $ 224,076     $ 208,167  
                

See accompanying notes to consolidated financial statements.

 

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THE WET SEAL, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

 

     Fiscal Years Ended  
     February 2,
2008
    February 3,
2007
    January 28,
2006
 
     (In thousands, except share data)  

Net sales

   $ 611,163     $ 564,324     $ 500,807  

Cost of sales

     408,892       370,888       339,483  
                        

Gross margin

     202,271       193,436       161,324  

Selling, general and administrative expenses

     177,468       178,703       171,988  

Store closure (adjustments) costs

     —         (730 )     4,517  

Asset impairment

     5,546       425       989  
                        

Operating income (loss)

     19,257       15,038       (16,170 )
                        

Interest income

     5,489       4,387       2,288  

Interest expense

     (1,136 )     (31,955 )     (15,150 )
                        

Interest income (expense), net

     4,353       (27,568 )     (12,862 )
                        

Income (loss) before provision for income taxes

     23,610       (12,530 )     (29,032 )

Provision for income taxes

     378       308       330  
                        

Net income (loss)

     23,232       (12,838 )     (29,362 )

Accretion of non-cash dividends on convertible preferred stock

     —         —         (23,317 )
                        

Net income (loss) attributable to common stockholders

   $ 23,232     $ (12,838 )   $ (52,679 )
                        

Net income (loss) attributable to common stockholders per share, basic

   $ 0.24     $ (0.18 )   $ (1.19 )
                        

Net income (loss) attributable to common stockholders per share, diluted

   $ 0.23     $ (0.18 )   $ (1.19 )
                        

Weighted-average shares outstanding, basic

     91,154,133       72,577,398       44,340,894  
                        

Weighted-average shares outstanding, diluted

     100,938,542       72,577,398       44,340,894  
                        

 

 

See accompanying notes to consolidated financial statements.

 

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THE WET SEAL, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

 

    Common Stock     Paid-In
Capital
    Deferred
Stock
Compensation
    Accumulated
Deficit
    Treasury
Stock
  Comprehensive
Income
  Accumulated
Other
Comprehensive
Income
  Total
Stockholders’
Equity
 
    Class A Class B                
    Shares   Par
Value
  Shares     Par
Value
               
    (In thousands, except share data)  

Balance at January 29, 2005

  38,188,233   $ 3,819   423,599     $ 42     $ 144,231     $ (5,342 )   $ (105,697 )   $ —     $ —     $ —     $ 37,053  

Net loss

  —       —     —         —         —         —         (29,362 )     —       —       —       (29,362 )

Stock issued pursuant to long-term incentive plans

  8,481,893     848   —         —         (848 )     —         —         —       —       —       —    

Deferred stock compensation—non-employee performance shares

  —       —     —         —         550       (550 )     —         —       —       —       —    

Deferred stock compensation pursuant to long-term incentive plans

  —       —     —         —         2,079       (2,079 )     —         —       —       —       —    

Cancellation of deferred stock compensation due to employee terminations

  —       —     —         —         (595 )     595       —         —       —       —       —    

Amortization of deferred stock compensation

  —       —     —         —         —         2,419       —         —       —       —       2,419  

Deferred stock compensation—stock payment in lieu of rent

  365,000     37   —         —         1,029       (1,066 )     —         —       —       —       —    

Amortization of deferred stock compensation—stock payment in lieu of rent

  —       —     —         —         —         200       —         —       —       —       200  

Exercise of stock options

  501,000     50   —         —         881       —         —         —       —       —       931  

Exercise of common stock warrants

  3,753,284     376   —         —         7,006       —         —         —       —       —       7,382  

Shares converted from Class B to Class A

  423,599     42   (423,599 )     (42 )     —         —         —         —       —       —       —    

Beneficial conversion feature of convertible preferred stock

  —       —     —         —         14,692       —         —         —       —       —       14,692  

Issuance of common stock warrants

  —       —     —         —         8,509       —         —         —       —       —       8,509  

Conversions of convertible preferred stock into common stock

  4,980,000     498   —         —         14,442       —         —         —       —       —       14,940  

Transaction costs for convertible preferred stock and other equity securities

  —       —     —         —         (1,574 )     —         —         —       —       —       (1,574 )

Conversions of convertible notes into common stock

  6,943,634     694   —         —         9,721       —         —         —       —       —       10,415  

Stock-based compensation—non-employee performance shares

  —       —     —         —         21,877       305       —         —       —       —       22,182  

Accretion of non-cash dividends on convertible preferred stock

  —       —     —         —         —         —         (23,317 )     —       —       —       (23,317 )
                                                                         

 

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Table of Contents

THE WET SEAL, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (Continued)

 

    Common Stock   Paid-In
Capital
    Deferred
Stock
Compensation
    Accumulated
Deficit
    Treasury
Stock
    Comprehensive
Income
    Accumulated
Other
Comprehensive
Income
    Total
Stockholders’
Equity
 
    Class A Class B              
    Shares     Par Value
Shares
  Par
Value
             
    (In thousands, except share data)  

Balance at January 28, 2006

  63,636,643       6,364     —       —       222,000       (5,518 )     (158,376 )     —         —         —         64,470  

Net loss

  —         —       —       —       —         —         (12,838 )     —         —         —         (12,838 )

Reclassification of deferred stock compensation to paid-in capital upon adoption of SFAS No. 123(R)

  —         —       —       —       (5,518 )     5,518       —         —         —         —         —    

Stock issued pursuant to long-term incentive plans

  374,956       37     —       —       (37 )     —         —         —         —         —         —    

Stock-based compensation—directors and employees

  —         —       —       —       5,219       —         —         —         —         —         5,219  

Stock-based compensation—non-employee performance shares

  —         —       —       —       9,797       —         —         —         —         —         9,797  

Amortization of stock payment in lieu of rent

  —         —       —       —       216       —         —         —         —         —         216  

Exercise of stock options

  18,333       2     —       —       98       —         —         —         —         —         100  

Exercise of common stock warrants

  7,204,866       721     —       —       18,550       —         —         —         —         —         19,271  

Conversions of convertible preferred stock into common stock

  2,497,667       250     —       —       7,243       —         —         —         —         —         7,493  

Conversions of secured convertible notes into common stock

  25,003,783       2,500     —       —       35,005       —         —         —         —         —         37,505  

Adjustment to initially apply SFAS No. 158, net of tax

  —         —       —       —       —         —         —         —         —         626       626  

Repurchase of common stock

  —         —       —       —       —         —         —         (15,062 )     —         —         (15,062 )

Retirement of treasury stock

  (2,518,235 )     (252 )   —       —       (12,410 )     —         —         12,662       —         —      
                                                                               

Balance at February 3, 2007

  96,218,013       9,622     —       —       280,163       —         (171,214 )     (2,400 )     —         626       116,797  

Net income

  —         —       —       —       —         —         23,232       —         23,232       —         23,232  

Stock issued pursuant to long-term incentive plans

  1,201,460       120     —       —       (120 )     —         —         —         —         —         —    

Stock-based compensation—directors and employees

  —         —       —       —       5,207       —         —         —         —         —         5,207  

Amortization of stock payment in lieu of rent

  —         —       —       —       216       —         —         —         —         —         216  

Exercise of stock options

  48,334       5     —       —       172       —         —         —         —         —         177  

Exercise of common stock warrants

  909,752       91     —       —       2,210       —         —         —         —         —         2,301  

Amortization of actuarial gain under Supplemental Employee Retirement Plan

  —         —       —       —       —         —         —         —         (26 )     (26 )     (26 )

Actuarial net loss under Supplemental Employee Retirement Plan

  —         —       —       —       —         —         —         —         (4 )     (4 )     (4 )
                           

Comprehensive income

                  $ 23,202      
                           

Repurchase of common stock

  —         —       —       —       —         —         —         (20,061 )         (20,061 )
                                                                         

Balance at February 2, 2008

  98,377,559     $ 9,838     —     $ —     $ 287,848     $ —       $ (147,982 )   $ (22,461 )     $ 596     $ 127,839  
                                                                         

See accompanying notes to consolidated financial statements.

 

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THE WET SEAL, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

     Fiscal Years Ended  
     February 2,
2008
    February 3,
2007
    January 28,
2006
 
     (in thousands)  

CASH FLOWS FROM OPERATING ACTIVITIES:

      

Net income (loss)

   $ 23,232     $ (12,838 )   $ (29,362 )

Adjustments to reconcile net income (loss) to net cash provided by operating activities:

      

Depreciation and amortization

     13,673       12,388       11,810  

Amortization of discount on secured convertible notes

     516       29,588       9,214  

Amortization of deferred financing costs

     143       3,505       1,901  

Amortization of stock payment in lieu of rent

     216       216       200  

Adjustment of derivatives to fair value

     70       (370 )     (216 )

Interest added to (extinguished from) principal of bridge loan payable and secured convertible notes

     328       (1,167 )     2,999  

Store closure costs

     —         —         262  

Asset impairment

     5,546       425       989  

Loss on disposal of equipment and leasehold improvements

     558       186       500  

Stock-based compensation

     5,207       15,016       24,601  

Changes in operating assets and liabilities:

      

Income taxes receivable

     (111 )     80       411  

Other receivables

     (2,111 )     (1,223 )     295  

Merchandise inventories

     2,641       (8,756 )     (7,103 )

Prepaid expenses and other current assets

     (2,196 )     (5,635 )     (189 )

Other non-current assets

     (51 )     (18 )     (38 )

Accounts payable and accrued liabilities

     (4,475 )     (4,271 )     (615 )

Income taxes payable

     (128 )     128       —    

Deferred rent

     8,533       1,835       (4,597 )

Other long-term liabilities

     (121 )     (255 )     (45 )
                        

Net cash provided by operating activities

     51,470       28,834       11,017  
                        

CASH FLOWS FROM INVESTING ACTIVITIES:

      

Purchase of equipment and leasehold improvements

     (38,523 )     (16,965 )     (5,418 )

Proceeds from disposal of equipment and leasehold improvements

     —         302       117  

Investments in marketable securities

     (72,659 )     —         —    

Proceeds from sales of marketable securities

     72,659       —         —    
                        

Net cash used in investing activities

     (38,523 )     (16,663 )     (5,301 )
                        

 

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Table of Contents

THE WET SEAL, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

 

    Fiscal Years Ended  
    February 2,
2008
    February 3,
2007
    January 28,
2006
 
    (in thousands)  

CASH FLOWS FROM FINANCING ACTIVITIES:

     

Repurchase of common stock

    (20,061 )     (15,062 )     —    

Proceeds from exercise of stock options

    177       100       931  

Proceeds from exercise of common stock warrants

    2,301       19,271       7,382  

Repayment of term loan

    —         (8,000 )     —    

Payment of deferred financing costs

    —         (32 )     (89 )

Proceeds from issuance of convertible preferred stock and common stock warrants

    —         —         24,600  

Payment of convertible preferred stock and other equity securities transaction costs

    —         —         (1,574 )

Repayment of bridge loan

    —         —         (11,862 )
                       

Net cash (used in) provided by financing activities

    (17,583 )     (3,723 )     19,388  
                       

NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS

    (4,636 )     8,448       25,104  

CASH AND CASH EQUIVALENTS, beginning of year

    105,254       96,806       71,702  
                       

CASH AND CASH EQUIVALENTS, end of year

  $ 100,618     $ 105,254     $ 96,806  
                       

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:

     

Cash paid during the year for:

     

Interest

  $ 66     $ 469     $ 3,177  

Income taxes

  $ 586     $ 180       —    

SUPPLEMENTAL DISCLOSURES OF NON-CASH TRANSACTIONS:

     

Allocation of a portion of proceeds from issuance of convertible preferred stock to beneficial conversion feature

  $ —       $ —       $ 14,692  

Allocation of a portion of proceeds from issuance of convertible preferred stock to Registration Rights Agreement

  $ —       $ —       $ 116  

Conversion of 7,493 and 14,940 shares of convertible preferred stock into 2,497,667 and 4,980,000 shares of Class A common stock, respectively

  $ —       $ 7,493     $ 14,940  

Conversion of secured convertible notes into 25,003,783 and 6,943,634 shares of Class A common stock, respectively

  $ —       $ 37,506     $ 10,415  

Issuance of common stock warrants

  $ —       $ —       $ 8,509  

Conversions of Class B common stock to Class A common stock

  $ —       $ —       $ 42  

Restricted stock grants pursuant to long-term incentive plans

  $ —       $ —       $ 2,021  

Cancellation of restricted stock grants due to employee terminations

  $ —       $ —       $ 557  

Issuance of restricted stock to non-employee

  $ —       $ —       $ 550  

common stock issued in lieu of rent

  $ —       $ —       $ 1,066  

Accretion of non-cash dividends on convertible preferred stock

  $ —       $ —       $ 23,317  

Reclassification of deferred stock compensation to paid-in capital upon adoption of Statement of Financial Accounting Standards No. 123(R)

  $ —       $ 5,518     $ —    

Retirement of treasury stock

  $ —       $ 12,662     $ —    

Adjustment to initially apply SFAS No. 158, net of tax

  $ —       $ 626     $ —    

Amortization of actuarial gain under Supplemental Employee Retirement Plan

  $ 26     $ —       $ —    

Actuarial net loss under Supplemental Employee Retirement Plan

  $ 4     $ —       $ —    

Purchase of equipment and leasehold improvements unpaid at end of period

  $ 3,283     $ 3,169     $ 299  

See accompanying notes to consolidated financial statements.

 

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Table of Contents

THE WET SEAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

For the fiscal years ended February 2, 2008, February 3, 2007, and January 28, 2006

NOTE 1:    Summary of Significant Accounting Policies

Nature of the Business

The Wet Seal, Inc. (the “Company”) is a national specialty retailer operating stores selling fashionable and contemporary apparel and accessory items designed for female customers aged 13 to 35. The Company operates two nationwide, primarily mall-based, chains of retail stores under the names “Wet Seal” and “Arden B”. The Company’s success is largely dependent upon its ability to gauge the fashion tastes of its customers and to provide merchandise that satisfies customer demand.

The Company’s fiscal year ends on the Saturday closest to the end of January. The reporting periods include 52 weeks of operations in fiscal 2007, 53 weeks of operations in fiscal 2006 and 52 weeks of operations in fiscal 2005.

Principles of Consolidation

The consolidated financial statements include the accounts of The Wet Seal, Inc. and its subsidiaries, which are all wholly owned subsidiaries. All inter-company balances and transactions have been eliminated in consolidation.

Basis of Presentation

The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP).

Estimates and Assumptions

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Actual results could differ from those estimates.

The Company’s most significant areas of estimation and assumption are:

 

   

determination of the appropriate amount and timing of markdowns to clear unproductive or slow-moving inventory;

 

   

estimation of future cash flows used to assess the recoverability of long-lived assets, including goodwill;

 

   

estimation of ultimate redemptions of awards under the Company’s Arden B division customer loyalty program;

 

   

determination of the revenue recognition pattern for cash received under the Company’s Wet Seal frequent buyer program;

 

   

estimation of expected customer merchandise returns;

 

   

estimation of expected gift card, gift certificate and store credit breakage;

 

   

determination of the appropriate assumptions to use to estimate the fair value of stock-based compensation for purposes of recording stock-based compensation and disclosing pro forma net loss;

 

   

estimation of its net deferred income tax asset valuation allowance; and

 

   

estimation, using actuarially determined methods, of its self-insured claim losses under its workers’ compensation and employee health care plans.

 

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Table of Contents

THE WET SEAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

For the fiscal years ended February 2, 2008, February 3, 2007, and January 28, 2006

NOTE 1:    Summary of Significant Accounting Policies (Continued)

 

Cash and Cash Equivalents

The Company considers all highly liquid debt instruments purchased with an initial maturity of three months or less to be cash equivalents. Cash equivalents are carried at cost, which approximates their fair market value. As of February 2, 2008 cash equivalents principally consist of investments in money market funds. The Company is potentially exposed to concentration of credit risk when cash deposits in banks are in excess of federally insured limits.

Merchandise Inventories

Merchandise inventories are stated at the lower of cost or market. Market is determined based on the estimated net realizable value, which generally is the merchandise selling price. Cost is calculated using the retail inventory method. Under the retail inventory method, inventory is stated at its current retail selling value and then is converted to a cost basis by applying a cost-to-retail ratio based on beginning inventory and the fiscal year purchase activity. The retail inventory method inherently requires management judgments and estimates, such as the amount and timing of permanent markdowns to clear unproductive or slow-moving inventory, which may impact the ending inventory valuation as well as gross margins.

Markdowns are recorded when the sales value of the inventory has diminished. Factors considered in the determination of permanent markdowns include current and anticipated demand, customer preferences, age of the merchandise and fashion trends. When a decision is made to permanently markdown merchandise, the resulting gross margin reduction is recognized in the period the markdown is recorded. Total markdowns on a cost basis in fiscal 2007, 2006 and 2005 were $84.5 million, $72.2 million, and $60.6 million, respectively, and represented 13.8%, 12.8%, and 12.1% of net sales, respectively.

The Company accrued for planned but unexecuted markdowns as of February 2, 2008, and February 3, 2007, of $3.5 million and $4.7 million, respectively. To the extent the Company’s estimates differ from actual results, additional markdowns may be required that could reduce the Company’s gross margin, operating income and the carrying value of inventories.

Equipment and Leasehold Improvements

Equipment and leasehold improvements are stated at cost. Expenditures for betterment or improvement are capitalized, while expenditures for repairs and maintenance that do not significantly increase the life of the asset are expensed as incurred.

Depreciation and amortization is provided using the straight-line method over the estimated useful lives of the assets. Furniture, fixtures and equipment are typically depreciated over three to five years. Leasehold improvements and the cost of acquiring leasehold rights are amortized over the lesser of the term of the lease or 10 years.

Long-Lived Assets

The Company evaluates the carrying value of long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment of Long-Lived Assets.” Factors that are considered important that could trigger an impairment review include a current-period

 

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Table of Contents

THE WET SEAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

For the fiscal years ended February 2, 2008, February 3, 2007, and January 28, 2006

NOTE 1:    Summary of Significant Accounting Policies (Continued)

 

operating or cash flow loss combined with a history of operating or cash flow losses and a projection or forecast that demonstrates continuing losses or insufficient income associated with the use of a long-lived asset or asset group. Other factors include a significant change in the manner of the use of the asset or a significant negative industry or economic trend. This evaluation is performed based on estimated undiscounted future cash flows from operating activities compared with the carrying value of the related assets. If the undiscounted future cash flows are less than the carrying value, an impairment loss is recognized, measured by the difference between the carrying value and the estimated fair value of the assets, with such estimated fair values determined using the best information available, generally the discounted future cash flows of the assets using a rate that approximates the Company’s weighted-average cost of capital.

No less frequently than quarterly, the Company assesses whether events or changes in circumstances have occurred that potentially indicate the carrying value of long-lived assets may not be recoverable. The Company’s evaluations during fiscal 2007 and 2006 indicated that operating losses or insufficient operating income existed at certain retail stores with a projection that the operating losses or insufficient operating income for these locations would continue. As such, the Company recorded non-cash charges of $2.0 million, $0.4 million and $1.0 million during fiscal 2007, 2006 and 2005, respectively, within asset impairment in the consolidated statements of operations to write down the carrying value of these stores’ long-lived assets to their estimated fair values.

Goodwill

Goodwill and intangible assets that have indefinite useful lives are tested for impairment no less frequently than annually and are also tested for impairment between annual tests when circumstances or events have occurred that may indicate a potential impairment has occurred. The performance of the impairment test requires a two-step process. The first step involves comparing the reporting unit’s estimated fair value with its carrying value. If the estimated fair value exceeds the carrying value, the assets are not considered to be impaired and no additional steps are necessary. If the carrying value exceeds the estimated fair value, the Company performs the second step of the impairment test to determine the amount of impairment loss. The second step involves comparing the carrying amount of the reporting unit’s goodwill with its implied fair value. If the carrying amount of the goodwill exceeds the respective reporting unit’s implied fair value, an impairment loss would be recognized in an amount equal to the excess. Accordingly, management conducted annual impairment evaluations in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” as of the end of fiscal 2007, 2006 and 2005. Based on its fiscal 2007 analysis, due to the deteriorating operating performance of the Arden B division and the Company’s resulting outlook for that business, the Company determined its $3.5 million in goodwill, which was all associated with its Arden B division, had been impaired. As such, the Company wrote down the carrying value of goodwill as of February 2, 2008, by $3.5 million, which was recorded within asset impairment in the consolidated statements of operations. As a result, no goodwill remains on the Company’s consolidated balance sheet as of February 2, 2008. No impairment losses were recorded in fiscal 2006 or 2005.

Deferred Financing Costs

Costs incurred to obtain long-term financing are amortized over the terms of the respective debt agreements using the interest method. In addition, deferred financing costs associated with the Company’s secured convertible notes are expensed immediately, upon the conversion of portions of such notes into Class A common stock. Amortization expense included in interest expense and amortization of deferred financing costs was $0.1 million, $3.5 million and $1.9 million in fiscal 2007, 2006 and 2005, respectively.

 

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Table of Contents

THE WET SEAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

For the fiscal years ended February 2, 2008, February 3, 2007, and January 28, 2006

NOTE 1:    Summary of Significant Accounting Policies (Continued)

 

Discount on Secured Convertible Notes

As discussed further in Note 6, upon issuance of its secured convertible notes, the Company recorded such notes net of a discount of $45.0 million. The Company is amortizing this discount over the seven-year term of the secured convertible notes using the interest method. In addition, the unamortized portion of the discount on secured convertible notes is expensed immediately upon conversions of portions of such notes into Class A common stock. Amortization of this discount included in interest expense and amortization of discount on secured convertible notes was $0.5 million, $29.6 million and $9.2 million in fiscal 2007, 2006 and 2005, respectively.

Revenue Recognition

Sales are recognized upon purchases by customers at the Company’s retail store locations. Taxes collected from the Company’s customers are and have been recorded on a net basis. For online sales, revenue is recognized at the estimated time goods are received by customers. Based upon an analysis completed by the Company during the first fiscal quarter of 2007, customers typically receive goods within four days of being shipped versus a previously estimated five to seven days. This change in estimate did not have a significant effect on the amount of revenue recognized for online sales during fiscal 2007. Shipping and handling fees billed to customers for online sales are included in net sales. The Company has recorded accruals to estimate sales returns by customers based on historical sales return results. A customer generally may return merchandise within 30 days of the original purchase date. Actual return rates have historically been within management’s estimates and the accruals established. As the accrual for merchandise returns is based on estimates, the actual returns could differ from the accrual, which could impact net sales. The accrual for merchandise returns is recorded in accrued liabilities on the consolidated balance sheets and was $0.7 million and $0.8 million at February 2, 2008 and February 3, 2007, respectively. For fiscal 2007, 2006 and 2005, shipping and handling fee revenues were $1.9 million, $1.5 million, and $0.7 million, respectively.

The Company recognizes the sales from gift cards, gift certificates and store credits as they are redeemed for merchandise. Prior to redemption, the Company maintains an unearned revenue liability for gift cards, gift certificates and store credits until the Company is released from such liability, which includes consideration of potential obligations arising from state escheatment laws. The Company’s gift cards, gift certificates and store credits do not have expiration dates; however, over time, a percentage of gift cards, gift certificates and store credits are not redeemed or recovered (“breakage”). Historically, due to the lack of sufficient historical redemption trend data, the Company had not recognized breakage on gift cards, gift certificates and store credits. In the fourth quarter of fiscal 2007, the Company analyzed company-specific historical redemption patterns and determined that the likelihood of redemption of unredeemed gift cards, gift certificates and store credits three years after their issuance is remote. Beginning in the fourth quarter of fiscal 2007, the Company adjusted its unearned revenue liability to recognize estimated unredeemed amounts and recorded breakage as additional sales for gift cards, gift certificates and store credits that remained unredeemed three years after their issuance. The Company’s net sales in the fourth quarter of fiscal 2007 included a benefit for an adjustment of $3.7 million to reduce its unearned revenue liability for estimated unredeemed amounts. The unearned revenue for gift cards, gift certificates and store credits is recorded in accrued liabilities on the consolidated balance sheets and was $6.3 million and $8.9 million at February 2, 2008 and February 3, 2007, respectively. If actual redemptions ultimately differ from the assumptions underlying the Company’s breakage adjustments, or the Company’s future experience indicates the likelihood of redemption of gift cards, gift certificates and store credits becomes remote at a different point in time after issuance, the Company may recognize further significant adjustments to its accruals for such unearned revenue, which could have a significant effect on the Company’s net sales and results of operations.

 

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Table of Contents

THE WET SEAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

For the fiscal years ended February 2, 2008, February 3, 2007, and January 28, 2006

NOTE 1:    Summary of Significant Accounting Policies (Continued)

 

The Company maintains a frequent buyer program through its Wet Seal division. Under the program, customers receive a 10% to 20% discount on all purchases made during a twelve-month period and are provided $5-off coupons that may be used on purchases during such period. The annual membership fee of $20 is non-refundable.

The Company historically recognized membership fee revenue under the frequent buyer program on a straight-line basis over the twelve-month membership period due to a lack of sufficient program history to determine customer usage patterns. During November 2007, the Company changed from in-store delivery to e-mail delivery of the program’s $5-off coupons, which eliminated the customer’s ability to use such coupons at the time of initial purchases. The Company believes this change will affect customer usage patterns. The Company also continues to test alternative program structures and may decide to further modify the program in ways that could also affect customer usage patterns. As a result of the recent program change and potential further modifications, the Company believes it is appropriate to maintain straight-line recognition of membership fee revenue. The Company may, in the future, determine that recognition of membership fee revenue on a different basis is appropriate, which would affect net sales.

Discounts received by customers on purchases using the frequent buyer program are recognized at the time of such purchases. The unearned revenue for this program is recorded in accrued liabilities on the consolidated balance sheets and was $9.6 million and $10.1 million at February 2, 2008 and February 3, 2007, respectively.

The Company maintains a customer loyalty program through its Arden B division. Under the program, customers accumulate points based on purchase activity. Once a loyalty program member achieves a certain point level, the member earns awards that may be redeemed for merchandise. Merchandise redemptions are accrued as unearned revenue and recorded as a reduction of net sales as points are accumulated by the member.

During fiscal 2006, the Company modified the terms of the Arden B loyalty program with respect to the number of points required to earn an award and the value of awards when earned. At the time of the program change, the Company also established expiration terms (i) for prospectively earned awards of two months from the date the award is earned and (ii) for pre-existing awards of either two or twelve months from the program change date. This resulted in a reduction to the Company’s estimate of ultimate award redemptions under the program. Additionally, during fiscal 2006, the Company further reduced its estimate of ultimate redemptions based upon lower than anticipated redemption levels under the program’s revised terms. As a result, in fiscal 2006, the Company recorded a benefit of $3.7 million, which was recorded as an increase to net sales and a decrease to accrued liabilities.

During fiscal 2007, the Company further modified the terms of the Arden B loyalty program whereby, quarterly, the Company converts into fractional awards the points accumulated by customers who have not made purchases within the preceding 18 months. Similar to all other awards currently being granted under the program, such fractional awards expire if unredeemed after 60 days.

The unearned revenue for this program is recorded in accrued liabilities on the consolidated balance sheets and was $2.0 million and $1.9 million at February 2, 2008 and February 3, 2007, respectively. If actual redemptions ultimately differ from accrued redemption levels, or if the Company further modifies the terms of the program in a way that affects expected redemption value and levels, the Company could record adjustments to the unearned revenue accrual, which would affect net sales.

 

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Table of Contents

THE WET SEAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

For the fiscal years ended February 2, 2008, February 3, 2007, and January 28, 2006

NOTE 1:    Summary of Significant Accounting Policies (Continued)

 

Cost of Sales

Cost of sales includes the cost of merchandise, markdowns, inventory shortages, inbound freight, payroll expenses associated with design, buying, planning and allocation, inspection cost, processing, receiving and other warehouse costs, rent and depreciation and amortization expense associated with the Company’s stores and distribution center.

Leases

The Company recognizes rent expense for operating leases on a straight-line basis (including the effect of reduced or free rent and rent escalations) over the lease term, as defined by SFAS No. 13, “Accounting for Leases,” as amended. The difference between the cash paid to the landlord and the amount recognized as rent expense on a straight-line basis is included in deferred rent on the consolidated balance sheets. Cash reimbursements received from landlords for leasehold improvements and other cash payments received from landlords as lease incentives are also recorded as deferred rent and are amortized using the straight-line method over the lease term as an offset to rent expense.

Store Pre-Opening Costs

Store opening and pre-opening costs are charged to expense as they are incurred.

Advertising Costs

Costs for advertising related to operations, consisting of magazine advertisements, in-store signage, promotions and internet marketing are expensed as incurred. Total advertising expenses were $6.7 million, $6.3 million, and $4.1 million in fiscal 2007, 2006, and 2005, respectively.

Vendor Discounts

The Company receives certain discounts from its vendors in accordance with agreed-upon payment terms. These discounts are reflected as a reduction of merchandise inventories in the period they are received and charged to cost of sales when the items are sold.

Income Taxes

The Company accounts for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes,” which requires that the Company recognize deferred tax assets, which include net operating loss carryforwards and tax credits, and liabilities based on the differences between the financial statement carrying amounts and the tax bases of assets and liabilities, using enacted tax rates in effect in the years the differences are expected to reverse. Deferred income tax benefit (expense) results from the change in net deferred tax assets or deferred tax liabilities. SFAS No. 109 requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the net deferred tax assets will not be realized. Due to the Company’s historical operating losses, the Company provides a valuation allowance for 100% of its deferred tax assets. In addition, the Company discontinued recording income tax benefits in the consolidated statements of operations. The Company will not record such income tax benefits until it is determined that it is more likely than not that the Company will generate sufficient taxable income to realize the deferred income tax assets.

 

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Table of Contents

THE WET SEAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

For the fiscal years ended February 2, 2008, February 3, 2007, and January 28, 2006

NOTE 1:    Summary of Significant Accounting Policies (Continued)

 

The provision for tax liabilities and recognition of tax benefits involves evaluations and judgments of uncertainties in the interpretation of complex tax regulations by various taxing authorities. In situations involving uncertain tax positions related to income tax matters, the Company does not recognize benefits unless it is more likely than not that they will be sustained (see Note 3). As additional information becomes available, or these uncertainties are resolved with the taxing authorities, revisions to these liabilities or benefits may be required, resulting in additional provision for or benefit from income taxes reflected in the Company’s consolidated statements of operations.

As discussed further in Note 3, the Company is subject to certain limitations on its ability to utilize its federal and state net operating loss carryforwards.

Comprehensive Income (Loss)

In accordance with SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans—an amendment of FASB Statements No. 87, 88, 106 and 132(R),” employers are required to recognize the over or under funded status of defined benefit plans and other postretirement plans in the statement of financial position and to recognize changes in the funded status in the year in which the changes occur through comprehensive income. The Company was required to adopt the provisions of SFAS No. 158 as of the end of fiscal 2006, resulting in the recognition of other comprehensive income on the consolidated balance sheet for the difference between the previous carrying value of the accrued liability under the Company’s supplemental employee retirement plan and the carrying value required per SFAS No. 158 (see Note 13). For fiscal 2006 and 2005 there was no difference between the Company’s net loss and comprehensive loss.

Insurance/Self-Insurance

The Company uses a combination of insurance and self-insurance for its workers’ compensation and employee health care programs. A portion of the employee health care plan is funded by employees. Under the workers’ compensation insurance program, the Company is liable for a deductible of $0.25 million for each individual claim and an aggregate annual liability of $1.6 million. Under the group health plan, the Company is liable for a deductible of $0.15 million for each individual claim and an aggregate monthly liability of $0.5 million. The monthly aggregate liability is subject to adjustment based on the number of participants in the plan each month. For both of the insurance plans, the Company records a liability for the costs associated with reported claims and a projected estimate for unreported claims considering historical experience and industry standards. The Company adjusts these liabilities based on historical claims experience, demographic factors, severity factors and other actuarial assumptions. A significant change in the number or dollar amount of claims could cause the Company to revise its estimates of potential losses, which would affect its reported results. During fiscal 2007, the Company incurred $1.3 million of unusual claim activity in the Company’s employee health care plan. The following summarizes the activity within the Company’s accrued liability for the self-insured portion of unpaid claims and estimated unreported claims:

 

     February 2,
2008
    February 3,
2007
    January 28,
2006
 
     (in thousands)  

Balance at beginning of period

   $ 1,681     $ 1,715     $ 2,026  

Accruals

     6,898       5,374       3,687  

Payment of claims

     (6,814 )     (5,408 )     (3,998 )
                        

Balance at end of period

   $ 1,765     $ 1,681     $ 1,715  
                        

 

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Table of Contents

THE WET SEAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

For the fiscal years ended February 2, 2008, February 3, 2007, and January 28, 2006

NOTE 1:    Summary of Significant Accounting Policies (Continued)

 

Stock-Based Compensation

Prior to January 28, 2006, the Company accounted for its share-based compensation under the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), the disclosure-only provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” related to options issued to employees, and SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure—an amendment of FASB Statement No. 123.” Under APB 25, the Company recognized stock-based compensation associated with stock options and awards under the intrinsic value method, whereby stock-based compensation was determined as the difference, if any, between the current fair value of the related common stock on the measurement date and the price an employee had to pay to exercise the award. Accordingly, stock-based compensation expense had been recognized for restricted stock grants as well as for stock options that were granted at prices that were below the fair market value of the related stock at the measurement date.

Effective January 29, 2006, the Company adopted SFAS No. 123(R), “Share-Based Payment,” in accordance with the modified-prospective-transition method and therefore has not restated prior period results. Under this transition method, the Company began recognizing compensation expense using the fair-value method as determined using SFAS No. 123 for stock options granted during fiscal 2005 or in prior years and that were not yet fully vested as of January 29, 2006 and the fair-value method, as determined using SFAS No. 123(R), for stock options granted or modified subsequent to January 29, 2006.

Derivative Financial Instruments

The Company accounts for derivative financial instruments in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended by SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 133 requires that all derivative financial instruments be recorded on the consolidated balance sheets at fair value.

As of February 2, 2008, the Company’s only derivative financial instrument was an embedded derivative associated with the Company’s secured convertible notes (see Note 6). The gain or loss as a result of the change in fair value of the embedded derivative associated with the Company’s secured convertible notes is recognized in interest expense in the consolidated statements of operations each period.

The Company applies the Black-Scholes and Monte-Carlo simulation models to value this embedded derivative. In applying the Black-Scholes and Monte-Carlo simulation models, changes and volatility in the Company’s common stock price, and changes in risk-free interest rates, the Company’s expected dividend yield and expected returns on its common stock could significantly affect the fair value of this derivative instrument, which could then result in significant charges or credits to interest expense in the consolidated statements of operations.

The Company has determined that fair value is best represented by a blend of valuation outcomes under Black-Scholes modeling and Monte-Carlo simulation. In addition to the estimate changes noted above, if circumstances were to change such that the Company determined that the embedded derivative value was better represented by an alternative valuation method, and such changes resulted in a significant change in the value of the embedded derivative, such changes could also significantly affect future interest expense.

 

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Table of Contents

THE WET SEAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

For the fiscal years ended February 2, 2008, February 3, 2007, and January 28, 2006

NOTE 1:    Summary of Significant Accounting Policies (Continued)

 

Segment Information

In accordance with SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” which establishes standards for reporting information about a company’s operating segments, the Company has two operating segments representing its two retail divisions (“Wet Seal” and “Arden B”). Internet operations for Wet Seal and Arden B are included in their respective operating segments. Prior to fiscal 2007, the Company had aggregated these segments into one reportable segment due to the similarities of the economic and operating characteristics of the operations represented by the Company’s two divisions. However, in fiscal 2007, due to the poor profit performance of the Arden B division, and the disparity in financial performance between the two segments, the Company no longer considers the operating segments economically similar under the aggregation criteria of SFAS No. 131.

Recently Adopted Accounting Pronouncements

Effective February 4, 2007, the Company adopted the provisions of Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 requires that a position taken or expected to be taken in a tax return be recognized in the financial statements when it is more likely than not that the position would be sustained upon examination by tax authorities. A recognized tax position is then measured at the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. The cumulative effect, if any, of applying FIN 48 is to be reported as an adjustment to the opening balance of accumulated deficit in the year of adoption. FIN 48 also requires that, subsequent to initial adoption, a change in judgment that results in subsequent recognition, derecognition or change in a measurement of a tax position taken in a prior annual period (including any related interest and penalties) be recognized as a discrete item in the period in which the change occurs. FIN 48 also requires expanded disclosures, including identification of tax positions for which it is reasonably possible that total amounts of unrecognized tax benefits will significantly change in the next twelve months, a description of tax years that remain subject to examination by major tax jurisdiction, a tabular reconciliation of the total amount of unrecognized tax benefits at the beginning and end of each annual reporting period, the total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate and the total amounts of interest and penalties recognized in the statements of operations and financial position. The adoption of FIN 48 had no effect on the Company’s consolidated financial statements (see Note 3).

In May 2007, the FASB issued FASB Staff Position (“FSP”) No. FIN 48-1 (“FSP 48-1”), “Definition of Settlement in FASB Interpretation No. 48”. FSP 48-1 amended FIN 48 to provide guidance on how an enterprise should determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. FSP 48-1 required application upon the initial adoption of FIN 48. The adoption of FSP 48-1 did not affect the Company’s consolidated financial statements.

In June 2006, the FASB ratified the consensus reached on Emerging Issues Task Force (“EITF”) Issue No. 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (that is, Gross versus Net Presentation).” The EITF reached a consensus that the presentation of taxes on either a gross or net basis is an accounting policy decision that requires disclosure. EITF Issue No. 06-3 was effective for the first interim or annual reporting period beginning after December 15, 2006. Taxes collected from the Company’s customers are and have been recorded on a net basis. The Company did not modify this accounting policy. As such, the adoption of EITF Issue No. 06-3 did not have an effect on the Company’s consolidated financial statements.

 

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Table of Contents

THE WET SEAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

For the fiscal years ended February 2, 2008, February 3, 2007, and January 28, 2006

NOTE 1:    Summary of Significant Accounting Policies (Continued)

 

New Accounting Pronouncements Not Yet Adopted

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 provides a new single authoritative definition of fair value and provides enhanced guidance for measuring the fair value of assets and liabilities and requires additional disclosures related to the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. Adoption of SFAS No. 157 is required for companies with fiscal years beginning after November 15, 2007. In February 2008, the FASB issued FSP Nos. 157-1 and 157-2 which partially deferred the effective date of SFAS No. 157 for one year for certain nonfinancial assets and liabilities and removed certain leasing transactions from its scope. The Company has not yet determined the impact that the adoption of SFAS No. 157 will have on its consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115” (“SFAS No. 159”). SFAS No. 159 provides companies with an option to report many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. The objective of SFAS No. 159 is to reduce both complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently. The FASB believes that SFAS No. 159 helps to mitigate accounting-induced volatility by enabling companies to report related assets and liabilities at fair value, which would likely reduce the need for companies to comply with detailed rules for hedge accounting. SFAS No. 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities, and would require entities to display the fair value of those assets and liabilities for which the company has chosen to use fair value on the face of the balance sheet. The new statement does not eliminate disclosure requirements included in other accounting standards, including requirements for disclosures about fair value measurements included in SFAS No. 157, “Fair Value Measurements.” The Company will be required to adopt SFAS No. 159 as of the beginning of the fiscal year beginning February 3, 2008. The Company does not intend to apply the fair value option to any of its assets or liabilities upon adoption of SFAS No. 159 and, accordingly, does not believe adoption of SFAS No. 159 will have any effect on its consolidated financial statements.

In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (“SFAS No. 141R”). The objective of SFAS No. 141R is to improve the relevance, representational faithfulness, and comparability of the information that a company provides in its financial reports about a business combination and its effects. Under SFAS No. 141R, a company is required to recognize the assets acquired, liabilities assumed, contractual contingencies, and contingent consideration measured at their fair value at the acquisition date. It further requires that research and development assets acquired in a business combination that have no alternative future use to be measured at their acquisition-date fair value and then immediately charged to expense, and that acquisition-related costs are to be recognized separately from the acquisition and expensed as incurred. Among other changes, this statement also requires that “negative goodwill” be recognized in earnings as a gain attributable to the acquisition, and any deferred tax benefits resulting from a business combination are recognized in income from continuing operations in the period of the combination. SFAS No. 141R is effective for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Currently, the Company does not believe adoption of SFAS No. 141R will have any effect on its consolidated financial statements. However, SFAS No. 141R could affect how the Company accounts for business acquisitions occurring after its adoption date.

 

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Table of Contents

THE WET SEAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

For the fiscal years ended February 2, 2008, February 3, 2007, and January 28, 2006

NOTE 1:    Summary of Significant Accounting Policies (Continued)

 

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements—an amendment of ARB No. 51” (“SFAS No. 160”). The objective of this Statement is to improve the relevance, comparability, and transparency of the financial information that a company provides in its consolidated financial statements. SFAS No. 160 requires a company to clearly identify and present ownership interests in subsidiaries held by parties other than the company in the consolidated financial statements within the equity section but separate from the company’s equity. It also requires the amount of consolidated net income attributable to the parent and to the noncontrolling interest be clearly identified and presented on the face of the consolidated statement of income; changes in ownership interest be accounted for similarly, as equity transactions; and when a subsidiary is deconsolidated, any retained noncontrolling equity investment in the former subsidiary and the gain or loss on the deconsolidation of the subsidiary be measured at fair value. SFAS No. 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. The Company does not believe adoption of SFAS No. 160 will have any effect on its consolidated financial statements.

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities—An Amendment of FASB Statement No. 133” (“SFAS No. 161”). The objective of SFAS No. 161 is to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. It is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. The Company has not yet determined the impact that the adoption of SFAS No. 161 will have on its consolidated financial statements.

 

NOTE 2: Stock-Based Compensation