UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

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

For the quarterly period ended OctoberJuly 31, 20092010

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)

 

 

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  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

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

 

Large accelerated filer:  ¨

 

Accelerated filer:  x

 

Nonaccelerated filer:  ¨

 

Smaller reporting company:  ¨

  

(Do not check if a smaller

reporting company)

 

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

The number of shares outstanding of the registrant’s Class A common stock, par value $0.10 per share, at November 30, 2009,August 27, 2010, was 97,423,777.101,739,011. There were no shares outstanding of the registrant’s Class B common stock, par value $0.10 per share, at November 30, 2009.August 27, 2010.

 

 

 


THE WET SEAL, INC.

FORM 10-Q

Index

 

PART I. FINANCIAL INFORMATION

  

Item 1.

  

Financial Statements (Unaudited)

  
  

Condensed Consolidated Balance Sheets (Unaudited) as of OctoberJuly 31, 2009,2010, January 31,30, 2010, and August 1, 2009 and November 1, 2008

  2-3
  

Condensed Consolidated Statements of Operations (Unaudited) for the 13 and 3926 Weeks Ended OctoberJuly 31, 2009,2010, and NovemberAugust 1, 20082009

  4
  

Condensed Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Unaudited) for the 3926 Weeks Ended OctoberJuly 31, 2009,2010, and NovemberAugust 1, 20082009

  5-6
  

Condensed Consolidated Statements of Cash Flows (Unaudited) for the 3926 Weeks Ended OctoberJuly 31, 2009,2010, and NovemberAugust 1, 20082009

  7
  

Notes to Condensed Consolidated Financial Statements (Unaudited)

  8-20

Item 2.

  

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

  21-3521-34

Item 3.

  

Quantitative and Qualitative Disclosures About Market Risk

  3534

Item 4.

  

Controls and Procedures

  3534-35

PART II. OTHER INFORMATION

  

Item 1.

  

Legal Proceedings

  35-36

Item 1A.

  

Risk Factors

  36

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

  3736

Item 3.

  

Defaults Upon Senior Securities

  3736

Item 4.

  

Submission of Matters to a Vote of Security HoldersRemoved and Reserved

  3736

Item 5.

  

Other Information

  3736

Item 6.

  

Exhibits

  37

SIGNATURE PAGESIGNATURES

  38

EXHIBIT 31.1

  

EXHIBIT 31.2

  

EXHIBIT 32.1

  

EXHIBIT 32.2

  

1


Part I. Financial Information

 

Item 1.Financial Statements (Unaudited)

THE WET SEAL, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

(Unaudited)

 

  October 31,
2009
  January 31,
2009
 November 1,
2008
  July 31,
2010
  January 30,
2010
 August 1,
2009
ASSETS          

CURRENT ASSETS:

          

Cash and cash equivalents

  $144,161   $142,064   $127,555    $165,516     $161,693    $143,987   

Income taxes receivable

   —      —      119 

Other receivables

   389    1,784    2,209    1,381     479    795   

Merchandise inventories

   39,761    25,529    41,234    39,285     29,159    38,050   

Prepaid expenses and other current assets

   11,087    10,600    11,165    12,150     10,939    10,829   

Deferred tax assets

   19,600     19,600    —     
                  

Total current assets

   195,398    179,977    182,282    237,932     221,870    193,661   
                  

EQUIPMENT AND LEASEHOLD IMPROVEMENTS:

          

Leasehold improvements

   109,641    102,062    108,218    112,058     108,958    106,281   

Furniture, fixtures and equipment

   67,462    65,378    68,130    74,969     66,708    68,570   
                  
   177,103    167,440    176,348    187,027     175,666    174,851   

Less accumulated depreciation and amortization

   (95,509)   (92,571  (97,775)   (99,998)   (97,603  (95,382)  
                  

Net equipment and leasehold improvements

   81,594    74,869    78,573    87,029     78,063    79,469   
                  

OTHER ASSETS:

          

Deferred financing costs, net of accumulated amortization of $5,660, $5,586 and $5,562 at October 31, 2009, January 31, 2009, and November 1, 2008, respectively

   99    173    197 

Deferred tax assets

   46,909     51,713    —     

Other assets

   2,489    1,640    1,635    2,560     2,584    2,247   
                  

Total other assets

   2,588    1,813    1,832    49,469     54,297    2,247   
                  

TOTAL ASSETS

  $279,580   $256,659   $262,687    $374,430     $354,230    $275,377   
                  
LIABILITIES AND STOCKHOLDERS’ EQUITY          

CURRENT LIABILITIES:

          

Accounts payable – merchandise

  $19,445   $8,388   $15,572    $21,970     $14,588    $19,760   

Accounts payable – other

   12,713    9,188    14,050    15,665     9,480    12,434   

Income taxes payable

   200    228    182    —       47    103   

Accrued liabilities

   23,044    28,079    27,226    24,561     24,918    24,009   

Current portion of deferred rent

   2,886    3,378    3,479    2,876     2,735    3,468   
                  

Total current liabilities

   58,288    49,261    60,509    65,072     51,768    59,774   
                  

LONG-TERM LIABILITIES:

          

Secured convertible notes, including accrued interest of $904, $752 and $702 at October 31, 2009, January 31, 2009, and November 1, 2008, respectively, and net of unamortized discount of $2,261, $2,712 and $2,838 at October 31, 2009, January 31, 2009, and November 1, 2008, respectively

   3,310    2,707    2,531 

Secured convertible notes, including accrued interest of $0, $956 and $853 at July 31, 2010, January 30, 2010, and August 1, 2009, respectively, and net of unamortized discount of $0, $2,083 and $2,425 at July 31, 2010, January 30, 2010, and August 1, 2009, respectively

   —       3,540    3,095   

Deferred rent

   29,123    30,051    30,498    28,988     28,827    28,832   

Other long-term liabilities

   1,700    1,821    1,800    1,707     1,785    1,727   
                  

Total long-term liabilities

   34,133    34,579    34,829    30,695     34,152    33,654   
                  

Total liabilities

   92,421    83,840    95,338    95,767     85,920    93,428   
                  

See notes to condensed consolidated financial statements.

2


THE WET SEAL, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS (Continued)

(In thousands, except share data)

(Unaudited)

 

  October 31,
2009
 January 31,
2009
 November 1,
2008
   July 31,
2010
 January 30,
2010
 August 1,
2009

COMMITMENTS AND CONTINGENCIES (Note 6)

        

CONVERTIBLE PREFERRED STOCK, $0.01 par value, authorized 2,000,000 shares; 1,611 shares issued and outstanding at October 31, 2009, January 31, 2009, and November 1, 2008, respectively

   1,611    1,611    1,611  

CONVERTIBLE PREFERRED STOCK, $0.01 par value, authorized 2,000,000 shares; no shares issued and outstanding at July 31, 2010, and 1,611 shares issued and outstanding at January 30, 2010, and August 1, 2009, respectively

   —      1,611    1,611   
                   

STOCKHOLDERS’ EQUITY:

        

Common stock, Class A, $0.10 par value, authorized 300,000,000 shares; 104,107,202 shares issued and 97,423,777 outstanding at October 31, 2009; 103,319,360 shares issued and 96,635,935 shares outstanding at January 31, 2009; and 103,071,941 shares issued and 96,388,516 shares outstanding at November 1, 2008

   10,411    10,332    10,307  

Common stock, Class A, $0.10 par value, authorized 300,000,000 shares; 111,976,044 shares issued and 101,739,011 outstanding at July 31, 2010; 106,889,150 shares issued and 98,046,279 shares outstanding at January 30, 2010; and 103,773,868 shares issued and 97,090,443 shares outstanding at August 1, 2009

   11,198    10,689    10,377   

Common stock, Class B convertible, $0.10 par value, authorized 10,000,000 shares; no shares issued and outstanding

   —      —      —       —      —      —     

Paid-in capital

   302,241    300,607    299,413  

Accumulated deficit

   (105,182  (117,828  (122,120

Treasury stock, 6,683,425 shares at cost, at October 31, 2009, January 31, 2009, and November 1, 2008, respectively

   (22,461  (22,461  (22,461

Paid-in capital (Note 3)

   324,594    312,689    304,517   

Accumulated deficit (Note 3)

   (22,585  (27,342  (112,640)  

Treasury stock, 10,237,033 shares; 8,842,871 shares; and 6,683,425 shares; at cost, at July 31, 2010, January 30, 2010, and August 1, 2009, respectively

   (34,957  (29,758  (22,461)  

Accumulated other comprehensive income

   539    558    599     413    421    545   
                   

Total stockholders’ equity

   185,548    171,208    165,738     278,663    266,699    180,338   
                   

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

  $279,580   $256,659   $262,687     $374,430    $354,230    $275,377   
                   

See notes to condensed consolidated financial statements.

3


THE WET SEAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except share data)

(Unaudited)

 

  13 Weeks Ended 39 Weeks Ended  13 Weeks Ended 26 Weeks Ended 
      October 31,    
2009
     November 1,    
2008
     October 31,    
2009
     November 1,    
2008
  July 31,
2010
 August 1,
2009
 July 31,
2010
 August 1,
2009
 

Net sales

  $141,546   $146,644   $409,921   $438,094   $131,541    $136,366    $269,303    $268,375  

Cost of sales

   100,517    100,739    290,541    293,463   93,159    97,196    185,798    190,024  
                         

Gross margin

   41,029    45,905    119,380    144,631   38,382    39,170    83,505    78,351  

Selling, general, and administrative expenses

   35,995    38,334    104,289    116,236   34,737    34,321    69,801    68,294  

Asset impairment

   334    519    1,886    822   1,041    1,552    1,131    1,552  
                         

Operating income

   4,700    7,052    13,205    27,573   2,604    3,297    12,573    8,505  
                         

Interest income

   98    587    413    1,884   85    132    159    316  

Interest expense

   (261  (209  (697  (2,601)

Interest expense (Note 3)

   (25  (246  (2,992  (437
                         

Interest (expense) income, net

   (163  378    (284  (717) 

Interest income (expense), net

   60    (114  (2,833  (121
                         

Income before provision for income taxes

   4,537    7,430    12,921    26,856   2,664    3,183    9,740    8,384  

Provision for income taxes

   23    644    275    994

Provision for income taxes (Note 1)

   1,049    80    4,983    252  
                         

Net income

  $4,514   $6,786   $12,646   $25,862   $1,615    $3,103    $4,757    $8,132  
                         

Net income per share, basic

  $0.04   $0.07   $0.13   $0.26   $0.02    $0.03    $0.05    $0.08  
                         

Net income per share, diluted

  $0.04   $0.07   $0.12   $0.26   $0.02    $0.03    $0.05    $0.08  
                         

Weighted-average shares outstanding, basic

   95,685,372    94,680,063    95,556,814    92,564,341   100,257,750    95,594,834    98,756,560    95,492,536  
                         

Weighted-average shares outstanding, diluted

   96,405,850    96,111,993    96,134,860    94,022,901   100,556,634    96,159,261    99,414,245    95,988,664  
                         

See notes to condensed consolidated financial statements.

4


THE WET SEAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME

(In thousands, except share data)

(Unaudited)

 

  Common Stock    Paid-In  
Capital
  Accumulated
Deficit
  Treasury
Stock
  Comprehensive
Income
  Accumulated
Other
Comprehensive
Income
  Total
Stockholders’
Equity
   Common Stock  Paid-In
Capital
  Accumulated
Deficit
  Treasury
Stock
  Comprehensive
Income
  Accumulated
Other
Comprehensive
Income
  Total
Stockholders’
Equity
 
  Class A  Class B        Class A  Class B      
      Shares      Par Value  Shares  Par Value        Shares  Par Value  Shares  Par Value      

Balance at January 31, 2009

  103,319,360  $10,332  —    $—    $300,607   $(117,828 $(22,461   $558   $171,208  

Balance at January 30, 2010

  106,889,150  $10,689  —    $—    $312,689   $(27,342 $(29,758   $421   $266,699  

Net income

  —     —    —     —     —      12,646    —     $12,646   —      12,646    —     —    —     —     —      4,757    —     $4,757   —      4,757  

Stock issued pursuant to long-term incentive plans

  600,936   61  —     —     (61  —      —      —     —      —      213,900   21  —     —     (21  —      —      —     —      —    

Stock-based compensation - directors and employees (Note 2)

  —     —    —     —     1,148    —      —      —     —      1,148    —     —    —     —     619    —      —      —     —      619  

Amortization of stock payment in lieu of rent

  —     —    —     —     73    —      —      —     —      73    —     —    —     —     49    —      —      —     —      49  

Exercise of stock options

  3,334   —    —     —     8    —      —      —     —      8    64,168   7  —     —     199    —      —      —     —      206  

Exercise of common stock warrants

  183,572   18  —     —     466    —      —      —     —      484    1,160,715   116  —     —     4,155    —      —      —     —      4,271  

Conversions of secured convertible notes into common stock

  3,111,111   311  —     —     5,347    —      —      —     —      5,658  

Conversions of convertible preferred stock into common stock

  537,000   54  —     —     1,557    —      —      —     —      1,611  

Amortization of actuarial gain under Supplemental Employee Retirement Plan

  —     —    —     —     —      —      —      (19)   (19  (19  —     —    —     —     —      —      —      (8)   (8  (8
                                  

Comprehensive income

             $12,627                $4,749   
                                                

Balance at October 31, 2009

  104,107,202  $10,411  —    $—    $302,241   $(105,182 $(22,461   $539   $185,548  

Repurchase of common stock

  —  

 

   

 

—  

 

  —  

 

   

 

—  

 

   

 

—  

 

  

 

  

 

—  

 

  

 

  

 

(5,199)

 

  

 

    

 

—  

 

  

 

  

 

(5,199)

 

  

 

                                                            

Balance at July 31, 2010

  111,976,044  $11,198  —    $—    $324,594   $(22,585 $(34,957   $413   $278,663  
                              

See notes to condensed consolidated financial statements.

5


THE WET SEAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME

(In thousands, except share data)

(Unaudited)

 

  Common Stock  Paid-In
Capital
  Accumulated
Deficit
  Treasury
Stock
  Comprehensive
Income
  Accumulated
Other
Comprehensive
Income
  Total
Stockholders’
Equity
  Common Stock  Paid-In  Accumulated  Treasury  Comprehensive  Accumulated
Other
Comprehensive
Income
  Total
Stockholders’
Equity
 
  Class A  Class B       Class A  Class B      
  Shares  Par Value  Shares  Par Value       Shares  Par Value  Shares  Par Value  Capital Deficit Stock Income   

Balance at February 2, 2008

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

Balance at January 31, 2009

  103,319,360  $10,332  —    $—    $303,551   $(120,772 $(22,461   $558   $171,208  

Net income

  —     —    —     —     —      25,862    —     $25,862   —     25,862  —     —    —     —     —      8,132    —     $8,132   —      8,132  

Stock issued pursuant to long-term incentive plans

  682,525   68  —     —     (68  —      —      —     —     —    267,602   27  —     —     (27  —      —      —     —      —    

Stock-based compensation - directors and employees

  —     —    —     —     2,361    —      —      —     —     2,361

Stock-based compensation - directors and employees (Note 2)

  —     —    —     —     471    —      —      —     —      471 

Amortization of stock payment in lieu of rent

  —     —    —     —     134    —      —      —     —     134  —     —    —     —     48    —      —      —     —      48  

Exercise of stock options

  6,000   1  —     —     9    —      —      —     —     10  3,334   —    —     —     8    —      —      —     —      8  

Exercise of common stock warrants

  1,545,720   154  —     —     5,407    —      —      —     —     5,561  183,572   18  —     —     466    —      —      —     —      484  

Conversions of secured convertible notes into common stock

  2,274,804   227  —     —     3,185    —      —      —     —     3,412

Conversions of convertible preferred stock into common stock

  185,333   19  —     —     537    —      —      —     —     556

Amortization of actuarial net loss under Supplemental Employee Retirement Plan

  —     —    —     —     —      —      —      3   3   3

Amortization of actuarial gain under Supplemental Employee Retirement Plan

  —     —    —     —     —      —      —      (13)   (13  (13
                                   

Comprehensive income

             $25,865                 $8,119   
                                                             

Balance at November 1, 2008

  103,071,941  $10,307  —    $—    $299,413   $(122,120 $(22,461   $599  $165,738

Balance at August 1, 2009

  103,773,868  $10,377  —    $—    $304,517   $(112,640 $(22,461   $545   $180,338  
                                                           

See notes to condensed consolidated financial statements.

6


THE WET SEAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands, except share data)

(Unaudited)

 

  39 Weeks Ended   26 Weeks Ended
  October 31,
2009
 November 1,
2008
   July 31,
2010
  August 1,
2009

CASH FLOWS FROM OPERATING ACTIVITIES:

       

Net income

  $12,646   $25,862     $4,757     $8,132    

Adjustments to reconcile net income to net cash provided by operating activities:

       

Depreciation and amortization

   11,166    10,792     7,988     7,270    

Amortization of discount on secured convertible notes

   451    2,620  

Amortization/acceleration of discount on secured convertible notes

   2,083     287    

Amortization of deferred financing costs

   74    260     145     49    

Amortization of stock payment in lieu of rent

   73    134     49     48    

Adjustment of derivatives to fair value

   (40  (80   (20)    (40)   

Interest added to (extinguished from) principal of secured convertible notes

   152    (260

Interest added to principal of secured convertible notes

   35     101    

Conversion inducement fee

   700     —    

Loss on disposal of equipment and leasehold improvements

   172    368     537     127    

Asset impairment

   1,886    822     1,131     1,552    

Deferred income taxes

   4,804     —    

Stock-based compensation (Note 2)

   1,148    2,361     619     471    

Changes in operating assets and liabilities:

       

Income tax receivable

   —      48  

Other receivables

   1,395    3,506     (902)    989    

Merchandise inventories

   (14,232  (9,644   (10,126)    (12,521)   

Prepaid expenses and other current assets

   (487  (219   (1,356)    (229)   

Other non-current assets

   (849  67     24     (483)   

Accounts payable and accrued liabilities

   7,182    (73   7,628     8,294    

Income taxes payable

   (28  182     (47)    (125)   

Deferred rent

   (1,420  (438   302     (1,129)   

Other long-term liabilities

   (100  (76   (66)    (67)   
             

Net cash provided by operating activities

   19,189    36,232     18,285     12,726    
             

CASH FLOWS FROM INVESTING ACTIVITIES:

       

Purchase of equipment and leasehold improvements

   (17,584  (14,866   (13,040)    (11,295)   
             

Net cash used in investing activities

   (17,584  (14,866   (13,040)    (11,295)   
             

CASH FLOWS FROM FINANCING ACTIVITIES:

       

Proceeds from exercise of stock options

   8    10     206     8    

Conversion inducement fee

   (700)    —    

Proceeds from exercise of common stock warrants

   484    5,561     4,271     484    

Repurchase of common stock

   (5,199)    —    
             

Net cash provided by financing activities

   492    5,571  

Net cash (used in) provided by financing activities

   (1,422)    492    
             

NET INCREASE IN CASH AND CASH EQUIVALENTS

   2,097    26,937     3,823     1,923    

CASH AND CASH EQUIVALENTS, beginning of period

   142,064    100,618     161,693     142,064    
             

CASH AND CASH EQUIVALENTS, end of period

  $144,161   $127,555     $165,516     $143,987    
             

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:

       

Cash paid during the period for:

       

Interest

  $49   $52     $34     $33    

Income taxes

  $378   $813     $597     $378    

SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING AND FINANCING TRANSACTIONS:

       

Conversion of secured convertible notes into 2,274,804 shares of Class A common stock

  $—     $3,412  

Conversion of convertible preferred stock into 185,333 shares of Class A common stock

  $—     $556  

Conversion of secured convertible notes into 3,111,111 shares of Class A common stock

   $5,658     $—    

Conversion of convertible preferred stock into 537,000 shares of Class A common stock

   $1,611     $—    

Purchase of equipment and leasehold improvements unpaid at end of period

  $5,299   $6,090     $8,209     $5,189    

Amortization of actuarial (gain) loss under Supplemental Employee Retirement Plan

  $(19 $3  

Amortization of actuarial gain under Supplemental Employee Retirement Plan

   $(8)    $(13)   

See notes to condensed consolidated financial statements.

7


THE WET SEAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the 3926 weeks ended OctoberJuly 31, 2009,2010, and NovemberAugust 1, 20082009

(Unaudited)

NOTE 1 – Basis of Presentation, Significant Accounting Policies, Recently Adopted Accounting Pronouncements and New Accounting Pronouncements Not Yet Adopted

Basis of Presentation

The information set forth in these condensed consolidated financial statements is unaudited. These statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial information, the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements.

In the opinion of management, all adjustments necessary for a fair presentation have been included. The results of operations for the 3926 weeks ended OctoberJuly 31, 2009,2010, are not necessarily indicative of the results that may be expected for the fiscal year ending January 30, 2010.29, 2011. For further information, refer to the consolidated financial statements and notes thereto included in the Annual Report on Form 10-K of The Wet Seal, Inc. (the “Company”) for the fiscal year ended January 31, 2009.30, 2010.

Significant Accounting Policies

Revenue Recognition

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. 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”). Based upon an analysis completed by the Company during the second fiscal quarter of 2009, historical redemption patterns indicated that the likelihood of redemption of unredeemed gift cards, gift certificates, and store credits greater than two years after their issuance is remote. As a result, beginning in the second quarter of fiscal 2009, the Company adjusted its unearned revenue liability to recognize the change in estimated timing of when breakage of gift cards, gift certificates and store credits is recognized from greater than three years after their issuance dates to greater than two years after their issuance dates. The Company’s net sales during the 39 weeks ended October 31, 2009, included a benefit of $1.2 million due to this change in estimate to reduce the Company’s unearned revenue liability for estimated unredeemed amounts. The unearned revenue for gift cards, gift certificates, and store credits is recorded in accrued liabilities in the consolidated balance sheets and was $4.4 million, $6.5 million and $5.1 million at October 31, 2009, January 31, 2009, and November 1, 2008, 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.

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. 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 projection or 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 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, based on discounted cash flows using the Company’s weighted average cost of capital, with such estimated fair values determined using the best information available.

8


THE WET SEAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For The Company has considered all relevant valuation techniques that could be obtained without undue cost and effort and has determined that the 39 weeks ended October 31, 2009,discounted cash flow approach continues to provide the most relevant and November 1, 2008

(Unaudited)

NOTE 1 – Basis of Presentation, Significant Accounting Policies, Recently Adopted Accounting Pronouncements and New Accounting Pronouncements Not Yet Adopted (Continued)

reliable means by which to determine fair value in this circumstance.

At least 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 the 13 and 3926 weeks ended OctoberJuly 31, 2009,2010, and the 13 and 39 weeks ended NovemberAugust 1, 2008,2009, 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 those locations would continue. As such, the Company recorded non-cash charges of $0.3$1.0 million, $1.9$1.1 million, $0.5$1.6 million and $0.8$1.6 million during the 13 and 3926 weeks ended OctoberJuly 31, 2009,2010, and the 13 and 39 weeks ended NovemberAugust 1, 2008,2009, respectively, within asset impairment in the condensed consolidated statements of operations, to write down the carrying values of these stores’ long-lived assets to their estimated fair values.

Income Taxes

The Company began fiscal 20092010 with approximately $117.9$116.6 million of federal net operating loss (“NOL”) carry forwardscarryforwards (NOLs) available to offset taxable income in fiscal 20092010 and thereafter, subject to certain annual limitations based on the provisions of Section 382 of the Internal Revenue Code (“Section 382”). Subject to potential further adjustment,

For the Company believes NOL carry forwards available will be sufficient to offset any possible federal regular taxable income in fiscal 2009. Accordingly, if13 weeks ended July 31, 2010, the Company generates taxable income in fiscal 2009, the Company expects it would report anCompany’s effective income tax rate was approximately 39%, which is the rate the Company currently expects to incur for the remainder of the fiscal year. The Company incurred a higher effective income tax rate than it had in 2009 primarily as a result of the reversal of its deferred tax asset valuation allowance at the end of fiscal 2009.

The Company’s effective income tax rate for the 26 weeks ended July 31, 2010 was approximately 2.7% related51%. This rate was higher due to a limited$2.8 million in interest charges incurred in the first fiscal quarter upon the conversion of the Company’s remaining Secured Convertible Notes (the “Notes”) and Series C Convertible Preferred Stock (the “Preferred Stock”), which are not tax-deductible. The impact of these non-deductible charges on the effective income tax rate in the first fiscal quarter and the 26 weeks ended July 31, 2010, was approximately 16% and 12%, respectively.

THE WET SEAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the 26 weeks ended July 31, 2010, and August 1, 2009

(Unaudited)

NOTE 1 – Basis of Presentation, Significant Accounting Policies, and New Accounting Pronouncements Not Yet Adopted (Continued)

Due to its expected utilization of federal and state NOL carry forwards during fiscal 2010, the Company anticipates cash income taxes for the fiscal year will be approximately 2% of pre-tax income, representing the portion of federal and state alternative minimum taxes that cannot be offset by NOL carry forwards, income taxes inNOLs. The difference between the State of California, which cannot be offset by NOL carry forwards, and certain other state income taxes.

Currently, the Company maintains a 100% valuation allowance against its net deferred income tax assets, which are comprised primarily of its NOL carry forwards. As of October 31, 2009, evidence does not support realization of these net deferred income tax assets. The Company continues to evaluate available evidence, it is possible that some or all of the Company’s deferred income tax assets may be deemed realizable and, accordingly, the valuation allowance recorded against those deferred income tax assets may be reversed at or before the end of the current fiscal year. If such valuation allowance is reversed, the Company would record an immediate benefit to income taxes for a substantial majority of the reversal and would record an increase to additional paid-in capital for the remainder of the reversal. Prospectively, the Company would then report an effective income tax rate much closer to statutory rates, whichand the Company estimates to be in the range of 38% to 39%. However, this would not change the Company’s current expectations that it will not incur significantanticipated cash income tax payments in fiscal 2009 or fiscal 2010taxes is recorded as it continues to utilize available NOL carry forwards.a non-cash provision for deferred incomes taxes.

The Company’s current expectations regarding the federal NOL carry forwards it may use annually are based on calculations made by management. Through these calculations, management which calculations determined that, in April 2005 and December 2006, the Company incurred “ownership changes,” as defined in Section 382 in April 2005 and December 2006 that require re-calculation of NOL carry forward annual utilization limits. Such ownership changes can result merely from an accumulation of normal market trading activity in the Company’s Class A common stock (“common stock”) over time. The NOL carry forward annual utilization limits determined upon an ownership change depend on, among other things, the Company’s market capitalization and long-term federal interest rates on the ownership change date. If the Company were to determine it had incurred another ownership change at some time after December 2006, the Company would be required to re-calculate its annual federal NOL carry forward utilization limit, which could result in a decrease to NOL carry forwards annually available to offset taxable income.

Recently Adopted Accounting Pronouncements

Effective July 2009, the Financial Accounting Standards Board (FASB) codified accounting literature into a single source of authoritative accounting principles, except for certain authoritative rulesincome and interpretive releases issued by the Securities and Exchange Commission. Since the codification did not alter existing GAAP, it did not have an impact on the Company’s condensed consolidated financial statements. All references to pre-codified GAAP have been removed from this Form 10-Q.

9


THE WET SEAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the 39 weeks ended October 31, 2009, and November 1, 2008

(Unaudited)

NOTE 1 – Basis of Presentation, Significant Accounting Policies, Recently Adopted Accounting Pronouncements and New Accounting Pronouncements Not Yet Adopted (Continued)

In June 2008, the FASB issued guidance which requires entities to apply the two-class method of computing basic and diluted earnings per share to participating securities with nonforfeitable dividend rights, irrespective of whether the entity declaresincrease in cash income tax payments in fiscal 2010 and/or pays a dividend. This guidance was effective for financial statements issued for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2008, and all prior-period earnings per share data presented shall be adjusted retrospectively. Effective February 1, 2009, the Company adopted this guidance and it did not significantly impact the Company’s condensed consolidated financial statements. Refer to Note 5 of the Notes to Condensed Consolidated Financial Statements for further information.

In May 2009, the FASB issued guidance which establishes general standards of accounting for and disclosures of events that occur after the balance sheet date but before the condensed consolidated financial statements are issued or are available to be issued. Among other items, this guidance requires the disclosure of the date through which an entity has evaluated subsequent events and the basis for that date. This guidance is effective for interim and annual periods ending after June 15, 2009, and the Company’s adoption of it on August 1, 2009 resulted in no impact on the Company’s condensed consolidated financial statements except for the necessary disclosures. The Company has evaluated subsequent events through the date of issuance of these condensed consolidated financial statements, December 2, 2009.thereafter.

New Accounting Pronouncements Not Yet Adopted

In October 2009, the FASBFinancial Accounting Standards Board (“FASB”) issued guidance related to revenue arrangements with multiple deliverables. Under the new guidance, when vendor specific objective evidence or third party evidence for deliverables in an arrangement cannot be determined, a best estimate of the selling price is required to separate deliverables and allocate arrangement consideration using the relative selling price method. Such guidance is to be applied on a prospective basis for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with early adoption permitted. The Company does not believe adoption of this guidance will have any effect on its condensed consolidated financial statements.

In January 2010, the FASB issued guidance and clarifications for improving disclosures about fair value measurements. This guidance requires enhanced disclosures regarding transfers in and out of the levels within the fair value hierarchy. Separate disclosures are required for transfers in and out of Level 1 and 2 fair value measurements, and the reasons for the transfers must be disclosed. In the reconciliation for Level 3 fair value measurements, separate disclosures are required for purchases, sales, issuances, and settlements on a gross basis. The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements, which are effective for interim and annual reporting periods beginning after December 15, 2010. Effective January 31, 2010, the Company adopted the new and updated disclosure guidance, aside from those deferred to periods after December 15, 2010, and it did not significantly impact the Company’s condensed consolidated financial statements. The Company does not believe adoption of the remaining guidance on disclosures will have any effect on its condensed consolidated financial statements.

NOTE 2 – Stock-Based Compensation

The Company had the following two stock incentive planshas a 2005 Stock Incentive Plan (the “2005 Plan”) under which shares were available for grant at OctoberJuly 31, 2009: the 2005 Stock Incentive Plan (the “2005 Plan”) and the 2000 Stock Incentive Plan (the “2000 Plan”).2010. The Company also previously granted share awards under its 1996 Long-Term Incentive Plan (the “1996 Plan”) and its 2000 Stock Incentive Plan (the “2000 Plan”) that remain unvested and/or unexercised as of OctoberJuly 31, 2009;2010; however, the 1996 Plan expired during fiscal 2006 and the 2000 Plan expired during fiscal 2009, and no further share awards may be granted under the 1996 Plan and 2000 Plan. The 2005 Plan, the 2000 Plan, and the 1996 Plan are collectively referred to as the “Plans.”

THE WET SEAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the 26 weeks ended July 31, 2010, and August 1, 2009

(Unaudited)

NOTE 2 – Stock-Based Compensation (Continued)

The 2005 Plan and 2000 Plan permitpermits the granting of options, restricted common stock, performance shares, or other equity-based awards to the Company’s employees, officers, directors, and consultants. The Company believes the granting of equity-based awards helps to align the interests of its employees, officers, directors, and consultants with those of its stockholders. The Company has a practice of issuing new shares to satisfy stock option exercises, as well as for restricted stock and performance share grants. The 2005 Plan was approved by the Company’s stockholders on January 10, 2005, as amended with stockholder approval on July 20, 2005, for the issuance of incentive awards covering 12,500,000 shares of Class A common stock. Additionally, an amended and restated 2005 Plan was approved by the Company’s stockholders on May 19, 2010, which increased the incentive awards capacity under the 2005 Plan to 17,500,000 shares of the Company’s Class A common stock. An aggregate of 19,653,50326,281,061 shares of the Company’s Class A common stock have been issued or may be issued pursuant to the Plans. As of OctoberJuly 31, 2009, 2,096,5042010, 6,582,188 shares were available for future grants.

Options

The Plans provide that the per-share exercise price of a stock option may not be less than the fair market value of the Company’s Class A common stock on the date the option is granted. Under the Plans, outstanding options generally vest over periods ranging from three to five years from the grant date and generally expire from five to ten years after the grant date. Certain stock option and other equity-based awards provide for accelerated vesting if there is a change in control (as defined in the Plans). The Company records compensation expense for employee stock options based on the estimated fair value of the options on the date of grant using the Black- ScholesBlack-Scholes option-pricing model. The Company uses historical data, the implied volatility of market-traded options and other factors to estimate the expected price volatility, option lives, and forfeiture rates.

10


THE WET SEAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the 39 weeks ended October 31, 2009, and November 1, 2008

(Unaudited)

NOTE 2 – Stock-Based Compensation (Continued)

The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant forand the estimated life of the option. The following weighted-average assumptions were used to estimate the fair value of options granted during the periods indicated using the Black-Scholes option-pricing model:

 

  13 Weeks Ended    39 Weeks Ended  13 Weeks Ended 26 Weeks Ended 
  October 31,
2009
  November 1,
2008
    October 31,
2009
  November 1,
2008
  July 31,
2010
 August 1,
2009
 July 31,
2010
 August 1,
2009
 

Dividend Yield

  0.00%    0.00%      0.00%  0.00%    0.00 0.00 0.00 0.00

Expected Volatility

  56.00%    53.00%      56.00%  53.00%    59.00 56.00 59.00 56.00

Risk-Free Interest Rate

  1.65%    2.60%      1.63%  2.44%    1.29 1.60 1.56 1.58

Expected Life of Options (in Years)

  3.3        3.3          3.3      3.3        3.3   3.3   3.3   3.3  

The Company recorded compensation expense of less than $0.1 million, $0.1 million, $0.2 million, and a compensation benefit of less than $0.1 million, compensation expense of $0.4 million and $0.3$0.2 million, in each case less than $0.01 per basic and diluted share, related to stock options outstanding during the 13 and 3926 weeks ended OctoberJuly 31, 2009,2010 and the 13 and 39 weeks NovemberAugust 1, 2008,2009, respectively. Refer to “Change in Estimated Forfeiture Rate” later within this Note 2 for additional information.

At OctoberJuly 31, 2009,2010, there was $0.8$0.6 million of total unrecognized compensation expense related to nonvested stock options under the Company’s share-based payment plans, which will be recognized over an average period of 2.01.7 years, over the course ofrepresenting the remaining vesting periods of such options through fiscal 2012.2013.

The following table summarizes the Company’s stock option activities with respect to its Plans for the 3926 weeks ended OctoberJuly 31, 2009,2010, as follows (aggregate intrinsic value in thousands):

 

Options

  Number of
Shares
 Weighted-
Average
Exercise
Price Per
Share
  Weighted-
Average
Remaining
Contractual Life
(in years)
  Aggregate
Intrinsic
Value
  Number of
Shares
 Weighted-
Average
Exercise
Price Per
Share
  Weighted-
Average
Remaining
Contractual Life
(in years)
  Aggregate
Intrinsic
Value

Outstanding at January 31, 2009

  2,367,202   $7.17    

Outstanding at January 30, 2010

  2,234,752   $6.77    

Granted

  286,500   $3.35      32,000   $4.54    

Exercised

  (3,334 $2.40      (64,168 $3.21    

Canceled

  (442,615 $6.29      (443,144 $4.81    
                  

Outstanding at October 31, 2009

  2,207,753   $6.86  2.98  $97

Vested and expected to vest in the future at October 31, 2009

  2,060,748   $7.08  2.89  $83

Exercisable at October 31, 2009

  1,574,862   $8.09  2.50  $33

Outstanding at July 31, 2010

  1,759,440   $6.94  2.68  $148

Vested and expected to vest in the future at July 31, 2010

  1,685,572   $7.09  2.62  $140

Exercisable at July 31, 2010

  1,231,457   $8.40  2.17  $84

11


THE WET SEAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the 3926 weeks ended OctoberJuly 31, 2009,2010, and NovemberAugust 1, 20082009

(Unaudited)

 

NOTE 2 – Stock-Based Compensation (Continued)

 

Options vested and expected to vest in the future is comprised of all options outstanding at OctoberJuly 31, 2009,2010, net of estimated forfeitures. Additional information regarding stock options outstanding as of OctoberJuly 31, 2009,2010, is as follows:

 

   Options Outstanding    Options Exercisable

Range of Exercise Prices

  Number
Outstanding
as of
October 31,
2009
  Weighted-
Average
Remaining
Contractual Life
(in years)
  Weighted-
Average
Exercise
Price Per
Share
    Number
Exercisable
as of
October 31,
2009
  Weighted-
Average
Exercise
Price Per
Share

$ 1.81 - $   3.67

  454,500  4.44  $3.04    119,902  $2.95

   3.78 -      5.46

  457,313  4.02   4.36    212,327   4.54

   5.51 -      6.39

  538,000  1.61   5.92    501,673   5.88

   6.50 -    11.76

  611,190  2.51   9.49    594,210   9.57

 11.79 -    23.02

  146,750  2.20   18.92    146,750   18.92
              

$ 1.81 - $ 23.02

  2,207,753  2.98  $6.86    1,574,862  $8.09
              
   Options Outstanding  Options Exercisable

Range of Exercise Prices

  Number
Outstanding
as of
July 31,
2010
  Weighted-
Average
Remaining
Contractual Life
(in years)
  Weighted-
Average
Exercise
Price Per
Share
  Number
Exercisable
as of
July 31,
2010
  Weighted-
Average
Exercise
Price Per
Share

$    1.81 - $  2.93

  157,500  2.80  $2.61  99,169  $2.58

      2.96 -     4.83

  608,500  4.11   3.70  153,180   3.95

      4.86 -     8.00

  486,440  2.03   6.39  472,108   6.44

      8.08 -   12.28

  386,500  1.57   10.62  386,500   10.62

    15.02 -   23.02

  120,500  1.43   19.40  120,500   19.40
            

$    1.81 - $23.02

  1,759,440  2.68  $6.94  1,231,457  $8.40
            

The weighted-average grant-date fair value of options granted during the 13 and 3926 weeks ended OctoberJuly 31, 2010, and August 1, 2009, was $1.65, $1.91, $1.36 and the 13 and 39 weeks ended November 1, 2008, was $1.35, $1.35, $1.67 and $1.50,$1.37, respectively. The total intrinsic value for options exercised during each of the 3913 and 26 weeks ended OctoberJuly 31, 2009,2010, and the 39 weeks ended NovemberAugust 1, 2008,2009, was less than $0.1 million.million, $0.1 million, less than $0.1 million and less than $0.1 million, respectively.

Cash received from option exercises under all Plans for each of the 3926 weeks ended OctoberJuly 31, 2010, and August 1, 2009, was $0.2 million and November 1, 2008, was less than $0.1 million.million, respectively. The Company did not recordrealize tax benefits for the tax deductions from option exercises as it has been determined that it is currently more likely than not thatmust first utilize its regular NOL prior to realizing the Company will not generate sufficient taxable income to realize its deferred incomeexcess tax assets.benefits.

Restricted Common Stock and Performance Shares

Under the 2005 Plan and 2000 Plan, the Company grants directors, certain executives, and other key employees restricted common stock with vesting generally contingent upon completion of specified service periods.periods ranging from one to three years. The Company also grants certain executives and other key employeesemployee’s performance share awards with vesting generally contingent upon a combination of specified service periods and the Company’s achievement of specified common stock price levels.

During the 3926 weeks ended OctoberJuly 31, 2009,2010, and NovemberAugust 1, 2008,2009, the Company granted 263,436213,900 and 249,025263,436 shares, respectively, of restricted common stock to certain employees and directors under the Plans. Restricted common stock awards generally vest over periods ranging from one to three years. The weighted-average grant-date fair value of the restricted common stock granted during the 3926 weeks ended OctoberJuly 31, 2010, and August 1, 2009, was $3.35 and November 1, 2008, was $2.71 and $3.10 per share, respectively. The Company recorded approximately $0.4$0.3 million, $0.9$0.6 million, $0.5$0.3 million and $1.2$0.5 million of compensation expense related to outstanding shares of restricted common stock held by employees and directors during the 13 and 3926 weeks ended OctoberJuly 31, 2010, and August 1, 2009, respectively. During the 26 weeks ended July 31, 2010, and August 1, 2009, the Company granted no performance shares under the 2005 Plan. The Company recorded a compensation benefit of $0.2 million and $0.1 million, and compensation expense of $0.2 million and $0.2 million during the 13 and 3926 weeks ended NovemberJuly 31, 2010, and August 1, 2008, respectively.2009, respectively, related to performance shares previously granted to officers. The benefit recorded in the 13 and 26 weeks ended July 31, 2010 was related to higher forfeiture adjustment in such periods. Refer to “Change in Estimated Forfeiture Rate” later within this Note 2 for additional information.

During the 39 weeks ended October 31, 2009, the Company granted no performance shares under the 2005 Plan. During the 39 weeks ended November 1, 2008, the Company granted 90,000 performance shares under the 2005 Plan. The Company recorded $0.1 million, $0.3 million, $0.1 million and $0.8 million of compensation expense during the 13 and 39 weeks ended October 31, 2009, and the 13 and 39 weeks ended November 1, 2008, respectively, related to performance shares granted to officers. Refer to “Change in Estimated Forfeiture Rate” later within this Note 2 for additional information.

12


THE WET SEAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the 3926 weeks ended OctoberJuly 31, 2009,2010, and NovemberAugust 1, 20082009

(Unaudited)

 

NOTE 2 – Stock-Based Compensation (Continued)

 

The fair value of nonvested restricted common stock awards is determined based on the closing trading price of the Company’s common stock on the grant date. The fair value of nonvested performance shares granted to officers is determined based on a number of factors, including the closing trading price of the Company’s common stock and the estimated probability of achieving the Company’s stock price performance conditions as of the grant date. The following table summarizes activity with respect to the Company’s nonvested restricted common stock and performance shares for the 3926 weeks ended OctoberJuly 31, 2009:2010:

 

Nonvested Restricted Common Stock and Performance Shares

  Number of
Shares
 Weighted-
Average Grant-
Date Fair Value
  Number of
Shares
 Weighted-
Average Grant-
Date Fair Value

Nonvested at January 31, 2009

  1,820,260   $2.55

Nonvested at January 30, 2010

  1,596,318   $2.37

Granted

  263,436   $2.71  213,900   $3.35

Vested

  (437,652 $3.35  (254,038 $2.81

Forfeited

  —     $—    (30,000 $3.09
          

Nonvested at October 31, 2009

  1,646,044   $2.37

Nonvested at July 31, 2010

  1,526,180   $2.42
          

The fair value of restricted common stock and performance shares that vested during the 3926 weeks ended OctoberJuly 31, 2009,2010, was $1.4$0.9 million.

At OctoberJuly 31, 2009,2010, there was $0.9$0.5 million of total unrecognized compensation expense related to nonvested restricted common stock and performance shares under the Company’s share-based payment plans, of which $0.7$0.4 million relates to restricted common stock and $0.2$0.1 million relates to performance shares. That cost is expected to be recognized over a weighted-average period of 0.80.4 years. These estimates utilize subjective assumptions about expected forfeiture rates, which could change over time. Therefore, the amount of unrecognized compensation expense noted above does not necessarily represent the expense that will ultimately be recognized by the Company in its condensed consolidated statements of operations.

The following table summarizes stock-based compensation recorded in the condensed consolidated statements of operations (in thousands):

 

  13 Weeks Ended  39 Weeks Ended  13 Weeks Ended  26 Weeks Ended 
  October 31,
2009
  November 1,
2008
  October 31,
2009
  November 1,
2008
  July 31,
2010
 August 1,
2009
  July 31,
2010
 August 1,
2009
 

Cost of sales

  $(51)     $116     $(230)   $203     $(156 $113  $(130 $(180

Selling, general, and administrative expenses

   728      843      1,378    2,158      259    539   749    651  
                         

Stock-based compensation

  $677     $959     $1,148   $2,361     $103   $652  $619   $471  
                         

Change in Estimated Forfeiture Rate

In the first quartersquarter of fiscal 2009, and fiscal 2008, based on historical experience, the Company modified the estimated annual forfeiture rate used in recognizing stock-based compensation expense, from a 10% forfeiture rate to a 15% forfeiture rate in the first quarter of fiscal 2009 and, for its executives, from a 5% forfeiture rate to a 10% forfeiture rate in the first quarter of fiscal 2008.rate. During thesethis same periods,period, the Company also realized benefits from actual forfeiture experience that was higher than previously estimated for unvested stock options and restricted common stock, resulting primarily from executive and other employee departures from the Company. The impact of these events were benefits during the 3926 weeks ended October 31,August 1, 2009, and the 39 weeks ended November 1, 2008, of approximately $0.9 million, and $0.9 million, respectively, of which $0.4 million and $0.3 million, respectively, was included in cost of sales and $0.5 million and $0.6 million, respectively, was included in selling, general, and administrative expenses in the condensed consolidated statements of operations.

13 During the 26 weeks ended July 31, 2010, the estimated annual forfeiture rate has remained at 15%.


THE WET SEAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the 3926 weeks ended OctoberJuly 31, 2009,2010, and NovemberAugust 1, 20082009

(Unaudited)

 

NOTE 3 – Senior Revolving Credit Facility, Secured Convertible Notes, Convertible Preferred Stock, and Common Stock Warrants

The Company maintains a $35.0 million senior revolving credit facility (the “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 Facility. The Facility expires in May 2011.2011 and the Company intends to either replace or renew the Facility. Under the Facility, the Company is subject to borrowing base limitations on the amount that can be borrowed and certain customary covenants, including covenants limiting the ability to incur additional indebtedness, make investments and acquisitions, grant liens, pay dividends, close stores, and dispose of assets, subject to certain exceptions, without the lender’s consent. The ability of the Company and its subsidiaries to borrow and request the issuance of letters of credit is subject to the requirement that the Company maintainsmaintain an excess of the borrowing base over the outstanding credit extensions of not less than $5.0 million. The interest rate on the revolving line of credit under the Facility is the prime rate or, if the Company elects, the London InterbankInterBank Offered Rate (“LIBOR”)(LIBOR) plus a margin ranging from 1.0% to 1.5%. The applicable LIBOR margin is based on the level of average Excess Availability,excess availability, as defined under the Facility, at the time of election, as adjusted quarterly. The applicable LIBOR margin was 1.0% as of OctoberJuly 31, 2009.2010. The Company also incurs fees on outstanding letters of credit under the Facility 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 Facility ranks senior in right of payment to the Company’s Secured Convertible Notes (the “Notes”). Borrowings under the Facility are secured by all presently owned and hereafter acquired assets of the Company and two of its wholly-ownedwholly owned subsidiaries, The Wet Seal Retail, Inc. and Wet Seal Catalog, Inc., each of which may be a borrower under the Facility. The obligations of the Company and the subsidiary borrowers under the Facility are guaranteed by another wholly-ownedwholly owned subsidiary of the Company, Wet Seal GC, SMLLC.LLC.

At OctoberJuly 31, 2009,2010, the amount outstanding under the Facility consisted of $6.5$3.8 million in open commercialdocumentary letters of credit related to merchandise purchases and $1.7$1.5 million in outstanding standby letters of credit, and the Company had $26.8$29.7 million available under the Facility for cash advances and/or the issuance of additional letters of credit.

At July 31, 2010, the Company was in compliance with all covenant requirements related to the Facility.

During the 3926 weeks ended November 1, 2008,July 31, 2010, investors in the Company’s Notes converted $3.4$4.7 million of the Notes into 2,274,8043,111,111 shares of the Company’s Class A common stock. As a result of these conversions, the Company recorded net non-cash interest charges of $1.9$2.1 million during the 3926 weeks ended November 1, 2008,July 31, 2010, to write-off a ratable portion of unamortized debt discount and deferred financing costs and accrued interest associated with the Notes. Additionally, a ratable portion of accrued interest of $1.0 million was forfeited by the holder when the Notes were converted and it was written off to paid-in capital. Finally, the Company provided the holder with a $0.7 million conversion inducement, which was recorded as an interest charge during the 26 weeks ended July 31, 2010. The Company also repurchased an insignificant remaining Note balance from another holder. As a result of these transactions, there are no longer any remaining Notes outstanding as of July 31, 2010 and there was a satisfaction and discharge of our obligations under the Indenture governing the Notes. No Notes were converted during the 26 weeks ended August 1, 2009.

Prior to the first quarter of fiscal 2010, the Company recognized the ratable portion of accrued interest forfeited by Note holders upon conversions as a reduction of interest expense. The Company has determined that the correct treatment of accrued interest forfeited is a credit to paid-in capital rather than a reduction of interest expense. In the condensed consolidated balance sheets as of January 30, 2010, and August 1, 2009, the Company has retrospectively reclassified $2.9 million from accumulated deficit to paid-in capital to reflect the correct treatment of accrued interest forfeited in periods prior to fiscal 2010. This reclassification has no effect on the previously reported total stockholders’ equity or cash flows and is not material to all periods presented.

During the 3926 weeks ended OctoberJuly 31, 2009,2010, and NovemberAugust 1, 2008,2009, certain investors exercised portions of outstanding common stock warrants, resulting in the issuance of 183,5721,160,715 and 1,545,720183,572 shares, respectively, of the Company’s Class A common stock in exchange for $0.5$4.3 million and $5.6$0.5 million, respectively, of proceeds to the Company.

During the 3926 weeks ended November 1, 2008,July 31, 2010, investors in the Company’s Convertible Preferred Stock (the “Preferred Stock”) converted $0.6$1.6 million of Preferred Stock into 185,333537,000 shares of the Company’s Class A common stock. As a result of this transaction, there is no longer any Preferred Stock outstanding as of July 31, 2010. No Preferred Stock was converted during the 26 weeks ended August 1, 2009.

At October

THE WET SEAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the 26 weeks ended July 31, 2009, the Company was in compliance with all covenant requirements related to the Facility2010, and the Notes.August 1, 2009

(Unaudited)

NOTE 4 – Fair Value Measurements

Fair value is defined as the price that would be received upon sale of an asset or paid upon transfer of a liability in an orderly transaction between market participants at the measurement date and in the principal or most advantageous market for that asset or liability. The fair value should be calculated based on assumptions that market participants would use in pricing the asset or liability, not on assumptions specific to the entity. In addition, the fair value of liabilities should include consideration of non-performance risk, including the Company’s own credit risk.

14


THE WET SEAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the 39 weeks ended October 31, 2009, and November 1, 2008

(Unaudited)

NOTE 4 – Fair Value Measurements (Continued)

Inputs used in measuring fair value are prioritized into a three-level hierarchy based on whether the inputs to those measurements are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. The fair-value hierarchy requires the use of observable market data when available and consists of the following levels:

 

Level 1 – Quoted prices for identical instruments in active markets;

 

Level 2 – Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs are observable in active markets; and

 

Level 3 – Valuations derived from valuation techniques in which one or more significant inputs are unobservable.

The following table presentstables present information on the Company’s financial instruments (in thousands):

 

  Carrying
Amount
  Fair Value Measurements
at Reporting Date Using
  Carrying
Amount
at July 31,
2010
  Fair Value Measurements
at Reporting Date Using
  October 31,
2009
  Level 1      Level 2          Level 3       Level 1  Level 2  Level 3

Financial assets:

                

Cash and cash equivalents

  $144,161    $144,161  $—    $—    $165,516  $21,095  $144,421  $—  

Other receivables

   389     389   —     —  

Long-term tenant allowance receivables

   762   —     —     762
  Carrying
Amount
January 30,
2010
  Fair Value Measurements
at Reporting Date Using
  Level 1  Level 2  Level 3

Financial assets:

        

Cash and cash equivalents

  $161,693  $17,306  $144,387  $—  

Long-term tenant allowance receivables

   711     —     —     711     728   —     —     728

Financial liabilities:

                

Accounts payable

   32,158     32,158   —     —  

Embedded derivative instrument

   20     —     20   —     20   —     20   —  

Notes

   3,310     9,924   —     —     3,540   10,422   —     —  

Preferred Stock

   1,611     1,713   —     —     1,611   1,799   —     —  
  Carrying
Amount
at August 1,
2009
  Fair Value Measurements
at Reporting Date Using
  Level 1  Level 2  Level 3

Financial assets:

        

Cash and cash equivalents

  $143,987  $4,685  $139,302  $—  

Financial liabilities:

        

Embedded derivative instrument

   20   —     20   —  

Notes

   3,095   10,267   —     —  

Preferred Stock

   1,611   1,772   —     —  

THE WET SEAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the 26 weeks ended July 31, 2010, and August 1, 2009

(Unaudited)

NOTE 4 – Fair Value Measurements (Continued)

Cash and cash equivalents are carried at either cost or amortized cost, which approximates fair value, due to their short term maturities. Money market funds are valued through the use of quoted market prices, or $1, which is generally the net asset value of these funds. The Company believes the carrying amounts of cash and cash equivalents, other receivables, long-term tenant allowance receivables and accounts payable approximate fair value. The fair value of the long-term tenant allowance receivables was determined by discounting them to present value, and they are included in other assets within the condensed consolidated balance sheet. The Company determinesdetermined the fair value of its embedded derivative instrument using a combination of the Black-Scholes model and Monte-Carlo simulation. The estimated fair values for the Notes and Preferred Stock were determined to be the market value of the Company’s Class A common stock as of October 31,January 30, 2010, and August 1, 2009, as applicable, multiplied by the number of shares of common stock into which such securities could be converted. There are no longer any embedded derivatives, Notes or Preferred Stock outstanding as of July 31, 2010, as a result of the conversions discussed in Note 3.

The table below segregates all non-financial assets and liabilities as of OctoberJuly 31, 2010, January 30, 2010, and August 1, 2009, that are measured at fair value on a nonrecurring basis in periods subsequent to initial recognition into the most appropriate level within the fair value hierarchy based on the inputs used to determine the fair value at the measurement date:

 

  Carrying
Amount
at July 31,
2010
  Fair Value Measurements
at Reporting Date Using
  Total Gains
(Losses)
 
  Level 1  Level 2  Level 3  

Long-lived assets held and used

  $87,029  $—    $—    $87,029  $(1,131
                

Total assets

  $87,029  $—    $—    $87,029  $(1,131
                
  Carrying
Amount
  Fair Value Measurements
at Reporting Date Using
   
  October 31,
2009
      Level 1          Level 2      Level 3  Total Gains
(Losses)
  Carrying
Amount
January 30,
2010
  Fair Value Measurements
at Reporting Date Using
  Total Gains
(Losses)
 
  Level 1  Level 2  Level 3  

Long-lived assets held and used

    $81,594      $—      $—      $81,594     $(1,886)   $78,063  $—    $—    $78,063  $(2,341
                               

Total assets

  $78,063  $—    $—    $78,063  $(2,341
                
          
  Carrying
Amount
at August 1,
2009
  Fair Value Measurements
at Reporting Date Using
  Total Gains
(Losses)
 
  Level 1  Level 2  Level 3  

Long-lived assets held and used

  $79,469  $—    $—    $79,469  $(1,552)
                

Total assets

    $81,594      $—      $—      $81,594     $(1,886)   $79,469  $—    $—    $79,469  $(1,552)
                               

The Company performs impairment tests whenever there are indicators of impairment. Refer to Note 1 for further information.

15Long-lived assets held and used with a carrying value of $87.0 million and $79.5 million, respectively, represent their fair values, after the impairment charges of $1.0 million, $1.1 million, $1.6 million and $1.6 million, respectively, during the 13 and 26 weeks ended July 31, 2010, and August 1, 2009.


THE WET SEAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the 3926 weeks ended OctoberJuly 31, 2009,2010, and NovemberAugust 1, 20082009

(Unaudited)

NOTE 4 – Fair Value Measurements (Continued)

The Company performs impairment tests whenever there are indicators of impairment. These tests typically consider which assets are impaired at a store level. The Company recognizes an impairment loss only if the carrying value of a long-lived asset or group of assets is not recoverable from undiscounted cash flows, and measures an impairment loss as the difference between the carrying value and fair value of the assets based on discounted cash flows, using the Company’s weighted average cost of capital. The Company has considered all relevant valuation techniques that could be obtained without undue cost and effort, and has determined that the discounted cash flow approach continues to provide the most relevant and reliable means by which to determine fair value in this circumstance.

As of October 31, 2009, long-lived assets held and used with a carrying value of $83.5 million were written down to their fair value, resulting in impairment charges of $0.3 million and $1.9 million, respectively, during the 13 and 39 weeks ended October 31, 2009.

NOTE 5 – Net Income Per Share

Net income per share, basic, is computed based on the weighted-average number of common shares outstanding for the period, including consideration of the two-class method with respect to certain of the Company’s other equity securities (see below). Net income per share, diluted, is computed based on the weighted-average number of common and potentially dilutive common equivalent shares outstanding for the period, also with consideration given to the two-class method.

The dilutive effect of stock warrants is determined using the “treasury stock” method, whereby exercise is assumed at the beginning of the reporting period and proceeds from such exercise are assumed to be used to purchase the Company’s Class A common stock at the average market price during the period. The dilutive effect of stock options is also determined using the “treasury stock” method, whereby proceeds from such exercise, unamortized compensation on share-based awards, and excess tax benefits arising in connection with share-based compensation are assumed to be used to purchase the common stock at the average market price during the period.

The Notes and Preferred Stock arewere convertible into shares of Class A common stock. Both of these securities includeincluded rights whereby, upon payment of dividends or other distributions to Class A common stockholders, the Notes and Preferred Stock would participate ratably in such distributions based on the number of common shares into which such securities were convertible at that time. Because of these rights, the Notes and Preferred Stock arewere considered to be participating securities requiring the use of the two-class method for the computation of earnings per share. For the dilutive computation, under the two-class method, determination of whether the Notes and Preferred Stock arewere dilutive iswas based on the application of the “if-converted” method. At OctoberAlthough the Notes and Preferred Stock were fully converted and represented Class A common shares outstanding as of July 31, 2009,2010, they were included in the computation of diluted earnings for the 26 weeks ended July 31, 2010 with respect to the period they were outstanding prior to conversion. For the 26 weeks ended July 31, 2010 and Novemberthe 13 and 26 weeks ended August 1, 2008,2009, the effect of the Notes and Preferred Stock was anti-dilutivenot dilutive to the computation of diluted earnings per share.

Effective February 1, 2009, the Company adopted guidance issued by the FASB, which states that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are considered participating securities and shall be included in the computation of earnings per share pursuant to the two-class method. While the Company historically has paid no cash dividends, participants in the Company’s equity compensation plans who were granted restricted stock and performance shares are allowed to retain cash dividends paid on unvested restricted stock and unvested performance shares. Therefore,The Company’s unvested restricted stock and unvested performance shares also qualify as participating securities and are included in the computation of earnings per share must be calculated usingpursuant to the two-class method. All prior-period earnings per share data presented must be adjusted retrospectively. For the dilutive computation, under the two-class method, determination of whether the unvested share-based payment awards are dilutive is based on the application of the “treasury stock” method and whether the performance criteria has been met. At OctoberFor the 13 and 26 weeks ended July 31, 2009,2010, and NovemberAugust 1, 2008,2009, the effect of the unvested share-based payment awards was anti-dilutive to the computation of diluted earnings per share.

16


THE WET SEAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the 39 weeks ended October 31, 2009, and November 1, 2008

(Unaudited)

NOTE 5 – Net Income Per Share (Continued)

The two-class method requires allocation of undistributed earnings per share among the common stock, Notes, Preferred Stock and unvested share-based payment awards based on the dividend and other distribution participation rights under each of these securities. The following table summarizes the allocation of undistributed earnings among common stock and other participating securities using the two-class method and reconciles the weighted average common shares used in the computation of basic and diluted earnings per share (in thousands, except share data):

 

  13 Weeks Ended  13 Weeks Ended
  October 31, 2009  November 1, 2008  July 31, 2010  August 1, 2009
  Net Income Shares  Per Share
Amount
  Net Income Shares  Per Share
Amount
  Net Income Shares  Per Share
Amount
  Net Income Shares  Per Share
Amount

Basic earnings per share:

                    

Net income

  $4,514       $6,786       $1,615       $3,103     

Less: Undistributed earnings allocable to participating securities

   (243      (368      (23      (159   
                                    

Basic earnings per share

  $4,271   95,685,372  $0.04  $6,418   94,680,063  $0.07  $1,592   100,257,750  $0.02  $2,944   95,594,834  $0.03
                                

Diluted earnings per share:

                    

Net income

  $4,514       $6,786       $1,615       $3,103     

Less: Undistributed earnings allocable to participating securities

   (242      (362      (23      (158   

Effect of dilutive securities

   720,478     1,431,930     298,884     564,427  
                                    

Diluted earnings per share

  $4,272   96,405,850  $0.04  $6,424   96,111,993  $0.07  $1,592   100,556,634  $0.02  $2,945   96,159,261  $0.03
                                    
  39 Weeks Ended
  October 31, 2009  November 1, 2008
  Net Income Shares  Per Share
Amount
  Net Income Shares  Per Share
Amount

Basic earnings per share:

          

Net income

  $12,646       $25,862     

Less: Undistributed earnings allocable to participating securities

   (686      (1,736   
                  

Basic earnings per share

  $11,960   95,556,814  $0.13  $24,126   92,564,341  $0.26
                

Diluted earnings per share:

          

Net income

  $12,646       $25,862     

Less: Undistributed earnings allocable to participating securities

   (682      (1,710   

Effect of dilutive securities

   578,046     1,458,560  
                  

Diluted earnings per share

  $11,964   96,134,860  $0.12  $24,152   94,022,901  $0.26
                  

17


THE WET SEAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the 3926 weeks ended OctoberJuly 31, 2009,2010, and NovemberAugust 1, 20082009

(Unaudited)

 

NOTE 5 – Net Income Per Share (Continued)

 

   26 Weeks Ended
   July 31, 2010  August 1, 2009
   Net Income  Shares  Per Share
Amount
  Net Income  Shares  Per Share
Amount

Basic earnings per share:

          

Net income

  $4,757       $8,132     

Less: Undistributed earnings allocable to participating securities

   (127      (418   
                      

Basic earnings per share

  $4,630   98,756,560  $0.05  $7,714   95,492,536  $0.08
                    

Diluted earnings per share:

          

Net income

  $4,757       $8,132     

Less: Undistributed earnings allocable to participating securities

   (126      (416   

Effect of dilutive securities

   657,685     496,128  
                      

Diluted earnings per share

  $4,631   99,414,245  $0.05  $7,716   95,988,664  $0.08
                      

The computations of diluted earnings per share excluded the following potentially dilutive securities exercisable or convertible into Class A common stock for the periods indicated because their effect would not have been anti-dilutive.dilutive.

 

    13-Week Period Ended    39-Week Period Ended  13-Week Period Ended  26-Week Period Ended
    October 31,
2009
    November 1,
2008
    October 31,
2009
    November 1,
2008
  July 31,
2010
  August 1,
2009
  July 31,
2010
  August 1,
2009

Stock options outstanding

    2,009,813    2,332,848    2,004,600    2,346,324  1,558,143  2,082,286  1,502,585  2,080,692

Performance shares and nonvested restricted stock awards

    1,785,238    1,653,547    1,833,914    1,730,316  1,481,180  1,508,872  1,538,774  1,525,165

Stock issuable upon conversion of secured convertible notes

    3,111,113    3,111,113    3,111,113    4,227,684  —    3,111,113  991,453  3,111,113

Stock issuable upon conversion of preferred stock

    537,000    657,161    537,000    700,609  —    537,000  168,181  537,000

Stock issuable upon exercise of warrants:

                        

June 2004 warrants

    1,723,705    1,723,705    1,723,705    1,968,041  —    1,723,705  —    1,723,705

Series E warrants

    6,092,116    —      6,092,116    —    —    6,092,116  —    6,092,116
                                

Total

    15,258,985    9,478,374    15,302,448    10,972,974  3,039,323  15,055,092  4,200,993  15,069,791
                                

Based upon the respective exercise prices and number of outstanding warrants, exercise of all outstanding warrants via cash payment by the warrant holders as of July 31, 2010 would have resulted in proceeds to the Company of $18.1 million.

NOTE 6 – Commitments and Contingencies

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 the Company’s current and former employees that were employed and paid by the Company on an hourly basis during the four-year period from July 19, 2002 through July 19, 2006. The Company was 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. On November 30, 2006, the Company 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, subject to appeal. On April 28, 2008, a notice of appeal of the judgment was filed. On May 6, 2009, the Court reversed and remanded the case forto the Superior Court to re-evaluate the fairness of the settlement, which is expected toand a final hearing will take place in December 2009.September 2010. As of OctoberJuly 31, 2009,2010, the Company hadhas accrued an amount equal to the settlement amount in accrued liabilities onin its condensed consolidated balance sheet.

THE WET SEAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the 26 weeks ended July 31, 2010, and August 1, 2009

(Unaudited)

NOTE 6 – Commitments and Contingencies (Continued)

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 the Company’s current and former employees thatwho were employed and paid by the Company during the four-year period from May 22, 2003 through May 22, 2007.the present. The Company was 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. Discovery is ongoing and the Court has indicated that thePlaintiffs filed their motion for class certification filing datein July 2010. The Company’s opposition to Plaintiffs’ motion is due on September 24, 2010, and briefing schedule will be set at a status conference on December 15, 2009.the hearing is scheduled for October 8, 2010. The Company is vigorously defending this litigation and is unable to predict the likely outcome and whether such outcome may have a material adverse effect on the Company’sits results of operations or financial condition. Accordingly, no provision for a loss contingency has been accrued as of OctoberJuly 31, 2009.2010.

On September 29, 2008, a complaint was filed in the Superior Court of the State of California for the County of San Francisco on behalf of certain of the Company’s current and former employees thatwho were employed and paid by the Company during the four-year period from September 29, 2004 through September 29, 2008.the present. The Company was named as a defendant. The complaint alleges various violations under the State of California Labor Code and the State of California Business and Professions Code. The Company’s responsive pleaPlaintiffs recently filed an amended complaint, and the Company filed a motion to strike allegations of the third amended complaint on or about February 16, 2010 which was filed on November 14, 2008.held in abeyance. The case has been transferred to the complex panel of the San Francisco Superior Court for case management purposes. No class certification motion filing deadline has been set by the court, and discovery is ongoing. The Company is vigorously defending this litigation and is unable to predict the likely outcome and whether such outcome may have a material adverse effect on the Company’sits results of operations or financial condition. Accordingly, no provision for a loss contingency has been accrued as of OctoberJuly 31, 2009.

18


THE WET SEAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the 39 weeks ended October 31, 2009, and November 1, 2008

(Unaudited)

NOTE 6 – Commitments and Contingencies (Continued)

2010.

On March 18, 2009, a complaint was filed in the Superior Court of the State of California for the County of Orange on behalf of certain of the Company’s current and former employees that were employed and paid by the Company sincefrom March 18, 2005.2005 through March 18, 2009. The Company was 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. TheOn October 23, 2009, the Company reached an agreement to pay approximately $0.2 million to settle this matter, subject to Superior Court approval. As of October 31, 2009,The Court has preliminarily approved the settlement and set a final approval hearing for September 2, 2010. The Company had accrued an amount equal topaid the preliminary settlement amount in accrued liabilities on its condensed consolidated balance sheet.August 2010.

On April 24, 2009 the Pennsylvania Equal Employment Opportunity CouncilCommission requested information and records relevant to several charges of discrimination by the Company against employees of the Company. In the course of this investigation, the EEOC served the Company by otherwith a subpoena seeking information related to current and former employees throughout the United States. In April 2010, the Company filed an action for declaratory and injunctive relief in the U.S. District Court for the Central District of California seeking relief from the Company.subpoena, which action it has since voluntarily dismissed. Later that same month, the EEOC filed an application to enforce the subpoena in the U.S. District Court for the Eastern District of Pennsylvania, and is in the process of a nationwide investigation. The Company is vigorously defending thisawaiting the results of the EEOC’s investigation and is unable to predict the likely outcome and whether such outcome may have a material adverse effect on the Company’sits results of operations or financial condition. Accordingly, no provision for a loss contingency has been accrued as of OctoberJuly 31, 2009.2010.

From time to time, the Company is involved in other litigation matters relating to claims arising out of its operations in the normal course of business. ManagementThe Company believes that, in the event of a settlement or an adverse judgment on certain of these claims arising out of the pending litigation,normal course of business, the Company has insurance coverage to cover a portion of such losses; however, certain other matters may exist or arise for which the Company does not have insurance coverage. As of OctoberJuly 31, 2009,2010, the Company was not engaged in any other legal proceedings that are expected, individually or in the aggregate, to have a material adverse effect on its results of operations or financial condition.

THE WET SEAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the 26 weeks ended July 31, 2010, and August 1, 2009

(Unaudited)

NOTE 7 – Segment Reporting

The Company operates exclusively in the retail apparel industry in which it sells fashionable and contemporary apparel and accessories items, primarily through mall-based chains of retail stores, to female consumers with a young, active lifestyle. The Company has identified two operating segments (“Wet Seal” and “Arden B”). Internet operations for Wet Seal and Arden B are included in their respective operating segments.

Information for the 13 and 3926 weeks ended OctoberJuly 31, 2009,2010, and the 13 and 39 weeks ended NovemberAugust 1, 2008,2009, for the two reportable segments is set forth below (in thousands, except percentages):

 

13 Weeks Ended October 31, 2009

  Wet Seal  Arden B Corporate
and
Unallocated
 Total

13 Weeks Ended July 31, 2010

  Wet Seal Arden B Corporate
and
Unallocated
 Total 

Net sales

  $119,105  $22,441     $—        $141,546  $108,875   $22,666  $—     $131,541  

Percentage of consolidated net sales

   84%   16%      —         100%   83  17%  —      100

Operating income (loss)

  $10,378  $1,444     $(7,122)     $4,700  $6,219   $2,676  $(6,291) $2,604  

Depreciation and amortization expense

  $3,266  $401     $229      $3,896  $3,398   $370  $226  $3,994  

Interest income

  $—    $—       $98      $98  $—     $—     $85  $85  

Interest expense

  $—    $—       $261      $261  $—     $—     $25  $25  

Income (loss) before provision for income taxes

  $10,378  $1,444     $(7,285)     $4,537  $6,219   $2,676  $(6,231 $2,664  

13 Weeks Ended November 1, 2008

  Wet Seal  Arden B Corporate
and
Unallocated
 Total

13 Weeks Ended August 1, 2009

  Wet Seal Arden B Corporate
and
Unallocated
 Total 

Net sales

    $ 122,487    $ 24,157     $—     $146,644  $111,517   $24,849  $—     $136,366  

Percentage of consolidated net sales

   84%   16%    —      100%   82  18%  —      100

Operating income (loss)

    $16,760    $(2,257   $(7,451 $7,052  $6,043   $3,253  $(5,999 $3,297  

Depreciation and amortization expense

    $2,591    $755     $255   $3,601  $2,996   $407  $228   $3,631  

Interest income

    $—      $—       $587   $587  $—     $—     $132   $132  

Interest expense

    $—      $—       $209   $209  $—     $—     $246   $246  

Income (loss) before provision for income taxes

    $16,760    $(2,257   $(7,073 $7,430  $6,043   $3,253  $(6,113 $3,183  

26 Weeks Ended July 31, 2010

  Wet Seal Arden B Corporate
and
Unallocated
 Total 

Net sales

  $222,786   $46,517  $—     $269,303  

Percentage of consolidated net sales

   83  17%  —      100

Operating income (loss)

  $20,548   $5,913  $(13,888) $12,573  

Depreciation and amortization expense

  $6,764   $743  $481  $7,988  

Interest income

  $—     $—     $159  $159  

Interest expense

  $—     $—     $2,992  $2,992  

Income (loss) before provision for income taxes

  $20,548   $5,913  $(16,721 $9,740  

26 Weeks Ended August 1, 2009

  Wet Seal Arden B Corporate
and
Unallocated
 Total 

Net sales

  $219,882   $48,493  $—     $268,375  

Percentage of consolidated net sales

   82  18%  —      100

Operating income (loss)

  $15,937   $5,776  $(13,208 $8,505  

Depreciation and amortization expense

  $5,982   $833  $455   $7,270  

Interest income

  $—     $—     $316   $316  

Interest expense

  $—     $—     $437   $437  

Income (loss) before provision for income taxes

  $15,937   $5,776  $(13,329 $8,384  

19


THE WET SEAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the 3926 weeks ended OctoberJuly 31, 2009,2010, and NovemberAugust 1, 20082009

(Unaudited)

 

NOTE 7 – Segment Reporting (Continued)

 

39 Weeks Ended October 31, 2009

  Wet Seal  Arden B  Corporate
and
Unallocated
  Total

Net sales

  $338,987   $70,934   $—     $409,921

Percentage of consolidated net sales

   83  17  —      100%

Operating income (loss)

  $26,315   $7,221   $(20,331 $13,205

Depreciation and amortization expense

  $9,247   $1,233   $686   $11,166

Interest income

  $—     $—     $413   $413

Interest expense

  $—     $—     $697   $697

Income (loss) before provision for income taxes

  $26,315   $7,221   $(20,615 $12,921

39 Weeks Ended November 1, 2008

  Wet Seal  Arden B  Corporate
and
Unallocated
  Total

Net sales

  $360,365   $77,729   $—     $438,094

Percentage of consolidated net sales

   82  18  —      100%

Operating income (loss)

  $51,934   $(2,112 $(22,249 $27,573

Depreciation and amortization expense

  $7,662   $2,336   $794   $10,792

Interest income

  $—     $—     $1,884   $1,884

Interest expense

  $—     $—     $2,601   $2,601

Income (loss) before provision for income taxes

  $51,934   $(2,112 $(22,966 $26,856

In the tables above, Wet Seal and Arden B reportable segments include net sales generated from their respective stores and Internet operations. The “Corporate and Unallocated” column is presented solely to allow for reconciliation of segment contribution to consolidated operating income, interest income, interest expense and income before provision for income taxes. Wet Seal and Arden B segment results include net sales, cost of sales, asset impairment and other direct store and field management expenses, with no allocation of corporate overhead or interest income and expense.

NOTE 8 – Subsequent EventWet Seal operating segment results during the 13 and 26 weeks ended July 31, 2010, and August 1, 2009 include $1.0 million, $1.1 million, $1.6 million and $1.6 million, respectively, of asset impairment charges.

On November 18, 2009,Corporate expenses during the Company’s Board26 weeks ended July 31, 2010, include non-cash interest expense of Directors authorized spending$2.1 million as a result of up to $12.5accelerated write-off of remaining unamortized debt discount and deferred financing costs upon conversion of Notes and $0.7 million to repurchase outstanding shares of the Company’s Class A Commoninterest expense for a conversion inducement associated with conversions of Notes and Preferred Stock. Repurchases are at the option of the Company and can be discontinued at any time. There is currently no expiration date for this repurchase plan.

20


Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations

Introduction

Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our unaudited condensed consolidated financial statements and the notes thereto. The following discussion and analysis contains forward-looking statements. 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” or similar expressions. In addition, any statements concerning future financial performance, ongoing concept strategies or prospects, and possible future actions 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” included in our Annual Report on Form 10-K for the fiscal year ended January 31, 2009,30, 2010, and elsewhere in this Quarterly Report onof Form 10-Q.

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 years old. As of OctoberJuly 31, 2009,2010, we operated 500508 retail stores in 47 states, Puerto Rico and Washington D.C.District of Columbia. Our products can also be purchased online.

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 for 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 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 the decrease, if any, 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—We view operating income as a key indicator of our financial success. The key drivers of operating income 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.

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 similarhave many similarities in their products, production processes, distribution methods, and regulatory environment, theythere are differences in most of these areas and distinct differences in their economic characteristics. As a result, we consider these segments asto be two distinct reportable segments.

21


Wet Seal. Wet Seal is a junior apparel brand for teenage girls thatwho 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 and basic apparel and accessories. Wet Seal stores average approximately 3,900 square feet in size. As of OctoberJuly 31, 2009,2010, we operated 420432 Wet Seal stores.

Arden B. Arden B is a fashion brand at value price points for the feminine contemporary woman with sex appeal.woman. Arden B targets customers aged 25 to 35 years old and seeks to deliver contemporary collections of fashion and basic separates and accessories for various aspects of the customers’ lifestyles. Arden B stores average approximately 3,0003,100 square feet in size. As of OctoberJuly 31, 2009,2010, we operated 8076 Arden B stores.

We maintain a Web-based store located atwww.wetseal.com that offersoffering Wet Seal merchandise, comparable to that carried in our stores, to customers over the Internet.internet. We also maintain a Web-based store located atwww.ardenb.com that offersoffering Arden B apparel and accessories,merchandise, comparable to thosethat carried in our stores, to customers over the Internet.internet. 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 2009, 2008, and 2007, 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 7 of the Notesnotes to Condensed Consolidated Financial Statements and Segment Information elsewhere within this Management’s Discussion and Analysis of Financial Condition and Results of Operationscondensed consolidated financial statements for financial information regarding segment reporting.reporting, which information is incorporated herein by reference.

Current Trends and Outlook

We currently operate in a challenging retail environment driven by several factors, including disruptions in the U.S. housing and financial markets increasingand high unemployment rates across all regions of the U.S. and significant declinesBeginning in consumer confidence and spending. During the fourth calendar quarter of 2008 and continuing through the first and second calendar quartersquarter of 2009, U.S. gross domestic product decreased 6.3%, 1.0% and 6.4%, respectively, on a year-over-year basis. Although U.S. gross domestic product showedhas shown improvement insince the third calendar quarter of 2009, with an increase of 3.5% on a year-over-year basis,the increases have been modest and we continue to experience a volatile, and generally weak, retail environment. Our operating performance is susceptible to these general economic conditions, which have impacted consumer confidence and discretionary consumer spending in the United States. These trends have led to a highly promotional retail environment, negatively impacting our margins. If the conditions remain uncertain or continue to be volatile,U.S. Although our operating performance may continueimproved for the 26 weeks ended July 31, 2010, it declined during the 13 weeks ended July 31, 2010, and these uncertain and volatile conditions could adversely affect our ability to be adversely affected.sustain or further improve our operating performance.

Our comparable store sales decreased 6.2%4.3% for the 13 weeks ended OctoberJuly 31, 2009,2010, driven by a 7.6%4.3% comparable store sales declinedecrease in our Wet Seal division partially offset byand a 1.3%4.5% comparable store sales increasedecrease in our Arden B division. The Wet Seal division comparable store sales declinedecrease was primarily driven by average unit retail price anda decrease in transaction volume, declines. These declines were partially offset by an increase in average dollar sales. Directionally, the shifts in transaction volume and average unit retail metrics were in line with our expectations and resulted from our planned merchandise content shift at Wet Seal’s units purchased per customer.Seal more towards apparel and away from lower-priced accessories relative to the prior year quarter. The Arden B division comparable store sales increasedecrease was primarily driven by a significant increasedeclines in its average unit selling price and transaction volumes,volume, partially offset by a declinean increase in comparable store average dollar sales, which were both due to our strategic decision to lower price points approximately 20% to 25% across all product categories in January 2009.units purchased per customer.

We continue to makemade progress on several key initiatives at both divisionssince the end of fiscal 2009. Although we experienced negative comparable store sales declines during 2009. We hired two new divisional merchandise managersthe second quarter of fiscal 2010, primarily related to weak denim business at Wet Seal, we achieved merchandise margin improvement in July 2009 and appointed Sharon Hughes, formerly a consultantthe Wet Seal division due to the business since February 2008, asimproved merchandise mix in tops, activewear and jewelry and the Presidentuse of our markdown optimization system. Arden B continued to generate stable and Chief Merchandise Officerstrong merchandise margins in the second quarter of fiscal 2010 due to strong performance in denim, accessories, related separates and knit tops. In addition, we continue to maintain slightly higher inventory levels at Arden B in November 2009. Recently, however, our President and Chief Merchandise Officer of our Wet Seal division resigned, and we have commenced a search for her replacement. We continue to focus upon inventory management, operating efficiencies at both divisions, increasing store level efficiencies and lowering operating costs. We will continue to take steps to re-grow sales productivity at Arden B, including sustaining higher inventory levels in an effort to facilitate consistentsupport continued comparable store sales growth under our new low-price model. We continued with our Wet Seal store expansion by opening 11 new Wet Seal stores in the second fiscal quarter of 2010 and balancingare on track to open a net 25 stores for the right number of styles and mix of price points by store.year. We will also continueplan to open 60 Wet Seal stores in fiscal 2011 with a focus on refining merchandise mix atoff-mall power centers in select markets throughout the country and on malls in which we previously had highly productive Wet Seal. At the same time, we will remain focused on continuing productivity and cost savings initiatives, as well as on several initiativesSeal stores. We expect to improve sales productivity at both divisions.

Our strategy is to return to positive comparable store sales growth, sustain improvements in ouropen a net 3 Arden B business, expand our existing retail store base and expand our online businesses.stores in fiscal 2010. We are also taking several stepsworking on plans for continued moderate growth of Arden B stores in fiscal 2011. Lastly, we plan to

immediately increase our investment in our e-commerce inventories, marketing and team infrastructure to drive highermore aggressive 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 target customer wants and improve supply chain efficiency through better coordination among and within our vendor, internal distribution and store operations organizations.growth online.

Our operating performance since fiscal 2005 has resulted in increased liquidity and improved credit standing with suppliers. However, we may experience continued declinesnot generate increases 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

22


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 potential cash constraints, including seeking debt and/or equity financing.flow.

Store Openings and Closures

During the 3926 weeks ended OctoberJuly 31, 2009,2010, we opened 1312 and closed twofour Wet Seal stores and we opened one and closed eightfour Arden B stores. We believe future closuresstores, supporting our plan to exit locations that are not productive and in which we do not see strong potential 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.improvement.

During the fourth quarter of fiscal 2009, weWe expect to open approximately four newa net of 25 Wet Seal stores and anticipate closing a similar number of combined Wet Seal andthree Arden B stores, when their leases expire, so we estimate nominal store count change, if any, incontingent upon lease negotiations, during fiscal 2009.2010.

Critical Accounting Policies and Estimates

Our condensed consolidated financial statements were prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements.

The preparation of financial statements in conformity with GAAP 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 condensed 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 and in Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the fiscal year ended January 31, 2009.30, 2010.

The policies and estimates discussed below involve the selection or application of alternative accounting policies that are material to our condensed 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, stock-based compensation, accounting for income taxes and insurance reserves. There have been no significant additions to or modifications of the application of the critical accounting policies described in our Annual Report on Form 10-K for the fiscal year ended January 31, 2009. However, we have made a change in estimated breakage for unredeemed gift cards, gift certificates and store credits and a change in forfeiture rate estimates for executives and other employees affecting stock based compensation, and we continue to evaluate available evidence supporting our 100% valuation allowance against our net deferred income tax assets.30, 2010. The following updates the Form 10-K discussions of our critical accounting policies for revenue recognition, stock-based compensationlong lived assets and accounting for income taxes.

Revenue RecognitionLong-Lived Assets

ChangeWe evaluate the carrying value of long-lived assets for impairment whenever events or changes in Estimated Breakage

Incircumstances indicate that the second quartercarrying value of fiscal 2009,such 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 projection or 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 historical redemption patterns, we modifiedestimated undiscounted future cash flows from operating activities compared with the timing of when we record breakage of gift cards, gift certificates and store credits from greater than three years after their issuance date to greater than two years after their issuance date. See Note 1carrying value of the Notes to Condensed Consolidated Financial Statements for further information.

Stock-Based Compensation

Change in Estimated Forfeiture Rate

Inrelated assets. If the first quarterundiscounted 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 fiscal 2009,the assets, based on historical analysis,discounted cash flows using our weighted average cost of capital, with such estimated fair values determined using the best information available. We have considered all relevant valuation techniques that could be obtained without undue cost and effort and have determined that the discounted cash flow approach continues to provide the most relevant and reliable means by which to determine fair value in this circumstance.

At least quarterly, we modifiedassesses whether events or changes in circumstances have occurred that potentially indicate the carrying value of long-lived assets may not be recoverable. Our evaluations during the 13 and 26 weeks ended July 31, 2010, and August 1, 2009, 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 those locations would continue. As such, we recorded non-cash charges of $1.0 million, $1.1 million, $1.6 million and $1.6 million during the 13 and 26 weeks ended July 31, 2010, and August 1, 2009, respectively, within asset impairment in the condensed consolidated statements of operations, to write down the carrying values of these stores’ long-lived assets to their estimated annual forfeiture rate used in recognizing stock-based compensation expensefair values.

Accounting for our executives and other employees, from a 10% forfeiture rate to a 15% forfeiture rate. See Note 2 of the Notes to Condensed Consolidated Financial Statements for further information.

23


Income Taxes

We began fiscal 20092010 with approximately $117.9$116.6 million of federal net operating loss (“NOL”) carry forwardscarryforwards (NOLs) available to offset taxable income in fiscal 20092010 and thereafter, subject to certain annual limitations based on the provisions of Section 382 of the Internal Revenue Code (“Section 382”). Subject to potential further adjustment, we believe NOL carry forwards available will be sufficient to offset any possible federal regular taxable income in fiscal 2009. Accordingly, if we generate taxable income in fiscal 2009, we expect we would report an

For the 13 weeks ended July 31, 2010, our effective income tax rate was approximately 39%, representing the rate that we currently expect to incur for the remainder of fiscal 2010. The effective rate of approximately 2.7% related51% for the 26 weeks ended July 31, 2010 is higher than the expected rate for future periods due to a limited$2.8 million in interest charges incurred in the first fiscal quarter upon the conversion of the our remaining Secured Convertible Notes (the “Notes”) and Series C Convertible Preferred Stock (the “Preferred Stock”), which are not tax-deductible. The impact of these non-deductible charges on the effective income tax rate in the first fiscal quarter and the 26 weeks ended July 31, 2010, was approximately 16% and 12%, respectively.

Due to our expected utilization of federal and state NOL carry forwards during fiscal 2010, we anticipate cash income taxes for the fiscal year will be approximately 2% of pre-tax income, representing the portion of federal and state alternative minimum taxes that cannot be offset by NOL carry forwards, income taxes inNOLs. The difference between the State of California, which cannot be offset by NOL carry forwards, and certain other state income taxes.

Currently, we maintain a 100% valuation allowance against our net deferred income tax assets, which are comprised primarily of our NOL carry forwards. As of October 31, 2009, evidence does not support realization of these net deferred income tax assets. As we continue to evaluate available evidence, it is possible that some or all of our deferred income tax assets may be deemed realizable and, accordingly, the valuation allowance recorded against those deferred income tax assets may be reversed at or before the end of the current fiscal year. If such valuation allowance is reversed, we would record an immediate benefit to income taxes for a substantial majority of the reversal and would record an increase to additional paid-in capital for the remainder of the reversal. Prospectively, we would then report an effective income tax rate much closer to statutory rates, which we estimate to be inand the range of 38% to 39%. However, this would not change our current expectation that we will not incur significantanticipated cash income tax payments in fiscal 2009 or fiscal 2010taxes is recorded as we continue to utilize available NOL carry forwards.

Our current expectations regarding the federal NOL carry forward we may use annually is based on calculations made by management which calculations determined that we incurred “ownership changes”, as defined in Section 382, in April 2005 and December 2006 that require re-calculation of NOL carry forward annual utilization limits. Such ownership changes can result merely from an accumulation of normal market trading activity in our Class A common stock (“common stock”) over time. The NOL carry forward annual utilization limits determined upon an ownership change depend on, among other things, our market capitalization and long-term federal interest rates on the ownership change date. If we were to determine we had incurred another ownership change at some time after December 2006, we would be required to re-calculate our annual federal NOL carry forward utilization limit, which could result in a decrease to NOL carry forwards annually available to offset taxable income.

Recently Adopted Accounting Pronouncements

Effective July 2009, the Financial Accounting Standards Board (FASB) codified accounting literature into a single source of authoritative accounting principles, exceptnon-cash provision for certain authoritative rules and interpretive releases issued by the Securities and Exchange Commission. Since the codification did not alter existing GAAP, it did not have an impact on our condensed consolidated financial statements. All references to pre-codified GAAP have been removed from this Form 10-Q.

In June 2008, the FASB issued guidance which requires entities to apply the two-class method of computing basic and diluted earnings per share to participating securities with nonforfeitable dividend rights, irrespective of whether the entity declares and/or pays a dividend. Guidance was effective for financial statements issued for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2008, and all prior-period earnings per share data presented shall be adjusted retrospectively. Effective February 1, 2009, we adopted this guidance and it did not significantly impact our condensed consolidated financial statements. Refer to Note 5 of the Notes to Condensed Consolidated Financial Statements for further information.

In May 2009, the FASB issued guidance which establishes general standards of accounting for and disclosures of events that occur after the balance sheet date but before the condensed consolidated financial statements are issued or are available to be issued. Among other items, this guidance requires the disclosure of the date through which an entity has evaluated subsequent events and the basis for that date. This guidance is effective for interim and annual periods ending after June 15, 2009, and our adoption of it on August 1, 2009 resulted in no impact on our condensed consolidated financial statements except for the necessary disclosures. We have evaluated subsequent events through the date of issuance of these condensed consolidated financial statements, December 2, 2009.deferred incomes taxes.

New Accounting Pronouncements Not Yet Adopted

In October 2009, the FASBFinancial Accounting Standards Board (“FASB”) issued guidance related to revenue arrangements with multiple deliverables. Under the new guidance, when vendor specific objective evidence or third party evidence for deliverables in an arrangement cannot be determined, a best estimate of the selling price is required to separate deliverables and allocate arrangement consideration using the relative selling price method. Such guidance is to be applied on a prospective basis for revenue arrangements

24


entered into or materially modified in fiscal years beginning on or after June 15, 2010, with early adoption permitted. We do not believe adoption of this guidance will have any effect on our condensed consolidated financial statements.

In January 2010, the FASB issued guidance and clarifications for improving disclosures about fair value measurements. This guidance requires enhanced disclosures regarding transfers in and out of the levels within the fair value hierarchy. Separate disclosures are required for transfers in and out of Level 1 and 2 fair value measurements, and the reasons for the transfers must be disclosed. In the reconciliation for Level 3 fair value measurements, separate disclosures are required for purchases, sales, issuances, and settlements on a gross basis. The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements, which are effective for interim and annual reporting periods beginning after December 15, 2010. Effective January 31, 2010, we adopted the new and updated guidance for disclosures, aside from those deferred to periods after December 15, 2010, and it did not significantly impact our condensed consolidated financial statements. We do not believe adoption of the remaining disclosure guidance will have any effect on our condensed consolidated financial statements.

Results of Operations

The following table sets forth selected condensed consolidated statements of operations data as a percentage of net sales for the 13-week and 39-week26-week periods indicated. The discussion that follows should be read in conjunction with the table below:

 

  As a Percentage of Net Sales
13 Weeks Ended
  As a Percentage of Net Sales
39 Weeks Ended
  As a Percentage of Net Sales
13 Weeks Ended
  As a Percentage of Net Sales
26 Weeks Ended
  October 31,
2009
  November 1,
2008
  October 31,
2009
  November 1,
2008
  July 31,
2010
  August 1,
2009
  July 31,
2010
  August 1,
2009

Net sales

  100.0%  100.0%  100.0%  100.0%  100.0%   100.0%   100.0%   100.0% 

Cost of sales

  71.0     68.7     70.9   67.0   70.8       71.3       69.0       70.8     
                        

Gross margin

  29.0     31.3     29.1   33.0   29.2       28.7       31.0       29.2     

Selling, general, and administrative expenses

  25.5     26.1     25.4   26.5   26.4       25.2       25.9       25.4     

Asset impairment

  0.2     0.4     0.5   0.2   0.8       1.1       0.4       0.6     
                        

Operating income

  3.3     4.8     3.2   6.3   2.0       2.4       4.7       3.2     

Interest (expense) income, net

  (0.1)    0.2     (0.0)  (0.2)

Interest income (expense), net

  0.0       (0.1)      (1.1)      (0.1)    
                        

Income before provision for income taxes

  3.2     5.0     3.2   6.1   2.0       2.3       3.6       3.1     

Provision for income taxes

  0.0     0.4     0.1   0.2   0.8       0.0       1.8       0.1     
                        

Net income

  3.2%  4.6%  3.1%  5.9%  1.2%   2.3%   1.8%   3.0% 
                        

Thirteen Weeks Ended OctoberJuly 31, 2009,2010, Compared to Thirteen Weeks Ended NovemberAugust 1, 20082009

Net sales

 

  13 Weeks
Ended
October 31, 2009
  Change From
Prior Fiscal Period
 13 Weeks
Ended
November 1, 2008
  13  Weeks
Ended
  July 31, 2010  
  Change From
Prior Fiscal  Period
 13  Weeks
Ended
  August 1, 2009  
     ($ in millions)       ($ in millions)  

Net sales

  $141.5    $(5.1 (3.5)%  $146.6    $131.5    $(4.9)  (3.5) $136.4    

Comparable store sales decrease

     (6.2)%        (4.3) 

Net sales for the 13 weeks ended OctoberJuly 31, 2009,2010, decreased primarily as a result of the following:

 

A decrease of 6.2%4.3% in comparable store sales resulting from an 11.4% decrease in comparable store average transaction counts, partially offset by a 1.8% decline7.5% increase in comparable store average dollar sales and a 3.8% decrease in comparable store average transaction counts.per transaction. Comparable store average dollar sales decreasedper transaction increased mainly due to a 4.5% declinean 10.4% increase in our average unit retail prices, primarily driven by increased promotional activity and an increase in clearance sales at Wet Seal and our strategic decision to significantly lower price points at Arden B in January 2009, and a decline in Wet Seal frequent buyer program membership sales, partially offset by a 3.1% increase2.2% decrease in the number of units purchased per customer, primarily as a result of a merchandise content shift at Wet Seal towards apparel and away from lower-priced accessories, as compared to the prior year.year; and

The prior year included an increase of $1.2 million in net sales resulting from a change in estimated breakage for unredeemed gift cards, gift certificates and store credits remaining outstanding for more than two years from their respective issuance dates.

However, these factors were partially offset by:

 

An increase of $1.0$0.5 million in net sales for our internet business compared to the prior year, which is not a factor in calculating our comparable store sales.sales; and

 

25An increase in number of stores open, from 496 stores as of August 1, 2009, to 508 stores as of July 31, 2010.


Cost of sales

 

  13 Weeks
Ended
October 31, 2009
 Change From
Prior Fiscal Period
 13 Weeks
Ended
November 1, 2008
   13 Weeks
Ended
July 31, 2010
 Change From
Prior Fiscal Period
 13  Weeks
Ended
 August 1, 2009 
 
    ($ in millions)       ($ in millions)   

Cost of sales

  $100.5   $(0.2 (0.2)%  $100.7    $93.2   $(4.0 (4.2)%  $97.2  

Percentage of net sales

   71.0  2.3  68.7   70.8  (0.5)%   71.3

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 as a percentage of net sales increaseddecreased due primarily to a decreasean increase in merchandise margin as a result of lowerhigher initial markup and a higher markdown raterates in our Wet Seal division,both divisions, partially offset by a decreasean increase in the markdown rate for our Arden B division,both divisions, as compared to the prior year. Additionally, cost of sales as a percentage of sales was favorably impacted due to a reduction in buying, planning and allocation costs as a result of our open Wet Seal division chief merchandise officer position and a reduction in incentive bonuses due to declining performance results. Cost of sales as a percentage of net sales and in absolute dollar amount was negatively impacted by an increase in occupancy costs, primarilycost due to normal inflation of rents and common area maintenance charges for new stores and remodels/relocations and the deleveraging effect on occupancy cost from our decrease in comparable stores sales, decreaseas well as an increase in our Wet Seal division.number of stores open, from 496 stores as of August 1, 2009, to 508 stores as of July 31, 2010. Cost of sales was positivelyalso negatively impacted by a decrease in buying, planning and allocation costs, primarily due to eliminated positions upon restructuring of the Arden B buying and design organization, favorable impact on stock-based compensation from forfeitures from previously employed executives and a change in stock compensation forfeiture rate from 10% to 15% based on historical analysis, a reduction in recruiting as the prior year quarter included a recruiting retainer fee to search for a chief merchandise officer in the Wet Seal division and a decreasean increase in distribution costs due to operational efficiencies.a loss on disposal charge as a result of equipment replaced by our new merchandise sorter system and an increase in temporary labor as a result of an increase in units shipped and a variation in mix of merchandise.

Selling, general, and administrative expenses (SG&A)

 

  13 Weeks
Ended
October 31, 2009
 Change From
Prior Fiscal Period
 13 Weeks
Ended
November 1, 2008
   13 Weeks
Ended
July 31, 2010
 Change From
Prior Fiscal Period
 13 Weeks
Ended
August 1, 2009
 
    ($ in millions)       ($ in millions)   

Selling, general, and administrative expenses

  $36.0   $(2.3 (6.1)%  $38.3    $34.7   $0.4  1.2%   $34.3  

Percentage of net sales

   25.5  (0.6)%   26.1   26.4   1.2  25.2

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 Internetinternet 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.

In fiscal 2009, we continued to place major emphasis on reducing costs across all SG&A categories, resulting in a significant decline in SG&A in absolute dollars as well as a percentage of sales.

Selling expenses decreased approximately $1.7less than $0.1 million from the prior year to $28.8$28.2 million. As a percentage of net sales, selling expense was 20.4%21.5% of net sales, or 3080 basis points lower,higher, as a percentage of net sales, than a year ago.

The following contributed to the current year decrease in selling expenses:

 

A $1.8$0.2 million decrease in payroll and benefits costs as a result of lowerdecreased sales volume, improved efficiency in controlling labor hours and a decrease in claim costs in our employee health care plan;

A $0.1 million decrease in advertising and marketing expenditures due to a decrease in in-store signage and the shift to more cost-effective advertising activities at our Arden B division;

A $0.1 million decrease in store and field travel costs;volume; and

 

A $0.1$0.2 million net decrease in other selling expenses.credit card and bad debt charges as a result of decreased sales volume.

However, the decreases in selling expenses were partially offset by the following increases:

 

A $0.2 million increase in Internet productionadvertising and ordering costsmarketing expenditures due to higher sales volume;

A $0.1 millionan increase in store supply costs;in-store signage at both divisions, an increase in direct marketing at our Wet Seal division and an increase in our internet advertising, primarily due to our increased presence on Facebook; and

 

A $0.1 million increase in merchandise deliveryinternet production and ordering costs due to increased internet sales volume.

The increase in selling expenses, as a resultpercentage of annet sales, was primarily due to the unfavorable deleveraging effect on store and field payroll costs and increase in units processed compared to the prior year quarter.advertising and marketing expenditures, as noted above.

26


General and administrative expenses decreasedincreased approximately $0.6$0.4 million from the prior year to $7.2$6.5 million. As a percentage of net sales, general and administrative expenses were 5.1%4.9%, or 3040 basis points lower,higher, than a year ago.

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

 

A $0.3$0.2 million decreaseincrease in corporate wages, primarily due to reduced staffing levels from the January 2009 organizational restructuring;wages;

 

A $0.2$0.3 million decreaseincrease in corporate bonuses based on our financial performance relative to bonus targets;

A $0.1 million decrease in stock compensation, primarily due the favorable impact of forfeitures from previously employed executives and a change in stock compensation forfeiture rate from 10% to 15%;

A $0.1 million decrease in insurance due to favorably negotiated rates upon renewals;legal fees associated with various litigation matters; and

 

A $0.1 million decreasenet increase in consultant fees.other general and administrative expenses.

However, the decreasesincreases in general and administrative expenses were partially offset by the following increase:decreases:

 

A $0.2 million increasedecrease in legal fees associated with various litigation matters.stock-based compensation, primarily due to higher forfeitures as compared to the prior year.

Asset impairment

 

  13 Weeks
Ended
October 31, 2009
 Change From
Prior Fiscal Period
 13 Weeks
Ended
November 1, 2008
  13 Weeks
Ended
July 31, 2010
 Change From
Prior Fiscal Period
 13 Weeks
Ended
August 1, 2009
    ($ in millions)    ($ in millions)

Asset impairment

  $0.3   $(0.2)  (35.6)%  $0.5     $1.0   $(0.6 (32.9)%  $1.6    

Percentage of net sales

   0.2   (0.2)  0.4%   0.8  (0.3)%   1.1%

Based on our quarterly assessments of the carrying value of long-lived assets, during the 13 weeks ended OctoberJuly 31, 2009,2010, and the 13 weeks ended NovemberAugust 1, 2008,2009, we identified certain retail 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, resulting in non-cash charges of $0.3$1.0 million and $0.5$1.6 million, respectively.

Interest income (expense) income,, net

 

  13 Weeks
Ended
October 31, 2009
 Change From
Prior Fiscal Period
 13 Weeks
Ended
November 1, 2008
  13 Weeks
Ended
July 31, 2010
 Change From
Prior Fiscal Period
 13 Weeks
Ended
August 1, 2009
 
    ($ in millions)    ($ in millions) 

Interest (expense) income, net

  $(0.2)   $(0.6)  (143.1)%  $0.4

Interest income (expense), net

  $0.1   $0.2  152.6 $(0.1)  

Percentage of net sales

   (0.1)   (0.3)%   0.2%   0.0   0.1  (0.1)

We generated interest income, net, of $0.1 million in the 13 weeks ended July 31, 2010, comprised of:

Interest income of less than $0.1 million primarily from investments in cash and cash equivalents.

We incurred a nominal amount of interest expense, net, in the 13 weeks ended October 31,August 1, 2009, comprised of:

 

Non-cash interest expense of $0.2 million with respect to our secured convertible notes,Notes, comprised primarily of discount amortization and, to a lesser extent, annual interest at 3.76%, which we have elected to add to principal; partially offset by;by

 

Interest income of less than $0.1 million from investments in cash and cash equivalents.

We generated interest income, net, of $0.4 million in the 13 weeks ended November 1, 2008, comprised of:

Interest income of $0.6 million from investments in cash and cash equivalents; and

Non-cash interest expense of $0.2 million with respect to our secured convertible notes comprised primarily of discount amortization and, to a lesser extent, annual interest at 3.76%, which we have elected to add to principal.

27


Provision for income taxes

 

   13 Weeks
Ended
October 31, 2009
  Change From
Prior Fiscal Period
  13 Weeks
Ended
November 1, 2008
      ($ in millions)   

Provision for income taxes

  $0.0  $(0.6 96.4 $0.6  
   13 Weeks
Ended
July 31, 2010
  Change From
Prior Fiscal Period
  13 Weeks
Ended
August 1, 2009
      ($ in millions)   

Provision for income taxes

  $1.0  $    0.9  1,211.3 $0.1

In the second quarter of fiscal 2010, our effective income tax rate was approximately 39%, which is the rate we currently expect to incur for the remainder of the fiscal year. We haveincurred a higher effective income tax rate than we had in 2009 primarily as a result of the reversal of our deferred tax asset valuation allowance at the end of fiscal 2009.

Due to our expected utilization of federal and state NOL carry forwards available, subject to certain limitation, to offset our regular taxable income. We recognized a provision forduring fiscal 2010, we anticipate cash income taxes that resulted in an effective tax ratefor the fiscal year will only be approximately 2% of 2.7% for federal and statepre-tax income, taxes. This effective rate is based onrepresenting the portion of our estimated federal and state

alternative minimum taxable income for fiscal 2009taxes that cannot be offset by NOLs. DuringThe difference between the 13-week period ended October 31, 2009, we generated a nominaleffective income tax benefit to reflectrate and the anticipated cash income taxes is recorded as a prior period income tax overpayment to Puerto Rico.non-cash provision for deferred incomes taxes.

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 Internetinternet operations. Operating segment results include net sales, cost of sales, asset impairment and other direct store and field management expenses, with no allocation of corporate overhead or interest income or expense.

Wet Seal:

 

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

  13 Weeks
Ended
October 31, 2009
  13 Weeks
Ended
November 1, 2008
  13 Weeks    
Ended    
July 31, 2010    
     13 Weeks    
Ended    
August 1, 2009    

Net sales

  $119,105     $122,487     $108,875         $    111,517     

Percentage of consolidated net sales

   84%   84%   83%       82%  

Comparable store sales percentage decrease compared to the prior year fiscal quarter

   (7.6)%   (3.0)%      (4.3)%     (11.9)%

Operating income

  $10,378     $16,760     $6,219         $6,043     

Sales per square foot

  $68     $72     $61         $64     

Number of stores as of quarter end

   420      409      432          415     

Square footage as of quarter end

   1,655      1,610      1,709          1,636     

Wet Seal comparable stores sales decreased 7.6%4.3% during the 13 weeks ended OctoberJuly 31, 2009,2010, compared to a prior year quarter decrease of 3.0%11.9%. The decrease during the 13 weeks ended OctoberJuly 31, 2009,2010, was due primarily to a 6.6%12.2% decrease in comparable store average transaction countstransactions, partially offset by an increase of 8.4% in average dollar sales per store and a 0.2% decreasetransaction. The increase in comparable store average dollar sale. The decrease in comparable store average dollar salesales per transaction resulted from a 3.8% decreasean 11.5% increase in our average unit retail prices, and a decline in frequent buyer program membership sales, partially offset by a 4.2% increase2.2% decrease in units purchased per customer.customer, as a result of a merchandise content shift towards apparel and away from lower-priced accessories. The net sales decrease was attributable to the comparable store sales decline and the prior year quarter including $0.8 million of additional net sales resulting from a change in estimated breakage, partially offset by a $0.7$0.4 million increase in net sales in our internet business and a $4.7 millionthe increase in the number of stores not in the comparable store base.

While we believe the challenging economic environment contributedcompared to the Wet Seal performance decline, we also believe the softening in the screen tees trend within our tops business and our light positions in dresses and certain accessories, primarily jewelry, also negatively affected sales. We believe we have improved our inventory mix issues in the third quarter and believe we are positioned well for the holiday season. However, we will continue to focus on improving our inventory assortment in dresses to support continued sales improvement.prior year.

Wet Seal’s operating income decreasedincreased to 8.7%5.7% of net sales during the 13 weeks ended OctoberJuly 31, 2009,2010, from 13.7%5.4% of net sales during the 13 weeks ended NovemberAugust 1, 2008.2009. The decreaseincrease in operating income, as a percentage of sales, was due primarily to a decreasean increase in merchandise margin as a result of higher markdown rates, a decrease in initial markup rates and the deleveraging effect offavorable spring physical inventory shrink results, a decrease in comparable store sales on occupancybuying, planning and allocation costs comparedprimarily due to the prior year.our open chief merchandise officer position and a reduction in stock compensation expense as a result of higher forfeiture adjustments. Additionally, during the 13 weeks ended OctoberJuly 31, 2009,2010, and the 13 weeks ended NovemberAugust 1, 2008,2009, operating income included asset impairment charges of $0.3$1.0 million and $0.1$1.6 million, respectively, to write down the carrying value of long-lived assets that were identified during our quarterly impairment evaluations. The increase for the 13 weeks ended August 1, 2009 was partially offset by a $0.8 million of breakage benefit resulting from a change in estimated breakage for unredeemed gift cards, gift certificates and store credits remaining outstanding more than two years from their respective issuance dates.

28


Arden B:

 

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

  13 Weeks
Ended
October 31, 2009
 13 Weeks
Ended
November 1, 2008

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

  13 Weeks    
Ended    
July 31, 2010    
 13 Weeks
Ended
 August 1, 2009 

Net sales

      $22,441   $24,157      $  22,666   $24,849     

Percentage of consolidated net sales

   16  16%   17  18%

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

   1.3%    (25.0)%

Operating income (loss)

      $1,444   $(2,257)  

Comparable store sales percentage decrease compared to the prior year fiscal quarter

   (4.5)%   (4.1)%

Operating income

  $2,676   $3,253     

Sales per square foot

      $82   $78      $84   $86     

Number of stores as of quarter end

   80    91       76    81     

Square footage as of quarter end

   244    283       230    247     

Arden B comparable stores sales increased 1.3%decreased 4.5% during the 13 weeks ended OctoberJuly 31, 2009,2010, compared to a prior year quarter decrease of 25.0%4.1%. The increasedecrease during the 13 weeks ended OctoberJuly 31, 2009,2010, was due primarily to a 36.6% increase2.6% decrease in comparable store average transaction counts per store, partially offset bytransactions and a 25.9%1.9% decrease in comparable store average dollar sale, which reflects our strategic decision to significantly lower price points across all categories in January 2009.sales per transaction. The decrease in the average dollar sale per transaction resulted from a 28.8%4.9% decline in our average unit retail prices, partially offset by a 4.5%2.8% increase in units purchased per customer. The net sales decrease was attributable to the comparable store sales decrease and a decrease in the number of stores compared to the prior year, partially offset by the comparable store sales increase and a $0.3$0.2 million increase in net sales in our internet business.

Arden B generated operating income of 6.4%11.8% of net sales during the 13 weeks ended OctoberJuly 31, 2009,2010, compared to an operating lossincome of 9.3%13.1% of net sales during the 13 weeks ended NovemberAugust 1, 2008.2009. The improvementdecrease in operating results was due primarily to an increase in merchandise margin resultingoccupancy costs as a percentage of net sales as the prior year included a rent benefit for early termination of store leases and the deleveraging effect from a significantthe decrease in markdown rates, a decrease in buying costs upon restructuring the Arden B buyingcomparable store sales, and design groups, partially offset by an increase in seasonal merchant incentive bonus due to improvement in divisional performance, a decrease in occupancy costs due to a decrease in depreciation expense as a result of a number of underperforming Arden B stores being impaired during fiscal 2008, the decrease in store counts from 91 stores as of November 1, 2008, to 80 stores as of October 31, 2009, and a decrease in store payrollinternet production ordering costs as a result of lowerincreased net sales and improved efficiency in controlling labor hoursour internet business compared to the prior year. Additionally, duringoperating income for the 13 weeks ended October 31,August 1, 2009, and the 13 weeks ended November 1, 2008, operating income (loss) included asset impairment charges of less than $0.1 million and $0.4 million respectively, to write down the carrying value of long-lived assets that were identified during our quarterly impairment evaluations.breakage benefit resulting from a change in estimated breakage for unredeemed gift cards, gift certificates and store credits remaining outstanding more than two years from their respective issuance dates.

Thirty-NineTwenty-Six Weeks Ended OctoberJuly 31, 2009,2010, Compared to Thirty-NineTwenty-Six Weeks Ended NovemberAugust 1, 20082009

Net sales

 

  39 Weeks
Ended
October 31, 2009
  Change From
Prior Fiscal Period
 39 Weeks
Ended
November 1, 2008
  26 Weeks
Ended
July 31, 2010
  Change From
Prior Fiscal Period
 26 Weeks
Ended
August 1, 2009
     ($ in millions)       ($ in millions)  

Net sales

    $  409.9       $  (28.2)  (6.4)%      $  438.1      $269.3  $0.9  0.3 $268.4

Comparable store sales decrease

     (8.1)%         (1.1)%  

Net sales for the 3926 weeks ended OctoberJuly 31, 2009, decreased2010, increased primarily as a result of the following:

 

A decreaseAn increase of 8.1%$1.7 million in comparable storenet sales resulting from a 4.4% decline in comparable store average dollar sales and a 3.3% decrease in comparable store average transaction counts. Comparable store average dollar sales decreased mainly due to a 11.3% decline infor our average unit retail prices, primarily driven by increased promotional activity and an increase in clearance sales at Wet Seal and our strategic decision to significantly lower price points at Arden B in January 2009, and a decline in Wet Seal frequent buyer program membership sales, partially offset by an 8.5% increase in the number of units purchased per customer,internet business compared to the prior year, primarily at Wet Seal.which is not a factor in calculating our comparable store sales; and

An increase in number of stores open, from 496 stores as of August 1, 2009, to 508 stores as of July 31, 2010.

However, these factors were partially offset by:

 

AnA decrease of 1.1% in comparable store sales resulting from an 8.5% decrease in comparable store average transaction counts, partially offset by an 8.3% increase in comparable store average dollar sales per transaction. Comparable store average dollar sales per transaction increased mainly due to an 11.0% increase in our average unit retail prices, partially offset by a 2.6% decrease in the number of units purchased per customer, as compared to the prior year; and

The prior year included an increase of $1.2 million in net sales resulting from a change in estimated breakage for unredeemed gift cards, gift certificates and store credits remaining outstanding for more than two years from their respective issuance dates; anddates.

An increase of $1.9 million in net sales for our internet business compared to the prior year, which is not a factor in calculating our comparable store sales.

29


Cost of sales

 

  39 Weeks
Ended
October 31, 2009
  Change From
Prior Fiscal Period
  39 Weeks
Ended
November 1, 2008
  26 Weeks
Ended
July 31, 2010
 Change From
Prior Fiscal Period
 26 Weeks
Ended
August 1, 2009
 
     ($ in millions)       ($ in millions)   

Cost of sales

      $290.5       $(3.0)  (1.0)%      $293.5      $185.8   $(4.2 (2.2)%  $190.0  

Percentage of net sales

   70.9%    3.9%    67.0%   69.0  (1.8)%   70.8

Cost of sales decreased in dollars primarily as a result of the decrease in net sales. Cost of sales increased as a percentage of net sales decreased due primarily due to a decreasean increase in merchandise margin. Merchandise margin decreased as a result of higher initial markup rates in both divisions and favorable spring physical inventory shrink results, as compared to the prior year, partially offset by an increase in markdown rates for our Wet Seal division, partially offset bydue to the promotional environment. Cost of sales as a lower markdown rate in our Arden B division,percentage of sales and a decrease in initial markup rates in both divisions. Additionally, cost of salesabsolute dollar amount was negatively impacted bydue an increase in occupancy costs primarilycost due to normal inflation of rents and common area maintenance charges for new stores and remodels/relocations and the deleveraging effect on occupancy cost from our comparable stores sales decrease. Costdecrease, as well as an increase in number of sales was positively impacted by a decrease in buying, planning and allocation costs primarily duestores open, from 496 stores as of August 1, 2009, to eliminated positions upon restructuring508 stores as of the Arden B buying and design organization, favorable impact on stock-based compensation from forfeitures from previously employed executives and a change in stock compensation forfeiture rate from 10% to 15% based on historical analysis, a reduction in recruiting as the prior year period included a recruiting retainer fee to search for a chief merchandise officer in the Wet Seal division, and a decrease in distribution costs due to operational efficiencies.July 31, 2010.

Selling, general, and administrative expenses (SG&A)

 

  39 Weeks
Ended
October 31, 2009
  Change From
Prior Fiscal Period
 39 Weeks
Ended
November 1, 2008
  26 Weeks
Ended
July 31, 2010
 Change From
Prior Fiscal Period
 26 Weeks
Ended
August 1, 2009
 
     ($ in millions)      ($ in millions)   

Selling, general, and administrative expenses

      $104.3   $(11.9)  (10.3)     $116.2      $69.8   $1.5  2.2% $68.3  

Percentage of net sales

   25.4%    (1.1)  26.5%   25.9   0.5  25.4

Selling expenses decreasedincreased approximately $8.5$0.3 million from the prior year to $84.0$55.5 million. As a percentage of net sales, selling expense was 20.5%20.6% of net sales, or 6010 basis points lower,higher as a percentage of net sales as compared to a year ago.

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

A $0.5 million increase in advertising and marketing expenditures due to an increase in in-store signage at both divisions, an increase in direct marketing at our Wet Seal division and an increase in our internet advertising, primarily due to our increased presence on Facebook;

A $0.3 million increase in internet production and ordering costs due to increased internet sales volume; and

A $0.1 million net increase in other selling expenses.

However, the increases in selling expenses were partially offset by the following decreases:

A $0.3 million decrease in bags and boxes usage;

A $0.2 million decrease in bad debt and bank charges; and

A $0.1 million decrease in payroll and benefits costs.

General and administrative expenses increased approximately $1.2 million from the prior year, to $14.3 million. As a percentage of net sales, general and administrative expenses were 5.3%, or 40 basis points higher, than a year ago.

The following contributed to the current year decrease in selling expenses:

A $7.0 million decrease in payroll and benefits costs as a result of lower sales volume, improved efficiency in controlling labor hours and a decrease in claim costs in our employee health care plan;

A $0.6 million decrease in advertising and marketing expenditures due to a decrease in in-store signage and the shift to more cost-effective advertising activities at our Arden B division;

A $0.3 million decrease in merchandise delivery costs as a result of a decrease in units processed and slightly lower cost per unit due to lower fuel surcharges compared to the prior year;

A $0.2 million decrease in store and field travel costs;

A $0.2 million decrease in store and field meetings and seminars expense;

A $0.1 million decrease in bags and boxes usage as a result of lower sales volume;

A $0.1 million decrease in stock compensation expense related to forfeitures for terminated employees;

A $0.1 million decrease in inventory service fees as a result of favorable cost negotiations; and

A $0.1 million decrease in field bonuses due to fewer employees reaching sales goal targets.

However, the decreases in selling expenses were partially offset by the following increase:

A $0.2 million increase in credit card fees.

General and administrative expenses decreased approximately $3.4 million from the prior year to $20.3 million. As a percentage of net sales, general and administrative expenses were 4.9%, or 50 basis points lower, than a year ago.

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

 

A $1.2$0.4 million decreaseincrease in legal fees associated with various litigation matters;

A $0.3 million increase in corporate wages, primarily due to reduced staffing levels from the January 2009 organizational restructuring;wages;

 

30


A $1.1$0.1 million decreaseincrease in corporate bonuses as the prior year included a greater benefit based on ourprior year’s financial performance relative to bonus targets;

 

A $0.7$0.1 million decreaseincrease in stockstock-based compensation, primarily due the favorable impactas a result of forfeitures from previously employed executives and a change in stock compensationhigher forfeiture rate from 10% to 15%;

A $0.3 million decrease in consultant fees;adjustments;

 

A $0.2 million decreaseincrease in insuranceconsulting fees due to favorably negotiated rates upon renewals;

A $0.1 million decrease in depreciation duetiming of services performed and audit fees, compared to certain corporate assets becoming fully depreciated in the currentprior year; and

 

A $0.2 million net decreaseincrease in other general and administrative costs.

However, the decreasesincreases in general and administrative expenses were partially offset by the following increase:decrease:

 

A $0.3$0.1 million increasedecrease in legalboard of director fees associated with various litigation matters.due to fewer Board members as compared to the prior year.

Asset impairment

 

  39 Weeks
Ended
October 31, 2009
  Change From
Prior Fiscal Period
  39 Weeks
Ended
November 1, 2008
  26 Weeks
Ended
July 31, 2010
 Change From
Prior Fiscal Period
 26 Weeks
Ended
August 1, 2009
 
     ($ in millions)     ($ in millions) 

Asset impairment

      $1.9      $1.1  129.4%      $0.8      $1.1   $(0.5 (27.1)%  $1.6 

Percentage of net sales

   0.5%    0.3%   0.2%   0.4  (0.2)%   0.6

Based on our quarterly assessments of the carrying value of long-lived assets, during the 3926 weeks ended OctoberJuly 31, 2009,2010, and the 39 weeks ended NovemberAugust 1, 2008,2009, we identified certain retail 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, resulting in non-cash charges of $1.9$1.1 million and $0.8$1.6 million, respectively.

Interest expense, net

 

  39 Weeks
Ended
October 31, 2009
  Change From
Prior Fiscal Period
 39 Weeks
Ended
November 1, 2008
  26 Weeks
Ended
July 31, 2010
 Change From
Prior Fiscal Period
 26 Weeks
Ended
August 1, 2009
 
     ($ in millions)    ($ in millions) 

Interest expense, net

      $(0.3)      $(0.4)  (60.4)     $(0.7)      $(2.8 $(2.7 (2,241.3)%  $(0.1

Percentage of net sales

   (0.0)%    (0.2)  (0.2)%   (1.1)%   (1.0)%   (0.1)% 

We incurred interest expense, net, of $0.3$2.8 million in the 3926 weeks ended OctoberJuly 31, 2009,2010, comprised of:

Interest charges of $2.8 million, consisting of $2.1 million of non-cash charges and a $0.7 million conversion/exercise inducement, related to the conversion of $4.7 million of our Notes into 3,111,111 shares of our common stock and $1.6 million of our Preferred Stock into 537,000 shares of our common stock, and the exercise of Series E warrants into 625,000 shares of our common stock;

 

Non-cash interest expense of $0.6$0.1 million with respecton our Notes prior to our secured convertible notes,conversion and comprised primarily of discount amortization and, to a lesser extent, annual interest at 3.76%, which we have elected to add to principal; partially offset by;by

 

Interest income of $0.3$0.1 million from investments in cash and cash equivalents.

We incurred interest expense, net, of $0.7$0.1 million in the 3926 weeks ended NovemberAugust 1, 2008,2009, comprised of:

 

Net accelerated interest charges of $1.9 million upon the conversion of $3.4 million of convertible notes into 2,274,804 shares of our common stock;

A non-cashNon-cash interest expense of $0.6$0.4 million with respect toon our secured convertible notesNotes, comprised primarily of discount amortization and, to a lesser extent, annual interest at 3.76%, which we have elected to add to principal;

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

Non-cash interest credit of $0.1 million to recognize the decrease in market value of a derivative liability; and partially offset by

 

Interest income of $1.8less than $0.3 million from investments in cash and cash equivalents.

31


Provision for income taxes

 

   39 Weeks
Ended
October 31, 2009
  Change From
Prior Fiscal Period
  39 Weeks
Ended
November 1,

2008
      ($ in millions)   

Provision for income taxes

      $  0.3      $(0.7 72.3 $1.0
   26 Weeks
Ended
July 31, 2010
  Change From
Prior Fiscal Period
  26 Weeks
Ended
August 1, 2009
      ($ in millions)   

Provision for income taxes

  $5.0  $4.7  1,887.4 $0.3

We have NOL carry forwards available, subject to certain limitation, to offset our regular taxable income. We recognized a provision for income taxes that resulted in an effective tax rate of 2.7%51% for federal and state income taxes. This rate was higher than that expected for future periods due to $2.8 million in interest charges incurred upon the Note conversions, which are not tax-deductible in the first fiscal quarter of 2010. Excluding the effect of these non-deductible charges, the effective income tax rate for the first half of fiscal 2010 would have been approximately 39%, which is based onthe rate we currently expect to incur for the remainder of the fiscal year.

Due to our expected utilization of federal and state NOL carry forwards during fiscal 2010, we anticipate cash income taxes for the fiscal year will be approximately 2% of pre-tax income, representing the portion of our estimatedfederal and state alternative minimum taxable income for fiscal 2009taxes that cannot be offset by NOLs. DuringThe difference between the 39 weeks ended October 31, 2009, we generated a nominaleffective income tax benefit to reflectrate and the anticipated cash income taxes is recorded as a prior period income tax overpayment to Puerto Rico.non-cash provision for deferred incomes taxes.

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 and other direct store and field management expenses, with no allocation of corporate overhead or interest income or expense.

Wet Seal:

 

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

  39 Weeks
Ended
October 31, 2009
 39 Weeks
Ended
November 1, 2008
   26 Weeks    
Ended    
July 31, 2010    
     26 Weeks    
Ended    
August 1, 2009    

Net sales

    $  338,987       $  360,365    $222,786        $    219,882     

Percentage of consolidated net sales

   83  82%     83%     82%  

Comparable store sales percentage decrease compared to the prior year fiscal period

   (9.2)%   (2.7)% 

Comparable store sales percentage decrease compared to the prior year period

   (1.4)%     (10.0)%

Operating income

    $26,315       $51,934    $20,548        $15,937     

Sales per square foot

    $196       $215    $126        $128     

Number of stores as of period end

   420    409     432         415     

Square footage as of period end

   1,655    1,610     1,709         1,636     

Wet Seal comparable stores sales decreased 9.2%1.4% during the 3926 weeks ended OctoberJuly 31, 2009,2010, compared to a prior year decrease of 2.7%10.0%. The decrease during the 3926 weeks ended OctoberJuly 31, 2009,2010, was due primarily to a 2.9% decline9.4% decrease in comparable store average transactions, partially offset by a 9.0% increase in comparable store average dollar sale and a 5.8% decrease in comparable store average transaction countssales per store.transaction. The decreaseincrease in comparable store average dollar salesales per transaction resulted from a 11.0% decrease12.1% increase in our average unit retail prices, and a decline in frequent buyer program membership sales, partially offset by a 10.0% increase2.9% decrease in units purchased per customer.customer, as a result of a merchandise content shift towards apparel and away from lower-priced accessories. The net sales decreaseincrease was attributable to the increase in the number of stores compared to the prior year and a $1.0 million increase in net sales in our internet business, partially offset by a comparable store sales decline and the prior year including a $0.8 million of additional net sales resulting from a change in estimated breakage.

Wet Seal’s operating income increased to 9.2% of net sales during the 26 weeks ended July 31, 2010, from 7.2% during the 26 weeks ended August 1, 2009. The increase in operating income, as a percentage of sales, was due primarily to an increase in merchandise margin as a result of an increase in initial markup rates and favorable spring physical inventory shrink results and a decrease in buying, planning and allocation costs primarily due to our open chief merchandise officer position and a reduction in stock compensation expense as a result of higher forfeiture adjustments. Additionally, during the 26 weeks ended July 31, 2010, and the 26 weeks ended August 1, 2009, operating income included asset impairment charges of $1.1 million and $1.6 million, respectively, to write down the carrying value of long-lived assets that were identified during our quarterly impairment evaluations. The increase for the 26 weeks ended August 1, 2009 was partially offset by a $0.8 million of additional net salesbreakage benefit resulting from a change in estimated breakage for unredeemed gift cards, gift certificates and store credits remaining outstanding more than two years from their respective issuance dates and a $0.3 million increase in net sales in our internet business and a $8.4 million increase in stores not in the comparable store base.dates.

Wet Seal’s operating income decreased to 7.8% of net sales during the 39 weeks ended October 31, 2009, from 14.4% during the 39 weeks ended November 1, 2008. The decrease in operating income, as a percentage of sales, was due primarily to a decrease in merchandise margin as a result of higher markdown rates and a decrease in initial markup rates and the deleveraging effect of a decrease in comparable store sales on occupancy costs, compared to the prior year. Additionally, during the 39 weeks ended October 31, 2009, and the 39 weeks ended November 1, 2008, operating income included asset impairment charges of $1.8 million and $0.4 million, respectively, to write down the carrying value of long-lived assets that were identified during our quarterly impairment evaluations. Operating income for the 39 weeks ended October 31, 2009, also included the $0.8 million breakage benefit noted above.

32


Arden B:

 

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

  39 Weeks
Ended
October 31, 2009
  39 Weeks
Ended
November 1, 2008
 

Net sales

      $70,934       $77,729  

Percentage of consolidated net sales

   17  18

Comparable store sales percentage decrease compared to the prior year fiscal period

   (2.5)%   (20.2)% 

Operating income (loss)

      $7,221       $(2,112)  

Sales per square foot

      $251       $248  

Number of stores as of quarter end

   80    91  

Square footage as of quarter end

   244    283  

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

  26 Weeks    
Ended    
July 31, 2010    
     26 Weeks    
Ended    
August 1, 2009    

Net sales

  $46,517        $48,493     

Percentage of consolidated net sales

   17%     18%  

Comparable store sales percentage increase (decrease) compared to the prior year period

   0.1%     (4.1)%

Operating income

  $5,913        $5,776     

Sales per square foot

  $172        $169     

Number of stores as of period end

   76         81     

Square footage as of period end

   230         247     

Arden B comparable stores sales decreased 2.5%increased 0.1% during the 3926 weeks ended OctoberJuly 31, 2009,2010, compared to a prior year decrease of 20.2%4.1%. The decreaseincrease during the 3926 weeks ended OctoberJuly 31, 2009,2010, was due primarily to a 26.0%2.1% increase in comparable store average transactions, partially offset by a 1.6% decrease in comparable store average dollar sale, which reflects our strategic decision to significantly lower price points across all categories in January 2009, largely offset by a 31.7% increase in comparable store average transaction countssales per store.transaction. The decrease in the average dollar salesales per transaction resulted from a 27.4%7.5% decline in our average unit retail prices, slightlypartially offset by a 1.7%6.4% increase in units purchased per customer. The net sales decrease was primarily attributable to the comparable store sales decline and the decrease in the number of stores compared to the prior year partially offset byand the prior year including a $0.4 million of additional net sales resulting from a change in estimated breakage, partially offset by the comparable store sales increase and a $0.7 million increase in net sales in our internet business.

Arden B generated operating income of 12.7% of net sales during the 26 weeks ended July 31, 2010, compared to operating income of 11.9% of net sales during the 26 weeks ended August 1, 2009. The improvement in operating results was due primarily to a decrease in occupancy costs due to a reduction in minimum rent and common area maintenance charges as a result of favorable lease negotiations, the decrease in store counts from 81 stores as of August 1, 2009, to 76 stores as of July 31, 2010, and a decrease in store payroll costs as a result of improved efficiency on higher sales volume compared to the prior year. These increases were partially offset by operating income for the 26 weeks ended August 1, 2009, including a $0.4 million of breakage benefit resulting from a change in estimated breakage for unredeemed gift cards, gift certificates and store credits remaining outstanding more than two years from their respective issuance dates and a $1.6 million increase in net sales in our internet business.

Arden B generated operating income of 10.2% of net sales during the 39 weeks ended October 31, 2009, compared to an operating loss of 2.7% of net sales during the 39 weeks ended November 1, 2008. The improvement in operating results was due primarily to an increase in merchandise margin resulting from a significant decrease in markdown rates, a decrease in buying costs upon restructuring the Arden B buying and design groups, partially offset by an increase in seasonal merchant incentive bonus due to improvement in divisional performance, a decrease in occupancy costs due to a decrease in depreciation expense as a result of a number of underperforming Arden B stores being impaired during fiscal 2008, the decrease in store counts from 91 stores as of November 1, 2008, to 80 stores as of October 31, 2009, and a decrease in store payroll costs as a result of lower sales and improved efficiency in controlling labor hours compared to the prior year. Additionally, during the 39 weeks ended October 31, 2009, and the 39 weeks ended November 1, 2008, operating income (loss) included asset impairment charges of less than $0.1 million and $0.4 million, respectively, to write down the carrying value of long-lived assets that were identified during our quarterly impairment evaluations. Operating income for the 39 weeks ended October 31, 2009, also included the $0.4 million breakage benefit noted above.dates.

Liquidity and Capital Resources

Net cash provided by operating activities was $19.2$18.3 million for the 3926 weeks ended OctoberJuly 31, 2009,2010, compared to $36.2$12.7 million for the same period last year. For the 3926 weeks ended OctoberJuly 31, 2009,2010, cash provided by operating cash flows were due toactivities was comprised of our net income of $12.6$4.8 million, and net non-cash charges, primarily depreciation and amortization, asset impairment, stock-based compensation, provision for deferred income taxes and non-cash interest expense, of $15.1$17.4 million, and a $0.7 million add back for a conversion/exercise inducement fee, partially offset by an increase in merchandise inventories net of anover the increase in merchandise accounts payable,payables of $3.2$2.7 million and a net use of cash from changes in other operating assets and liabilities of $5.3 million, including gift card, gift certificate and store credit breakage of $1.2$1.9 million. For the 3926 weeks ended Octoberending July 31, 2009,2010, net cash used in investing activities of $17.6$13.0 million was comprised entirely of capital expenditures. Capital expenditures, for the period were primarily for remodeling of existing Wet Seal stores upon lease renewals and/or store relocations, the construction of new Wet Seal stores, and investment in the development of new markdown optimization,retail merchandising and point-of-sale operating systems and a distribution sorting system. Capital expenditures that remain unpaid as of OctoberJuly 31, 2009,2010, have increased $2.4$5.6 million since the end of fiscal 2008.2009. We expect to pay nearly all of the total balance of such amounts payable, in the amount of $5.3$8.2 million, during the fourththird quarter of fiscal 2009.2010.

We estimate that, in fiscal 2009,2010, capital expenditures will be approximately between $22$31 million and $23$32 million, net of approximately $2$4 million in landlord tenant improvement allowances. Of the total net capital expenditures, approximately $17$20 million to $21 million is expected to be for the remodeling of existing Wet Seal and Arden B stores upon lease renewals and/or store relocations orand the construction of new Wet Seal and Arden B stores.

For the 3926 weeks ended Octoberending July 31, 2009,2010, net cash providedused by financing activities was $0.5$1.4 million, comprised of $5.2 million used to repurchase 1,394,162 shares of our Class A common stock, which utilized all remaining capacity under a $12.5 million repurchase authorization granted by our Board of Directors in November 2009, and a $0.7 million conversion inducement fee to a Note holder, partially offset by $4.3 million of proceeds from investor exercises of common stock warrants, which resulted in the issuance of 183,5721,160,715 shares of our Class A common stock, and nominal$0.2 million of proceeds from the exercise of stock options.

In March 2010, a holder of our Notes, preferred stock and Series E warrants converted $4.7 million in principal amount of our Notes into 3,111,111 shares of our Class A common stock and 1,611 shares of our Preferred Stock into 537,000 shares of our Class A common stock, and exercised Series E warrants into 625,000 shares of our Class A common stock for an exercise price of $2.3 million. As an inducement for the holder to undertake these conversions and/or exercises of the Notes, Preferred Stock and Series E warrants, we provided the holder with a $0.7 million inducement fee. We also repurchased an insignificant remaining Note balance from another holder. As a result of these transactions, there are no longer any remaining Notes and Preferred Stock outstanding and there was a satisfaction and discharge of our obligations under the Indenture governing the Notes.

33


Total cash and cash equivalents at OctoberJuly 31, 2009,2010, was $144.2$165.5 million compared to $142.1$161.7 million at January 31, 2009.30, 2010.

We maintain a $35.0 million revolving credit facility (the “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. The revolving credit facilityFacility expires in May 2011.2011 and we intend to either replace or renew our Facility. Under our revolving credit facility,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 revolving credit facilityFacility is the prime rate or, if we elect, the London InterbankInterBank 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 revolving credit facility,Facility, at the time of election, as adjusted quarterly. The applicable LIBOR margin was 1.0% as of OctoberJuly 31, 2009.2010. We also incur fees on outstanding letters of credit under the revolving credit facility in effectFacility 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 revolving credit facility ranks senior in right of payment to our secured convertible notes. Borrowings under the revolving credit facilityFacility 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, SMLLC.LLC.

At OctoberJuly 31, 2009,2010, the amount outstanding under the revolving credit facilityFacility consisted of $6.5$3.8 million in open commercialdocumentary letters of credit related to merchandise purchases and $1.7$1.5 million in outstanding standby letters of credit. At OctoberJuly 31, 2009,2010, we had $26.8$29.7 million available for cash advances and/or for the issuance of additional letters of credit. At October 31, 2009,credit and we were in compliance with all covenant requirements in the revolving credit facility and the indenture governing our secured convertible notes.

On November 18, 2009, we announced our Board of Directors authorized us to repurchase shares of our Class A common stock having an aggregate purchase price of up to $12.5 million. Repurchases are at our option and can be discontinued at any time. There is currently no expiration date for this repurchase program. The repurchase program reflects what is currently permitted under our secured convertible notes indenture. In the future, we may seek additional stock repurchase capacity under the indenture and expand the stock repurchase program accordingly.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, the significant deterioration in fiscal 2008 and into fiscal 2009, consumer confidence and consumer spending deteriorated significantly, andexperienced over the past few years could remain depressed for an extended period. As a result of this currentcontinuing economic crisis, 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, or we falter in execution of our business strategy, including, among other things, the ability of one or more of our vendors to deliver their merchandise in a timely manner or otherwise meet their obligations, we may not achieve our financial performance goals, which could adversely impact our results of operations and operating cash flow. This could also cause a decrease in or elimination of excess availability under our revolving credit facility,Facility, which could force us to seek alternatives to address potential cash constraints, including seeking additional debt and/or equity financing.

The financial performance of our business is susceptible to the recent declines in discretionary consumer spending, availability of consumer credit and low consumer confidence in the United States. Volatile fuel prices and increasing commodity costs may also cause a shift in consumer demand away from the retail clothing products that we offer. There are no guarantees that government or other initiatives will limit the duration or severity of the current economic recession or stabilize factors that affect our sales and profitability. Recent adverse economic trends could affect us more significantly than companies in other industries.

One of the factors that provides financing to a small portion of our merchandise vendor base, CIT Group Inc. (“CIT”), has recently filed for bankruptcy, which may threaten its financial viability and its ability to provide factoring services to its customers. If the financial condition of CIT were to deteriorate further and our vendors were unable to procure alternative factoring arrangements from competitors of CIT on the same or substantially similar terms, our ability to timely procure merchandise for our stores could be adversely affected. This could require the devotion of significant time and attention by our management to adequately resolve such matters. In turn, our results of operation and financial condition could suffer.

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,

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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 less 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.

 

Item 3.Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Risk

To the extent that we borrow under our revolving credit facility,Facility, we are exposed to market risk related to changes in interest rates. At OctoberJuly 31, 2009,2010, no borrowings were outstanding under our revolving credit facility.Facility. As of OctoberJuly 31, 2009,2010, we are not a party to any material derivative financial instruments.

Foreign Currency Exchange Rate Risk

We contract for and settle all purchases in U.S. dollars. We only purchase a modest amount of goods directly from international vendors. Thus, we consider the effect of currency rate changes to be indirect and we believe the effect of a major shift in currency exchange rates on short-term results would be minimal. Over a longer period, the impact of such changes could be significant, albeit indirectly, through increased charges in USU.S. dollars from our vendors that source their products internationally.

 

Item 4.Controls and Procedures

Disclosure Controls and Procedures

We conducted an evaluation, under the supervision and with the participation of our Chief Executive Officerchief executive officer and Chief Financial Officer, of the effectiveness of the design and operationchief financial officer, of our disclosure controls and procedures, (asas such term is defined in RulesRule 13a-15(e) and 15d-15(e)

promulgated 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, ourAct. These disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis,designed to provide reasonable assurance that the information required to be disclosed by usthe Company in the reports that we fileit files or submitsubmits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the Commission’s rules and forms. Our disclosure controls and procedures are effective in ensuringalso designed to provide reasonable assurance 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 Officerchief executive officer and Chief Financial Officer, as appropriatechief financial officer, in order to allow timely decisions regarding required disclosure.disclosures. Based on this evaluation, our chief executive officer and our chief financial officer concluded that our disclosure controls and procedures were effective at a reasonable assurance level as of July 31, 2010.

Changes in Internal Control Over Financial Reporting

During the fiscal quarter ended OctoberJuly 31, 2009,2010, 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.

PART II. Other Information

 

Item 1.Legal Proceedings

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 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. 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, subject to appeal. On April 28, 2008, a notice of appeal of the judgment was filed. On May 6, 2009, the Court reversed and remanded the case forto the Superior Court to re-evaluate the fairness of the settlement, which is expected toand a final hearing will take place in December 2009.September 2010. As of OctoberJuly 31, 2009,2010, we have accrued an amount equal to the settlement amount in accrued liabilities in our condensed 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 who were employed and paid by us during the four-year period from May 22, 2003 through May 22, 2007.the present. 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. Discovery is ongoing and the Court has indicated that thePlaintiffs filed their motion for class certification filing date and briefing schedule will be set at a status conferencein July 2010. Our opposition to Plaintiffs’ motion is due on December 15, 2009. We are vigorously defending this litigation and are unable

35


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 as of October 31, 2009.

On September 29, 2008, a complaint was filed in the Superior Court of the State of California for the County of San Francisco on behalf of certain of our current and former employees who were employed and paid by us during the four-year period from September 29, 2004 through September 29, 2008. The complaint alleges various violations under the State of California Labor Code24, 2010, and the State of California Business and Professions Code. Our responsive plea was filed on November 14, 2008. The case has been transferred to the complex panel of the San Francisco Superior Courthearing is scheduled for case management purposes.October 8, 2010. 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 as of OctoberJuly 31, 2009.2010.

On September 29, 2008, a complaint was filed in the Superior Court of the State of California for the County of San Francisco on behalf of certain of our current and former employees who were employed and paid by us from September 29, 2004 through the present. We were named as a defendant. The complaint alleges various violations under the State of California Labor Code and the State of California Business and Professions Code. Plaintiffs recently filed an amended complaint, and we filed a motion to strike allegations of the third amended complaint on or about February 16, 2010. The case has been transferred to the complex panel of the San Francisco Superior Court for case management purposes. No class certification motion filing deadline has been set by the court, and discovery is ongoing. 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 as of July 31, 2010.

On March 18, 2009, 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 sincefrom March 18, 2005.2005 through March 18, 2009. 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. WeOn October 23, 2009, we reached an agreement to pay approximately $0.2 million to settle this matter, subject to Superior Court approval. As of October 31, 2009, we had accrued an amount equal toThe Court has preliminarily approved the settlement and set a final approval hearing for September 2, 2010. We paid the preliminary settlement amount in accrued liabilities on our condensed consolidated balance sheet.August 2010.

On April 24, 2009 the Pennsylvania Equal Employment Opportunity CouncilCommission requested information and records relevant to several charges of discrimination.discrimination by our company against employees of our company. In the course of this investigation, the EEOC served us with a subpoena seeking information related to current and former employees throughout the United States. In April 2010, we filed an action for declaratory and injunctive relief in the U.S. District Court for the

Central District of California seeking relief from the subpoena, which action it has since voluntarily dismissed. Later that same month, the EEOC filed an application to enforce the subpoena in the U.S. District Court for the Eastern District of Pennsylvania, and is in the process of a nationwide investigation. We are vigorously defending thisawaiting the results of the EEOC’s investigation 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 as of OctoberJuly 31, 2009.2010.

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 these claims arising out of the pending litigation,normal course of business, we have insurance coverage to cover a portion of such losses; however, certain other matters may exist or arise for which we do not have insurance coverage. As of OctoberJuly 31, 2009,2010, we were not engaged in any 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 1A.Risk Factors

The following risk factor represents an addition to the risk factors previously disclosed in our Annual Report on Form 10-K for the fiscal year ended January 31, 2009.30, 2010.

Our abilityWe are in the process of identifying a successor to procure merchandise could be adversely affected by changes in our vendors’ factoring arrangements with CIT Group, Inc.

CIT has recently filed for bankruptcy, whichpresident and chief executive officer and the resulting succession may threaten its financial viability and its ability to provide factoring services to its customers. Although we do not have a direct relationship with CIT, a small portion of our vendors who supply our company with merchandise have direct factoring arrangements with CIT. Vendors who engage in factoring transactions with CIT typically sell their accounts receivable to CIT at a discount in exchange for cash payments, which can be used to finance the business and operations of the vendors.

If the financial condition of CIT were to deteriorate further and certain of our vendors were unable to procure alternative factoring arrangements from competitors of CIT on the same or substantially similar terms,impact our ability to timely procure merchandise forexecute our stores could be adversely affected. This could require the devotion of significant time and attention by our management to adequately resolve such matters. In turn, our results of operation and financial condition could suffer.

Recent changesbusiness strategy in the senior managementnear term.

As previously announced, Mr. Edmond S. Thomas, our president, chief executive officer and a director, will resign from his positions with our company upon the expiration of his existing employment agreement on October 8, 2010. We have entered into a transition services agreement with Mr. Thomas for a period of four months following the end of his employment agreement. During this period, Mr. Thomas will serve as interim president and interim chief executive officer and will be compensated for such services rendered pursuant to the terms of the Wet Seal division may hinder our operations.

In November 2009, Ms. Maria Comfort announced her resignation as President and Chief Merchandise Officer of the Wet Seal division. Ms. Comfort had initially assumed this role after her predecessor resigned in May 2008. We have started a search to find a replacement for Ms. Comfort, but competition for qualified employees is intense and we may have difficulty attracting individualstransition services agreement. However, there can be no assurance that Mr. Thomas will continue to serve in any capacity during the role of senior management of the Wet Seal division. In addition, our search may divert the attention of senior management from the business and operations of our company. Onceentire transition period or that we identify and attractwill find a suitable replacement for Ms. Comfort,Mr. Thomas before the expiration of Mr. Thomas’ employment agreement or the conclusion of his transition period.

If we are not able to appoint a new president and chief executive officer in a timely manner, our business, financial condition, and results of operations could be materially and adversely affected. In addition, we anticipate that we will experience a transition period before the successorour new chief executive officer is fully integrated into the Wet Seal division.his/her new roles. We cannot provide any assurance that there will not be any disruption that adversely impacts our customer relationships, employee morale and our business.

 

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Item 2.Unregistered Sales of Equity Securities and Use of Proceeds

 

(a)

None.

 

(b)

None.

 

(c)

None.

 

Item 3.Defaults Upon Senior Securities

(a)

None.

(b)

None.

 

Item 4.Submission of Matters to a Vote of Security HoldersRemoved and Reserved

None.

Item 5.Other Information

None.

Item 6.Exhibits

 

4.4.4

Satisfaction and Discharge of Indenture entered into between our company the The Bank of New York Mellon, dated as of May 3, 2010 (incorporated by reference to Exhibit 99.1 of our company’s Current Report on Form 8-K filed on May 7, 2010)

10.5.2

Amendment to the 2005 Stock Incentive Plan (incorporated by reference in Exhibit B of our company’s Definitive Proxy Statement of Form DEF 14A, dated April 19, 2010)

31.1  

Certification of the Chief Executive Officer filed herewith pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2  

Certification of the Chief Financial Officer filed herewith pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1  

Certification of the Chief Executive Officer furnished herewith pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2  

Certification of the Chief Financial Officer furnished herewith pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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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)

Date: December 2, 2009

By:August 31, 2010

 

/s/By:

  /s/ Edmond S. Thomas

  

Edmond S. Thomas

  

President and Chief Executive Officer

Date: December 2, 2009

By:August 31, 2010

 

/s/By:

  /s/ Steven H. Benrubi

  

Steven H. Benrubi

  

Executive Vice President and Chief Financial Officer

 

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