Management's Discussion and Analysis of Financial Condition and Results of Operations
You should read the following discussion in conjunction with the consolidated financial statements and the accompanying notes and the information contained in other sections of this Annual Report on Form 10-K, or this "Report", particularly under the headings "Risk Factors" and "Business". This discussion and analysis is based on the beliefs of our management, as well as assumptions made by, and information currently available to, our management. The statements in this discussion and analysis concerning expectations regarding our future performance, liquidity and capital resources, as well as other non-historical statements in this discussion and analysis, are forward-looking statements. See "Forward-Looking Statements". These forward-looking statements are subject to numerous risks and uncertainties, including those described under "Risk Factors". Our actual results could differ materially from those suggested or implied by any forward-looking statements.
We operate on a fiscal calendar widely used by the retail industry that results in a given fiscal year consisting of a 52- or 53-week period ending on the Saturday closest to January 31 of the following year. References to "fiscal year 2025" or "fiscal 2025" refer to the fiscal year ended January 31, 2026, references to "fiscal year 2024" or "fiscal 2024" refer to the fiscal year ended February 1, 2025, and references to "fiscal year 2023" or "fiscal 2023" refer to the fiscal year ended February 3, 2024. Fiscal 2025 and 2024 both consisted of a 52-week period while fiscal 2023 consisted of a 53-week period.
The discussion and analysis of our financial condition and results of operations for fiscal 2025 compared to fiscal 2024 appears below. As permitted by SEC rules, we have omitted the discussion and analysis of our financial condition, cash flows and results of operations for fiscal 2024 compared to fiscal 2023. See Item 7,"Management's Discussion and Analysis of Financial Condition and Results of Operations", in our Annual Report on Form 10-K for the year ended February 1, 2025, for this discussion.
Overview
Tillys is a leading destination specialty retailer of casual apparel, footwear, accessories and hardgoods for young men, young women, boys and girls. We believe we bring together an unparalleled selection of iconic global, emerging and proprietary brands rooted in an active and outdoor lifestyle. The Tillys concept began in 1982 when our co-founders, Hezy Shaked and Tilly Levine, opened our first store in Orange County, California. As of January 31, 2026, we operated 223 stores in 33 states, averaging approximately 7,145 square feet per store. We also sell our products through our website, www.tillys.com.
Known or Anticipated Trends
We believe the combined impacts of persistent inflation, enacted and potential tariffs, regional conflicts, and potential economic recession in the current economic environment could negatively impact consumer spending generally and our customer base, in particular, which has had and may in the future have a significant, adverse impact on our operating results and financial condition.
Inflation has resulted in increased costs for many products and services that are necessary for the operation of our business, such as product costs, labor costs, shipping costs, and digital marketing costs, among others. For example, store payroll and payroll-related expenses represented approximately 46% of our total selling, general and administrative expense in fiscal 2025. Our average hourly rate for store payroll in fiscal 2025 was approximately 35% higher than in pre-pandemic fiscal 2019 and approximately 3% higher than in fiscal 2024. These and other cost increases may continue to have a material adverse impact on our results of operations and financial condition in fiscal 2026, particularly if we are unable to generate net sales growth.
We expect our effective income tax rate to be near zero on an annual basis until such time that we are able to return to generating operating profits on a consistent basis due to maintaining a full valuation allowance on all deferred tax assets as a result of our recent operating losses.
How We Assess the Performance of Our Business
In assessing the performance of our business, we consider a variety of performance and financial measures. The key indicators of the financial condition and operating performance of our business are net sales, comparable store sales, gross profit, selling, general and administrative expenses and operating loss.
Net Sales
Net sales reflect revenue from the sale of our merchandise at store locations and through e-com, net of sales taxes. Store sales are reflected in sales when the merchandise is received by the customer. For e-com sales, we recognize revenue, and the related cost of goods sold at the time the merchandise is shipped to the customer. Net sales also include shipping and handling fees for e-com shipments that have been shipped to the customer. Net sales are net of returns on sales during the period as well as an estimate of returns expected in the future stemming from current period sales. We recognize revenue from gift cards as they are redeemed for merchandise. Prior to redemption, we maintain a current liability for unredeemed gift card balances. Our gift cards do not have expiration dates and in most cases there is no legal obligation to remit unredeemed gift cards to relevant jurisdictions. Based on actual historical redemption patterns, we determined that a small percentage of gift cards are unlikely to
be redeemed (which we refer to as gift card "breakage"). Based on our historical gift card breakage rate, we recognize breakage revenue over the redemption period in proportion to actual gift card redemptions.
Our business is seasonal and as a result our revenues fluctuate from quarter to quarter. In addition, our revenues in any given quarter can be affected by a number of factors including the timing of holidays and weather patterns. The third and fourth quarters of the fiscal year, which include the back-to-school and holiday sales seasons, have historically produced stronger sales and disproportionately stronger operating results than have the first two quarters of the fiscal year.
Comparable Store Sales
Comparable store sales is a measure that indicates the change in year-over-year comparable store sales, which allows us to evaluate how our store base is performing. Numerous factors affect our comparable store sales, including:
•overall economic trends;
•our ability to attract traffic to our stores and online platform;
•our ability to identify and respond effectively to consumer preferences and fashion trends;
•competition;
•the timing of our releases of new and seasonal styles;
•changes in our product mix;
•pricing;
•the level of customer service that we provide in stores;
•our ability to source, distribute and allocate products efficiently;
•calendar shifts of holiday or seasonal periods;
•the number and timing of store openings and the relative proportion of new stores to mature stores; and
•the timing and success of promotional and advertising efforts.
Our comparable store sales are defined as sales from our e-com platform and stores open on a daily basis compared to the same respective fiscal dates of the prior year. A remodeled, relocated or refreshed store is included in comparable store sales, both during and after construction, if the square footage of the store used to sell merchandise was not changed by more than 20% in any fiscal month. We include sales from our e-com platform as part of comparable store sales as we manage and analyze our business on a single omni-channel basis and have substantially integrated our investments and operations for our stores and e-com platform to give our customers seamless access and increased ease of shopping. Comparable store sales exclude gift card breakage income and e-com shipping and handling fee revenue. Some of our competitors and other retailers may calculate comparable or "same store" sales differently than we do. As a result, data in this Report regarding our comparable store sales may not be comparable to similar data made available by other retailers.
Gross Profit
Gross profit is equal to our net sales less our cost of goods sold. Cost of goods sold reflects the direct cost of purchased merchandise as well as buying, distribution and occupancy costs. Buying costs include compensation and benefit expense for our internal buying organization. Distribution costs include costs for receiving, processing and warehousing our store merchandise, and shipping of merchandise to or from our distribution and e-com fulfillment centers and to our e-com customers and between store locations. Occupancy costs include the rent, common area maintenance, utilities, property taxes, security and depreciation costs of all store locations. These costs are significant and can be expected to continue to increase to the extent our store count grows over time. The components of our reported cost of goods sold may not be comparable to those of other retail companies.
We regularly analyze the components of gross profit as well as gross profit as a percentage of net sales. Specifically we look at the initial markup on purchases, markdowns and reserves, shrinkage, buying costs, distribution costs and occupancy costs. Any inability to obtain acceptable levels of initial markups, a significant increase in our use of markdowns or a significant increase in inventory shrinkage or inability to generate sufficient sales leverage on the buying, distribution and occupancy components of cost of goods sold could have an adverse impact on our gross profit and results of operations.
Gross profit is also impacted by shifts in the proportion of sales of proprietary branded products compared to third-party branded products, as well as by sales mix shifts within and between brands and between major product departments such as young men's and women's apparel, footwear or accessories. A substantial shift in the mix of products could have a material impact on our results of operations. In addition, gross profit and gross profit as a percent of sales have historically been higher in the third and fourth quarters of the fiscal year, as these periods include the back-to-school and winter holiday selling seasons. This reflects that various costs, including occupancy costs, generally do not increase in proportion to the seasonal sales increase.
Selling, General and Administrative Expenses
Our selling, general and administrative, or SG&A, expenses are comprised of store selling expenses and corporate-level general and administrative expenses. Store selling expenses include store and regional support costs, including personnel, advertising
and debit and credit card processing costs, e-com receiving and processing costs and store supplies costs. General and administrative expenses include the payroll and support costs of corporate functions such as executive management, legal, accounting, information systems, human resources, impairment charges and other centralized services. Store selling expenses generally vary proportionately with net sales and store growth. In contrast, general and administrative expenses are generally not directly proportional to net sales and store growth, but may be expected to increase over time to support the needs of our business to the extent our store count grows over time. SG&A expenses as a percentage of net sales are usually higher in lower volume periods and lower in higher volume periods.
Operating Loss
Operating loss equals gross profit less SG&A expenses. Operating loss excludes interest income, interest expense and income taxes. Operating loss percentage measures operating loss as a percentage of our net sales.
Results of Operations
The following tables summarize key components of our results of operations for the periods indicated, both in dollars and as a percentage of our net sales:
| Fiscal Year Ended (1) | |||||||||||||||||
|
January 31, 2026 |
February 1, 2025 |
February 3, 2024 | |||||||||||||||
| (in thousands) | |||||||||||||||||
| Statements of Operations Data: | |||||||||||||||||
| Net sales | $ | 553,585 | $ | 569,453 | $ | 623,083 | |||||||||||
| Cost of goods sold | 385,391 | 416,029 | 453,702 | ||||||||||||||
| Rent expense, related party | 3,727 | 3,727 | 3,724 | ||||||||||||||
| Total cost of goods sold | 389,118 | 419,756 | 457,426 | ||||||||||||||
| Gross profit | 164,467 | 149,697 | 165,657 | ||||||||||||||
| Selling, general and administrative expenses | 183,273 | 199,014 | 196,106 | ||||||||||||||
| Rent expense, related party | 534 | 532 | 533 | ||||||||||||||
| Total selling, general and administrative expenses | 183,807 | 199,546 | 196,639 | ||||||||||||||
| Operating loss | (19,340) | (49,849) | (30,982) | ||||||||||||||
| Other income, net | 1,751 | 3,837 | 5,199 | ||||||||||||||
| Loss before income taxes | (17,589) | (46,012) | (25,783) | ||||||||||||||
| Income tax (benefit) expense | (137) | 217 | 8,709 | ||||||||||||||
| Net loss | $ | (17,452) | $ | (46,229) | $ | (34,492) | |||||||||||
| Percentage of Net Sales: | |||||||||||||||||
| Net sales | 100.0 | % | 100.0 | % | 100.0 | % | |||||||||||
| Cost of goods sold | 69.6 | % | 73.1 | % | 72.8 | % | |||||||||||
| Rent expense, related party | 0.7 | % | 0.7 | % | 0.6 | % | |||||||||||
| Total cost of goods sold | 70.3 | % | 73.7 | % | 73.4 | % | |||||||||||
| Gross profit | 29.7 | % | 26.3 | % | 26.6 | % | |||||||||||
| Selling, general and administrative expenses | 33.1 | % | 34.9 | % | 31.5 | % | |||||||||||
| Rent expense, related party | 0.1 | % | 0.1 | % | 0.1 | % | |||||||||||
| Total selling, general and administrative expenses | 33.2 | % | 35.0 | % | 31.6 | % | |||||||||||
| Operating loss | (3.5) | % | (8.8) | % | (5.0) | % | |||||||||||
| Other income, net | 0.3 | % | 0.7 | % | 0.8 | % | |||||||||||
| Loss before income taxes | (3.2) | % | (8.1) | % | (4.1) | % | |||||||||||
| Income tax (benefit) expense | 0.0 | % | 0.0 | % | 1.4 | % | |||||||||||
| Net loss | (3.2) | % | (8.1) | % | (5.5) | % | |||||||||||
The following table presents store operating data for the periods indicated:
| Fiscal Year Ended | |||||||||||||||||
|
January 31, 2026 |
February 1, 2025 |
February 3, 2024 | |||||||||||||||
| Store Operating Data: | |||||||||||||||||
| Stores operating at end of period | 223 | 240 | 248 | ||||||||||||||
Comparable store sales change (2) | 0.3 | % | (8.0) | % | (10.6) | % | |||||||||||
| Total square feet at end of period (in thousands) | 1,593 | 1,730 | 1,801 | ||||||||||||||
Average net sales per brick-and-mortar store (in thousands) (3) | $ | 1,829 | $ | 1,791 | $ | 1,944 | |||||||||||
Average net sales per square foot (3) | $ | 255 | $ | 247 | $ | 267 | |||||||||||
E-com revenues (in thousands) (4) | $ | 122,456 | $ | 124,728 | $ | 137,453 | |||||||||||
| E-com revenues as a percentage of net sales | 22.1 | % | 21.9 | % | 22.1 | % | |||||||||||
(1)Each of the fiscal years ended January 31, 2026 and February 1, 2025 included 52 weeks. The fiscal year ended February 3, 2024 included 53 weeks.
(2)Our comparable store net sales are defined as sales from our e-com platform and stores open on a daily basis compared to the same respective fiscal dates of the prior year. A remodeled or relocated store is included in comparable store net sales, both during and after construction, if the square footage of the store used to sell merchandise was not changed by more than 20% in any fiscal month. We include sales from our e-com platform as part of our comparable store net sales as we manage and analyze our business on an omni-channel basis and have substantially integrated our investments and operations for our stores and e-com platform to give our customers seamless access and increased ease of shopping. Comparable store net sales exclude gift card breakage income and e-com shipping and handling fee revenue. The comparable store sales change for the period ended February 3, 2024 includes the 53rd week in fiscal year 2023.
(3)The number of stores and the amount of square footage reflect the number of days during the period that stores were open. E-com sales, e-com shipping and handling fee revenue and gift card breakage income are excluded from net sales in deriving average net sales per retail store and average net sales per square foot.
(4)E-com net sales include e-com sales and e-com shipping and handling fee revenue.
Fiscal Year 2025 Compared to Fiscal Year 2024
Net Sales
Total net sales were $553.6 million, a decrease of 2.8%. We ended fiscal 2025 with 17 fewer stores than at the end of fiscal 2024, a 7.1% reduction in total store count. Total comparable net sales, including both physical stores and e-commerce ("e-com"), increased by 0.3% for the year with sequential improvement in our comparable net sales trend in each quarter of the fiscal year, including an accelerating trend of comparable net sales growth for each of the final six fiscal months of fiscal 2025 relative to the comparable periods of fiscal 2024.
| $ millions | Attributable to | |||||||
| $1.6 | Increase in comparable net sales of 0.3%, including e-com | |||||||
| (17.5) | Decrease in non-comparable store sales, primarily from a decrease in net stores. | |||||||
| $(15.9) | Total | |||||||
•Net sales from physical stores were $431.1 million, a decrease of 3.1%, primarily due to operating 17 fewer net stores at the end of fiscal 2025 compared to the end of fiscal 2024. Comparable store net sales from physical stores increased by 0.9% in fiscal 2025 relative to the comparable period of fiscal 2024. Net sales from physical stores represented 77.9% of total net sales this year compared to 78.1% of total net sales last year.
◦Net sales from e-com were $122.5 million, a decrease of 1.8%. E-com net sales represented 22.1% of total net sales this year compared to 21.9% of total net sales last year.
Gross Profit
Gross profit, including buying, distribution, and occupancy costs, was $164.5 million, or 29.7% of net sales, an improvement of $14.8 million, or 340 basis points as a percentage of net sales, compared to $149.7 million, or 26.3% of net sales, last year. Product margins improved by 290 basis points primarily due to higher initial markups and lower markdowns as a result of operating with reduced, more current inventory. Buying, distribution, and occupancy costs improved by 50 basis points, or $7.1 million, collectively, primarily due to decreased occupancy costs associated with operating 17 fewer net stores compared to last year.
Selling, General and Administrative ("SG&A") Expenses
SG&A expenses were $183.8 million, or 33.2% of net sales, a reduction of $15.7 million, or 180 basis points as a percentage of net sales, compared to $199.5 million, or 35.0% of net sales, last year.
| % | $ millions | Primarily Attributable to | ||||||||||||
| (0.6)% | $(6.0) | Decrease in store payroll and related benefits | ||||||||||||
| (0.6)% | (3.2) | Decrease in non-cash store asset impairment charges | ||||||||||||
| (0.4)% | (2.6) | Decrease in e-com fulfillment temporary labor | ||||||||||||
| (0.1)% | (1.3) | Decrease in corporate payroll and related benefits | ||||||||||||
| (0.2)% | (1.0) | Decrease in donation expense | ||||||||||||
| 0.1% | (1.6) | Net change in all other SG&A expenses | ||||||||||||
| (1.8)% | $(15.7) | Total | ||||||||||||
Operating Loss
Operating loss was $19.3 million, or 3.5% of net sales, an improvement of $30.5 million, or 530 basis points as a percentage of net sales, compared to $49.8 million, or 8.8% of net sales, last year, due to the combined impact of the factors noted above.
Income Tax (Benefit) Expense
Income tax benefit was $137 thousand, or 0.8% of pre-tax loss, compared to income tax expense of $0.2 million, or 0.5% of pre-tax loss last year. Both years' income tax results include the continuing impact of a full, non-cash deferred tax asset valuation allowance.
Net Loss and Loss Per Share
Net loss was $17.5 million, or $0.58 per share, an improvement of $28.8 million, or $0.96 per share, compared to $46.2 million, or $1.54 net loss per share, last year.
Liquidity and Capital Resources
Our business relies on cash flows from operating activities as well as cash on hand as our primary sources of liquidity. We currently expect to finance company operations, store growth and remodels, and all of our planned capital expenditures with existing cash on hand, and cash flows from operations.
In addition to cash and cash equivalents, the most significant components of our working capital are merchandise inventories, accounts payable and accrued expenses. We believe that cash flows from operating activities, our cash on hand, and credit facility availability will be sufficient to cover our working capital requirements and anticipated capital expenditures for the next 12 months from the filing of this Report and do not anticipate needing to access our credit facility at any time during the next 12 months. If these sources are not sufficient or available to meet our capital requirements, then we will be required to obtain additional equity or debt financing in the future. There can be no assurance that equity or debt financing will be available to us when we need it or, if available, that the terms will be satisfactory to us and not dilutive to our stockholders.
Working Capital
Working capital at January 31, 2026, was $25.1 million compared to $31.6 million at February 1, 2025, a decrease of $6.5 million. The changes in our working capital during fiscal 2025 were as follows:
| $ millions | Description | |||||||
| $31.6 | Working capital at February 1, 2025 | |||||||
| (18.1) | Decrease in merchandise inventories, net of accounts payable | |||||||
| 6.8 | Increase due to a decrease in operating lease liabilities | |||||||
| 4.8 | Net change from all other changes in current assets and current liabilities | |||||||
| $25.1 | Working capital at January 31, 2026 | |||||||
Cash Flow Analysis
A summary of operating, investing and financing activities is shown in the following table:
| Fiscal Year Ended | |||||||||||||||||
|
January 31, 2026 |
February 1, 2025 |
February 3, 2024 | |||||||||||||||
| (in thousands) | |||||||||||||||||
| Net cash provided by (used in) operating activities | $ | 4,098 | $ | (42,018) | $ | (6,733) | |||||||||||
| Net cash provided by (used in) investing activities | 21,159 | 15,753 | (19,993) | ||||||||||||||
| Net cash provided by financing activities | - | 294 | 227 | ||||||||||||||
| Net change in cash and cash equivalents | $ | 25,257 | $ | (25,971) | $ | (26,499) | |||||||||||
Net Cash Provided By (Used In) Operating Activities
Operating activities consist primarily of net loss adjusted for non-cash items that include depreciation, asset impairment charges, deferred income taxes, gains on maturities of marketable securities and share-based compensation expense, plus the effect on cash of changes during the year in our assets and liabilities.
Net cash provided by operating activities was $4.1 million this year compared to net cash used of $42.0 million last year. The $46.1 million increase in net cash provided by operating activities compared to last year was primarily due to a decrease in net loss of $28.8 million in fiscal 2025 compared to fiscal 2024, and favorable changes in cash provided by merchandise inventories net of accounts payable compared to last year.
Net Cash Provided By (Used In) Investing Activities
Cash flows from investing activities consist primarily of capital expenditures and maturities and purchases of marketable securities.
Net cash provided by investing activities was $21.2 million this year compared to $15.8 million last year. Net cash provided by investing activities in fiscal 2025 consisted of maturities of marketable securities of $25.8 million, partially offset by capital expenditures totaling $4.7 million. Net cash provided by investing activities in fiscal 2024 consisted of maturities of marketable securities of $98.5 million, partially offset by purchases of marketable securities of $74.5 million and capital expenditures totaling $8.2 million.
Net Cash Provided By Financing Activities
Financing activities primarily consist of proceeds from employee exercises of stock options.
Credit Agreement
On April 27, 2023 (the "Closing Date"), we entered into an asset-backed credit agreement and revolving line of credit note (the "Note" and, collectively, the "Credit Agreement") with Wells Fargo Bank, National Association, as lender (the "Bank"). The Credit Agreement provides for an asset-based, senior secured revolving credit facility (as amended, the "Revolving Facility") of up to $65.0 million ("Revolving Commitment") consisting of revolving loans, letters of credit and swing line loans, with a sub-limit on letters of credit outstanding at any time of $10.0 million and a sub-limit for swing line loans of $7.5 million, which replaced our previous senior secured credit agreement. The Credit Agreement also includes an uncommitted accordion feature whereby we may increase the Revolving Commitment by an aggregate amount not to exceed $12.5 million, subject to certain conditions. On March 25, 2025, we entered into an amendment of the Credit Agreement which extended the maturity date to June 25, 2027. The payment and performance in full of the secured obligations under the Revolving Facility are secured by a lien on and security interest in all of our assets.
The maximum borrowings permitted under the Revolving Facility is equal to the lesser of (x) the Revolving Commitment and (y) the applicable borrowing base, which is equal to (i) 90% of our eligible credit card receivables, plus (ii) 90% of the cost of certain adjusted eligible inventory, less certain inventory reserves, plus (iii) 90% of the cost of certain adjusted eligible in-transit inventory, less certain inventory reserves, less (iv) certain other reserves established by the Bank.
The unused portion of the Revolving Commitment accrues a commitment fee of 0.25% or 0.375% per annum, based on the average daily borrowing capacity under the Revolving Facility under the applicable fiscal quarter. Borrowings under the Revolving Facility bear interest at a rate per annum that ranges from the Secured Overnight Financing Rate ("SOFR") plus a credit spread adjustment (equal to 10 basis points for one- and three-month term SOFR) plus 1.50% to 2.00%, or a base rate (as calculated in accordance with the Credit Agreement) (the "Base Rate") plus 0.50% to 1.00%, based on the average daily borrowing capacity under the Revolving Facility over the applicable fiscal quarter. We are allowed to elect to apply either SOFR or Base Rate interest to borrowings at our discretion, other than in the case of swing line loans, to which the Base Rate shall apply.
Under the Credit Agreement, we are subject to a variety of affirmative and negative covenants customary in an asset-based lending facility, including a financial covenant relating to availability (which is required to remain above the greater of: (i) ten percent (10%) of the Loan Cap (as defined in the Credit Agreement) and (ii) $6.0 million).
Events of default under the Credit Agreement include, among other things, failure to pay principal, interest, fees or other amounts; covenant defaults; material inaccuracy of representations and warranties; bankruptcy events; actual or asserted invalidity of any of the Credit Agreement or related loan documents; or a change of control.
In connection with the entry into the Credit Agreement, we entered into certain ancillary agreements including (i) a security agreement in favor of the Bank, and (ii) a guarantee by us in favor of the Bank.
As of January 31, 2026, we were in compliance with all of our covenants, were eligible to borrow up to a total of $41.5 million, and had no outstanding borrowings under the Credit Agreement. The only utilization of the letters of credit sub-limit under the Credit Agreement was a $1.7 million irrevocable standby letter of credit.
Contractual Obligations
We enter into long-term contractual obligations and commitments in the normal course of business, primarily non-cancellable operating leases and software maintenance agreements.
We lease approximately 172,000 square feet for our corporate headquarters and distribution center from a company that is owned by the co-founders of Tillys, one of which is currently our Executive Chairman of the Board of Directors. These buildings are located at 10 and 12 Whatney, Irvine, California. The lease is accounted for as an operating lease and expires on December 31, 2027.
We lease approximately 26,000 square feet of office and warehouse space from a company that is owned by one of the co-founders of Tillys who is currently our Executive Chairman of the Board of Directors. This building is located at 11 Whatney, Irvine, California. The lease is accounted for as an operating lease and expires on June 30, 2032.
We lease approximately 81,000 square feet for our e-com distribution center from a company that is owned by one of the co-founders of Tillys who is currently our Executive Chairman of the Board of Directors. This building is located at 17 Pasteur, Irvine, California. The lease is accounted for as an operating lease and expires on October 31, 2031.
Our store leases are generally non-cancellable operating leases expiring at various dates through fiscal year 2036. Certain leases provide for additional rent based on a percentage of sales and annual rent increases based upon the Consumer Price Index. In addition, many of our store leases contain certain co-tenancy provisions that permit us to pay rent based on a pre-determined percentage of sales when the occupancy of the retail center falls below minimums established in such lease.
Critical Accounting Policies and Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires the appropriate application of 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.
The policies and estimates discussed below involve the selection or application of alternative accounting policies that are material to our consolidated financial statements. With respect to critical accounting policies, even a relatively minor variance between actual and expected outcomes can potentially have a materially favorable or unfavorable impact on subsequent results of operations. However, our historical results for the periods presented in the consolidated financial statements have not been materially impacted by such variances. This summary should be read in conjunction with the more complete discussion of our accounting policies and procedures included in "Note 2: Summary of Significant Accounting Policies" in the notes to our consolidated financial statements included in this Annual Report on Form 10-K. Management has discussed the development and selection of these critical accounting policies and estimates with 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 reserves for sales returns, gift cards, loyalty program, inventory reserves, impairment of long-lived assets and accounting for income taxes, which are more fully described below.
Reserves for Sales Returns
Revenue is recognized net of estimates for sales returns from our customers. We accrue for estimated sales returns from customers based on historical sales returns results for a given period, taking into account the seasonal nature of our business.
Gift Cards
We estimate and record breakage revenue in proportion to actual redemptions on unredeemed gift cards based on historical and expected customer redemption trends. Actual customer redemptions may vary from our estimates. Based on actual historical redemption patterns, we determined that a small percentage of gift cards are unlikely to be redeemed.
Loyalty Program
Based on historical redemption patterns, unredeemed awards and accumulated partial points are accrued as deferred revenue with a corresponding impact to net sales. A liability is estimated based on estimated redemptions and the standalone selling price of points earned and expected future redemptions. Actual customer redemptions may vary from our estimates.
Inventory Reserves
Merchandise inventories are stated at the lower of cost or net realizable value 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 markdowns needed in order to sell through slow-moving inventories. During each accounting period we record adjustments to our inventories, which are reflected in cost of goods sold, if the cost of specific inventory items on hand exceeds the amount we expect to realize from the ultimate sale or disposal of the inventory. This adjustment calculation requires us to develop assumptions and estimates, which are based on factors such as merchandise seasonality, historical trends and inventory levels, including estimated sell-through rates of remaining units.
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, excessive inventories and more frequent and extensive markdowns, which would adversely affect our operating results.
We also record an inventory shrinkage reserve calculated as a percentage of net sales for estimated merchandise losses for the period between the last physical inventory count and the balance sheet date. These estimates are based on historical percentages and can be affected by changes in merchandise mix and changes in shrinkage trends. We perform physical inventory counts at least once per year for the entire chain of stores and our distribution center and adjust the inventory shrinkage reserve accordingly. If actual physical inventory losses differ significantly from the estimate, our results of operations could be adversely impacted. The inventory shrinkage reserve reduces the value of total inventory and is a component of inventories on the Consolidated Balance Sheets. The inventory shrinkage reserve at both January 31, 2026 and February 1, 2025 was not material.
Impairment of Long-Lived Assets
We evaluate the carrying value of our long-lived assets, consisting largely of leasehold improvements, furniture and fixtures and equipment at store, distribution center and corporate office locations, for impairment whenever events or changes in circumstances indicate that the carrying value of long-lived assets and operating lease right-of-use ("ROU") assets may not be recoverable. Factors that are considered important that could result in the necessity to perform an impairment review include a current-period operating or cash flow loss combined with a history of operating or cash flow losses and a forecast that indicates continuing losses or insufficient income associated with the realization 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 long-lived assets and operating lease ROU assets. If the undiscounted future cash flows are less than the carrying value, an impairment loss is recognized for the difference between the carrying value and the estimated fair value of assets based on the discounted cash flows of the assets using a rate that approximates the weighted average cost of capital plus a company specific risk premium determined by management. Impairment losses are allocated between the long-lived assets and ROU assets on a relative carrying amount basis. The fair values of ROU assets are estimated by an independent third party and represent the highest and best use to a market participant. The estimation of the fair values of ROU assets requires significant estimates including comparable market rents. Quarterly, we assess whether events or changes in circumstances have occurred that potentially indicate the carrying value of long-lived assets and operating lease ROU assets may not be recoverable.
The estimation of future cash flows from operating activities requires significant estimates of factors that include future sales and gross margin performance. Factors used in the valuation of long-lived assets with finite lives include, but are not limited to, discount rates, management's plans for future operations, recent operating results and projected future cash flows. If our net sales or gross profit 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 store assets may prove to be unrecoverable and we may incur additional impairment charges in the future.
Accounting for Income Taxes
We account for income taxes and the related accounts in accordance with FASB ASC Topic 740, Income Taxes, or ASC 740. Under this method, we accrue income taxes payable or refundable and recognize deferred tax assets and liabilities based on differences between accounting principles generally accepted in the United States and tax bases of assets and liabilities. We measure deferred tax assets and liabilities using enacted tax rates in effect for the years in which the differences are expected to reverse, and recognize the effect of a change in enacted rates in the period of enactment.
We record net deferred tax assets to the extent we believe these assets will more likely than not be realized. In making such determination, we consider all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax planning strategies, carry-back potential if permitted under the tax law, and recent financial operations.
We establish assets and liabilities for uncertain positions taken or expected to be taken in income tax returns, using a more-likely-than-not recognition threshold. We include in income tax expense any interest and penalties related to uncertain tax positions.
Recent Accounting Pronouncements
For a description of recently-issued accounting standards not yet adopted, refer to Note 2 to our consolidated financial statements included in this Report.