UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-K

 

 

Commission File No. 1-7832

 

PIER 1 IMPORTS, INC.

(Exact name of registrant as specified in its charter)

 

 

Company’s telephone number, including area code:

(817) 252-8000

 

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

 

 

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

None

 

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

 

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

 

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

 

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

 

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

 

Large accelerated filer o     Accelerated filer þ     Non-accelerated filer o

 

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

 

As of August 26, 2006, the approximate aggregate market value of voting stock held by non-affiliates of the registrant was $433,510,000 using the closing sales price on that day of $5.69.

 

As of May 9, 2007, 88,301,082 shares of the registrant’s common stock, $1.00 par value, were outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the following documents have been incorporated herein by reference:

 

1) Registrant’s Proxy Statement for the 2007 Annual Meeting in Part III hereof.

 

 

PIER 1 IMPORTS, INC.

 

FORM 10-K ANNUAL REPORT

Fiscal Year Ended March 3, 2007

 

TABLE OF CONTENTS

 

 

 

Throughout this report, references to the “Company” include Pier 1 Imports, Inc. and its consolidated subsidiaries. References to “Pier 1” relate to the Company’s retail locations operating under the name Pier 1 Imports^®. References to “Pier 1 Kids” relate to the Company’s retail locations operating under the name Pier 1 Kids^®.

 

On March 20, 2006, the Company announced the sale of its subsidiary based in the United Kingdom, The Pier Retail Group Limited (“The Pier”). At fiscal 2006 year end, The Pier was classified as held for sale and included in discontinued operations for all years presented in the Company’s financial statements; therefore, all discussions in this report relate to continuing operations, unless stated otherwise.

 

In fiscal 2007, the Company opened 34 new Pier 1 stores, closed 57 Pier 1 stores and closed seven Pier 1 Kids stores. Subject to changes in the retail environment, availability of suitable store sites, lease renewal negotiations and availability of adequate financing, the Company plans to open approximately five new Pier 1 stores and close approximately 60 stores, including 10 Pier 1 Kids stores, during fiscal 2008.

 

Set forth below is a list by city of Pier 1 stores opened in the United States and Canada in fiscal 2007:

 

 

Presently, the Company maintains regional distribution center facilities in or near Baltimore, Maryland; Chicago, Illinois; Columbus, Ohio; Fort Worth, Texas; Ontario, California; Savannah, Georgia; and Tacoma, Washington. Upon the expiration of its lease during fiscal 2007, the Pier 1 Kids distribution facility in Fort Worth, Texas was closed, and the merchandise was moved into the Company’s existing distribution center in Savannah, Georgia.

 

During fiscal 2007, the Company had an arrangement to supply Sears Roebuck de Mexico, S.A. de C.V. (“Sears Mexico”) with merchandise to be sold primarily in a “store within a store” format in certain Sears Mexico stores. The agreement with Sears Mexico expired December 31, 2006, and was renewed under similar terms with Sears Mexico’s parent company, Grupo Sanborns, S.A. de C.V., and will expire January 1, 2012. The agreement is structured in a manner, which substantially insulates the Company from currency fluctuations in the value of the Mexican peso. In fiscal 2007, Sears Mexico opened three new “store within a store” locations offering Pier 1 merchandise. As of March 3, 2007, Pier 1 merchandise was offered in 29 Sears Mexico stores. Sears Mexico’s expansion plans for fiscal 2008 include opening five new “store within a store” locations in Mexico to sell Pier 1 merchandise. Since Sears Mexico operates these locations, the Company has no employees or real estate obligations in Mexico.

 

The Company has a product distribution agreement with Sears Roebuck de Puerto Rico, Inc. (“Sears Puerto Rico”), which allows Sears Puerto Rico to market and sell Pier 1 merchandise in a “store within a store” format in certain Sears Puerto Rico stores. The Company has no employee or real estate obligations in

Puerto Rico because Sears Puerto Rico operates these locations. As of March 3, 2007, Pier 1 merchandise was offered in seven Sears Puerto Rico stores. Sears Puerto Rico has no plans for new “store within a store” locations in Puerto Rico during fiscal 2008.

 

During fiscal 2007, the Company sold its credit card operations, which included its credit card bank located in Omaha, Nebraska, that operated under the name Pier 1 National Bank, N.A. (the “Bank”) to Chase Bank USA, N.A. (“Chase”). The sale was comprised of the Company’s proprietary credit card receivables, certain charged-off accounts and the common stock of the Bank. The Company and Chase have entered into a long-term program agreement. Under this agreement, the Company will continue to support the card through marketing programs and will receive payments over the life of the agreement for transaction level incentives, marketing support and other program terms.

 

Since June 2000, the Company has operated an e-commerce web site, which received an average of 5.7 million visits per month in fiscal 2007, and can be accessed at www.pier1.com. This site is a useful marketing vehicle for the Company while providing customers with access to the Company’s products and services at their convenience. Customers can shop substantially all of the Company’s merchandise assortment, as well as purchase gift cards, create and manage bridal and gift registries, view interactive catalogs, watch the most recent TV commercials and sign up for marketing email and direct mail. In March 2007, the Company implemented new features on its e-commerce web site to allow customers to utilize discount and coupon codes at checkout and redeem the Company’s gift cards.

 

 

In fiscal 2007, the Company conducted business as one operating segment consisting of the retail sale of decorative home furnishings, gifts and related items.

 

Financial information with respect to the Company’s business is found in the Company’s Consolidated Financial Statements, which are set forth in Item 8 herein.

 

 

The specialty retail operations of the Company consist of retail stores operating under the names “Pier 1 Imports” and “Pier 1 Kids”, selling a wide variety of furniture, decorative home furnishings, dining and kitchen goods, bath and bedding accessories and other specialty items for the home.

 

On March 3, 2007, the Company operated 1,076 Pier 1 and 36 Pier 1 Kids stores in the United States, 84 Pier 1 stores in Canada, and supported three franchised stores in the United States. All three franchise agreements expire in June 2007. During fiscal 2007, the Company supplied merchandise and licensed the Pier 1 Imports name to Sears Mexico and Sears Puerto Rico, which sold Pier 1 merchandise primarily in a “store within a store” format in 29 Sears Mexico stores and in seven Sears Puerto Rico stores. Company-operated Pier 1 stores in the United States and Canada average approximately 9,800 gross square feet, which includes an average of approximately 7,900 square feet of retail selling space. The stores consist of freestanding units located near shopping centers or malls and in-line positions in major shopping centers. Pier 1 operates in all major U.S. metropolitan areas and many of the primary smaller markets. Pier 1 stores generally have their highest sales volumes during November and December as a result of the holiday selling season. In fiscal 2007, net sales of the Company totaled $1,623.2 million.

 

Pier 1 offers a diverse selection of current products consisting of approximately 3,000 items imported from over 40 countries around the world. While the broad categories of Pier 1’s merchandise remain constant, individual items within these product groupings change frequently in order to meet the demands of customers. The principal categories of merchandise include the following:

 

FURNITURE — This product group consists of furniture and furniture cushions to be used on patios and in living, dining, kitchen and bedroom areas, and in sunrooms. This product group constituted approximately 38% of Pier 1’s total U.S. and Canadian retail sales in fiscal year 2007, 40% in fiscal year 2006 and 39% in fiscal year 2005. These goods are imported from a variety of countries such as Italy, Malaysia, Brazil, Mexico, China, the Philippines and Indonesia, and are also obtained from domestic

sources. The furniture is made of metal or handcrafted natural materials, including rattan, pine, beech, rubberwood and selected hardwoods with either natural, stained or painted finishes. Pier 1 also sells upholstered furniture.

 

DECORATIVE ACCESSORIES — This product group constitutes the broadest category of merchandise in Pier 1’s sales mix and contributed approximately 27% to Pier 1’s total U.S. and Canadian retail sales in fiscal year 2007, 26% in fiscal year 2006 and 25% in fiscal year 2005. These items are imported from approximately 35 countries and include wood items, lamps, vases, dried and artificial flowers, baskets, wall decorations and numerous other decorative items. A majority of these products are handcrafted from natural materials.

 

HOUSEWARES — This product group is imported mainly from the Far East and Europe and includes ceramics, dinnerware and other functional and decorative items. These goods accounted for approximately 12% of Pier 1’s total U.S. and Canadian retail sales in fiscal year 2007, 13% in fiscal years 2006 and 2005.

 

BED, BATH & CANDLES — This product group is imported mainly from India, Germany, Thailand and China, and is also obtained from domestic sources. This group includes bath and fragrance products, candles and bedding. These goods accounted for approximately 17% of Pier 1’s total U.S. and Canadian retail sales in fiscal year 2007, 15% in fiscal year 2006 and 16% in fiscal year 2005.

 

SEASONAL — This product group consists of merchandise for celebrating holidays and spring/summer entertaining, imported mainly from Europe, Indonesia, China, the Philippines and India, and also obtained from domestic sources. These items accounted for approximately 6% of Pier 1’s total U.S. and Canadian retail sales in fiscal year 2007, 6% in fiscal year 2006 and 7% in fiscal year 2005.

 

Pier 1 merchandise largely consists of items that require a significant degree of handcraftsmanship and are mostly imported directly from foreign suppliers. For the most part, the imported merchandise is handcrafted in cottage industries and small factories. Pier 1 is not dependent on any particular supplier and has enjoyed long-standing relationships with many vendors and agents. The Company believes alternative sources of products could be procured over a relatively short period of time, if necessary. In selecting the source of a product, Pier 1 considers quality, dependability of delivery and cost. During fiscal 2007, Pier 1 sold merchandise imported from over 40 different countries with 35% of its sales derived from merchandise produced in China, 14% derived from merchandise produced in Indonesia, 13% derived from merchandise produced in India, 13% derived from merchandise produced in the United States and 21% derived from merchandise produced in Brazil, Thailand, Italy, the Philippines, Vietnam and Mexico. The remaining 4% of sales was from merchandise produced in various Asian, European, Central American, South American and African countries, and Canada.

 

Imported merchandise and a portion of domestic purchases are delivered to the Company’s distribution centers, unpacked and made available for shipment to the various stores in each distribution center’s region. Because of the time delays involved in procuring merchandise from foreign suppliers, the Company maintains a substantial inventory in its distribution center facilities to assure a sufficient supply of products to its stores.

 

The Company, through certain of its wholly owned subsidiaries, owns a number of federally registered service marks under which Pier 1 and Pier 1 Kids stores do business. Additionally, certain subsidiaries of the Company have registered and have applications pending for the registration of certain other Pier 1 and Pier 1 Kids trademarks and service marks in the United States and in numerous foreign countries. The Company believes that its marks have significant value and are important in its marketing efforts. The Company maintains a policy of pursuing registration of its marks and opposing any infringement of its marks.

 

The Company is in the highly competitive specialty retail business and competes primarily with specialty sections of large department stores, furniture and decorative home furnishings retailers, small specialty stores, mass merchandising discounters, and catalog and Internet retailers.

 

The Company allows customers to return merchandise within a reasonable time after the date of purchase without limitation as to reason. Most returns occur within 30 days of the date of purchase. The Company

monitors the level of and stated reasons for returns and maintains a reserve for future returns based on historical experience and other known factors.

 

On March 3, 2007, the Company employed approximately 15,400 associates in the United States and Canada, of which approximately 7,100 were full-time employees and 8,300 were part-time employees.

 

 

Information required by this Item is found in Note 1 of the Notes to the Consolidated Financial Statements.

 

 

The Company makes available free of charge through its Internet web site address (www.pier1.com) its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed with the Securities and Exchange Commission pursuant to Section 13(a) of the Securities Exchange Act of 1934 as soon as reasonably practicable after it electronically files such material with, or furnishes such material to, the Securities and Exchange Commission.

 

Certain statements contained in Item 1, Item 7 and elsewhere in this report may constitute “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934. The Company may also make forward-looking statements in other reports filed with the Securities and Exchange Commission and in material delivered to the Company’s shareholders. Forward-looking statements provide current expectations of future events based on certain assumptions. These statements encompass information that does not directly relate to any historical or current fact and often may be identified with words such as “anticipates,” “believes,” “expects,” “estimates,” “intends,” “plans,” “projects” and other similar expressions. Management’s expectations and assumptions regarding planned store openings, financing of Company obligations from operations, success of its marketing, merchandising and store operations strategies, and other future results are subject to risks, uncertainties and other factors that could cause actual results to differ materially from the anticipated results or other expectations expressed in the forward-looking statements. Risks and uncertainties that may affect Company operations and performance include, among others, the effects of terrorist attacks or other acts of war, conflicts or war involving the United States or its allies or trading partners, labor strikes, weather conditions or natural disasters, volatility of fuel and utility costs, the general strength of the economy and levels of consumer spending, consumer confidence, the availability of suitable sites for locating stores and distribution centers, availability of a qualified labor force and management, the availability and proper functioning of technology and communications systems supporting the Company’s key business processes, the ability of the Company to import merchandise from foreign countries without significantly restrictive tariffs, duties or quotas, and the ability of the Company to source, ship and deliver items from foreign countries to its U.S. distribution centers at reasonable prices and rates and in a timely fashion. The foregoing risks and uncertainties are in addition to others discussed elsewhere in this report. The Company assumes no obligation to update or otherwise revise its forward-looking statements even if experience or future changes make it clear that any projected results expressed or implied will not be realized.

 

The following information describes certain significant risks and uncertainties inherent in the Company’s business that should be carefully considered, along with other information contained elsewhere in this report and in other filings, when making an investment decision with respect to the Company. If one or more of these risks actually occurs, the impact on the Company’s operations, financial position, or liquidity could be material and the business could be harmed substantially. Additional risks and uncertainties not presently known to the Company or that it currently believes are immaterial may also adversely affect the Company’s business, financial condition, future results of operations and cash flow.

 

Strategic Risks and Strategy Execution Risks

 

The Company’s turnaround strategy may cause a disruption in operations and may not be successful.

 

The Company announced a strategy in April 2007, described in Item 7, for returning the Company to profitability. The turnaround strategy may negatively impact the Company’s operations, which could include disruptions from the realignment of operational functions within the home office, changes in the store administration reporting structure, and changes in the Company’s product assortments or marketing strategies. These changes could adversely affect the Company’s business operations and financial results. While the Company believes any disruptions would be short-term, it is unknown whether the impact would be material. In addition, if the Company’s turnaround strategy is not successful, or if it is not executed effectively, the Company’s business operations and financial results could be adversely affected.

 

The Company must be able to anticipate, identify and respond to changing trends and customer preferences for home furnishings.

 

The success of the Company’s specialty retail business depends upon its ability to predict trends in home furnishings consistently and to provide merchandise that satisfies consumer demand in a timely manner. Consumer preferences often change and may not be reasonably predicted. A majority of the Company’s merchandise is manufactured, purchased and imported from countries around the world and is typically ordered well in advance of the applicable selling season. Extended lead times may make it difficult to respond rapidly to changes in consumer demand and as a result, the Company may be unable to react quickly and source needed merchandise. In addition, the Company’s vendors may not have the ability to handle its increased demand for product. The seasonal nature of the business leads the Company to purchase and requires it to carry a significant amount of inventory prior to its peak selling season. As a result, the Company may be vulnerable to changes in evolving home furnishing trends, customer preferences, and pricing shifts, and may misjudge the timing and selection of merchandise purchases. The Company’s failure to anticipate, predict and respond in a timely manner to changing home furnishing trends could lead to lower sales and additional discounts and markdowns in an effort to clear merchandise, which could have a negative impact on merchandise margins and in turn the results of operations.

 

Failure to control merchandise returns could negatively impact the business.

 

The Company has established a provision for estimated merchandise returns based upon historical experience and other known factors. If actual returns are greater than those projected by management, additional reductions of revenue could be recorded in the future. Also, to the extent that returned merchandise is damaged, the Company may not receive full retail value from the resale of the returned merchandise. Introductions of new merchandise, changes in merchandise mix, merchandise quality issues, changes in consumer confidence, or other competitive and general economic conditions may cause actual returns to exceed the provision for estimated merchandise returns. An increase in merchandise returns that exceeds the Company’s current provisions could negatively impact the business and operating results.

 

A disruption in the operation of the domestic portion of the Company’s supply chain could impact its ability to deliver merchandise to its stores and customers, which could impact its sales and results of operations.

 

The Company maintains regional distribution centers in Maryland, Illinois, Ohio, Texas, California, Georgia and Washington. At these distribution centers, merchandise is received, allocated, and shipped to the Company’s stores. Additionally, the Company has outsourced the distribution of merchandise ordered through its e-commerce website to a third party who maintains its own distribution center in Tennessee. Major catastrophic events such as fire or flooding, malfunction or disruption of the information systems, or shipping problems could result in distribution delays of merchandise to the Company’s stores and customers. Such disruptions could have a negative impact on the Company’s sales and results of operations.

 

The success of the business is dependent on factors affecting consumer spending that are not controllable by the Company.

 

Consumer spending, including spending for the home and home-related furnishings, are dependent upon factors that include but are not limited to general economic conditions, levels of employment, disposable consumer income, prevailing interest rates, consumer debt, costs of fuel, recession and fears of recession, war and fears of war, inclement weather, tax rates and rate increases, consumer confidence in future economic conditions and political conditions, and consumer perceptions of personal well-being and security. Unfavorable changes in factors affecting discretionary spending could reduce demand for the Company’s products and therefore lower sales and negatively impact the business and its operating results.

 

Factors that may or may not be controllable by the Company may adversely affect the Company’s financial performance.

 

Increases in the Company’s expenses that are beyond the Company’s control including items such as higher interest rates, increases in fuel and transportation costs, increases in losses from damaged merchandise, inflation, higher costs of labor, insurance and healthcare, increases in postage and media costs, higher tax rates and changes in laws and regulations, including accounting standards, may increase the Company’s cost of sales and selling, general and administrative expenses, negatively impacting the Company’s operating results.

 

Failure to successfully manage and execute the Company’s marketing initiatives could have a negative impact on the business.

 

The success and growth of the Company is partially dependent on generating customer traffic in order to gain sales momentum in its stores and on its e-commerce web site. Successful marketing efforts require the ability to reach customers through their desired mode of communication utilizing various media outlets. Media placement decisions are generally made months in advance of the scheduled release date. The Company’s inability to accurately predict its consumers’ preferences may negatively impact the business and operating results.

 

Changes to estimates related to the Company’s property and equipment, or operating results that are lower than its current estimates at certain store locations, may cause the Company to incur impairment charges on certain long-lived assets.

 

The Company makes certain estimates and projections with regards to individual store operations in connection with its impairment analyses for long-lived assets in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” An impairment charge is required when the carrying value of the asset exceeds the estimated fair value or undiscounted future cash flows of the asset. The projection of future cash flows used in this analysis requires the use of judgment and a number of estimates and projections of future operating results. If actual results differ from the Company’s estimates, additional charges for asset impairments may be required in the future. If impairment charges are significant, the Company’s results of operations could be adversely affected.

 

Risks Related to Store Profitability

 

The Company’s success depends, in part, on its ability to operate in desirable locations at reasonable rental rates and to close underperforming stores at or before the conclusion of their lease terms.

 

The profitability of the business is dependent on opening and operating new stores at a reasonable profit, maintaining and growing the current store base at a reasonable profit, and identifying and closing underperforming stores. For a majority of the Company’s current store base, a large portion of a stores’ operating expense is the cost associated with leasing the location. Management actively monitors individual store performance to ensure stores can remain profitable or have the ability to rebound to a profitable state. Current locations may not continue to be desirable as demographics change, and the Company may choose to close an underperforming store before its lease expires. If management chooses to close an existing store before its lease expiration, the Company could suffer operating losses until the lease term expires or until the lease

arrangement has been restructured or the lease obligation has been settled. The Company cannot give assurance that a reduction in openings or increase in closings will result in greater profits.

 

Failure to attract and retain an effective management team or changes in the costs or availability of a suitable workforce to manage and support the Company’s stores and distribution facilities could adversely affect the business.

 

The Company’s success is dependent, in a large part, on being able to successfully attract, motivate and retain a qualified management team and employees. Sourcing qualified candidates to fill important positions within the Company, especially management, in the highly competitive retail environment may prove to be a challenge. The inability to recruit and retain such individuals could result in turnover in the stores and the distribution facilities, which could have an adverse effect on the business. Management will continue to assess the Company’s compensation structure in an effort to attract future qualified candidates or retain current experienced management team members.

 

Occasionally the Company experiences union organizing activities in its non-unionized distribution facilities. These types of activities may result in work slowdowns or stoppages and higher labor costs. Any increase in costs associated with labor organization at the distribution facilities could result in higher costs to distribute inventory and could negatively impact merchandise margins.

 

Factors affecting the general strength of the economy, should they decline, could result in reduced consumer demand for the Company’s products.

 

The Company’s successful execution relies on customer demand for its merchandise, which is affected by factors that are impacted by prevailing economic conditions. A general slowdown in the United States economy and an uncertain economic outlook may adversely affect consumer spending which in turn could result in lower sales and unfavorable operating results. A prolonged economic downturn could have a material adverse effect on the business, and its financial condition and results of operations.

 

The Company operates in a highly competitive retail environment with companies offering similar merchandise, and if customers are lost to the Company’s competitors, sales could decline.

 

The Company’s retail locations, e-commerce web site and direct mail catalog business operate in the highly competitive specialty retail business competing with specialty sections of large department stores, home furnishing stores, small specialty stores, mass merchandising discounters and catalog and Internet retailers. Management believes that in addition to competing for sales, it competes on the basis of pricing and quality of products, constantly changing merchandise assortment, visual presentation of its merchandise and customer service. The level of competition is not anticipated to decrease and if the Company is unable to maintain a competitive position, it could experience negative pressure on retail prices, which in turn could result in reduced merchandise margins and operating results.

 

The Company’s business is subject to seasonal variations, with a significant portion of its sales and earnings occurring during two months of the year.

 

Approximately 25% of the Company’s sales generally occur during the November-December holiday selling season. Failure to predict consumer demand correctly during these months could result in lost sales or gross margin erosion if merchandise must be marked down to clear inventory.

 

The Company’s business may be harmed by adverse weather conditions and natural disasters.

 

Extreme or undesirable weather can affect customer traffic in retail stores as well as customer shopping behavior. Natural disasters such as earthquakes, weather phenomena, and events causing infrastructure failures could adversely affect any of the Company’s retail locations, distribution centers, administrative facilities, ports, or locations of its suppliers domestically and in foreign countries.

 

Risks Associated with Dependence on Technology

 

The Company is heavily dependent on various kinds of technology in the operation of its business.

 

Failure of any critical software applications, technology infrastructure, telecommunications, data communications, or networks could have a material adverse effect on the Company’s ability to manage the merchandise supply chain, sell products, accomplish payment functions or report financial data. The Company maintains backup processing capabilities; however, not all processes and applications are duplicated, and a concentration of technology related risk does exist at the Company’s headquarters.

 

The Company outsources certain business processes to third party vendors that subject the Company to risks, including disruptions in business and increased costs.

 

Some business processes that are dependent on technology are outsourced to third parties. Such processes include gift card tracking and authorization, credit card authorization and processing, catalog and e-commerce fulfillment, insurance claims processing, U.S. customs filings and reporting, payroll payments and tax filings, and record keeping for retirement plans. The Company makes a diligent effort to insure that all providers of outsourced services observe proper internal control practices, such as redundant processing facilities; however, there are no guarantees that failures will not occur. Failure of third parties to provide adequate services could have an adverse effect on the Company’s results of operations, liquidity, or ability to accomplish its financial and management reporting.

 

Failure to protect the integrity and security of individually identifiable data of the Company’s customers and employees could expose the Company to litigation and damage the Company’s reputation.

 

The Company receives and maintains certain personal information about its customers and employees. If the Company’s security systems are compromised and this information is obtained by unauthorized persons, it could adversely affect the Company’s reputation, as well as operations, results of operations, financial condition and liquidity, and could result in litigation against the Company or the imposition of penalties. In addition, the use of this information by the Company is regulated at the federal and state levels. As privacy and information security laws and regulations change, the Company may incur additional costs to insure it remains in compliance.

 

Regulatory Risks

 

The Company is subject to laws and regulatory requirements in many jurisdictions. Changes in these laws and requirements may result in additional costs to the Company, including the costs of compliance as well as potential penalties for non-compliance.

 

The Company operates in many local, state, and federal taxing jurisdictions, including foreign countries. In most of these jurisdictions, the Company is required to collect state and local sales taxes at the point of sale and remit them to the appropriate taxing authority. The Company is also subject to income taxes, excise taxes, franchise taxes, payroll taxes and other special taxes. The Company is also required to maintain various kinds of business and commercial licenses to operate its stores and other facilities. Rates of taxation are beyond the Company’s control, and increases in such rates or taxation methods and rules could have a material impact on the Company’s profitability. Failure to comply with laws concerning the collection and remittance of taxes and with licensing requirements could also subject the Company to financial penalties or business interruptions.

 

Local, state, and federal legislation also has a potential material effect on the Company’s profitability or ability to operate its business. Compliance with certain legislation carries with it significant costs. The Company is subject to oversight by many governmental agencies in the course of operating its business because of its numerous locations, large number of employees, contact with consumers, granting of credit, and importation and exportation of product. Insuring compliance with regulations may cause the Company to incur significant expenses, including the costs associated with periodic audits. Failure to comply may also cause additional costs in the form of penalties.

 

Risks Associated with International Trade

 

As a retailer of imported merchandise, the Company is subject to certain risks that typically do not affect retailers of domestically produced merchandise.

 

The Company usually orders merchandise well in advance of delivery and generally takes title to the merchandise at the time it is loaded for transport to designated U.S. destinations. Global political unrest, war, threats of war, terrorist acts or threats, especially threats to foreign and U.S. ports, could affect the Company’s ability to import merchandise from certain countries. Fluctuations in foreign currency exchange rates, restrictions on the convertibility of the dollar and other currencies, duties, taxes and other charges on imports, dock strikes, import quota systems and other restrictions sometimes placed on foreign trade can affect the price, delivery and availability of imported merchandise as well as exports to the Company’s stores in other countries. The inability to import products from certain countries, unavailability of adequate shipping capacity at reasonable rates, or the imposition of significant tariffs could have a material adverse effect on the results of operations of the Company. Freight costs contribute a substantial amount to the cost of imported merchandise. Monitoring of foreign vendors’ compliance with U.S. laws and Company standards, including quality standards, is more difficult than monitoring of domestic vendors.

 

The United States government has the authority to enforce trade agreements, resolve trade disputes, and open foreign markets to U.S. goods and services. The United States government may also impose trade sanctions on foreign countries that are deemed to violate trade agreements or maintain laws or practices that are unjustifiable and restrict U.S. commerce. In these situations, the United States government may increase duties on imports into the United States from one or more foreign countries. In this event, the Company could be adversely affected by the imposition of trade sanctions.

 

In addition, the United States maintains in effect a variety of additional international trade laws under which the Company’s ability to import may be affected from time to time, including, but not limited to, the antidumping law, the countervailing duty law, the safeguards law, and laws designed to protect intellectual property rights. Although the Company may not be directly involved in a particular trade dispute under any of these laws, its ability to import, or the terms and conditions under which it can continue to import, may be affected by the outcome of such disputes.

 

In particular, because the Company imports merchandise from countries around the world, the Company may be affected from time to time by antidumping petitions filed with the United States Commerce Department and International Trade Commission by U.S. producers of competing products alleging that foreign manufacturers are selling their own products at prices in the United States that are less than the prices that they charge in their home country market or in third country markets or at less than their cost of production. Such petitions, if successful, could significantly increase the United States import duties on those products. In that event, the Company might possibly decide to pay the increased duties, thereby possibly increasing the Company’s price to consumers. Alternatively, the Company might decide to source the product or a similar product from a different country not subject to increased duties or else discontinue the importation and sale of the product.

 

In recent years, dispute resolution processes have been utilized to resolve disputes regarding market access between the European Union, China, the United States and other countries. In some instances, these trade disputes can lead to the threats by countries of sanctions against each other, which can include import prohibitions and increased duty rates on imported items. The Company considers any agreement that reduces tariff and non-tariff barriers in international trade beneficial to its business. Any type of sanction on imports is likely to increase the Company’s import costs or limit the availability of products purchased from sanctioned countries. In that case, the Company may be required to seek similar products from other countries.

 

Risks Relating to Liquidity

 

Insufficient cash flows from operations could result in the substantial utilization of the Company’s secured credit facility, which may impose certain financial covenants.

 

The Company maintains a secured credit facility to enable it to issue merchandise and special purpose standby letters of credit as well as occasionally to fund working capital requirements. Borrowings under the credit facility are subject to a borrowing base calculation consisting of a percentage of certain eligible assets of the Company. Substantial utilization of the availability under the borrowing base will result in various restrictions on the Company including: restricting the ability of the Company to repurchase its common stock or pay dividends, dominion over the Company’s cash accounts, and requiring compliance with a minimum fixed charge coverage ratio. Significant decreases in cash flow from operations and investing could result in the Company’s borrowing increased amounts under the credit facility to fund operational needs. Increases in utilization of letters of credit and/or increased cash borrowings could result in the Company’s being subject to these limitations.

 

None.

 

The Company is headquartered in Fort Worth, Texas. In August 2004, the Company completed construction of its corporate facilities, which contain approximately 460,000 square feet of office space. The Company transitioned Pier 1 Kids’ administrative offices from their 21,000 square-foot offices, also located in Fort Worth, Texas, to its corporate headquarters during the second quarter of fiscal 2007 prior to the expiration of that lease in September 2006.

 

The Company leases the majority of its retail stores, its warehouses and regional space. At March 3, 2007, the present value of the Company’s minimum future operating lease commitments discounted at 10% totaled approximately $902.5 million. The Company currently owns and leases distribution center space of approximately five million square feet. The Company also acquires temporary distribution center space from time to time through short-term leases.

 

The following table sets forth the distribution of Pier 1’s U.S. and Canadian stores by state and province as of March 3, 2007:

 

 

At the end of fiscal 2007, the Company had 11 Pier 1 Kids stores in Florida, eight stores in Texas, seven stores in North Carolina, three stores in Virginia, two stores in Georgia, two stores in Maryland, one store in Alabama, one store in Delaware and one store in New Jersey.

 

As of March 3, 2007, the Company owned or leased the following warehouse properties in or near the following cities:

 

 

The Company constructed a new distribution facility under a build-to-suit arrangement, with a resulting lease that qualified for operating lease treatment, near Tacoma, Washington and began operating this facility in March 2006. Upon the expiration of its lease during fiscal 2007, the Company transitioned Pier 1 Kids’ distribution facilities from a separate facility in Fort Worth, Texas into its existing distribution center in

Savannah, Georgia. The Savannah facility is closer to the Pier 1 Kids’ stores and will now service both Pier 1 and Pier 1 Kids stores.

 

During fiscal 2007, the Company recorded a pre-tax charge of $4.9 million for settlement of and legal fees related to class action lawsuits in California primarily regarding compensation matters. Cash outlays related to the settlement are expected to be completed in fiscal 2008.

 

There are various claims, lawsuits, investigations and pending actions against the Company and its subsidiaries incident to the operations of its business. The Company considers them to be ordinary and routine in nature. The Company maintains liability insurance against most of these claims. Excluding the class action lawsuits discussed above, it is the opinion of management, after consultation with counsel, that the ultimate resolution of such litigation will not have a material adverse effect, either individually or in aggregate, on the Company’s financial position, results of operations or liquidity.

 

There were no matters submitted to a vote of the Company’s security holders during the fourth quarter of the Company’s 2007 fiscal year.

 

Market Prices of Common Stock

 

The following table shows the high and low closing sale prices of the Company’s common stock on the New York Stock Exchange (the “NYSE”), as reported in the consolidated transaction reporting system for each quarter of fiscal 2007 and 2006.

 

 

Number of Holders of Record

 

The Company’s common stock is traded on the NYSE. As of April 30, 2007, there were approximately 9,900 shareholders of record of the Company’s common stock.

 

Dividends

 

During fiscal 2007, the Company paid cash dividends totaling approximately $17.4 million, or $0.20 per share. In October 2006, the Company announced that its Board of Directors discontinued the Company’s $0.10 per share quarterly dividend. The Company believes that discontinuing the cash dividend will provide financial flexibility as it executes the Company’s turnaround strategy. The Company does not currently

anticipate paying cash dividends in fiscal 2008 and its dividend policy in the near term will depend upon the earnings, financial condition and capital needs of the Company and other factors deemed relevant by the Company’s Board of Directors.

 

The following table shows the dividends paid per share for each quarter of fiscal 2007 and 2006:

 

 

Cash dividend payments are not restricted by the Company’s secured credit facility unless the availability under the Company’s credit facility is less than 30% of the Company’s borrowing base calculation. Such borrowing base calculation consists of a percentage of eligible inventory and third-party credit card receivables and varies according to the levels of the underlying collateral. As of March 3, 2007, the Company had no outstanding cash borrowings, approximately $124.0 million in letters of credit utilized against its secured credit facility, and the borrowing base was $239.7 million. The Company is not required to comply with financial covenants under its secured credit facility unless the availability under such agreement is less than $32.5 million. After excluding the $32.5 million, the Company had $83.2 million available for cash borrowings as of year end, therefore, was in compliance with required debt covenants at fiscal 2007 year end.

 

Securities Authorized for Issuance under Equity Compensation Plans

 

The following table summarizes the Company’s equity compensation plans as of March 3, 2007:

 

 

 

Performance Graph

 

The following graph compares the five-year cumulative total shareholder return for the Company’s common stock against the Standard & Poor’s 500 Stock Index and the Standard & Poor’s Retail Stores Composite Index. The annual changes for the five-year period shown on the graph are based on the assumption, as required by the Securities and Exchange Commission’s rules, that $100 had been invested in the Company’s stock and in each index on March 2, 2002, and that all quarterly dividends were reinvested at the average of the closing stock prices at the beginning and end of the quarter. The total cumulative dollar returns shown on the graph represent the value that such investments would have had on March 3, 2007.

 

PIER 1 IMPORTS, INC. STOCK PERFORMANCE GRAPH

 

 

 

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

 

There were no purchases of common stock of the Company made during the three months ended March 3, 2007, by Pier 1 Imports, Inc. or any “affiliated purchaser” of Pier 1 Imports, Inc. as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934.

 

FINANCIAL SUMMARY

 

 

 

 

MANAGEMENT OVERVIEW

 

Introduction

 

Pier 1 Imports, Inc. (together with its consolidated subsidiaries, the “Company”) is one of North America’s largest specialty retailers of unique decorative home furnishings, gifts and related items. The Company imports merchandise directly from over 40 countries, and sells a wide variety of furniture collections, decorative accessories, bed and bath products, housewares and other seasonal assortments in its stores. During fiscal year 2007, the Company opened 34 new stores and closed 64 stores. The Company operates stores in the United States and Canada under the names “Pier 1 Imports” (“Pier 1”), and “Pier 1 Kids.” Pier 1 Kids stores sell children’s home furnishings and decorative accessories. As of March 3, 2007, the Company operated 1,196 stores in the United States and Canada, including 36 Pier 1 Kids stores and 26 clearance stores. The Company conducts business as one operating segment.

 

During the fourth quarter of fiscal 2006, the Company’s Board of Directors authorized management to sell its operations of The Pier Retail Group Limited (“The Pier”), the Company’s subsidiary based in United Kingdom. The Company met the criteria of Statement of Financial Accounting Standards, No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” that allowed it to classify The Pier as held for sale and present its results of operations as discontinued as of February 25, 2006, with prior periods reclassified accordingly. On March 20, 2006, the Company sold The Pier to Palli Limited for approximately $15.0 million. Palli Limited is a wholly owned subsidiary of Lagerinn ehf, an Iceland corporation owned by Jakup a Dul Jacobsen. According to a Schedule 13D filing, collectively Lagerinn and Mr. Jacobsen beneficially owned approximately 9.9% of the Company’s common stock on March 20, 2006. Expenses incurred in March 2006 by the Company related to The Pier were $0.4 million, net of taxes.

 

The following discussion and analysis of financial condition, results of operations, liquidity and capital resources relates to continuing operations, unless otherwise stated, and should be read in conjunction with the accompanying audited Consolidated Financial Statements and notes thereto which can be found in Item 8 of this report. Fiscal 2007 consisted of a 53-week year while fiscal 2006 and fiscal 2005 were 52-week years.

 

Overview of Business

 

Net sales from continuing operations decreased 8.6% to $1,623.2 million in fiscal 2007 compared to $1,776.7 million in fiscal 2006, and comparable store sales declined 11.3%. The Company’s net loss from continuing operations was $227.2 million during fiscal 2007, or $2.59 per share, compared with a loss per share of $0.32 for the prior fiscal year. The Company ended the year with $167.2 million in cash and cash equivalents.

 

The Company’s key financial and operational indicators used by management to evaluate the performance of the business include the following (trends for these indicators are explained in the comparative discussions of this section):

 

 

Stores included in the comparable store sales calculation are those stores that were opened prior to the beginning of the preceding fiscal year and are still open. Also included are stores that were relocated during the year within a specified distance serving the same market, where there is not a significant change in store size and where there is not a significant overlap or gap in timing between the opening of the new store and the closing of the existing store. Stores that are expanded or renovated are excluded from the comparable store sales calculation during the period they are closed for such remodeling. When these stores re-open for business, they are included in the comparable store sales calculation in the first full month after the re-opening if there is no significant change in store size. If there is a significant change in store size, the store continues to be excluded from the calculation until it meets the Company’s established definition of a comparable store. Direct sales to customers (which include direct catalog sales and sales through the Company’s e-commerce website) are also included.

 

During fiscal 2007, the Company continued to experience declining sales and margins despite efforts to find the right product mix and merchandising and marketing programs to drive traffic into the stores and onto its web site to improve comparable store sales. In an attempt to reverse the negative trends, the Company introduced dramatic shifts in the look of its merchandising design, which failed to meet the expectations of the Company’s customer base and resulted in continued sales declines. In addition to the merchandise changes, the Company experimented with new marketing strategies, primarily increased television and direct mail advertising, which failed to generate the desired increase in traffic. Despite the operational struggles of the past several years and fierce competition in the home furnishings sector, management still believes that the Pier 1 brand is as relevant as ever.

 

In February 2007, the Company hired a new President and Chief Executive Officer as a result of the retirement of its former Chief Executive Officer. In April 2007, the Company’s management announced a plan to return the Company to profitability that is built on the following six business priorities:

 

1) Improve operational efficiency.  Over the course of the coming fiscal year, the Company will undertake a detailed review of all of its costs and seek out ways to streamline and simplify the organization at all levels. In March 2007, the Company announced a reduction of its workforce, which

included 100 home office and 75 field administration positions. Changes in the field organization included the elimination of the visual merchandising functions and a reduction of divisional director positions. The Company expects these changes to result in approximately $17 million in annualized savings. In addition, the Company anticipates related one-time charges of less than $5 million to be recorded in the first quarter of fiscal 2008. The Company has identified other cost savings opportunities throughout the organization and will implement changes during the next 12 months in an effort to capitalize on these opportunities.

 

2) Develop real estate strategies that protect the short-term and long-term future of the Company.  The Company will continue to review the individual contributions of its existing store portfolio, and will make decisions about the future of individual store locations in accordance with the Company’s overall turnaround strategy. The Company may decide to exit certain locations through natural expirations, economic terminations, lease buyouts, sublease opportunities or sale of the properties. At the same time, the Company will strategically seek out new and growing markets in which new store locations or the relocation of an existing store will fit within the long-term growth plans of the Company. During fiscal 2008, the Company plans to open five new store locations and close approximately 60 stores.

 

3) Provide a compelling merchandise selection.  To regain its competitive edge, the Company must provide a merchandise assortment that evolves and adapts to the changing needs and preferences of its customer base. The Company’s buying department is responsible for purchasing, developing, testing and creating the merchandise assortments offered. Historically, this department has been responsible for processes that are not part of product development and procurement and has been greatly under-resourced. Reassigning administrative tasks to other areas of the Company and increasing the number of buyers will provide the buying team more time to spend visiting new and existing vendors, and more time to identify and correct gaps and omissions in the Company’s product mix.

 

4) Create an effective planning and allocations team.  Historically, the Company’s merchandise planning group was part of the buying department, and the allocations team was part of the logistics department. In the reorganization of the home office, the Company combined these two groups into one unit. This newly combined team will oversee, among other things, inventory levels, markdowns, and purchase order management, and will absorb the administrative tasks that historically burdened the buying team. This change will ensure everything from assortment planning to store allocation is carefully and thoughtfully planned.

 

5) Improve supply chain efficiency.  The Company will review every operational practice including, but not limited to, freight costs, vendor payment terms, the use of outside storage facilities, and transportation and delivery contracts in an effort to find ways to simplify the process, improve supply chain visibility, reduce costs and increase inventory turns.

 

6) Create a cost-effective marketing plan.  In fiscal 2007, the Company experimented with changes in its marketing strategy and spent significant dollars on television and direct mail advertising efforts. The changes did not provide the desired increase in traffic or comparable store sales. Recognizing that a change is needed, the Company plans to make adjustments to its strategy for the second half of fiscal 2008, and will decrease its marketing expenditures this coming fiscal year. As its customer base is very diverse demographically, the Company will continue to research the ideal marketing mix to effectively communicate with its entire customer base while reaching groups of new customers as well. The Company’s goal is to strike a healthy balance between driving traffic, increasing comparable store sales and revitalizing the Pier 1 brand.

 

The Company’s management presently believes that if it effectively and efficiently executes these business priorities as part of its turnaround strategy, the Company should, over time, return to profitability.

 

FISCAL YEARS ENDED MARCH 3, 2007 AND FEBRUARY 25, 2006

 

Net Sales

 

Net sales consisted almost entirely of sales to retail customers, net of discounts and returns, but also included delivery revenues and wholesale sales and royalties received from franchise stores and Sears Roebuck de Mexico, S.A. de C.V. Sales by retail concept during fiscal years 2007, 2006 and 2005 were as follows (in thousands):

 

 

 

 

Net sales during fiscal 2007 were $1,623.2 million, a decrease of $153.5 million or 8.6%, from $1,776.7 million for the prior fiscal year. The decrease in sales for the fiscal year was comprised of the following components (in thousands):

 

 

Comparable store sales for fiscal 2007 declined 11.3%. The Company’s net sales from Canadian stores were subject to fluctuation in currency conversion rates. These fluctuations had an immaterial impact on both net sales and comparable store calculations in fiscal 2007 compared to fiscal 2006.

 

During fiscal 2007, the Company opened 34 and closed 64 stores in the United States and Canada, bringing its Pier 1 and Pier 1 Kids store count to 1,196 at year-end, compared to 1,226 last year. The Company continues to evaluate its real estate portfolio on a store-by-store and market-by-market basis and will open or close stores as deemed appropriate. During fiscal 2008, the Company expects to open five new Pier 1 stores and close approximately 60 stores, including 10 Pier 1 Kids stores. A summary reconciliation of the Company’s stores open at the beginning of fiscal 2007, 2006 and 2005 to the number open at the end of each period follows (openings and closings include relocated stores):

 

 

 

The Company’s proprietary credit card generated net sales of $355.4 million, a decrease of $67.1 million or 15.9% from last year’s proprietary credit card sales of $422.5 million. Sales on the proprietary credit card totaled 23.9% of U.S. store sales compared to 25.7% last year. Average ticket on the Company’s proprietary credit card declined to $160 in fiscal 2007 compared to $163 in fiscal 2006. In November 2006, the Company sold its proprietary credit card business to Chase Bank USA, N.A. (“Chase”). At that time, the Company also entered into a long-term program agreement with Chase. Under this agreement, the Company will continue to use the card as a marketing and communication tool to its most loyal customers.

 

Gross Profit

 

Gross profit after related buying and store occupancy costs, expressed as a percentage of sales, was 29.2% in fiscal 2007 compared to 33.9% a year ago. Merchandise margins, as a percentage of sales, declined from 50.2% in fiscal 2006 to 47.9% in fiscal 2007, a decrease of 230 basis points. The decline in merchandise margin rates resulted primarily from increased discounting and markdown activity throughout the year and an inventory write- down of $32.5 million incurred during the fourth quarter. The inventory write-down was the result of a strategic decision to sell off excess inventory by the end of the first quarter of fiscal 2008. Store occupancy costs during fiscal 2007 were $303.4 million or 18.7% of sales, an increase of $12.9 million and 230 basis points over store occupancy costs of $290.4 million or 16.3% of sales during fiscal 2006. This increase was primarily due to the deleveraging of relatively fixed rental costs over a lower sales base and an increase in rental expense, property taxes and utility costs.

 

Operating Expenses, Depreciation and Income Taxes

 

Selling, general and administrative expenses, including marketing, comprised 40.0% of sales in fiscal 2007, an increase of 690 basis points over last year’s 33.1% of sales. In total dollars, selling, general and administrative expenses increased $60.7 million in fiscal 2007 over fiscal 2006; $50.3 million of this increase is summarized in the table below. Expenses that normally vary with sales and number of new stores, such as store payroll, marketing, store supplies, and equipment rental, increased $8.5 million. These variable expenses increased 280 basis points as a percentage of sales for fiscal 2007 compared to fiscal 2006. Marketing expense increased $13.9 million or 140 basis points as a percentage of sales. During the year, the Company increased both the number of different catalogs published and the circulation while maintaining its other marketing initiatives focused on driving sales and reinforcing its brand position. Store salaries, including bonus, decreased $3.5 million from the prior year, yet increased 120 basis points as a percentage of sales, as sales were insufficient to leverage certain fixed portions of store payroll costs incurred to maintain minimum staffing levels to provide quality customer service. Other variable expenses such as equipment rental and store supplies decreased $1.9 million, yet increased 20 basis points as a percentage of sales.

 

Relatively fixed selling, general and administrative expenses increased $52.2 million in fiscal 2007, or 410 basis points as a percentage of sales over last year. This amount included the following items, which are summarized in the table below. The Company recognized impairment charges of $36.4 million on long-lived assets (including a goodwill impairment charge of $4.1 million related to Pier 1 Kids) versus $5.8 million in fiscal 2006. The impairment on fixed assets of $32.3 million resulted from lower than expected sales trends, which caused asset carrying values to exceed estimated future cash flows. The goodwill impairment charge was the result of the Company’s decision to start integrating Pier 1 Kids’ merchandise into its existing Pier 1 store base by including this merchandise as an additional product assortment line and to no longer expand Pier 1 Kids locations as a stand-alone store concept. The Company recorded a $4.9 million charge for the settlement of and legal fees related to class action lawsuits primarily regarding compensation matters in California. Other selling, general and administrative expenses that do not typically vary with sales increased $16.7 million, primarily as a result of settlement and curtailment charges related to retirement plans of

$6.8 million because of two officers retiring in fiscal 2007, $4.5 million expense for the relocation of Pier 1 Kids’ distribution facilities and integration of its headquarters, and compensation expense recognized on stock options of $4.5 million.

 

 

Depreciation and amortization for fiscal 2007 was $51.2 million, representing a decrease of approximately $5.0 million from last year’s depreciation and amortization expense of $56.2 million. This decrease was primarily the result of the impairment of certain store-level assets, a decrease in depreciation expense related to the 64 stores closed in the United States and Canada since the end of fiscal 2006 and an overall reduction in capital expenditures. These decreases were partially offset by increases in depreciation expense related to new store openings in the United States and Canada, and software applications launched subsequent to the end of fiscal 2006.

 

In fiscal 2007, the Company had an operating loss of $226.2 million, $183.4 million worse than the prior years’ operating loss of $42.8 million.

 

During the year, the Company recorded a charge of $24.7 million to establish a valuation allowance related to deferred tax assets from prior years. In evaluating the likelihood that sufficient earnings would be available in the near future to realize the deferred tax assets, the Company considered cumulative losses over three years including the current year. The Company concluded that a valuation allowance was necessary based upon this evaluation and the guidance provided in SFAS No. 109 “Accounting for Income Taxes”.

 

In addition, net deferred tax assets arising from current year losses in excess of the amount expected to be carried back to offset taxable income in a prior year were fully reserved through a valuation allowance recorded during the year. As these deferred tax assets were established and fully reserved during fiscal 2007, there was no net impact to the provision of income taxes. There was no tax benefit recorded on approximately $150.0 million of the current year’s losses. At the end of fiscal 2007, the net deferred tax assets and the offsetting valuation allowance totaled $86.3 million.

 

Net Loss

 

Net loss from continuing operations in fiscal 2007 was $227.2 million or $2.59 per share, a decrease of $199.8 million as compared to fiscal 2006’s net loss from continuing operations of $27.5 million, or $0.32 per share.

 

Net loss from discontinued operations was $0.4 million or $0.01 per share in fiscal 2007 and $12.3 million or $0.14 per share in fiscal 2006. See Note 2 of the Notes to Consolidated Financial Statements for additional information regarding discontinued operations.

 

Total net loss in fiscal 2007 was $227.6 million, or $2.60 per share, a decrease in earnings of $187.8 million as compared to fiscal 2006’s net loss of $39.8 million, or $0.46 per share.

 

FISCAL YEARS ENDED FEBRUARY 25, 2006 AND FEBRUARY 26, 2005

 

Net Sales

 

Net sales consisted almost entirely of sales to retail customers, net of discounts and returns, but also included delivery revenues and wholesale sales and royalties received from franchise stores and Sears Roebuck

de Mexico, S.A. de C.V. Sales by retail concept during fiscal years 2006, 2005 and 2004 were as follows (in thousands):

 

 

 

 

During fiscal 2006, the Company recorded net sales of $1,776.7 million, a decrease of $48.6 million, or 2.7%, from $1,825.3 million for fiscal year 2005. The decrease in sales for fiscal 2006 was comprised of the following components (in thousands):

 

 

Comparable store sales for fiscal 2006 decreased 7.1% primarily as a result of decreased store traffic and increased competition from other retailers. Throughout fiscal 2006, the Company struggled to maintain and increase customer traffic, which the Company believed was the result of its inability to differentiate its merchandise from competitors through its marketing campaign. In an effort to encourage customers to return to the stores, the Company distributed its first two nation-wide catalogs. The first catalog was mailed in the fall of 2005 and the second during the 2005 holiday season. The Company’s net sales from Canada were subject to fluctuations in currency conversion rates. These fluctuations had an immaterial favorable impact on both total net sales and comparable store sales calculations in fiscal 2006 compared to fiscal 2005.

 

The Company opened 69 and closed 38 stores in the United States and Canada during fiscal 2006, bringing the store count to 1,226 compared to 1,195 at the end of fiscal 2005. A summary reconciliation of the Company’s stores open at the beginning of fiscal 2006, 2005 and 2004 to the number open at the end of each period follows (openings and closings include relocated stores):

 

 

 

The Company’s proprietary credit card generated net sales of $422.5 million for fiscal 2006, a decrease of $38.7 million or 8.4% over fiscal 2005 proprietary credit card sales of $461.2 million. Sales on the proprietary credit card were 25.7% for fiscal 2006 of U.S. store sales compared to 27.1% in fiscal 2005. Average ticket on the Company’s proprietary credit card increased to $163 during fiscal 2006 from $159 during fiscal 2005. At the end of the second quarter of fiscal 2006, in an effort to stimulate sales, the Company began to offer a 12-month, no interest promotion on larger purchases as well as supporting special incentives for store associates to encourage customers to open new proprietary credit card accounts. While the proprietary credit card generated modest income, it primarily served as a tool for marketing and communication to the Company’s most loyal customers.

 

Gross Profit

 

Gross profit after related buying and store occupancy costs, expressed as a percentage of sales, was 33.9% in fiscal 2006 compared to 38.5% in fiscal 2005. Merchandise margins, as a percentage of sales, declined from 53.1% in fiscal 2005 to 50.2% in fiscal 2006, a decrease of 290 basis points. The decline in merchandise margin rates resulted primarily from the Company’s continued use of discounts and markdowns to stimulate sales as well as make way for new and unique merchandise lines. Store occupancy costs during fiscal 2006 were $290.4 million or 16.3% of sales, an increase of $24.1 million and 170 basis points over store occupancy costs of $266.3 million or 14.6% of sales during fiscal 2005. The increase was primarily due to an inability to leverage relatively fixed rental costs over a lower sales base.

 

Operating Expenses, Depreciation and Income Taxes

 

Selling, general and administrative expenses, including marketing, comprised 33.1% of sales in fiscal 2006, an increase of 300 basis points over fiscal 2005’s 30.1% of sales. In total dollars, selling, general and administrative expenses increased $38.6 million in fiscal 2006 over fiscal 2005, with $34.1 million of the increase attributable to expenses that normally vary with sales and number of new stores, such as marketing, store payroll, supplies, and equipment rental. These variable expenses increased 250 basis points as a percentage of sales for fiscal 2006 compared to fiscal 2005. Despite the negative comparable store sales in fiscal 2006, the Company intentionally did not decrease store payroll hours in an effort to maintain minimum staffing levels and continue to provide good customer service. In addition, the Company was unable to leverage certain fixed portions of store payroll costs over the lower sales base. In an effort to increase customer traffic to its stores, marketing expenditures during fiscal 2006 were planned to increase over fiscal 2005 and were up $16.0 million to 5.8% of sales, an increase of 105 basis points expressed as a percentage of sales. From October 2004 through February 2005, the Company discontinued its television advertising campaign because management viewed it as ineffective at increasing customer traffic and driving sales. During fiscal 2006, the Company re-launched a national television advertising campaign and distributed two nation-wide catalogs while discontinuing its newspaper insert programs. Store supplies and equipment rental increased $2.6 million and 20 basis points as a percentage of sales.

 

Relatively fixed selling, general and administrative expenses increased $4.6 million in fiscal 2006, or 50 basis points as a percentage of sales, over fiscal 2005. Other occupancy expenses (excluding store and distribution center occupancy expenses) increased $4.9 million or 30 basis points, primarily as a result of impairment charges of $5.8 million recognized on long-lived store-level assets compared to impairment charges in fiscal 2005 of $0.4 million. In addition, the Company had a $1.0 million write-off of the remaining book value of fixed assets and intangibles associated with early store closures in fiscal 2006. These non-cash charges were partially offset by a $2.3 million savings in home office rental expense as the corporate headquarters were rented for a portion of fiscal 2005 but were owned for all of fiscal 2006. Lease accounting

adjustments decreased $6.6 million or 40 basis points as a percentage of sales from fiscal 2005, primarily as a result of a cumulative correction of $6.3 million recognized in fiscal 2005 related to pre-opening store rental expense for leases entered into in years prior to fiscal 2005. The Company’s lease termination expense increased $1.8 million or 10 basis points as a percentage of sales, primarily as a result of closing stores in fiscal 2006 with longer remaining lease terms than those of the stores closed in fiscal 2005. Due to the Company’s thorough re-evaluation of individual store performance in fiscal 2006, more stores were closed prior to the lease expiration in an effort to improve the Company’s overall real estate portfolio. Net proprietary credit card income increased $4.0 million to $7.2 million, representing a 20 basis point decrease in relatively fixed selling, general and administrative expenses as a percentage of sales. This increase in income was primarily the result of increased finance charge income, a decrease in processing charges and a decrease in bad debt expense. The increase in finance charge income was primarily a result of a modest increase in late payment fees and a reduction of the number of days in the grace period before interest charges are imposed. Non-store payroll increased $8.9 million or 60 basis points as a percentage of sales for the year primarily as a result of a $4.6 million increase in officers’ retirement expense as well as planned payroll increases related to annual merit increases and long-term incentives. An additional $0.7 million of severance costs related to field and home-office restructurings also contributed to the increase in non-store payroll costs. All other relatively fixed selling, general and administrative expenses decreased $0.4 million and increased 10 basis points as a percentage of sales.

 

Depreciation and amortization for fiscal 2006 was $56.2 million, representing an increase of approximately $0.5 million over fiscal 2005’s depreciation and amortization expense of $55.8 million. This increase was primarily the result of an increase in net new store openings, depreciation on software applications that were launched subsequent to the end of fiscal 2005 and a full year of depreciation on the Company’s corporate headquarters in fiscal 2006 versus a partial year in fiscal 2005. These increases were partially offset by a slight reduction in depreciation expense for certain assets that were fully depreciated during fiscal 2006.

 

In fiscal 2006, the Company had an operating loss of $42.8 million, a decline of $141.1 million from the operating income of $98.2 million for fiscal 2005.

 

The Company’s effective tax rate was 34.5% of pretax income (loss) from continuing operations, compared to 36.7% in fiscal 2005 and 29.9% of pretax loss from discontinued operations. The decrease in the Company’s effective tax rate from continuing operations was primarily the result of state tax liabilities.

 

Net Loss

 

Net loss from continuing operations in fiscal 2006 was $27.5 million or $0.32 per share, a decrease of $90.2 million as compared to fiscal 2005’s net income from continuing operations of $62.8 million, or $0.71 per share on a diluted basis.

 

Net loss from discontinued operations was $12.3 million or $0.14 per share in fiscal 2006 and $2.3 million or $0.03 per share in fiscal 2005. The pre-tax loss of $17.6 million was the result of The Pier’s loss from operations of $10.1 million and a $7.4 million impairment charge to write the assets down to fair value less reasonable costs to sell. See Note 2 of the Notes to Consolidated Financial Statements for additional information regarding discontinued operations.

 

Total net loss in fiscal 2006 was $39.8 million, or $0.46 per share, a decrease in earnings of $100.3 million as compared to fiscal 2005’s net income of $60.5 million, or $0.68 per share on a diluted basis.

 

LIQUIDITY AND CAPITAL RESOURCES

 

For the purposes of liquidity and capital resource discussions, the Company’s discontinued operations will be included in financial results. The Company’s cash and cash equivalents including those from discontinued operations totaled $167.2 million at the end of fiscal 2007, a decrease of $86.0 million from the fiscal 2006 year end balance of $253.2 million. Operating activities used $104.9 million of cash primarily due to the Company’s net loss, the purchase of $100.0 million of proprietary credit card receivables from the Pier 1 Imports Credit Card Master Trust (the “Master Trust”) by sending cash to the Master Trust to redeem its

outstanding Class A Certificates, and the payment of $28.1 million in retirement benefits primarily by redeeming investments from a consolidated trust. These cash outflows were partially offset by $144.6 million ($157.6 million less $13.0 million received in connection with the sale of Pier 1 National Bank as described below) in cash proceeds received from Chase on the sale of the Company’s proprietary credit card receivables and the add back of certain non-cash charges. These non-cash charges included a $36.4 million impairment of fixed assets and goodwill and a $24.6 million valuation allowance on deferred tax assets.

 

During fiscal 2007, investing activities by the Company provided $31.8 million. Collections of principal on beneficial interest in securitized receivables provided $21.9 million. Proceeds from the sale of The Pier provided $15.0 million, partially offset by $3.4 million in cash held by The Pier on the date of the sale. Proceeds from the sale of Pier 1 National Bank provided $13.0 million, partially offset by $2.2 million in cash held by Pier 1 National Bank on the date of the sale. Capital expenditures were $28.6 million and consisted primarily of $12.2 million for fixtures and leasehold improvements related to new and existing stores, $11.4 million for information systems enhancements and home office capital additions, and $5.0 million in expenditures for the Company’s distribution centers. Fiscal 2008 capital expenditures are projected to be approximately $13.0 million.

 

Contributions of $9.7 million were made during fiscal 2007 to the consolidated trusts that have been established for the purpose of setting aside funds for various retirement obligations. The assets held by the trusts are classified as restricted investments. The Company sold $25.7 million of these restricted investments to settle the defined benefit plan obligations of certain retired executive officers of the Company during fiscal 2007. At year end, the trusts had assets of $14.5 million. Of this amount, $6.1 million is invested in money market funds and is designated for the settlement of lump-sum defined benefit plan obligations, $6.3 million of which are expected to be settled in the second quarter of fiscal 2008. Life insurance policies with cash surrender values totaling $6.9 million and money market funds valued at $1.5 million are held in trusts designated for the satisfaction of obligations related to non-qualified retirement savings plans. Future contributions to the trusts may be made in the form of cash or other assets such as Company-owned life insurance policies. See Note 10 of the Notes to Consolidated Financial Statements for additional information regarding the restricted assets and defined benefit plan obligations.

 

Fiscal 2007 financing activities used $13.0 million of the Company’s cash. The Company paid dividends totaling $17.4 million through the second quarter of fiscal 2007. No dividends have been declared since that time. The Company does not currently anticipate paying cash dividends in fiscal 2008 and its dividend policy in the near term will depend upon the earnings, financial condition and capital needs of the Company and other factors deemed relevant by the Company’s Board of Directors. Under the Company’s secured credit facility, the Company will not be restricted from paying cash dividends unless the availability under the credit facility is less than 30% of the Company’s calculated borrowing base. All other financing activities provided net cash of $4.4 million. The Company borrowed and repaid $69.0 million during the fiscal year; $22.0 million was the greatest amount of cash borrowings outstanding at any one time under the credit facility. As of March 3, 2007, the Company had no outstanding cash borrowings and approximately $124.0 million in letters of credit utilized against its secured credit facility. The borrowing base was $239.7 million, of which $83.2 was available for cash borrowings. This facility expires in November 2010.

 

In June 2004, the Company’s Board of Directors authorized up to $150 million for purchases of its common stock, replacing the previous authorization. As of April 30, 2007, approximately $107.4 million of the authorization remains available. During fiscal 2007, the Company did not make any repurchases under this board-approved program and has no immediate plans to repurchase shares of its outstanding common stock.

 

The Company’s sources of working capital for fiscal 2007 were cash flows from internally generated funds, the sale of the Company’s proprietary credit card receivables and credit card operations to Chase, the sale of the Company’s United Kingdom operations, and bank lines of credit. The Company’s secured credit facility may limit certain investments, and in some instances, limit the payment of cash dividends and repurchases of the Company’s common stock. The Company was in compliance with all required debt covenants at fiscal 2007 year end.

 

A summary of the Company’s contractual obligations and other commercial commitments as of March 3, 2007 is listed below (in thousands):

 

 

 

 

The present value of total existing minimum operating lease commitments discounted at 10% was $902.5 million at fiscal 2007 year end. The Company plans to fund these commitments from cash generated from the operations of the Company and from borrowings against lines of credit.

 

During fiscal 2008, the Company plans to open five new stores and close approximately 60 stores as leases expire or are otherwise ended. New store locations will be financed primarily through operating leases. Total capital expenditures for fiscal 2008 are expected to be approximately $13.0 million. Of this amount, the Company expects to spend approximately $6.5 million on store development, $4.5 million on information systems enhancements and approximately $2.0 million primarily related to the Company’s distribution centers.

 

In summary, the Company’s primary uses of cash in fiscal 2007 were to fund operating expenses; redeem outstanding Class A Certificates at the Master Trust; provide for new and existing store development; fund capital additions related to distribution centers and information systems development; and pay dividends. The Company has a variety of sources for liquidity, which include available cash balances, available lines of credit, cash surrender value of life insurance policies not restricted as to use, receipt of federal and state tax refunds, and real estate financing options. Among the financing options being considered for Company-owned real estate are sale or sale-leaseback transactions, traditional mortgages, and amending the secured credit facility to include Company-owned real estate in the borrowing base. Adding real estate to the secured credit facility would provide flexibility through additional availability under the Company’s line of credit and would reduce the Company’s dependence on inventory levels as the determinant of the size of its borrowing base. Given the various liquidity options available, the Company believes it has sufficient liquidity to fund operational obligations and capital expenditure requirements throughout fiscal 2008. In addition, the Company is currently projecting its cash and cash equivalents balance at fiscal 2008 year end to approximate its fiscal 2007 year end balance.

 

OFF-BALANCE SHEET ARRANGEMENTS

 

Other than the operating leases and letters of credit discussed above, the Company’s only other off-balance sheet arrangement related to the securitization of the Company’s proprietary credit card receivables. During fiscal 2007, the Company allowed its securitization agreement to expire and subsequently sold its proprietary credit card operations to Chase. At the time of the expiration of the securitization agreement, the Company purchased $144.0 million of proprietary credit card receivables, previously held by the Master Trust for $100.0 million in cash and in exchange for $44.0 million of beneficial interest. The Master Trust, upon approval from debt security (“Class A Certificates”) holders, paid $100.0 million to redeem the Class A Certificates that were outstanding.

 

Prior to the expiration of the securitization agreement, the Company sold, on a daily basis, its proprietary credit card receivables that met certain eligibility criteria to Pier 1 Funding, LLC (“Funding”), which transferred the receivables to the Master Trust. The Master Trust had issued $100 million face amount of Class A Certificates to a third party. This securitization of receivables provided the Company with a portion of its funding. However, neither Funding nor the Master Trust was consolidated in the Company’s financial statements, and the Company had no obligation to reimburse Funding, the Master Trust or purchasers of Class A Certificates for credit losses from the receivables. During fiscal 2006, the Company’s securitization agreements were amended to, among other things, extend the expiration date until September 2006 and to increase the amount of Class B Certificates required to be held by Funding. At the end of fiscal 2006, there were $13.6 million of Class B Certificates outstanding. All Class B Certificates were settled concurrent with the expiration of the securitization agreement. See Note 3 of the Notes to Consolidated Financial Statements for additional information regarding the securitization of the Company’s proprietary credit card receivables.

 

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

 

The preparation of the Company’s consolidated financial statements in accordance with accounting principles generally accepted in the United States requires the use of estimates that affect the reported value of assets, liabilities, revenues and expenses. These estimates are based on historical experience and various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for the Company’s conclusions. The Company continually evaluates the information used to make these estimates as the business and the economic environment changes. Historically, actual results have not varied materially from the Company’s estimates, with the exception of the impairment of long-lived assets, the early retirement of participants in its defined benefit plans and income taxes as discussed below, and the Company does not currently anticipate a significant change in its assumptions related to these estimates. Actual results may differ from these estimates under different assumptions or conditions. The Company’s significant accounting policies can be found in Note 1 of the Notes to Consolidated Financial Statements. The policies and estimates discussed below include the financial statement elements that are either judgmental or involve the selection or application of alternative accounting policies and are material to the Company’s financial statements. Unless

specifically addressed below, the Company does not believe that its critical accounting policies are subject to market risk exposure that would be considered material and as a result, has not provided a sensitivity analysis. The use of estimates is pervasive throughout the consolidated financial statements, but the accounting policies and estimates considered most critical are as follows:

 

Revenue recognition — The Company recognizes revenue from retail sales, net of sales tax and third party credit card processing fees, upon customer receipt or delivery of merchandise, including sales under deferred payment promotions on its proprietary credit card. Typically, credit card receivable deferral programs offer deferred payments for up to 90 days or monthly installment payments over 12 months. Historically these payment deferral programs have not resulted in significant increases in bad debt losses arising from such receivables. As a result of the sale of the Company’s credit card business in fiscal 2007, these deferred programs will result in an upfront reduction of sales based on the fees charged by Chase for such programs going forward. The Company records an allowance for estimated merchandise returns based on historical experience and other known factors. Should actual returns differ from the Company’s estimates and current provision for merchandise returns, revisions to the estimated merchandise returns may be required.

 

Gift cards — Revenue associated with gift cards is deferred until redemption of the gift card. Gift card breakage is estimated and recorded as income based upon an analysis of the Company’s historical redemption patterns and represents the remaining unused portion of the gift card liability for which the likelihood of redemption is remote. If actual redemption patterns vary from the Company’s estimates, actual gift card breakage may differ from the amounts recorded. For all periods presented, gift card breakage was recognized after a period of 30 months from the original issuance and was $6.2 million, $5.1 million and $4.5 million in fiscal 2007, 2006 and 2005, respectively.

 

Beneficial interest in securitized receivables — In September 2006, the Company allowed its securitization agreement to expire. At that time, the Company purchased $144.0 million of proprietary credit card receivables in exchange for $44.0 million of beneficial interest and $100.0 million of cash. Therefore, at fiscal 2007 year end, the Company had no beneficial interest. Additionally, all Class B Certificates, which are discussed below, were settled at the time the securitization agreement expired. Prior to the expiration of this agreement, the Company securitized its entire portfolio of proprietary credit card receivables. During most of fiscal 2007, and all of fiscal 2006 and 2005, the Company sold all of its proprietary credit card receivables, except an immaterial amount of those that failed certain eligibility requirements, to a special-purpose wholly owned subsidiary, Pier 1 Funding, LLC (“Funding”), which transferred the receivables to the Pier 1 Imports Credit Card Master Trust (“Master Trust”). Neither Funding nor the Master Trust was consolidated by the Company, and the Master Trust met the requirements of a qualifying special-purpose entity under SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” The Master Trust issued beneficial interests that represented undivided interests in the assets of the Master Trust consisting of the transferred receivables and all cash flows from collections of such receivables. The beneficial interests included certain interests retained by Funding, which were represented by Class B Certificates, and the residual interest in the Master Trust (the excess of the principal amount of receivables held in the Master Trust over the portion represented by the certificates sold to third-party investors and the Class B Certificates). Gain or loss on the sale of receivables depended in part on the previous carrying amount of the financial assets involved in the transfer, allocated between the assets sold and the retained interests based on their relative fair value at the date of transfer.

 

The beneficial interest in the Master Trust was accounted for as an available-for-sale security and was recorded at fair value. The Company estimated fair value of its beneficial interest in the Master Trust, both upon initial securitization and thereafter, based on the present value of future expected cash flows using management’s best estimates of key assumptions including credit losses and payment rates. As of February 25, 2006, the Company’s assumptions used to calculate the present value of the future cash flows included estimated credit losses of 4.75% of the outstanding balance, expected payment within a six-month period and a discount rate representing the average market rate the Company would expect to pay if it sold securities representing ownership in the excess receivables not required to collateralize the Class A Certificates. A sensitivity analysis performed assuming a hypothetical 20% adverse change in both interest rates and credit losses resulted in an immaterial impact on the fair value of the Company’s beneficial interest. See Note 3 of

the Notes to Consolidated Financial Statements for additional information regarding the beneficial interest in securitized receivables.

 

Inventories — The Company’s inventory is comprised of finished merchandise and is stated at the lower of average cost or market, cost being determined on a weighted average inventory method. Cost is calculated based upon the actual landed cost of an item at the time it is received in the Company’s warehouse using actual vendor invoices, the cost of warehousing and transporting product to the stores and other direct costs associated with purchasing products. Carrying values of inventory are analyzed and to the extent that the cost of inventory exceeds the expected selling prices less reasonable costs to sell, provisions are made to reduce the carrying amount of the inventory. The Company reviews its inventory levels in order to identify slow-moving merchandise and uses merchandise markdowns to sell such merchandise. Markdowns are recorded to reduce the retail price of such slow-moving merchandise as needed. Since the determination of carrying values of inventory involves both estimation and judgment with regard to market values and reasonable costs to sell, differences in these estimates could result in ultimate valuations that differ from the recorded asset.

 

The Company recognizes known inventory losses, shortages and damages when incurred and makes a provision for estimated shrinkage. The amount of the provision is estimated based on historical experience from the results of its physical inventories. Inventory is physically counted at substantially all locations at least once in each 12-month period, at which time actual results are reflected in the financial statements. Physical counts were taken at substantially all stores and distribution centers during each period presented in the financial statements. Although inventory shrinkage rates have not fluctuated significantly in recent years, should actual rates differ from the Company’s estimates, revisions to the inventory shrinkage expense may be required. Most inventory purchases and commitments are made in U.S. dollars.

 

Impairment of long-lived assets — Long-lived assets such as buildings, equipment, furniture and fixtures, and leasehold improvements are reviewed for impairment at least annually and whenever an event or change in circumstances indicates that their carrying values may not be recoverable. If the carrying values exceed the sum of the expected undiscounted cash flows, the assets are considered impaired. For store level long-lived assets, expected cash flows are estimated based on management’s estimate of changes in sales, merchandise margins, and expenses over the remaining expected terms of the leases. Impairment is measured as the amount by which the carrying value of the asset exceeds the fair value of the asset. Fair value is determined by discounting expected cash flows. Impairment, if any, is recorded in the period in which the impairment occurred. The Company recorded $31.9 million and $5.6 million in impairment charges in fiscal 2007 and fiscal 2006, respectively. As the projection of future cash flows requires the use of judgment and estimates, if actual results differ from the Company’s estimates, additional charges for asset impairments may be recorded in the future. For store level assets, if management had increased its assumptions of comparable store sales declines by an additional 3% over the next four years, additional impairment charges of approximately $5.0 million would have been recorded in fiscal 2007.

 

Insurance provision — The Company is self-insured with respect to medical coverage offered to eligible employees except that claims in excess of $200,000 per occurrence per year are covered by a purchased insurance policy. The Company records a provision for estimated claims that have been incurred but not reported. Such claim amounts are estimated based on historical average claims per covered individual per month and on the average historical lag time between the covered event and the time it is paid by the Company. The liability for estimated medical claims incurred but not reported at March 3, 2007 was $2.9 million.

 

During fiscal 2007, the Company maintained insurance for workers’ compensation and general liability claims with a deductible of $1,000,000 and $750,000, respectively, per claim. The liability recorded for such claims is determined by estimating the total future claims cost for events that occurred prior to the balance sheet date. The estimates consider historical claims development factors as well as information obtained from and projections made by the Company’s insurance carrier and underwriters. The recorded liabilities for workers’ compensation and general liability claims at March 3, 2007 were $17.3 million and $6.3 million, respectively.

 

The assumptions made in determining the above estimates are reviewed continually and the liability adjusted accordingly as new facts are revealed. Changes in circumstances and conditions affecting the assumptions used in determining the liabilities could cause actual results to differ from the Company’s recorded amounts.

 

Defined benefit plans — The Company maintains supplemental retirement plans (the “Plans”) for certain of its executive officers. The Plans provide that upon death, disability, reaching retirement age or certain termination events, a participant will receive benefits based on highest compensation and years of service. These benefit costs are dependent upon numerous factors, assumptions and estimates. Benefit costs may be significantly affected by changes in key actuarial assumptions such as the discount rate, compensation rates, or retirement dates used to determine the projected benefit obligation. Additionally, changes made to the provisions of the Plans may impact current and future benefit costs.

 

Income taxes — The Company records income tax expense using the liability method for taxes. The Company is subject to income tax in many jurisdictions, including the United States, various states and localities, and foreign countries. At any point in time, multiple tax years are subject to audit by various jurisdictions and the Company records reserves for estimates of probable tax exposures for foreign and domestic tax audits. The timing of these audits and negotiations with taxing authorities may affect the ultimate settlement of these issues. The process of determining tax expense by jurisdiction involves the calculation of actual current tax expense or benefit, together with the assessment of deferred tax expense resulting from differing treatment of items for tax and financial accounting purposes. Deferred tax assets and liabilities are recorded in the Company’s consolidated balance sheets and are classified as current or noncurrent based on the classification of the related assets or liabilities for financial reporting purposes. A valuation allowance is recorded to reduce the carrying amounts of deferred tax assets unless it is more likely than not those assets will be realized. If different assumptions had been used, the Company’s tax expense or benefit, assets and liabilities could have varied from recorded amounts. If actual results differ from estimated results or if the Company adjusts these assumptions in the future, the Company may need to adjust its deferred tax assets or liabilities, which could impact its effective tax rate. In evaluating the likelihood that sufficient earnings would be available in the near future to realize the deferred tax assets, the Company considered cumulative losses over three years including the current year.

 

During fiscal 2007, the Company concluded that a valuation allowance was necessary based upon this evaluation. In addition, net deferred tax assets arising from current year losses in excess of the amount expected to be carried back to offset taxable income in a prior year were fully reserved through a valuation allowance. As these deferred tax assets were established and fully reserved during fiscal 2007, there was no net impact to the provision of income taxes. At the end of fiscal 2007, the net deferred tax assets and the offsetting valuation allowance totaled $86.3 million.

 

IMPACT OF INFLATION AND CHANGING PRICES

 

Inflation has not had a significant impact on the operations of the Company during the preceding three years.

 

IMPACT OF NEW ACCOUNTING STANDARDS

 

In July 2006, the Financial Accounting Standards Board (the “FASB”) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109 (“FIN 48”), which clarifies the accounting for uncertainty in tax positions. FIN 48 prescribes the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. It also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. The provisions of FIN 48 are effective for the Company as of the beginning of fiscal 2008, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. The Company is currently analyzing the cumulative effect adjustment to retained earnings that will be recorded upon adoption.

 

In September 2006, the Securities and Exchange Commission staff published Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 explains how the effects of prior year uncorrected errors must be considered in quantifying misstatements in the current year financial statements. SAB 108 offers a special “one-time” transition provision for correcting certain prior year misstatements that were uncorrected as of the beginning of the fiscal year of adoption. SAB 108 is effective for the Company as of the end of fiscal year 2007. The adoption of this statement as of March 3, 2007, did not have an impact on the Company’s consolidated balance sheet and statements of operations, shareholders’ equity and cash flows.

 

In September 2006, the FASB issued SFAS No. 157 “Fair Value Measurement” (“SFAS 157”). SFAS 157 provides a definition of fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS 157 is effective for the Company as of the beginning of fiscal year 2009. The Company does not expect the adoption of this statement to have a material impact on its consolidated balance sheet and statements of operations, shareholders’ equity and cash flows.

 

In September 2006, the FASB issued SFAS No. 158 “Employers Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R)” (“SFAS 158”). SFAS 158 requires companies to recognize the funded status of postretirement benefit plans as an asset or liability in the financial statements. The transition date for recognition of an asset or liability related to the funded status of an entity’s plan is effective for the Company as of the end of fiscal year 2007. The Company adopted the funded status recognition portion of SFAS 158 as of March 3, 2007, and recorded an additional liability with an offset to other comprehensive income of $1,631,000. In addition, SFAS 158 requires an employer to measure its postretirement benefit plan assets and benefit obligations as of the date of the employer’s fiscal year end. This portion of the statement is effective for the Company for fiscal 2009 and is not expected to have a material impact on the Company’s consolidated financial statements.

 

Market risks relating to the Company’s operations result primarily from changes in foreign exchange rates and interest rates. The Company has only limited involvement with derivative financial instruments, does not use them for trading purposes and is not a party to any leveraged derivatives. Collectively, the Company’s exposure to market risk factors is not significant and has not materially changed from February 25, 2006.

 

Foreign Currency Risk

 

Though the majority of the Company’s inventory purchases are made in U.S. dollars in order to limit its exposure to foreign currency fluctuations, the Company periodically enters into forward foreign currency exchange contracts. The Company uses such contracts to hedge exposures to changes in foreign currency exchange rates associated with purchases denominated in foreign currencies, primarily euros. The Company also uses contracts to hedge its exposure associated with repatriation of funds from its Canadian operations. Changes in the fair value of the derivatives are included in the Company’s consolidated statements of operations as such contracts are not designated as hedges under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” Forward contracts that hedge merchandise purchases generally have maturities not exceeding six months. Changes in the fair value and settlement of these forwards are included in cost of sales. Contracts that hedge the repatriation of Canadian funds have maturities not exceeding 18 months and changes in the fair value and settlement of these contracts are included in selling, general and administrative expenses. At March 3, 2007, there were no outstanding contracts to hedge exposure associated with the Company’s merchandise purchases denominated in foreign currencies or the repatriation of Canadian funds.

 

Interest Rate Risk

 

The Company manages its exposure to changes in interest rates by optimizing the use of variable and fixed rate debt. The interest rate exposure on the Company’s secured credit facility and industrial revenue bonds is based upon variable interest rates and therefore is affected by changes in market interest rates. As of March 3, 2007, the Company had $19.0 million in borrowings outstanding on its industrial revenue bonds and no cash borrowings outstanding on its secured credit facility. A hypothetical 10% adverse change in the interest rates applicable to either or both of these variable rate instruments would have a negligible impact on the Company’s earnings and cash flows.

 

Additionally, the Company has $165.0 million in convertible senior notes outstanding, which mature in February 2036. The notes pay a fixed annual rate of 6.375% for the first five years and a fixed rate of 6.125% thereafter. Changes in market interest rates generally affect the fair value of fixed rate debt instruments, but would not affect the Company’s financial position, results of operations or cash flows related to these notes. As of March 3, 2007, the fair value of these notes was $156.7 million based on quoted market values.

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors of Pier 1 Imports, Inc.

 

We have audited the accompanying consolidated balance sheets of Pier 1 Imports, Inc. as of March 3, 2007 and February 25, 2006, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended March 3, 2007. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

 

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

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Pier 1 Imports, Inc. at March 3, 2007 and February 25, 2006, and the consolidated results of its operations and its cash flows for each of the three years in the period ended March 3, 2007, in conformity with U.S. generally accepted accounting principles.

 

As discussed in Note 1 to the consolidated financial statements, effective February 26, 2006, Pier 1 Imports, Inc. adopted Statement of Financial Accounting Standards No. 123 (Revised 2004), Share-Based Payment.  In addition, as discussed in Note 1 to the consolidated financial statements, effective March 3, 2007, Pier 1 Imports, Inc. adopted Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an Amendment of FASB Statements No. 87, 88, 106 and 132(R).

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Pier 1 Imports, Inc.’s internal control over financial reporting as of March 3, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated May 8, 2007 expressed an unqualified opinion thereon.

 

 

Fort Worth, Texas

May 8, 2007

Pier 1 Imports, Inc.

 

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands except per share amounts)

 

 

The accompanying notes are an integral part of these financial statements.

Pier 1 Imports, Inc.

 

CONSOLIDATED BALANCE SHEETS

(In thousands except share amounts)

 

 

The accompanying notes are an integral part of these financial statements.

Pier 1 Imports, Inc.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)