Annual Reports

 
Quarterly Reports

 
8-K

 
Other

EBHI Holdings, Inc. 10-K 2008
e10vk
Table of Contents

 
 
     
þ
  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the fiscal year ended December 29, 2007
or
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the Transition Period From          to
 
Commission file number 001-33070
 
     
Delaware
  42-1672352
(State of or other jurisdiction of   (I.R.S. Employer
incorporation or organization)
  Identification No.)
 
10401 NE 8th Street, Suite 500
Bellevue, WA 98004
(425) 755-6544
(Address and telephone number, including area code, of registrant’s principal executive offices)
 
Securities Registered Pursuant to Section 12(b) of the Act:
Common Stock, Par Value $0.01 per share
 
Name of each exchange on which registered
The NASDAQ Stock Market LLC
 
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes 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 registrant’s knowledge, in any definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
             
Large accelerated filer o
  Accelerated filer þ   Non-accelerated filer o
(Do not check if a smaller reporting company)
  Smaller reporting company 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
 
The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant was $204,351,790 based on the closing price of the registrant’s common stock on June 30, 2007, the last business day of the registrant’s most recently completed second fiscal quarter.
 
Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13 or 15(d) of Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court.  Yes þ     No o
 
The number of shares of the registrant’s common shares outstanding as of March 3, 2008 was 30,677,886.
 
 
Portions of the proxy statement for the Registrant’s 2008 annual meeting of stockholders, to be filed subsequently with the Securities and Exchange Commission pursuant to Regulation 14A, are incorporated by reference into Part III of this Annual Report on Form 10-K.
 


 

 
 
                 
        Page
 
        Safe Harbor Statement     (iii )
      Business     1  
      Risk Factors     16  
      Unresolved Staff Comments     25  
      Properties     25  
      Legal Proceedings     26  
      Submission of Matters to a Vote of Security Holders     27  
 
PART II
      Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Repurchases of Equity Securities     27  
      Selected Financial Data     29  
      Management’s Discussion and Analysis of Financial Condition and Results of Operations     36  
      Quantitative and Qualitative Disclosures About Market Risk     69  
      Financial Statements and Supplementary Data     71  
      Changes in and Disagreements with Accountants on Accounting and Financial Disclosure     71  
      Controls and Procedures     71  
      Other Information     74  
 
PART III
      Directors, Executive Officers and Corporate Governance     74  
      Executive Compensation     74  
      Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters     74  
      Certain Relationships and Related Transactions and Director Independence     74  
      Principal Accounting Fees and Services     74  
 
PART IV
      Exhibits, Financial Statement Schedules     75  
 EXHIBIT 10.29
 EXHIBIT 10.34
 EXHIBIT 10.35
 EXHIBIT 10.47
 EXHIBIT 10.48
 EXHIBIT 10.49
 EXHIBIT 10.50
 EXHIBIT 23
 EXHIBIT 31.1
 EXHIBIT 31.2
 EXHIBIT 32.1
 EXHIBIT 32.2


(ii)


Table of Contents

 
 
Any forward-looking statements (as such term is defined in the Private Securities Litigation Reform Act of 1995) contained in this report or made by us involve risks and uncertainties and are subject to change based on various important factors, many of which are beyond our control. Accordingly, our future performance and financial results may differ materially from those expressed or implied in any such forward-looking statements. Words such as “estimate,” “project,” “plan,” “believe,” “expect,” “anticipate,” “intend,” “planned,” “potential” and similar expressions may identify forward-looking statements. The following factors, among others, in some cases have affected and in the future could affect our financial performance and actual results and could cause actual results to differ materially from those expressed or implied in any forward-looking statements included in this report or otherwise made by us:
 
  •  our ability to implement new marketing, merchandising, sourcing and operations plans to rebuild the Eddie Bauer brand and increase retail sales;
 
  •  our ability to effectively complete the organizational realignments of responsibilities commenced in 2008;
 
  •  consumer acceptance of our products and our ability to keep up with fashion trends, develop new merchandise, launch new product lines successfully, offer products at the appropriate price points and enhance our brand image;
 
  •  the highly competitive nature of the retail industry generally and the segment in which we operate particularly;
 
  •  our ability to hire, train and retain key personnel and management;
 
  •  the possible lack of availability of suitable store locations on appropriate terms;
 
  •  our reliance on foreign sources of production, including risks related to the disruption of imports by labor disputes, political instability, legal and regulatory matters, duties, taxes, other charges and quotas on imports, local business practices and political issues and risks related to currency and exchange rates;
 
  •  our ability to service our current debt and to continue to remain in compliance with the covenants under our term loan and revolving loan facilities;
 
  •  our ability to utilize net loss carryforwards in future years;
 
  •  shifts in general economic conditions, consumer confidence and consumer spending patterns;
 
  •  the seasonality of our business;
 
  •  the ability of our manufacturers to deliver products in a timely manner or meet quality standards;
 
  •  the lack of effectiveness of our disclosure controls and procedures currently or in the future;
 
  •  increases in the costs of paper for and printing and mailing of our catalogues;
 
  •  the price and supply volatility of energy supplies;
 
  •  our reliance on information technologies, including risks related to the lack of functionality of older systems and software, the implementation of new information technology systems, service interruptions and unauthorized access to third party information;
 
  •  natural disasters;
 
  •  the potential impact of national and international security concerns on the retail environment, including any possible military action, terrorist attacks or other hostilities; and
 
  •  the other risks identified in this Annual Report on Form 10-K.
 
These forward-looking statements speak only as of the date stated and, except as required by law, we do not intend to make publicly available any update or other revisions to any of the forward-looking statements contained in this report to reflect circumstances existing after the date of this report or to reflect the occurrence of future events even if experience or future events make clear that any expected results expressed or implied by those forward-looking statements will not be realized.


(iii)


Table of Contents

 
 
Item 1.   BUSINESS
 
Eddie Bauer Holdings, Inc. was formed in June 2005 as a new parent company in connection with the emergence from bankruptcy of our principal operating subsidiary, Eddie Bauer, Inc. When we use the terms “Eddie Bauer,” “we,” “us,” “our,” “the Company” or similar words in this annual report, unless the context otherwise requires, we are referring to Eddie Bauer Holdings, Inc. and its subsidiaries, including Eddie Bauer, Inc. For more information on the bankruptcy, see “The Spiegel Bankruptcy” under this Item 1.
 
 
In 1920, our founder, Eddie Bauer (1899-1986), opened his first store in Seattle, Washington, to sell outdoor sporting and recreational equipment, clothing and accessories. The first store specialized in sporting goods such as tennis rackets, fishing tackle and golf clubs hand-made by Mr. Bauer — giving us our field and stream heritage. Mr. Bauer’s own experience with hypothermia on a fishing trip in 1935 led to the invention of the Skyliner down parka, which was patented in 1940. During World War II, the U.S. Army Corps commissioned more than 50,000 “Eddie Bauer B-9 Flight Parkas” designed to keep pilots warm during high altitude flights. Mr. Bauer also produced 250,000 down sleeping bags and many other items to meet military purchase orders. Eddie Bauer was the first government supplier granted permission to put his label on his products during World War II, which raised brand awareness and built a market for his merchandise. Throughout our history, we have outfitted notable scientific and exploratory expeditions in Eddie Bauer outerwear, including that of Jim Whittaker, who became the first American to summit Mt. Everest in 1963, wearing Eddie Bauer outerwear. From 1953 to 1983, Eddie Bauer outfitted more than 30 major mountaineering expeditions, including the first American ascents of Mt. Everest, Dhaulagiri, Peak Lenin and Makalu; as well as the first worldwide ascents of Gasherbrum I and Vinson Massif. Through these expeditions, the Company fine-tuned its designs and field-tested its gear under the most demanding conditions. The result was that the name Eddie Bauer became synonymous with the finest expedition-quality outerwear in the world.
 
From the beginning, the Eddie Bauer brand has stood for legendary quality, service and value. Our Creed and Guarantee, which Mr. Bauer himself wrote, are the foundation of everything we do. When Mr. Bauer introduced his unconditional lifetime guarantee on everything that he sold, it was a radical concept. Now it has become the standard for exemplary customer service, and is a tradition we are proud to continue to this day.
 
In 1945, we issued our first mail-order catalog. In 1971, we were acquired by General Mills, Inc., and in 1972 we opened our first store outside of Seattle in San Francisco, California. We celebrated our first $100 million sales year in 1983, at which time we operated 27 retail stores. In July 1988 we were acquired by Spiegel, Inc. (“Spiegel”). By the end of fiscal 2002, our retail stores increased from 58 to 399 and our outlet stores from 3 to 102. In addition, from fiscal 1990 to fiscal 2002, our catalog circulation increased from 61.2 million to 101.6 million (excluding Eddie Bauer Home catalogs). In 1996, we started selling products over the Internet. While the Spiegel era was one of rapid growth, it was also a period in which the Company lost focus, direction and brand identity, as the brand shifted from its outdoor outfitter heritage to a casual apparel company aimed primarily at women.
 
In March 2003, Spiegel, together with 19 of its subsidiaries and affiliates, including our principal operating subsidiary, Eddie Bauer, Inc., filed petitions for relief under Chapter 11 of the U.S. Bankruptcy Code. See “Business — The Spiegel Bankruptcy”. From 2003 to mid- 2005, the majority of our efforts were focused on maintaining our existing business, rather than strategizing for business growth. In June 2005, we emerged from bankruptcy as a stand-alone company for the first time in 34 years. The following two years were marked by a number of changes in strategy, direction and management. In July 2007, the Board and its newly-appointed Chief Executive Officer (“CEO”), Neil Fiske, set the Company on a course to return the brand to its roots and heritage in a contemporary context.
 
Our mission is to be the preeminent active, outdoor, lifestyle brand combining an untamable spirit of adventure and a sense of style with the legendary quality, inventiveness and customer service that has been our hallmark since 1920.
 
Our creed, established by our founder, Eddie Bauer, has been and will continue to be:
 
To give you such outstanding quality, value, service and guarantee
that we may be worthy of your high esteem.®


1


Table of Contents

 
 
Eddie Bauer is a specialty retailer that sells mens’ and womens’ outerwear, apparel and accessories for the modern outdoor lifestyle. Our primary target customers are women and men who are 30-54 years old with an average annual household income of $75,000. Eddie Bauer is a nationally recognized brand that stands for high quality, innovation, style and customer service. Eddie Bauer was ranked as the number four outerwear brand in a Womens’ Wear Daily survey in July 2007, and 27th in a companion Womens’ Wear Daily Top 100 Brands survey, also in July 2007.
 
We sell our products through three interdependent sales channels that share product sourcing, design and marketing resources:
 
  •  retail stores, which sell our premium Eddie Bauer merchandise;
 
  •  outlet stores, which sell high quality Eddie Bauer merchandise and inventory overstocks at value or clearance price points; and
 
  •  direct, which consists of our Eddie Bauer catalogs and our website www.eddiebauer.com .
 
We design and source most of the clothing and accessories that we sell through our stores and direct sales channel. We structure our operations to offer our customers a seamless transition between our sales channels. Customers can purchase our products through any of our sales channels and return or exchange our products at any of our stores, regardless of the channel of purchase. Our U.S. stores also offer a direct phone connection to our customer call centers that allows an in-store customer to order for home delivery a particular size, color or item that may not be available in the store. During 2007, we had 38.1 million visits to our two websites, www.eddiebauer.com and www.eddiebaueroutlet.com, and circulation of approximately 82.4 million catalogs.
 
We are minority participants in joint venture operations in Japan and Germany that operate retail and outlet stores, as well as catalog and website sales channels, and license our trademarks and tradenames to the joint ventures. See “Joint Ventures” below. We also license the Eddie Bauer name to various consumer product manufacturers and other retailers for use on products that we believe enhance the brand image of Eddie Bauer. See “Licensing” below.
 
The following summarizes the number of retail and outlet stores we opened and closed throughout fiscal 2007:
 
                         
    Retail     Outlet     Total  
 
Stores as of December 30, 2006
    279       115       394  
Stores Opened in 2007
    21       8       29  
Stores Closed in 2007
    (29 )     (3 )     (32 )
Stores as of December 29, 2007
    271       120       391  
 
We expect to open 13 stores and outlet locations in 2008, and close approximately 28 stores in early 2008. The closures are all as a result of lease expirations.
 
Major Developments in 2007.  In November 2006, we announced that we had entered into a merger agreement with a company owned by affiliates of Sun Capital Partners, Inc. and Golden Gate Capital. Under the terms of the merger agreement all of the Company’s outstanding shares of common stock were to be converted into the right to receive $9.25 per share in cash upon closing of the transaction. On February 8, 2007, at a special meeting of our stockholders, an insufficient number of shares were voted in favor of approving the merger. As a result, we terminated the merger agreement and are now refocused on the long-term effort of rebuilding brand image and increasing our sales per square foot to historic levels.
 
In the first half of 2007, we saw the departure of our Chief Executive Officer and several senior members of management. The Chief Financial Officer had resigned in 2006, and we had yet to hire a replacement. Following the failure to approve the merger, we began recruitment efforts aimed at building a management team to formulate and implement a turnaround of our business. By the end of fiscal 2007, we hired a new Chief Executive Officer (“CEO”), a new Chief Financial Officer(“CFO”), a new General Counsel and Senior


2


Table of Contents

Vice Presidents of Sourcing and Supply and Human Resources to fill vacant positions in the management team.
 
2008 and Beyond: Five Key Initiatives.  The new management team has set initiatives, formulated strategies to achieve these initiatives, and begun to take action to implement the initiatives in 2008, with the goal of rebuilding the Eddie Bauer brand as a leader in outerwear and apparel for an active outdoor lifestyle. Given the 12- to 18-month lead time to develop and introduce merchandise into our sales channels, the turnaround of the Eddie Bauer business will be a multi-year effort.
 
Our five key initiatives for 2008 are:
 
  •  clarify the brand position and rebuild brand identity
 
  •  upgrade the quality of the merchandise and align the assortment strategy to the new brand position
 
  •  revamp the creative marketing function and fully exploit our marketing advantage as a direct multi-channel retailer
 
  •  cut costs to become more competitive and profitable
 
  •  realign the organization and build talent to accomplish our goals
 
Brand Identity.  We are rebuilding the Eddie Bauer brand as an active, outdoor lifestyle brand, modernizing our heritage as “The Original Outdoor Outfitter“tm and fully exploiting our rich history. In pursuit of our mission, we are re-emphasizing the fundamentals of quality, value, service and style. Finally, we are working to restore the true dual gender nature of the Eddie Bauer brand by adding a revamped men’s business to a solid foundation in women’s.
 
Merchandising Strategies and Execution.  As we align our merchandise strategy to the brand position, we are putting particular emphasis on rebuilding our historic strength in outerwear and mens apparel, while adding a more active orientation to the assortment. We have created a new group in Design and Merchandising to build merchandise lines in outerwear, activewear and gear. We have added a Senior Vice President of Sourcing and Supply to improve our quality and costs and to remove the distraction of this function from the merchandising groups. We intend to strengthen the value perception of the brand, both through more competitive opening price points and with better quality, innovation and style for the price paid. We are building the foundation of the merchandise assortment with a concerted effort on improving our core basics.
 
Marketing.  Our marketing strategy hinges on exploiting our competitive advantage as a true multi-channel retailer and using our catalog as our primary advertising vehicle. Multi-channel customers who shop in two or more of our store, catalog and internet channels have great value to us as customers and represent approximately 48% percent of our sales. The direct nature of our relationship with customers allows us to tailor communication and marketing to specific customer segments with specific needs. We are aligning all of our brand marketing to our positioning, while upgrading the quality of our models and imagery.
 
Costs.  We are working to reduce costs in all areas of the Company and have announced a goal of taking $25-30 million out of the operating cost structure of the business in 2008. These cost reductions will come from overhead, marketing and distribution costs. As part of the implementation of this initiative, in January 2008, we announced that 123 jobs had been eliminated from our corporate support organizations as the initial step in reducing our selling, general and administrative expenses.
 
Talent and Organization.  During the second half of 2007, we made substantial progress in building the executive team, hiring a new CEO, CFO, General Counsel and Senior Vice Presidents of Human Resources and of Sourcing and Supply. As part of the first quarter 2008 organizational realignment and reduction in workforce, we have made a number of organizational changes to focus on our key initiatives and move talent to areas with the highest priorities, including the following:
 
  •  appointing a new Senior Vice President of Merchandising
 
  •  splitting our design group into two core groups: Outerwear, Active Wear and Gear; and Sportwear — both reporting to the CEO


3


Table of Contents

 
  •  moving all “customer facing” service functions under the Senior Vice President of Retail, to provide end-to-end accountability for customer service under one leader
 
  •  realigning our marketing groups to two separate groups: Creative; and Marketing Programs, in order to improve decision making and focus
 
  •  creating a separate group specifically charged with building a talent pool for the organization
 
  •  establishing a separate sourcing and supply group under our new Senior Vice President of Sourcing and Supply to improve product quality and reduce product cost
 
 
Our apparel lines consist of clothing for women and men, including outerwear, pants, jeans, dresses, skirts, sweaters, shirts, sleepwear, underwear, swimwear, gadgets and gift items. We offer a wide variety of options in fabric, color, style, fit and size and a mix of basic offerings and seasonal collections. In addition, we offer accessories such as scarves, belts, hats, jewelry, daypacks, bags and footwear that complement our outdoor-inspired apparel lines. We also offer select down products for the home, such as comforters, pillows and throws. Moving into 2008 and beyond, we will be focusing on outerwear and apparel items for the active, outdoor lifestyle that reflect the Company’s heritage and its continued reputation for quality. Product strategies for 2008 and beyond include:
 
  •  Rebuilding our strength in outerwear.  Eddie Bauer has a long history of leadership in outerwear, from the first patented down jacket to Air Force parkas in World War II to outfitting over 30 major expeditions to the world’s most extreme mountains. Eddie Bauer was ranked as the number four outerwear brand in a Womens’ Wear Daily survey in July 2007, and 27th in a companion Womens’ Wear Daily Top 100 Brands survey, also in July 2007. As an active, outdoor lifestyle brand, we are committed to building a category-leading outerwear assortment.
 
  •  Leveraging our heritage.  We plan to infuse products with heritage elements, while modernizing many of our historic best sellers. These heritage pieces reinforce our positioning as “The Original Outdoor Outfitter.”
 
  •  Focusing on the fundamentals.  We plan to improve our core programs as the foundation for seasonal collections and fashion. We are making a concerted effort to improve our top selling items and key programs through better fit, fabrics, detailing, color and style.
 
  •  Focusing the assortment.  We believe we have a significant opportunity to narrow the assortment, cut unproductive styles and make fewer, clearer merchandising statements.
 
  •  Rebuilding the men’s business.  We plan to add product with an active, rugged, adventure-oriented sensibility.
 
  •  Driving better perceptions of value through more competitive opening price points, and better quality for the price paid.
 
  •  Differentiate on style.  We see a significant opportunity to increase the styling of our products and differentiate our assortment from our competitors.
 
These strategies, if properly executed, will improve the customer’s perception of quality, value and style and reinforce Eddie Bauer as a premium performance brand.
 
 
Our primary target customers are women and men who are 30-54 years old with an average annual household income of $75,000. According to the 2006 Apparel Market Research Yearbook published by Richard K. Miller & Associates, in 2004, apparel spending in the United States by women and men between the ages of 35 and 54 totaled $31 billion and $17 billion, respectively. According to the Bureau of Labor Statistics, women and men between the ages of 45 and 54 spend more on apparel than any other segment of


4


Table of Contents

the population (approximately $782 per woman per year and $439 per man per year) and belong to the highest household income bracket (an average of $77,000). We intend to capitalize on this market opportunity by leveraging our established reputation and brand image among this demographic group that has historically made up our core customer base and that has historically spent a larger portion of discretionary income on specialty apparel.
 
 
Our sales performance improved in fiscal 2007 for the first time in seven years. Net merchandise sales increased in 2007 to $989.4 million from $956.7 million in 2006, after having declined since fiscal 2000 from a peak of $1.6 billion in net merchandising sales (2000 was the first year for which financial statements excluding Eddie Bauer Home were available). Comparable store sales increased in each of the four quarters of 2007, with an increase of 4.8% and 4.4% in the fourth quarter and full fiscal year of 2007, respectively. This increase included 8.6% and 8.9% increases in retail comparable store sales in the fourth quarter and full fiscal year, respectively and 9.7% and 8.4% increases in the fourth quarter and full fiscal year sales, respectively, in our direct channel, offset by 1.9% and 2.3% decreases in outlet comparable store sales in the fourth quarter and full fiscal year, respectively.
 
The Fall/Holiday 2005 Re-Launch of the Brand.  As a result of the negative sales trends described above, we attempted to re-launch the Eddie Bauer brand in late 2005. We believed one of the key reasons for our declining net merchandise sales, generally negative comparable store sales and declining traffic in our stores that we experienced since 2000 was that over time our product design had lost its strong brand identity and had become indistinguishable from other specialty retailers’ products. Our results from the Fall/Holiday 2005 roll-out as a whole were disappointing and indicated that our customers did not respond positively to the changes we made to our product offerings or marketing approach. Compared to the same quarters in the prior year, net merchandise sales were down. Results for the first three quarters of fiscal 2006 continued to be disappointing.
 
Fall/Holiday 2006.  In 2006, we made significant changes in the fabric, materials and fit used in both our men’s and women’s pants sold in our stores and via direct channels, and updated the styles in these lines with a goal of improving the appeal and functionality of our line. The promotion we ran in September 2006 to publicize these changes received positive customer response with sales in these categories tracking above the previous year’s disappointing results. Our results began to show improvement in the fourth quarter of fiscal 2006, with an increase in net merchandise sales and comparable store sales. Product with similarly revised fabric, materials and styles were introduced gradually in our Eddie Bauer outlet stores over the course of 2007.
 
Fall/Holiday 2007.  The Fall/Holiday 2007 merchandise maintained the successful foundations of the 2006 line, with a more focused offering in both men’s and women’s apparel on our key categories of pants and outerwear. In pants, we continued to drive sales growth first seen in the fourth quarter of 2006. In outerwear, we introduced new styles and fabrics, with a focus on down outerwear. We have been building our business in down outerwear for the last three years, and the Fall/Holiday 2007 results in down products continued to improve, with success in both men’s and women’s products. We also added more women’s outfitting options for head-to-toe dressing, which drove higher units purchased per transaction.
 
2008 and Beyond.  As part of the key initiatives described above, we have begun working on the creation of new outerwear lines and new apparel items that take the successful products throughout our history and update them for our current customers. We are also concentrating on rebuilding our business in men’s apparel, with a focus on regaining traction in knits and woven shirts.
 
Although we believe that the initiatives already underway should strengthen our business, there are significant risks and challenges, as discussed in more detail under “Risk Factors” below, to our ability to successfully commence and complete a turnaround of this business. Moreover, even if we are successful, we do not expect significant improvements in operating results for approximately 12-18 months.


5


Table of Contents

 
We describe the Eddie Bauer organization as “Merchant Led, Design Driven, Marketing Powered and Associate Delivered,” reflecting the order in which ideas are strategized and brought to market. Merchants lead the process by defining the merchandise strategy, commercial priorities and opportunities, competitive benchmarks and standards, price points and margins, and line plans. Design then translates the merchandise strategy into seasonal collections.
 
In 2008, we have split our design team into two functional groups focused on Outerwear, Active Wear and Gear and on Sportswear. The design process begins with our designers’ development of four seasonal collections 10 to 12 months in advance of each season. Our design teams regularly travel nationally and internationally to develop color, fabric and design ideas. Once a design team has developed a season’s color palette and design concepts, a tableau is built to identify the critical ideas to be executed within the season. The tableau is created using original and purchased samples, photos and other inspirational objects and materials that express the theme of the season as well as business initiatives within the season. A prototype sample collection is then developed to evaluate the styles, details, such as how color takes to a particular fabric, how a fabric performs to our fit specifications, and the overall look and feel of the garment with our coordinated accessories.
 
Merchants provide our design teams with periodic updates regarding the results of product performance. This feedback helps guide the designers as they create and update products for upcoming seasons, focusing on the top twenty-five styles by gender as well as important marketing ideas. Our design process is iterative, with regularly scheduled sessions between the merchandising and design groups to ensure that new products meet internal and customer expectations.
 
Our designers then create a seasonal line presentation with samples, fabric swatches and drawings reiterating the tableau so our merchandising teams can edit the collection as necessary to increase its commercial strength. Our teams communicate regularly and work closely with each other to leverage market data, ensure the quality of our products, margins and to remain true to a unified brand image. Our technical design teams develop construction and fit specifications for every product, ensuring quality workmanship and consistency across product lines. We are able to efficiently offer an assortment of styles within each season’s line while still maintaining a unified brand image, because our product offerings originate from a single concept collection. As a final guarantee of brand image consistency, senior management reviews the four seasonal collections before selections are finalized.
 
Apparel products designed for our outlet stores generally follow a design and merchandising process similar to core products designed for our retail stores, with the same level of quality and fit, but with slightly less expensive fabrics and trims.
 
As the product line begins to take shape, the merchant and marketing teams collaborate to identify the “big ideas” and focal points for the season. Marketing then develops programs to maximize the potential of each of the major ideas. As ideas come to market, associates in our stores and call center are trained to sell and support the new assortment.
 
 
Sourcing Strategy.  We contract with third-party sourcing agents and vendors for sourcing and manufacturing of all of our merchandise. Our sourcing strategy emphasizes the quality fabrics and construction that our customers expect of our brand, and to ensure that our standards of product quality and timely product delivery are met, we:
 
  •  retain close control over our product quality and design costs by designing and developing most clothing and accessory products in-house;
 
  •  working with a select group of sourcing agents and vendors, directly negotiate product cost with our vendors and send detailed specification packages to these sourcing agents and vendors;


6


Table of Contents

 
  •  inspect pre-production samples, make periodic site visits to our vendors’ factories and selectively inspect inbound shipments at our distribution center; and
 
  •  establish quality standards at our headquarters in Bellevue, Washington, that are included in our policies with these sourcing agents and vendors and enforced by our associates.
 
We believe our sourcing strategy to date has helped us maintain our quality control standards while allowing us to enhance our speed to market to respond to our customers’ preferences. In 2008, we will be reviewing our sourcing and supply procedures to further reduce costs while improving adherence to new, higher quality standards. We have four sourcing seasons per year and typically place orders with our vendors approximately six months prior to the initial sale date, with approximately 11 to 12 weeks for reorders and seven to nine weeks for replenishment of our basic non-seasonal items. We use a similar sourcing calendar for each of our sales channels. We purchase approximately 85% to 90% of inventory for our stores in advance so as to permit all of our stores to have sufficient product to support demand. In the case of direct sales, we purchase only approximately 75% to 80% of inventory in advance because we can better gauge anticipated demand for products through our preview catalog, which we send to customers approximately 10 to 12 weeks in advance of a season’s product launch.
 
Sourcing Agents.  For fiscal 2007, on a purchase value basis, we sourced:
 
  •  approximately 76% of our products through our main sourcing agent, Eddie Bauer International, Ltd. (“EBI”). EBI is a subsidiary of Otto International (Hong Kong) Ltd. (“OIHK”), a former affiliate of Spiegel;
 
  •  approximately 14% of our merchandise (primarily non-apparel and swimwear) direct or from domestic importers; and
 
  •  the remainder (primarily footwear and home products) through other buying agents.
 
Eddie Bauer manages cost negotiations and production directly with factories in Mexico, Central and South America and the Caribbean for basic bottoms and knit products. EBI maintains an office in Hong Kong and sources merchandise primarily from Asia. We are EBI’s sole customer, although the parent company, Otto Asia Holding KG and affiliates provide similar buying agency services for third parties and affiliates of OIHK. EBI provides various services to us, including market research, product development, vendor screening, quality control standards implementation, labor compliance reviews and product delivery scheduling. EBI operates on a commission-rate basis and our arrangements with EBI are automatically renewed each year, unless terminated by either party upon one-year written notice. Under a Vendor Service Payment Agreement with OIHK, OIHK pays our vendors for inventory, less volume discounts and a small transaction fee paid by the vendor. We maintain a $500,000 reserve balance with OIHK, and typically reimburse OIHK in advance of payment to a vendor. This arrangement is less expensive than obtaining a letter of credit for each vendor from whom we source products. Substantially all of our foreign purchases are negotiated and paid for in U.S. dollars.
 
Vendors.  As of December 29, 2007, our sourcing network consists of more than 200 vendors, who operate in 34 countries. In 2007, our largest countries of import were China (37% of total imports, of which 4% were from Hong Kong), Thailand (8% of total imports), Mexico (7% of total imports) and Sri Lanka (6% of total imports). In fiscal 2007, our top 30 vendors supplied approximately 71% of our total vendor purchases and no single vendor supplied more than 6% of our total vendor purchases. Our top 30 vendors have supplied us for an average of approximately 10 years. We believe our long-term relationships with our vendors have also provided us with the ability to resolve supply issues efficiently and negotiate favorable pricing terms over time, further improving our overall cost structure. Beginning in 2008, we intend to improve our sourcing operations by reducing the number of vendors and countries from which we source, to attain volume pricing and more consistent quality of goods.
 
Global Labor Practices Program.  Our Global Labor Practices Program, established in 1995, seeks to protect and promote workplace human rights by training, education, monitoring and, where necessary, corrective action of vendor factories for compliance with our standards. Our standards include prohibitions


7


Table of Contents

against forced labor, child labor, harassment and abuse. They also address non-discriminatory practices, health and safety, freedom of association and collective bargaining, wages and benefit standards, hours of work, overtime compensation and environmental standards. All of our vendors who manufacture products for us must agree to comply with our Global Labor Practices Program. Our sourcing agent, EBI, and external monitors conduct annual vendor audits on our behalf. Since 2001, we also have been active participants in the Fair Labor Association (“FLA”), a non-profit monitoring system established to protect the rights of workers and improve working conditions worldwide. FLA provides systematic risk assessments, identification of best practices, collaboration on workplace improvements, expanded factory inspections, outreach to special interest groups knowledgeable about local issues, and use of external auditors and public reporting on our compliance program. In May 2005, our Global Labor Practices Program was accredited by the FLA, as being in substantial compliance with FLA requirements on workplace codes of conduct in apparel factories. In accordance with FLA requirements, our Global Labor Practices Program will be reviewed for re-accreditation every two years.
 
 
We distribute our apparel and accessories through our retail channel and outlet store channels, and through our direct channel, which consists of our Eddie Bauer catalogs and, in 2007, our websites located at www.eddiebauer.com and www.eddiebaueroutlet.com. In 2008, we launched a new, combined website under www.eddiebauer.com. See “Websites” below.
 
Retail Stores.  Our retail stores generated net merchandise sales (net of returns) of $462.1 million in fiscal 2007, comprising 46.7% of our net merchandise sales. Our retail stores are generally located in regional malls and lifestyle centers and in metropolitan areas. We also have stores in smaller markets where we believe concentrations of our target customers exist. We believe situating our stores in desirable locations is key to the success of our business, and we determine store locations based on several factors, including geographic location, demographic information, presence of anchor tenants in mall locations and proximity to other specialty retail stores that target a similar demographic. Our retail stores are designed and fixtured to create a distinctive and inviting atmosphere, with clear displays and information about product quality and fabrication.
 
We believe that approximately 5,500 square feet is the appropriate size for most of our retail stores, as we believe this size allows us to achieve the correct balance between product assortment, inventory and sales. As of December 29, 2007, approximately 62% of our retail stores were within plus or minus 15% of our model retail store size. We are in the process of realigning our remaining retail stores as opportunities arise, mainly through down-sizing and opening new retail stores in select locations with a more uniform size and configuration that we believe will improve the sales per square foot realized in the retail store. Additionally, we intend to increase the sales per square foot and comparable store sales by, among other things, focusing on outerwear, offering products featuring improved fit and higher quality fabric, trim and hardware and emphasizing our outdoor heritage to drive traffic and conversion. We expect to open up to seven retail stores in 2008, and expect to close up to 24 stores, with most closures having occurred in January 2008.
 
We train our retail sales associates to provide a high standard of customer service and to create appealing head-to-toe outfit displays to show our customers how to wear our apparel to encourage multiple purchases by customers. To provide our sales associates with an incentive to deliver superior customer service and to drive sales, each retail sales associate’s compensation consists of a base hourly rate supplemented by eligibility for incentive bonuses based on overall store performance. Our associates are eligible to earn an incentive based on monthly store sales thresholds, payable after the end of each month in which the threshold sales goal has been met. We believe our compensation policies enable us to maintain high standards of customer service in our stores.
 
Outlet Stores.  Our outlet stores generated net merchandise sales of $249.4 million in fiscal 2007, comprising 25.2% of our net merchandise sales. Our outlet stores target customers seeking Eddie Bauer apparel at lower prices. Our outlet merchandise consists of apparel designed exclusively for the outlet stores and excess inventory from our retail stores, and we regularly monitor this mix. Apparel products designed for our outlet stores leverage the same design process, brand image principles and quality standards as apparel sold in our retail stores, but with less expensive fabrics and hardware. Outlet products typically are priced at


8


Table of Contents

least 20% to 40% below full retail store product prices. Our outlet stores are located predominantly in outlet centers, value strip centers and “destination” outlet areas such as Palm Springs, California, and Hilton Head, South Carolina. See “Item 2. Properties.” In fiscal 2008, we expect to open approximately six additional outlet stores and expect to close four outlet stores.
 
Sales associates in our outlet stores adhere to customer service practices similar to our retail stores, and are trained to provide similar services to those provided in our retail stores. The compensation policies for our outlet sales associates are the same as those of our retail sales associates.
 
Direct Channel.  In fiscal 2007, our direct channel generated net merchandise sales of $277.9 million, comprising 28.1% of our net merchandise sales. We believe that the increasing trend of consumers shopping via the Internet will drive growth in our Internet sales, offsetting anticipated declines in our catalog sales. Our direct channel consists of our catalog and website operations, both of which we believe reinforce our brand image and drive sales across both of our sales channels. Our catalogs and websites offer the broadest assortment of available colors, styles and sizes, including petite, tall and plus, as well as certain products, such as swimwear, dresses and footwear, that are not available in our stores. Our U.S. stores offer a direct phone connection to our customer call centers that allows an in-store customer to order for home delivery a particular size, color or item that may not be available in the store. We account for these sales under direct channel sales. In addition, our website and catalogs are linked through our “Catalog Quick Order” feature, which allows a customer to input a catalog item number to place an order on the website.
 
As of December 29, 2007, we maintained a three-year active customer database of approximately nine million households, of which approximately four million were households that had purchased from us at least once in the past 12 months, and approximately three million were customers with e-mail addresses who receive regular promotional e-mails from us. We update our customer database on a continuous basis. Our customer database enables us to analyze customer purchases by numerous metrics, including frequency and average transaction size, which allows us to implement more advanced circulation and strategic marketing programs. We focus on continually improving the segmentation of our customer database and the acquisition of additional customer names from several sources, including our retail stores, our websites, list rentals and list exchanges with other catalog companies.
 
Catalogs.  In fiscal 2007, we distributed 24 catalog editions with an aggregate circulation of approximately 82 million catalogs. Our top catalog customers receive a new catalog every two to three weeks. In addition, we target our best customers to receive preview catalogs with incentives to purchase items approximately 10 to 12 weeks prior to the official launch of a new season. Customer response to these preview catalogs is important information we use to adjust our product offerings in our direct channel and also enables us to better control inventory commitments and assortments. All creative work on our catalogs is coordinated by our in-house personnel, and we believe this allows us to shape and reinforce our brand image.
 
Websites.  Our www.eddiebauer.com and www.eddiebaueroutlet.com websites were launched in 1996 and 1999, respectively, and allow our customers to purchase our merchandise over the Internet. We design and operate our websites using an in-house technical staff and outside web hosting provider. Our websites emphasize simplicity and ease of customer use while integrating our brand’s modern outdoor lifestyle imagery used in our catalogs. In fiscal 2007, our websites had over 38 million visits. Our websites have received a number of awards, being named a “Top 50 Best of the Web” online retailing website for 2005 by Internet Retailer in November 2005. In the first quarter of 2008, we launched a new website, under the www.eddiebauer.com address, with new graphics that better represent our brand image, and easier, more consumer-intuitive functionality to increase the number of visitors who actually purchase from the site. The new website integrates our two prior websites (retail and outlet) into one site for ease of shopping and for greater efficiencies internally.
 
 
Trademarks.  Substantially all of our trademarks are owned by Eddie Bauer, Inc. As of December 29, 2007, we had over 67 trademark registrations in the U.S. and over 368 registered trademarks in foreign


9


Table of Contents

countries. Our pending trademark applications may not result in issued trademark registrations. Our primary trademarks include Eddie Bauer ®, the Eddie Bauer signature logo and the Eddie Bauer goose logo.
 
We regard our trademarks as key assets and believe they have substantial value in the marketing of our products. We protect these trademarks by registering them with the U.S. Patent and Trademark Office and with governmental agencies in other countries, particularly where our products are manufactured and/or sold. We work vigorously to enforce and protect our trademark rights by engaging in monitoring services, issuing cease-and-desist letters against third parties infringing or denigrating our trademarks and initiating litigation as necessary. We also work with trade groups and industry participants seeking to strengthen laws relating to the protection of intellectual property rights in markets around the world. We also grant licenses to other parties to manufacture and sell certain products with our trademarks.
 
Joint Ventures.  We participate in joint ventures in Japan and Germany, under which we have granted the joint ventures the right to sell a mixture of Eddie Bauer apparel and accessories from the U.S. core assortment, in addition to products developed by the joint venture partner exclusively for the applicable market. We also license our name to the joint ventures. We provide oversight on product development, catalogs, merchandising, store design and marketing efforts, and retain the right to approve all products offered by the joint ventures that carry the Eddie Bauer brand. In exchange, we receive a share, as an equity holder, in the earnings or losses of each joint venture. In January 2007 Eddie Bauer Germany made the decision to close its retail stores, and as of the date of this report has closed all its stores, with the exception of two stores, one retail and one outlet, one of which is scheduled to close in October 2008 upon lease expiration. Eddie Bauer Germany will continue to sell its products through its catalogs, website and one outlet store.
 
As of December 29, 2007, our equity investment balances were approximately $12.7 million and $3.8 million in Eddie Bauer Japan and Eddie Bauer Germany, respectively.
 
Eddie Bauer Japan.  We own 30% of Eddie Bauer Japan, a joint venture with Otto-Sumisho, Inc. (a joint venture company of Otto KG, a former Spiegel affiliate, and Sumitomo Corporation). Eddie Bauer Japan reported joint venture net sales of $130.9 million in fiscal 2007. In fiscal 2007, we received approximately $4.4 million in royalties from the joint venture and recorded a loss of approximately $0.2 million for our equity share. During fiscal 2007, Eddie Bauer Japan paid us a dividend of $0.3 million.
 
Eddie Bauer Germany.  We own 40% of Eddie Bauer Germany, a joint venture with Heinrich Heine GmbH and Sport-Scheck GmbH (both former Spiegel affiliates and subsidiaries of Otto KG). Eddie Bauer Germany reported joint venture net sales of $53.5 million in fiscal 2007. In fiscal 2007, we recorded a receivable of approximately $1.9 million in royalties from the joint venture and recorded a loss of approximately $0.9 million for our equity share of its losses. During fiscal 2007 and 2006 we offset $1.5 million and $1.9 million, respectively, of royalty payments due to us against our proportionate share of the joint venture’s losses. We have received notice from the general partner of the joint venture of its election to terminate the joint venture arrangement at the end of February 2009. We have also begun discussions with a third party who desires to purchase our joint venture interests, along with the interests of the other joint venturers, in exchange for releases from future liabilities, and a license arrangement for the continued use of our tradenames and marks.
 
 
We selectively license our brand name and logo to be included on products sold by other companies to enhance and extend the Eddie Bauer brand. We received $13.8 million in royalty revenues in fiscal 2007 relating to our licensing arrangements.
 
We seek licensees who are leaders in the outdoor, juvenile, home, SUV and personal categories. We typically enter into multi-year license agreements with one licensee per product category to prevent price competition and market saturation of our brand. In each of our licensing arrangements, we work closely with


10


Table of Contents

our licensees and have a final right of approval to ensure our brand is consistently presented. Our top performing licenses by royalty revenues received for fiscal 2007 were:
 
     
Name of Licensee
  Licensed Products
Cosco Management, Inc.
  Infant/juvenile car seats and strollers
Ford Motor Company
  SUVs
American Recreation Products
  Camping gear
Lowes Companies
  Interior paint and products
 
As part of our emergence as a stand-alone company, we have closed our Eddie Bauer Home operations and are pursuing additional licensing opportunities in the home furnishings category.
 
 
Our marketing investment focuses on retaining our core customers and profitably acquiring new customers. In 2007, we focused primarily on the following:
 
  •  Creating a single powerful brand message across all channels
 
  •  Ensuring our stores are a compelling shopping destination via powerful graphics, props and product displays that amplify our monthly product news
 
  •  Using 82 million distributed catalogs that influence sales in all channels and establish our brand image amongst existing and new customers
 
  •  Building our membership in our new Eddie Bauer Friends loyalty program to 2.9 million customers as of the end of fiscal 2007 and leveraging our private label credit card customers
 
  •  Limited time promotional offers and incentives that drive seasonal traffic and sales
 
Our Marketing Strategy.  We design our marketing strategy to present a consistent and unified brand image grounded in our outdoor heritage to increase traffic, purchase frequency and sales through both of our sales channels and create an emotional connection between our target customers and the Eddie Bauer brand. Our target customers are women and men, ages 30-54, who desire high-quality outdoor-inspired activewear, outerwear and casual sportswear. Our goal is to create marketing campaigns that amplify our seasonal merchandising messages and make our target customers aware of new merchandise, special events and sale offers. Our primary methods of driving traffic to our sales channels are extensive catalog and e-mail circulation, compelling visual displays and signage in our stores and our customer loyalty and credit card programs. Through the efforts of our public relations department, in 2007 we also received more than 200 uncompensated product coverages from independent publications such as Cosmopolitan, Womens’ Wear Daily and the New York Times Magazine Fashion Edition.
 
To drive brand awareness and purchase frequency, we utilize our in-house customer database of approximately 22 million customers to develop our year-round catalog circulation strategies. We consistently add new customers to our database through online advertising (e.g., Google, Yahoo, etc.), third party catalog mailings and by recruiting new members into our customer loyalty and credit card programs. We also utilize an email database of over three million names to further strengthen our current customer relationships and drive sales to all channels.
 
Loyalty Program.  In September 2006, we launched our first full-scale customer loyalty program, Eddie Bauer Friends. Customers may enroll in the program for free via our stores, catalog call centers or at www.eddiebauerfriends.com. The loyalty program allows customers in the United States to accrue points that may be redeemed for Eddie Bauer reward certificates or used toward acquiring special Eddie Bauer merchandise at www.eddiebauerfriends.com. We operate a similar program in Canada under the name Canadian Rewards. The full terms and conditions of the loyalty program are available at www.eddiebauerfriends.com. As of December 29, 2007, approximately 2.9 million customers have enrolled in our loyalty program. We believe that the program is a valuable tool in retaining our core customers, driving incremental customer loyalty and building our database to better track and market to our customers.


11


Table of Contents

Our Private-Label Credit Card.  We seek to increase customer loyalty and sales by offering customers our private-label Eddie Bauer credit card through a third party, World Financial Network National Bank (“WFNNB”), a subsidiary of Alliance Data Systems. Customers apply for the Eddie Bauer credit card, and if approved in accordance with WFNNB’s credit criteria policies, customers can use the Eddie Bauer credit card in any of our sales channels. Nearly all Eddie Bauer Credit card holders are members of our Friends loyalty program. As of December 29, 2007, we had approximately 600,000 customers who had used the Eddie Bauer credit card at least once in the past 12 months. Sales using our credit card, after discounts, comprised approximately 12% of our total net merchandise sales in fiscal 2007.
 
Marketing expenses accounted for 10.5% (including catalog production costs) of our net merchandise sales in fiscal 2007.
 
 
Distribution Centers.  Our wholly-owned subsidiary, Eddie Bauer Fulfillment Services, or EBFS, supports our U.S. distribution, fulfillment and inbound/outbound transportation requirements. Under the Spiegel Plan of Reorganization, we acquired ownership to a 2.2 million square foot distribution center in Groveport, Ohio from Spiegel. This facility handles logistics and distribution for our U.S. retail, U.S. outlet and direct operations, including direct-to-consumer ship and return services, purchasing of non-merchandise inventory and services, processing of non-merchandise supply accounts payable, and shipping and transportation coordination. We also lease a 97,200 square foot distribution center in Vaughan, Ontario, to provide distribution services for our Canadian retail stores. As of December 29, 2007, approximately 606 associates were employed by our distribution centers: 583 associates in Groveport; and 23 associates in Vaughan, with the number of associates typically increasing in the fourth quarter to handle larger processing volume during the Holiday season.
 
Each overseas vendor sends the finished products to a designated shipper or consolidator who assembles the shipments into containers. Shipments for the U.S. retail market generally arrive in Tacoma/Seattle and then move by rail to our Groveport, Ohio distribution center, while shipments for the Canadian retail market arrive in Vancouver, British Columbia, and move by rail to our Vaughan, Ontario distribution center. We typically use United Parcel Service for delivering shipments from our distribution center in Groveport, Ohio, to our retail and outlet stores across the U.S. and for expedited and non-U.S. shipments to our customers. All U.S. ground shipments originating from our catalogs or website are delivered to our customers by the United States Postal Service.
 
Information Technology.  We acquired from Spiegel an approximately 50,000 square foot information technology (“IT”) center in Westmont, Illinois, that houses all of our information systems relating to product development, merchandising, marketing, planning, store operations, sourcing, finance, accounting, call centers, Internet, inventory and order fulfillment. As of December 29, 2007, approximately 101 associates were employed at the IT center. In January 2008, 32 support positions at the IT center were eliminated as part of our reduction in workforce.
 
Our websites are hosted by a third party at its data center. We maintain a disaster recovery plan that can be implemented in the event we lose our capacity to perform daily data operations. All critical data is backed up and sent off site on a daily basis specifically for recovery purposes. We have contracted with a disaster recovery vendor to provide the necessary computing equipment at a hot site so that operations can be restored. We test the plan periodically to ensure its validity.
 
In 2007, our IT group accomplished the following:
 
  •  upgraded our mainframe processing infrastructure to get to supported levels and reduce software and hardware maintenance costs
 
  •  converted the majority of our stores network to higher speed, lower cost DSL technology
 
  •  established roles-based access security as part of our identity and access management SOX efforts


12


Table of Contents

 
  •  established the infrastructure required for the move to a new headquarters building in Bellevue, Washington.
 
In 2008, the IT group is focusing on:
 
  •  launching our new website, under development since the beginning of 2005, to provide a significantly enhanced customer experience and more flexibility to modify the website, move us to a long term technology platform, and improve the integration of the website to our back end systems
 
  •  completing the roll out of DSL to our stores
 
In keeping with our key initiatives for 2008, the IT group will be limiting application development projects to high priority enhancements as part of our overall cost reduction initiative.
 
Call Center.  We operate an approximately 38,000 square foot call center in St. John, New Brunswick, Canada, at which our 380 associates handle calls and emails from customers. Our associates are split into four teams: sales, service, ecommerce and support. Our sales associates handle calls and emails related to catalog orders, make suggestions to customers about additional products and assist customers with purchases. Our service team handles all calls regarding issues with quality and service in our three channels, as well as customer feedback. Our ecommerce team handles calls and emails and provides both sales and service functions for website customers. Our support team handles all processing functions required to complete orders through the catalog and website.
 
 
The retail apparel industry is highly competitive. We believe that the primary competitive factors in the industry are brand recognition, the selection, availability, quality and fit of products, the ability to anticipate and react to changing customer demands and fashion trends in a timely manner, price, effectiveness of marketing and advertising, and effectiveness of customer service. We compete with a variety of retailers, including national department store chains, national and international specialty apparel chains, global discount chains, outdoor specialty stores, catalog businesses, sportswear marketers and online businesses that sell similar lines of merchandise. In the United States, our retail stores compete primarily with other specialty retailers, such as Ann Taylor, Banana Republic, Talbots, Chico’s, Coldwater Creek, Gap, J. Crew, J. Jill and Timberland and national department store chains such as Macy’s and Nordstrom. We also compete with catalog businesses such as L.L. Bean and Lands’ End and outdoor specialty stores such as Columbia Sportswear, North Face, Patagonia and REI. In Canada, we compete primarily with retail stores such as Bluenotes and Roots, as well as various national and international department store chains. Our outlet stores compete with the outlet stores of other specialty retailers such as Ann Taylor, Banana Republic, Gap, J. Crew and Ralph Lauren/ Polo, as well as with other value-oriented apparel chains and national department store chains.
 
We believe that our primary competitive advantages are customer recognition of the Eddie Bauer brand name, our integration of our retail and direct sales channels, our customer service and our satisfaction guarantee. We believe that we also differentiate ourselves from competitors on the basis of our tradition of offering outdoor-inspired clothing and accessories and our focus on the quality of our product offerings. We believe our success depends in substantial part on our ability to convey our brand identity and provide clothing that fulfills our stated position as a leader in clothing for an active, outdoor lifestyle, as well as anticipate, gauge and react in a timely manner to changing consumer preferences which, in turn, allows us to drive traffic to our channels, increase purchase frequency and improve conversions.
 
Many of our competitors may have greater financial, distribution, logistics and marketing resources than us. In addition, many of our competitors are not in the early stages of trying to stabilize their business and revitalize their brand. Many of our competitors therefore may be able to adapt to changes in customer requirements more quickly, devote greater resources to the design, sourcing, distribution, marketing and sale of their products, generate greater national brand recognition or adopt more aggressive pricing policies than we can.


13


Table of Contents

For information on the primary factors on which we compete and the risks we face from competition, see “Risk Factors — Risks Relating to Our Industry — If we cannot compete effectively in the apparel industry our business and financial condition may be adversely affected” under Item 1A.
 
 
We are a seasonal business, with our sales and earnings peaking during the fourth quarter, particularly during the November through December holiday periods. In addition, we typically experience higher sales of mens’ products and accessories in June for Father’s Day. As a result of our seasonal sales patterns, we increase our inventory levels during these selling periods.
 
 
As of December 29, 2007, we had approximately 2,681 full-time associates and 6,948 part-time retail associates in the U.S. and Canada. We had approximately 2,263 corporate support personnel in our Bellevue, Washington headquarters, our Westmont, Illinois IT center, our call center in St. John, New Brunswick, Canada and our distribution centers in Groveport, Ohio and Vaughan, Ontario, Canada. As a result of our seasonal sales patterns, we hire additional temporary staff at our retail stores and at our distribution and call centers during the fourth quarter. Our associates are not represented by unions and are not covered by any collective bargaining agreements. We have had no labor-related work stoppages, and we consider relations with our associates to be good. In January 2008, we completed a reduction in work force that eliminated 123 corporate support personnel from our organization.
 
 
 
We are subject to federal, state and local laws and regulations affecting our business, including those related to labor, employment, worker health and safety, environmental protection, products liability, product labeling, consumer protection, privacy and anti-corruption. These laws include the Occupational Safety and Health Act, the Consumer Product Safety Act, the Trade Act of 2003, the Flammable Fabrics Act, the Textile Fiber Product Identification Act, the Foreign Corrupt Practices Act and the rules and regulations of the Consumer Products Safety Commission and the Federal Trade Commission. We also voluntarily participate in the Customs — Trade Partnership Against Terrorism (“C-TPAT”) and received our Tier Three validation status at the end of 2006. We also are subject to import and export laws, including U.S. economic sanction and embargo regulations and other related laws such as the U.S. anti-boycott law and the U.S. export controls regulations.
 
 
We are subject to Canadian and other foreign laws and regulations affecting our business, including those related to labor, employment, worker health and safety, environmental protection, products liability, product labeling, consumer protection and anti-corruption. In addition, our imported merchandise is subject to U.S. and Canadian duties and quotas on a few apparel categories. We are subject to, and take advantage of the elimination or reduction of tariffs, as well as other trade liberalization elements on imported merchandise afforded by a variety of U.S. and Canadian free trade and benefit agreements such as the North American Free Trade Agreement (NAFTA), the Singapore Free Trade Agreement (SFTA) and the African Growth and Opportunity Act (AGOA).
 
In addition, much of our imported merchandise is subject to U.S. and Canadian duties and quotas on a few apparel categories. We have taken advantage of the elimination of quotas for apparel manufactured by vendors located in World Trade Organization (WTO) member countries. However, quotas were extended on a few categories of apparel from China through 2008 and there is some possibility that these could be extended on a year-by-year basis until 2013. Quotas may require that we resource some of our goods from other countries, causing delays in receipt of goods and potentially increasing the cost of goods. We also receive a small portion of our products from Vietnam, which is not a member of the WTO, and we therefore are still


14


Table of Contents

subject to quotas for products imported from Vietnam. There is an existing threat that the U.S. government could “self-initiate” an anti-dumping action against apparel imports from Vietnam. However, to date it has declined to do so.
 
Congress is widely expected to pass legislation in 2008 that would impose greater testing and or labeling requirements on imports and strengthen powers of the Consumer Products Safety Commission. Passage of legislation intended to curb imports from China, such as a measure targeted at alleged currency manipulation and amendments to existing anti-dumping and subsidies laws also could negatively impact the costs of imports from that country.
 
We believe we are in substantial compliance with all U.S. and foreign regulations that apply to our business.
 
 
The Spiegel Group.  During 2001 and 2002, net sales declined at Spiegel’s three merchant divisions, including Eddie Bauer, Inc. In addition, as a result of the FCNB (Spiegel’s special-purpose bank that offered private-label credit cards imprinted with an Eddie Bauer, Newport News or Spiegel logo as well as standard credit cards) expansion of credit to high risk, low-credit score customers, the performance of the credit card receivables declined significantly. These events led to lower liquidity and contributed to the noncompliance by Spiegel and its affiliates with certain financial and other covenants under their financing arrangements. A principal source of liquidity for the Spiegel group was FCNB’s ability to sell substantially all of the private-label credit card and bankcard receivables to securitization vehicles. In addition, in 2002 FCNB entered into an agreement with the Office of the Comptroller of the Currency which required FCNB to comply with certain requirements and restrictions. As a result, certain triggering events occurred under the securitizations, and substantially all monthly excess cash flow from the securitizations was diverted to repay principal to investors in the securitization vehicles on an accelerated basis, rather than to pay the cash to FCNB upon deposit of new receivables. Accordingly, Spiegel and 19 affiliates (including Eddie Bauer) (the “Debtors”) lost a significant source of liquidity to fund their operations.
 
In March 2003, the merchant divisions ceased honoring the private-label credit cards issued to their customers by FCNB, FCNB discontinued charging privileges on all MasterCard tm and Visa tm bankcards issued by FCNB to its customers, and FCNB began to liquidate. The liquidation of FCNB contributed significantly to our decreased revenues in 2003. Also in March 2003, the SEC commenced a civil proceeding against Spiegel alleging, among other things, that Spiegel’s public disclosures violated the Securities Exchange Act of 1934, as amended. Spiegel entered into a consent and stipulation with the SEC.
 
In view of the foregoing, Spiegel’s ongoing liquidity crisis, and various additional lawsuits that were filed against Spiegel and certain of its subsidiaries and affiliates, the Debtors concluded that it was in the best interests of their creditors, stockholders and other parties-in-interest for the Debtors to seek protection under the Bankruptcy Code.
 
On March 17, 2003, the Debtors, including Eddie Bauer, Inc., filed petitions for relief under Chapter 11 of the U.S. Bankruptcy Code with the U.S. Bankruptcy Court of the Southern District of New York. The bankruptcy court confirmed the Amended Joint Plan of Reorganization relating to the bankruptcy on May 25, 2005, and the Plan of Reorganization became effective on June 21, 2005.
 
Plan of Reorganization.  On June 21, 2005, the Plan of Reorganization became effective and Eddie Bauer Holdings, Inc. was formed as a new holding company to serve as the parent company for Eddie Bauer, Inc. and its subsidiaries. In exchange for the Company’s issuance of 30 million shares of common stock to certain unsecured creditors of the Debtors, certain subsidiary operations were transferred to the Company. In order to take advantage of tax net operating losses (“NOLs”) available to Eddie Bauer Holdings from certain subsidiaries, we included ownership limitations on our newly issued common stock in our certificate of incorporation and bylaws. We agreed to use commercially reasonable best efforts to become a reporting company under the Exchange Act and cause, as soon as reasonably practicable, our common stock to be quoted on the Nasdaq National Market. Under the Plan of Reorganization, Eddie Bauer, Inc. and Eddie Bauer


15


Table of Contents

Holdings, Inc, along with our U.S. subsidiaries as guarantors, were required to enter into a $300 million senior secured term loan agreement, the proceeds from which were used to pay Spiegel creditors and not to fund operations of the Company or its subsidiaries. See “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources — Sources of Liquidity” for further discussion of the Term Loan, including the April 2007 Term Loan refinancing.
 
Item 1A.   RISK FACTORS
 
Any of the risks discussed below, as well as any of the other risks described in this Form 10-K, could materially affect our business, financial condition, results of operations and cash flows.
 
 
 
The retail apparel industry is highly competitive. We compete with a variety of retailers, including national department store chains, national and international specialty apparel chains, outdoor specialty stores, apparel catalog businesses, sportswear marketers and online apparel businesses that sell similar lines of merchandise. Our outlet stores compete with the outlet stores of other specialty retailers as well as with other value-oriented apparel chains and national department store chains. Our competitors may be able to adapt to changes in customer requirements more quickly, devote greater resources to the design, sourcing, distribution, marketing and sale of their products, generate greater national brand recognition or adopt more aggressive pricing policies than we can. If we are unable to overcome these potential competitive disadvantages or effectively place our products relative to our competition, our business and results of operations will suffer.
 
 
The specialty retail apparel industry is heavily dependent on discretionary consumer spending patterns. Our business is sensitive to numerous factors that affect discretionary consumer income, including adverse general economic conditions, changes in employment trends and levels of unemployment, increases in interest rates, weather, a significant rise in energy prices or other events or actions that may lead to a decrease in consumer confidence or a reduction in discretionary income. In addition, increased fuel costs may discourage customers from driving to our retail and outlet locations, reducing store traffic and possibly sales. Declines in consumer spending on apparel and accessories, especially for extended periods, could have a material adverse effect on our business, financial condition and results of operations.
 
 
Trade restrictions, including increased tariffs or quotas, embargoes, safeguards and customs restrictions against apparel items could increase the cost or reduce the supply of apparel available to us or may require us to modify our current business practices, any of which could hurt our business, financial condition and results of operations. Safeguard quotas imposed by the U.S. on categories of goods and apparel imported from China, may impact our sourcing patterns and costs. We also cannot predict whether any of the countries in which our merchandise is currently manufactured or may be manufactured in the future will be subject to additional trade restrictions imposed by the U.S., Canadian and foreign governments, nor can we predict the likelihood, type or effect of any such restrictions.
 
 
Increasing pressure on retailers to reduce prices of their products as a result of increased competition, the increased outsourcing of product manufacturing to countries with lower labor costs, trade liberalization, consolidation among retailers and lower barriers to entry for manufacturers and retailers may force us to lower


16


Table of Contents

prices, or make us unable to sell our higher-priced products, in which case our business, financial condition and results of operations could suffer materially.
 
 
The retail apparel industry is highly seasonal, with the highest levels of sales during the fourth quarter. Our profitability depends, to a significant degree, on the sales generated during these peak periods. Any decrease in sales or margins during these periods, whether as a result of economic conditions, poor weather or other factors, could have a material adverse effect on our company.
 
 
The apparel industry is characterized by rapidly changing customer preferences and quickly emerging and dissipating trends. Failure to effectively gauge the direction of customer preferences and anticipate trends, or convey a compelling brand image or price/value equation to consumers may result in lower sales and resultant lower gross margins to sell inventory. We typically place orders with our vendors approximately six months prior to the initial sale date, and so can make only limited modifications to orders in response to changes in customer preferences. If we are unable to successfully identify changes in customer preferences or anticipate customer demand from season to season, we could experience lower sales, excess inventories, higher mark-downs and decreased earnings.
 
Risks Relating to Our Business
 
 
Our net merchandise sales declined during each of the fiscal years between 2000 and 2006 and comparable store sales also decreased in 23 of the 28 quarters between 2000 and 2006. As we discuss in “Item 1. Business — 2008 and Beyond: Five Key Initiatives,” we have taken, and intend to take, strategic, operational and management actions designed to reconnect with our customers and revitalize Eddie Bauer as a premium quality brand. However, we cannot be assured that the changes we have made, or the additional actions we are taking or intend to take, will be successful, or that such actions and changes will not result in the following:
 
  •  our desire to attract additional male customers may result in the loss of existing female customers;
 
  •  our addition of higher priced merchandise may drive away existing customers and may not attract new customers;
 
  •  our efforts to increase traffic and sales in our retail and outlet stores may not be cost effective; or
 
  •  our marketing efforts to promote our revitalized brand may not be effective.
 
If we cannot successfully revitalize the Eddie Bauer brand, or if the revitalization takes longer than anticipated, our business and our financial condition and results of operations will be adversely impacted. If customer purchases lag behind our expectations, we may experience decreased net merchandise sales, negative comparable store sales and higher operating losses.


17


Table of Contents

 
As a result of our involvement in the Spiegel bankruptcy proceedings, we were required to take actions that we might not otherwise have taken as a stand-alone company, including:
 
  •  distributing a significant portion of our cash flow and the proceeds of the $300 million senior secured term loan to the creditors of Spiegel in June 2005, instead of reinvesting that capital in our business and infrastructure during the bankruptcy process;
 
  •  borrowing significant amounts (including $300 million under our senior secured term loan and amounts from time to time under our senior secured revolving credit facility of up to $150 million) and as a result becoming subject to the restrictions and limitations imposed by the lenders under our financing facilities;
 
  •  assuming ongoing obligations equal to approximately $17 million associated with Spiegel’s former pension and other retirement plans;
 
  •  assuming the obligations of Spiegel and its subsidiaries to indemnify officers or employees for liability associated with their service; and
 
  •  inheriting support facilities that were not optimally suited for our operations and, as a result, having to sell, streamline, consolidate or relocate some of these facilities.
 
We have been operating as a stand-alone entity for a limited period of time and face additional costs and risks as a result. We must continue to streamline the back-end distribution and logistics operations we inherited and reduce costs throughout our organization. If we are unable to do so successfully, our business, financial condition and results of operations could be harmed.
 
 
Most of the members of our senior management team have been in their positions for less than six months. Our success will depend to a significant extent on our ability to attract qualified individuals to our leadership team and to retain the services of members of our senior management team in the long term through attractive incentive arrangements. Competition for qualified personnel is intense. We may not be able to retain current employees or attract new employees due to uncertainty relating to our future business prospects. The loss, for any reason, of the services of key individuals or the failure to attract and retain additional members of our management team could have a material adverse effect on us. Our success also depends on our ability to hire, motivate and retain other qualified associates who reflect and enhance our customer-service oriented culture, including our store managers, sales associates and staff at our call centers. If we are unable to hire and keep enough qualified associates, especially during our peak season, our customer service levels and our business, financial condition and results of operations may be hurt.
 
 
In preparing our financial statements in 2005, 2006 and early 2007, management identified weaknesses in our internal control over financial reporting that adversely affected our ability to initiate, authorize, record, process, or report external financial data reliably in accordance with generally accepted accounting principles.
 
Areas in which weaknesses were identified included the lack of sufficient controls to ensure adequate analysis and documentation regarding “fresh-start” accounting adjustments, accounting for income taxes, including the development of the tax provision, accounting for tax net operating losses (“NOLs”) and related valuation allowances, identification and classification of deferred tax assets and liabilities and our reliance upon manual closing and reconciliation systems. We believe we have corrected such weaknesses that lead to errors in financial reporting, but if we fail to identify or are unable to adequately remediate future weaknesses,


18


Table of Contents

investors could lose confidence in the accuracy and reliability of our financial statements, which would cause the market price of our stock to decline and could lead to stockholder litigation.
 
 
The growth of sales in our stores is significantly dependent on our ability to operate stores in desirable locations with capital investments and lease costs that allow us to earn a reasonable return. Desirable locations and configurations for reasonable costs may not be available to us because of our inability to improve sales per square foot.
 
 
Substantially all of our store locations are leased from landlords in regional malls and lifestyle centers and in metropolitan areas. As a result, each year, a portion of the locations under lease is due for renewal or renegotiation. In addition, we relocate a certain number of our store locations each year. Landlords typically evaluate the creditworthiness of a tenant and the expected sales volume of the store location in connection with the negotiation of lease terms. Weakening of our financial performance or financial profile, including our sales per square foot, or potential covenant defaults on our debt instruments could ultimately lead landlords to conclude that we do not meet their criteria for risk and return, and result in our inability to negotiate leases on reasonable terms or renew leases.
 
 
Many of our stores are located in shopping malls. Sales at these stores are derived, in part, from the volume of traffic in those malls. Traffic in malls where we have stores may be adversely affected by regional economic downturns, the closing of anchor tenants and competition from non-mall retailers and other malls where we do not have stores, which will hurt our business, financial condition and results of operations.
 
 
The success of our catalogs is a key factor in our efforts to revitalize our brand, as we believe the catalogs reinforce our brand image and drive sales across in our retail and outlet stores and direct channels. If we are unable to continue to attract customers to our catalogs by providing them with appealing and extensive product offerings, our business, financial condition and results of operations may suffer. Factors that may impact our ability to maintain and grow our catalog sales include: customer acceptance of our catalog presentations; increases in paper and printing costs; postage rates and other costs relating to our catalog mailings; a failure in the timing of catalog deliveries; and the accuracy, breadth and depth of the information contained in our customer database so we can correctly analyze our mailing lists and maximize our customer targeting efforts.
 
 
The success of our website is subject to risks and uncertainties associated with the Internet, including changing customer preferences and buying trends relating to Internet usage, changes in required technology interfaces, increasing costs of placing advertisements and keywords online, website downtime and other technical failures, changes in applicable U.S. and foreign regulation, security breaches and consumer privacy concerns. Our failure to successfully respond to these risks and uncertainties might hurt our website sales and damage our brand’s reputation. Internet sales may also be affected since, unlike some of our online competitors, we collect a sales tax on Internet sales.
 
 
Our collection and processing of transactions through our sales channels require us to receive and store a large volume of personally identifiable data. This type of data is subject to legislation and regulation in various


19


Table of Contents

jurisdictions. Our business, financial condition and results of operations could be adversely affected if the laws and regulations are expanded, implemented or interpreted to require changes to our business practices and methods of data collection. In addition, as personal and legal issues relating to privacy and data protection become more sensitive, we may become exposed to potential liabilities with respect to the data we collect, manage and process, and may incur legal costs if our information security policies and procedures are not effective or if we are required to defend our methods of collection, processing and storage of personal data.
 
 
If the use of any of our products causes, or is alleged to have caused, an injury we may become subject to claims or lawsuits relating to such matters. Even if a product liability claim is unsuccessful or is not fully pursued, the negative publicity surrounding any assertion that our products caused injury or death could adversely affect our reputation with existing and potential customers and our corporate and brand image. Under certain circumstances, we may be required to recall products, leading to a material adverse effect on our business. Even if a situation does not necessitate a recall, product liability claims might be asserted against us. A product liability judgment against us or a product recall could have a material adverse effect on our business or consolidated financial results.
 
 
In 2007, on a purchase value basis, we sourced approximately 76% of our products through one sourcing agent, EBI. Our sourcing agreement with EBI is on a commission basis and is automatically renewed each year unless terminated by either party upon one year written notice. If the agreement with EBI were terminated or if the terms of the agreement were modified substantially and we did not find an appropriate replacement in a timely manner and on reasonable terms, or if we were unable to transition the EBI functions in-house in a cost-effective manner, we could experience shortages or delays in receipt of our merchandise, higher costs and quality control issues. Any of these events could have a material adverse effect on our business, financial condition and results of operations. In addition, some of our competitors may perform all or a larger portion of their sourcing functions in-house, and, as a result, have lower sourcing costs than we do.
 
 
Some of our back-end systems, particularly relating to information technology, are dated and are an amalgamation of multiple applications, rather than one overarching state-of -the-art system. If we are unable to effectively streamline these systems and update them where necessary, this could have a material adverse effect on our business, financial condition and results of operations. In addition, any significant interruption in our back-end operations resulting from systems failures, associate grievances, natural disasters, inclement weather, accidents or other unforeseen events could lead to delays or other lapses in service relating to the distribution of merchandise to our stores and to our customers, or in the processing of returns from our customers. If our current back-end operations cannot handle a significant increase in transaction volume, we may experience inaccuracy in processing orders or delays in delivering orders. Any delays or lapses in service could have a material adverse effect on our business, financial condition and results of operations.
 
 
We use many trademarks and product designs in our business. As appropriate, we rely on the trademark and copyright laws to protect these designs even if not formally registered as marks, copyrights or designs. We believe these trademarks and product designs are important to our competitive position and success. Third parties may sue us for alleged infringement of their proprietary rights. The party claiming infringement might have greater resources than we do to pursue its claims, and we could be forced to incur substantial costs and devote significant management resources to defend the litigation. Moreover, if the party claiming infringement were to prevail, we could be forced to discontinue the use of the related trademark, patent or design and/or pay significant damages, or to enter into expensive royalty or licensing arrangements with the prevailing party,


20


Table of Contents

assuming these royalty or licensing arrangements are available at all on an economically feasible basis, which they may not be. Additionally, we may experience difficulty in effectively limiting unauthorized use of our trademarks and product designs worldwide. Unauthorized use of our trademarks or other proprietary rights may cause significant damage to our brand name and our ability to effectively represent ourselves to our agents, suppliers, vendors, licensees and/or customers. While we intend to enforce our trademark and other proprietary rights, there can be no assurance that we are adequately protected in all countries or that we will prevail when defending our trademark and proprietary rights.
 
 
While our Global Labor Practices Program and our vendor operating guidelines promote ethical business practices, we do not control our independent vendors or their business practices. Accordingly, we cannot guarantee their compliance with our guidelines. Violation of labor or other laws by our vendors, or the divergence of a vendor’s labor practices from those generally accepted as ethical in the U.S. could materially hurt our reputation, which can impact our business, financial condition and results of operations.
 
 
Our business is adversely affected by unseasonal weather conditions. Sales of our outerwear and sweaters are dependent in part on the weather and may decline in years in which weather conditions do not favor the use of these products. Further, sales of our Spring and Summer products, which traditionally consist of lighter clothing, are adversely impacted by cool or wet weather. In addition, severe weather events typically lead to temporarily reduced traffic at malls where most of our stores are located. Severe weather events may impact our ability to supply our stores, deliver orders to our customers and staff our stores and call centers.
 
 
 
In connection with the Plan of Reorganization, we and our subsidiaries entered into a $300 million senior secured term loan agreement, which has since been restated and reduced to $225 million, and a $150 million senior secured revolving credit facility. We also have $75 million in 5.25% senior convertible notes. As a result, we have, and will continue to have, a substantial amount of debt. Our term loan facility requires that we comply with a substantial number of covenants and conditions related to our operations and financial performance. Our level of debt requires us to use a substantial portion of our cash flow from operations to pay interest on our debt, which reduces our funds available for working capital, capital expenditures and other general corporate purposes; limits our flexibility in planning for or reacting to, and heighten our vulnerability to, changes or downturns in our business, the industry or in the general economy; may result in higher interest expense if interest rates increase on our floating rate borrowings; and may also prevent us from taking advantage of business opportunities as they arise or successfully carrying out expansion plans, if any.
 
In addition, the terms of our debt contain various restrictive covenants that limit our ability to, among other things: incur additional debt; grant liens; dispose of certain property; make certain capital expenditures; and engage in sale-leaseback transactions and transactions with affiliates. We are also required to meet a fixed charge coverage ratio and a leverage ratio under our term loan and, if certain availability thresholds are not met, a fixed charge coverage ratio under our revolving credit facility. These restrictions and covenants inhibit our operational flexibility and restrict or prohibit our ability to take actions that could be beneficial to our company and our stockholders. This may place us at a competitive disadvantage to our competitors who may not be subject to similar restrictions.


21


Table of Contents

 
Upon the occurrence of certain fundamental changes, including certain change of control transactions as set forth in the indenture governing the convertible notes, the Company will be required to offer to repurchase the convertible notes for cash at 100% of the principal amount thereof plus accrued and unpaid interest and additional interest, if any, to but not including the date of repurchase. In certain events of default under the indenture, either the trustee thereunder or the holders of at least 25% in principal amount of the then-outstanding convertible notes may declare 100% of the principal of the convertible notes and accrued and unpaid interest, including additional interest, to be due and payable. In addition, upon conversion of the notes after April 1, 2013, we have the right to deliver, in lieu of shares of common stock, cash or a combination of cash and shares of our common stock. We may not have sufficient cash to pay the principal and accrued interest, together with any premiums due as a result of a fundamental change, on the convertible notes, should there be a fundamental change prior to the time that the limitations on ownership contained in our Certificate of Incorporation lapse by their terms. In addition, we may not have sufficient cash to pay in lieu of shares upon conversion. Limitations in our credit facilities may not allow us to borrow the necessary cash to pay the note holders.
 
 
The success of our business depends, in part, upon our ability to increase sales at our existing stores. Our comparable store sales have fluctuated and we expect that they will continue to do so in the future. Various factors affect our comparable store sales, including the number of stores we open and close in any period, the general retail sales environment, changes in our merchandise, competition, customer preferences, current economic conditions, energy prices, the timing of our releases of new merchandise and promotional events, the success of our marketing programs, the approach and timing of mark-down strategies, weather conditions and the overlapping of existing store sales by new stores in existing markets. Our ability to maintain and improve our comparable store sales results depends in large part on improving our forecasting of customer demand and preferences and adjusting our inventory levels accordingly, increasing the number of transactions in each store, selecting effective marketing techniques, providing an appropriate mix of merchandise for our broad and diverse customer base and using more effective pricing strategies. Any failure to meet the comparable store sales expectations could significantly reduce the market price of our common stock.
 
 
From time to time, we are a party to legal proceedings arising in the ordinary course of business. In addition, an increasing number of cases are being filed against companies generally that contain class-action allegations under federal and state wage and hour laws. We estimate our exposure to these legal proceedings and establish accruals for the estimated liabilities in accordance with generally accepted accounting principles. Assessing and predicting the outcome of these matters involves substantial uncertainties. Although not currently anticipated by management, unexpected outcomes in these legal proceedings, or changes in management’s evaluations or predictions related to potential exposure in such suits, could have a material adverse impact on our financial results.
 
 
Our financial statements reflect the adoption of fresh start accounting under American Institute of Certified Public Accountants Statement of Position 90-7, or SOP 90-7. Fresh start accounting principles provided, among other things, that we determined the reorganization value of our company and allocated such reorganization value to the fair value of our tangible assets, finite-lived intangible assets and indefinite-lived intangible assets in accordance with the provisions of Statement of Financial Accounting Standards No. 141, Business Combinations (“SFAS 141”) as of our emergence from bankruptcy. An independent third party


22


Table of Contents

appraisal firm was engaged to assist us in determining our reorganization value. Although we allocated our reorganization value among our assets in accordance with SFAS 141, our allocations were based on estimates and assumptions that may not be realized and are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control. If these results are not achieved, the resulting values could be materially different from our estimates, which could cause us to write down the value of our assets and record non-cash impairment charges which could make our earnings volatile.
 
 
We have made certain assumptions regarding our ability to fully utilize our net loss carryforwards, including those from the time of emergence from bankruptcy, as well as losses subsequently generated. Our ability to fully and timely utilize such net loss carryforwards may be impaired if we do not extend the current date upon which the ownership limitations contained in our Certificate of Incorporation expire and a change of ownership, as defined in the Internal Revenue Code, subsequently occurs before we have applied the loss carryforwards described above.
 
 
 
While our common stock is currently quoted on the Nasdaq Global Market, we cannot assure that an active market for our common stock will continue to exist. In addition, the market price for our common stock may be highly volatile. In addition, it is possible that investors who have been trading in our stock have been engaging in short-selling, which could further cause the price of our common stock to decline. The trading price of our common stock could also fluctuate due to the factors discussed in this “Risk Factors” section. The trading market for our common stock also may be influenced by the research and reports that industry or securities analysts publish about us or our industry. In addition, the stock market in general has experienced extreme price and volume fluctuations. These broad market and industry factors may decrease the market price of our common stock, regardless of our actual operating performance. In the past, following periods of volatility in the overall market and the market price of a company’s securities, securities class action litigation has often been instituted against these companies. Litigation, if instituted against us, could result in substantial costs and a diversion of our management’s attention and resources.
 
 
We have operated as a public company for a limited period of time. Beginning with this annual report, Section 404 of Sarbanes-Oxley requires us to include a report each year on management’s assessment of the effectiveness of our internal control over financial reporting as of the end of the fiscal year. Future identified material weaknesses could result in additional costs for accountants to assist us in identifying and correcting weaknesses and for the costs of any required new systems. Additionally, our independent registered public accounting firm is required to issue a report on their evaluation of the operating effectiveness of our internal control over financial reporting. Our assessment requires us to make subjective judgments and our independent registered public accounting firm may not agree with our assessment. At some time in the future, our independent registered public accounting firm may not agree with our management’s assessment or conclude that our internal control over financial reporting is not operating effectively, resulting in a decrease in investor confidence in our financial statements and potential shareholder litigation.


23


Table of Contents

 
 
Provisions in our certificate of incorporation, bylaws and Senior Officer Change in Control Compensation Benefits Plan, as well as Delaware corporate law, may have the effect of delaying, deferring or preventing a change in control. These provisions include:
 
  •  our ability to issue “blank check” preferred stock;
 
  •  provisions restricting stockholders from calling a special meeting of stockholders;
 
  •  provisions that set forth advance notice procedures for meetings of stockholders; and
 
  •  payments of certain bonus and severance amounts to covered employees in certain circumstances.
 
In addition, under our certificate of incorporation, a person or entity who seeks to acquire 4.75% or more of our outstanding common stock, or a person or entity who already is a direct or indirect 4.75% stockholder and wishes to increase its ownership, may not acquire such shares unless it has obtained the prior written consent of our board of directors until such time as these restrictions lapse, which will be no later than January 4, 2009. Our board may deny any such proposed transaction if it determines in its reasonable assessment that the proposed transaction could jeopardize realization of the full benefits of unrestricted use of our net operating loss carryovers. In accordance with our certificate of incorporation, any transaction in violation of these ownership restrictions will be void so that a purported transferee will not have any ownership rights with respect to any shares acquired in excess of these ownership restrictions. Therefore, a purported transferee will not be entitled to any rights as a stockholder, including voting, dividend or distribution rights, with respect to any excess shares. In addition, Eddie Bauer has the right to demand any purported transferee of excess shares to transfer to an agent of our designation its excess shares for resale by the agent or, if the excess shares have already been sold by the purported transferee, to transfer to the agent any proceeds from the sale by the purported transferee of such excess shares. These provisions may make it more difficult for other persons or entities, without the approval of our board of directors, to make a tender offer or otherwise acquire substantial amounts of our common stock, or to launch other takeover attempts that a stockholder might consider to be in such stockholder’s best interest. These provisions also may limit the price that certain investors might be willing to pay in the future for shares of our common stock.
 
 
As of December 29, 2007, we estimated our Federal NOLs to be approximately $124.9 million (tax affected) and our state NOLs to be approximately $14.5 million (tax affected). Under Section 382 of the Internal Revenue Code, if a corporation undergoes an “ownership change,” the corporation’s ability to use its pre-change NOLs and other pre-change tax attributes to offset its post-change income may be limited. An ownership change is generally defined as a greater than 50% change in its equity ownership by value over a three-year period. Our NOLs are currently limited under Section 382 as a result of the ownership change triggered upon our emergence from bankruptcy. We may experience a second ownership change in the future as a result of the lapse of the ownership restrictions within our certificate of incorporation, or as a result of conversion of our outstanding convertible notes into shares of our common stock. If we were to trigger a second ownership change in the future as defined under Section 382, our ability to use any NOLs existing at that time could be further limited.
 
 
We may issue securities in the future and may do so in a manner that results in substantial dilution for our stockholders. In addition, we may issue debt or equity from time to time that ranks in preference to our common stock in the event of a liquidation or winding up or that is secured by an interest in some or all of our assets. Sales of common stock by existing stockholders in the public market, our issuances of new securities or debt, or the expectation that any of these events might occur could materially and adversely affect the market price of our common stock.


24


Table of Contents

 
We do not anticipate paying dividends on our common stock for the foreseeable future. Our ability to pay dividends depends on our receipt of cash dividends from our subsidiaries because we are a holding company. The terms of certain of our outstanding indebtedness prohibit us from paying dividends. Accordingly, investors must be prepared to rely on sales of their common stock after price appreciation to earn an investment return, which may never occur. Investors seeking cash dividends should not purchase our common stock. Any determination to pay dividends in the future will be made at the discretion of our board of directors and will depend on our results of operations, financial conditions, contractual restrictions, restrictions imposed by applicable law and other factors our board deems relevant.
 
Item 1B.   UNRESOLVED STAFF COMMENTS
 
Not applicable.
 
Item 2.   PROPERTIES
 
The following is an overview of key properties used in the operation of our business. We believe all of our facilities are suitable and adequate for our current and anticipated operations.
 
Corporate Headquarters.  We moved into a 230,000 square foot leased corporate headquarters in Bellevue, Washington in the summer of 2007. Our lease has a term of 15 years. Approximately one-half of our build-out costs were reimbursed by the landlord.
 
Retail and Outlet Stores.  All of our retail and outlet stores are leased. Our retail stores are generally located in regional malls, lifestyle centers, with a few stand-alone stores in metropolitan areas. We also have retail stores in smaller markets where a concentration of our target customers exists. We look at catalog distributions, loyalty program information and a custom software program in determining the locations of target customers. Our outlet stores are located predominantly in destination outlet centers. Our retail stores average approximately 6,900 gross square feet, while our outlet stores average approximately 7,500 gross square feet. In most cases, our retail store leases have ten-year terms and our outlet store leases have five-year terms, with one five-year option to renew. Approximately 25% of our retail store leases allow us the one-time right to terminate the lease three to five years after the commencement of the lease if previously agreed upon sales thresholds are not achieved. The majority of our store leases normally provide for base rent and the payment of a percentage of sales as additional rent when certain sales thresholds are reached. We are typically responsible for our share of common area and maintenance charges, real estate taxes and certain other expenses. We receive tenant allowances from most of our landlords for approximately one-half of our tenant build out costs, which averaged $185 per square foot in fiscal 2007.
 
As of December 29, 2007, we had 234 U.S. retail stores located in 47 states and 37 retail stores located in Canada. In 2007, we had more than ten retail/outlet stores located in each of the following states: California (15), Colorado (12), Georgia (10), Illinois (15), Michigan (15), Minnesota (11), Missouri (10), North Carolina (11), New York (12), Ohio (11), Oregon (11), Pennsylvania (17), Texas (23), Virginia (11) and Washington (11). As of December 29, 2007, we had 119 U.S. outlet stores located in 34 states, with 14 outlet stores in California. We had one outlet store in Ontario, Canada. In fiscal 2008, we intend to open approximately 7 additional retail stores and 6 outlet stores in the aggregate in the United States and Canada. We closed 24 retail and 3 outlet stores in January 2008. We intend, as a part of our normal-course operations, to continue to open new retail stores in advantageous locations and close underperforming retail stores upon natural expiration of store leases.


25


Table of Contents

The following summarizes the number of retail and outlet stores we opened and closed throughout fiscal 2007:
 
                         
    Retail     Outlet     Total  
 
Stores as of December 30, 2006
    279       115       394  
Stores Opened in 2007
    21       8       29  
Stores Closed in 2007
    (29 )     (3 )     (32 )
Stores as of December 29, 2007
    271       120       391  
 
We expect to open 13 retail stores and outlet locations in 2008, and close approximately 28 stores in early 2008. The closures are all as a result of lease expirations.
 
 
Distribution Centers.  Eddie Bauer Fulfilment Services (“EBFS”) operates our two main facilities in Groveport, Ohio, and Vaughan, Ontario, Canada. EBFS owns our facility in Groveport, Ohio, which consists of approximately 2.2 million square feet. We lease our facility in Vaughan, Ontario, which consists of approximately 97,200 square feet. The lease expires in April 2012.
 
Customer Contact Center.  Our customer contact center is located in Saint John, New Brunswick, Canada. We lease 37,815 square feet and the lease expires in May 2011.
 
Information Technology Center.  We own an approximately 50,000 square foot IT facility in Westmont, Illinois. This facility houses all of our systems and network services, including those related to product development, merchandising, marketing, planning, store operations, sourcing, finance, accounting, call centers, Internet, inventory and order fulfillment.
 
Item 3.   LEGAL PROCEEDINGS
 
In June 2006, a class action suit captioned Tara Hill v. Eddie Bauer, Inc., was filed in Los Angeles Superior Court, State of California. The suit alleged violations by the Company of the California Labor Code and Business and Professions Code relating to the adequacy of wage statements, reimbursements for business expenses, meal and rest periods and other claims, on behalf of a class comprised of all employees in the California stores. The Company and plaintiff reached a settlement in April, 2007 and have provided notice to class members regarding the potential settlement. A hearing on final court approval of the settlement was scheduled for March, 2008, but will be postponed for an undetermined period of time pending the filing of certain notices related to class action lawsuits. A notice of objection to the settlement has been filed by the plaintiff in the Scherer v. Eddie Bauer, Inc. suit referenced below. The Company intends to vigorously contest the objection to the settlement. In connection with the proposed settlement, the Company accrued $1.6 million in the first quarter of 2007.
 
In September 2007, a purported class action suit captioned Kristal Scherer, on behalf of herself, all others similarly situated v. Eddie Bauer, Inc. and Does 1 to 100 was filed in Superior Court of California, County of San Diego, alleging violations of the California Labor Code and Business and Professions Code relating to the payment of incentive bonuses and the Company’s policy on forfeiture of personal days. The case has been removed to U.S. District Court, Southern District of California. The Company intends to vigorously contest the characterization of the suit as a class action, and the bases of the claims alleged. In December 2007, the Company filed a partial motion to dismiss certain counts of plaintiff’s complaint for failure to state a claim. The complaint was amended in January 2008 to add an additional named plaintiff.
 
In November 2006, three purported class action complaints were filed by putative stockholders of the Company in the Superior Court of the State of Washington, King County against the Company and its Board of Directors. The complaints alleged, among other things, that the Board of Directors breached its fiduciary duties in connection with a proposed merger of the Company with an affiliate of Sun Capital Partners, Inc. and Golden Gate Capital that was ultimately rejected by the Company’s shareholders, and that the consideration to have been paid to holders of Eddie Bauer’s common stock was inadequate. The complaints sought,


26


Table of Contents

among other things, to enjoin the consummation of the merger. An order of dismissal without prejudice with respect to one of the complaints was entered in December 2006, and the remaining two actions were subsequently consolidated. In June 2007, plaintiffs’ motion for an award of attorneys’ fees was denied, and plaintiffs appealed. In December 2007, after a stipulated motion to dismiss was filed by the plaintiffs, the Court of Appeals dismissed the appeal, and in January 2008, the Superior Court of the State of Washington dismissed the remaining case with prejudice.
 
In the ordinary course of business, the Company may be subject from time to time to various other proceedings, lawsuits, disputes or claims. These actions may involve commercial, intellectual property, product liability, labor and employment related claims and other matters. Although the Company cannot predict with assurance the outcome of any litigation, it does not believe there are currently any such actions that, if resolved unfavorably, would have a material impact on the Company’s financial condition or results of operations except as disclosed herein.
 
Item 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
None.
 
 
Item 5.   MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER REPURCHASES OF EQUITY SECURITIES
 
 
From June 3, 2005 through October 11, 2006, our common stock was traded over-the-counter. Since October 12, 2006, Eddie Bauer’s common stock has been traded on The NASDAQ Global Market under the trading symbol “EBHI.” The following table sets forth, for the periods indicated, the high and low sales prices per share for the Eddie Bauer common stock as quoted on the OTC Bulletin Board or reported by The NASDAQ Global Market, as applicable:
 
                 
    High     Low  
 
Fiscal 2006
               
First Quarter Ended March 31, 2006
  $ 16.00     $ 11.75  
Second Quarter Ended July 1, 2006
  $ 15.00     $ 6.00  
Third Quarter Ended September 30, 2006
  $ 15.00     $ 8.30  
Fourth Quarter Ended December 30, 2006
  $ 11.00     $ 6.88  
Fiscal 2007
               
First Quarter Ended March 31, 2007
  $ 11.56     $ 6.50  
Second Quarter Ended June 30, 2007
  $ 14.27     $ 10.11  
Third Quarter Ended September 29, 2007
  $ 14.25     $ 7.29  
Fourth Quarter Ended December 29, 2007
  $ 9.42     $ 5.56  
 
(B)   Holders
 
As of March 3, 2008, there were 30,677,886 shares of Eddie Bauer common stock outstanding. As of March 3, 2008, our common stock was held by approximately 505 holders of record.
 
(C)   Dividends
 
We do not anticipate paying any dividends on our common stock in the foreseeable future. In addition, covenants in our term loan agreement and revolving credit facility restrict our ability to pay dividends and may prohibit the payment of dividends and certain other payments.


27


Table of Contents

(D)   Securities Authorized for Issuance Under Equity Compensation Plans
 
The information called for by this Item is contained in “Item 12 — Security Ownership of Certain Beneficial Owners and Management and Related Stockholders Matters.”
 
(E)   Performance Graph
 
The following performance graph is furnished to show the percentage change in cumulative total return to a holder of Eddie Bauer common stock (NASDAQ:EBHI) compared with the cumulative total return, assuming dividend reinvestment, of the NASDAQ Composite Index and the industry peer group indicated below, during the period from June 3, 2005 through December 29, 2007. The Company paid no cash dividends during the periods presented.
 
 
(PERFORMANCE GRAPH)
 
Peer Group
Chico’s FAS, Inc. (NYSE:CHS)
The Gap, Inc. (NYSE: GPS)
Limited Brands, Inc. (NYSE:LTD)
AnnTaylor Stores Corporation (NYSE:ANN)
Coldwater Creek Inc. (NASDAQ:CWTR)
The Talbots, Inc. (NYSE:TLB)
 
(F)   Unregistered Sales of Equity Securities and Use of Proceeds and Issuer Purchases of Equity Securities
 
None.


28


Table of Contents

Item 6.   SELECTED FINANCIAL DATA
 
 
 
On March 17, 2003, Spiegel and the other Debtors, including Eddie Bauer, Inc., our principal operating subsidiary, filed petitions for relief under Chapter 11 of the U.S. Bankruptcy Code with the U.S. Bankruptcy Court of the Southern District of New York. The bankruptcy court confirmed the Plan of Reorganization on May 25, 2005, it became effective on June 21, 2005 (“Effective Date”), and on that date the Debtors emerged from bankruptcy.
 
Pursuant to the Plan of Reorganization, Eddie Bauer Holdings, Inc. (“Eddie Bauer”) was formed as a new holding company and, in exchange for Eddie Bauer issuing shares of common stock to certain unsecured creditors of the Debtors, Spiegel transferred to Eddie Bauer 100% of its ownership interest in:
 
  •  Eddie Bauer, Inc., including its subsidiaries;
 
  •  Two non-operating subsidiaries (FSAC and SAC) that held securitization interests in certain pre-petition securitization transactions to which Spiegel and its subsidiaries (including FSAC and SAC, as applicable) were a party;
 
  •  A distribution center in Groveport, Ohio (EBFS), which provides catalog and retail distribution services for us; and
 
  •  A call center in Saint John, New Brunswick, Canada (EBCS), which provides call center support for us (“Saint John”).
 
Eddie Bauer then contributed to Eddie Bauer, Inc. its shares in EBFS and EBCS such that these entities became wholly-owned subsidiaries of Eddie Bauer, Inc. In addition, EBIT was formed as a wholly-owned subsidiary of Eddie Bauer, Inc. Spiegel Management Group, after having transferred to Spiegel all of its assets that did not comprise or support its IT operation (the “IT Group”), merged with and into EBIT, with the result that the IT Group became part of EBIT.
 
 
We refer to the entities prior to emergence from bankruptcy as the “Predecessor” and to the emerged entities as the “Successor.” The Predecessor consists of Eddie Bauer, Inc., EBFS, the IT Group and Saint John. The Successor consists of Eddie Bauer, Eddie Bauer, Inc., FSAC, SAC, EBFS, EBCS, EBIT and the obligations associated with Spiegel’s former pension and other post-retirement plans that were assumed by Eddie Bauer.
 
Our historical financial statements for periods prior to July 2, 2005 were prepared on a combined, carve-out basis and reflect the financial results of the Predecessor. Our consolidated financial statements for periods as of and subsequent to July 2, 2005 reflect the financial results of the Successor.
 
The Predecessor’s results of operations for periods prior to our emergence from bankruptcy are not comparable to the Successor’s results of operations for periods after our emergence from bankruptcy. The primary differences include:
 
Reorganization costs and expenses, net:  In accordance with Statement of Position 90-7, Financial Reporting by Entities in Reorganization under the Bankruptcy Code (“SOP 90-7”), our financial statements prior to July 2, 2005 reflect our revenues, expenses, realized gains and losses, and provisions for losses resulting from the reorganization separately as “reorganization costs and expenses, net” in our combined statements of operations. In addition, our cash flows related to our reorganization have been separately reflected in our combined statements of cash flows. Our results of operations for periods subsequent to July 2, 2005 no longer include reorganization expenses related to our bankruptcy proceedings.
 
Allocations of certain costs of Spiegel:  In accordance with the carve-out accounting provisions of Staff Accounting Bulleting (“SAB”) Topic 1.B, Allocation of Expenses and Related Disclosure in Financial


29


Table of Contents

Statements of Subsidiaries, Divisions or Lesser Business Components of Another Entity, our historical combined financial statements for periods prior to July 2, 2005 included allocations of certain costs of Spiegel in order to present our results of operations on a stand-alone basis. As our historical results of operations included allocations of certain costs of Spiegel, they may not be indicative of our results of operations had we been a separate, stand-alone entity for those periods, nor may they be indicative of our future results. Our results of operations for periods subsequent to July 2, 2005 no longer include allocated management fees from Spiegel, but instead include the additional expenses associated with being a stand-alone, public company.
 
Discontinuation of Eddie Bauer Home — In February 2005 we announced our plan to discontinue operating our “Eddie Bauer Home” concept. As such, we have reflected the historical results of the Eddie Bauer Home group within discontinued operations in our financial statements. All Eddie Bauer Home store locations were closed by September 2005.
 
 
Although we emerged from bankruptcy on June 21, 2005, in accordance with SOP 90-7, we have applied the accounting and reporting requirements of “fresh start” accounting to the Successor effective July 2, 2005. We chose the date of July 2, 2005 because it corresponded with the end of our second quarter of fiscal 2005 and applying fresh start accounting as of June 21, 2005 versus July 2, 2005 would not have resulted in a material difference to our results of operations or financial condition. Pursuant to the principles of fresh start accounting, we determined the reorganization value of our company and allocated such reorganization value to the fair value of our tangible assets, finite-lived intangible assets and indefinite-lived intangible assets in accordance with the provisions of Statement of Financial Accounting Standards No. 141, Business Combinations (“SFAS 141”).
 
 
For fiscal 2005, the results of the Successor for the six months ended December 31, 2005 and the results of the Predecessor for the six months ended July 2, 2005 have been combined for convenience of discussion since separate presentation and discussions of the Predecessor and Successor periods would not be meaningful in terms of operating results or comparisons to other periods. We refer to the combined results collectively as fiscal 2005. As a result of applying fresh start accounting, the Successor’s results of operations for periods after our emergence from bankruptcy are not comparable to the Predecessor’s results of operations for periods prior to our emergence from bankruptcy, and therefore, the combined results for fiscal 2005 should not be taken as indicative of our historical or future results.
 
 
We assess the performance of our business using various financial and operating measures, which primarily include:
 
  •  Net merchandise sales — Net merchandise sales include sales of merchandise from our retail and outlet stores and our direct business, which includes sales from our catalogs and website, less discounts and sales return allowances. Upon the sale of a gift card or gift certificate, we defer the revenue and record a liability. We reduce the liability and record merchandise sales when the gift card or gift certificate is redeemed by the customer. A significant percentage of our customers make purchases through more than one sales channel.
 
  •  Comparable store sales — Comparable store sales include net merchandise sales from retail and outlet stores that have been open for one complete fiscal year. We exclude new store locations from our comparable store sales until they have been in operation for one complete fiscal year. Similarly, stores that are expanded or down-sized by more than 30% are also excluded from our comparable store base until they have been in operation in their new configuration for one complete fiscal year. Stores that are closed for more than 10 consecutive days are also excluded from our comparable store base. Certain financial adjustments, including the sales impact from our customer loyalty program, are excluded from our comparable store sales. Comparable store sales do not include net sales from our catalogs and website.


30


Table of Contents

 
  •  Average sales per square foot — Average sales per square foot is determined on an annual basis by dividing net merchandise sales from our retail and outlet stores for the fiscal year by the monthly average of the gross square feet during such fiscal year. References to square feet represent gross square feet and not net selling space.
 
  •  Other revenues — Other revenues include revenues associated with the royalties we receive from licensing agreements for the use of the Eddie Bauer trademark, royalties we receive from our international joint ventures and shipping revenues from shipments to customers from our direct channel.
 
  •  Gross margin — Gross margin is equal to our net merchandise sales less our costs of sales. We include in our costs of sales the direct cost of purchased merchandise, inbound freight, inventory write downs, design, buying and production costs and occupancy costs related to store operations and warehouses. We record costs of sales expense related to our customer loyalty program as points are earned by the customer, net of estimated breakage. We reduce costs of sales expense and record a reduction to revenue, which therefore has no impact to our gross margin, when the reward certificates are redeemed by the customer. Costs of sales also include the amortization expenses associated with our finite-lived intangible assets. As noted below, our warehousing and distribution expenses (excluding occupancy costs related to our warehouses) and shipping costs are included in selling, general and administrative expenses and are therefore excluded from our calculation of gross margin and gross margin percentage. As a result, our gross margin and gross margin percentages may not be comparable to those of other retailers.
 
  •  Gross margin% — Gross margin% is calculated as our gross margin as a percentage of our net merchandise sales.
 
  •  Impairment of indefinite-lived intangible assets  — These expenses include impairment charges related to our goodwill and trademarks.
 
  •  Selling, general and administrative (“SG&A”) — These expenses include all operating expenses not included within costs of sales, such as store expenses other than occupancy costs, administrative expenses, marketing and advertising expenses, catalog production and mailing costs, program costs related to our customer loyalty program, warehousing and distribution expenses (excluding occupancy costs related to our warehouses, which are reflected in costs of sales), call center expenses (excluding occupancy costs related to our call center), shipping costs associated with our catalog and Internet sales and depreciation and amortization of our non-store related property and equipment and computer software costs. Selling, general and administrative expenses also include gift card breakage related to gift cards purchased, which is the estimated amount of gift cards and gift certificates that will go unredeemed. Gift card breakage is recorded as a reduction to selling, general and administrative expenses for amounts when redemption is determined to be remote, based upon historical breakage percentages.
 
  •  Interest expense — Interest expense for periods prior to July 2, 2005 represents interest charged by our former parent, Spiegel, on our intercompany borrowings. Interest expense for periods subsequent to July 2, 2005 includes interest on our senior secured revolving credit facility; interest on our senior secured term loan, which was amended in April 2006 and April 2007; interest expense and discount amortization on our 5.25% convertible notes issued in April 2007; and amortization of our deferred financing fees. Interest expense is reduced for interest we capitalize.
 
  •  Other income, net — Other income, net primarily includes interest income earned on our cash and cash equivalents; gains or losses on our derivative instruments, including fair value adjustments we are required to make on the embedded derivative liability associated with our convertible notes; the net accretion on the financing receivables and liabilities associated with our securitization interests; and other non-operating items, which included the loss of extinguishment of debt and gain on the sale of our net financing receivables during fiscal 2007.
 
  •  Equity in earnings (losses) of foreign joint ventures  — This includes our proportionate share of the earnings or losses of our joint ventures in Germany and Japan. We own a 30% interest in Eddie Bauer


31


Table of Contents

  Japan, Inc. and a 40% interest in Eddie Bauer GmbH & Co. We account for these investments under the equity method of accounting as we do not control these entities.
 
  •  Gain on discharge of liabilities — In conjunction with our emergence from bankruptcy, we recognized a net gain of $107.6 million for the six months ended July 2, 2005 associated with the discharge of our liabilities in accordance with the Plan of Reorganization.
 
  •  Reorganization costs and expenses, net — In accordance with SOP 90-7, our financial statements prior to our emergence from bankruptcy reflected our revenues, expenses, realized gains and losses, and provisions for losses resulting from the reorganization separately as “reorganization costs and expenses, net” in our combined statements of operations.
 
  •  Discontinuation of Eddie Bauer Home — In February 2005 we announced our plan to discontinue operating our “Eddie Bauer Home” concept. As such, we have reflected the historical results of the Eddie Bauer Home group within discontinued operations in our financial statements. All Eddie Bauer Home store locations were closed by September 2005.


32


Table of Contents

SELECTED HISTORICAL FINANCIAL INFORMATION
 
The following tables set forth selected historical financial and other information for the Predecessor and Successor entities as of the dates and for the periods indicated. Financial information for periods prior to July 2, 2005 relates to the Predecessor and financial information for periods as of and subsequent to July 2, 2005 relates to the Successor. Because of our emergence from bankruptcy and our corresponding adoption of fresh start accounting and for the reasons stated above in “Predecessor and Successor Entities”, our financial information for any period prior to July 2, 2005 will not be comparable to financial information for periods after that date.
 
Our selected historical balance sheet information as of December 29, 2007, December 30, 2006, December 31, 2005, July 2, 2005 (the date we adopted fresh start accounting), January 1, 2005 and January 3, 2004 is derived from our audited consolidated and combined balance sheets. Our selected historical statement of operations information for the fiscal years ended December 29, 2007 and December 30, 2006, the six months ended December 31, 2005 and July 2, 2005, and fiscal years ended January 1, 2005 and January 3, 2004 are derived from our audited consolidated and combined statements of operations.
 
For all periods presented, income from continuing operations excludes the results of our discontinued Eddie Bauer Home business unit. The results of operations of this business unit are presented separately as discontinued operations, net of tax.


33


Table of Contents

The following financial information should be read in conjunction with our financial statements and related notes included elsewhere in this annual report, and with “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
 
                                                         
                Successor
    Predecessor
                   
                Six Months
    Six Months
                   
                Ended
    Ended
                   
    Successor
    Successor
    December 31,
    July 2,
    Combined
    Predecessor
    Predecessor
 
    2007     2006     2005     2005     2005     2004     2003  
    ($ in thousands, except per share data)  
 
Statement of Operations Information:
                                                       
Net sales and other revenues
  $ 1,044,353     $ 1,013,447     $ 593,711     $ 465,723     $ 1,059,434     $ 1,120,761     $ 1,243,927  
Revenue from Spiegel-affiliated parties
                                  37,154       73,288  
                                                         
Total revenues
    1,044,353       1,013,447       593,711       465,723       1,059,434       1,157,915       1,317,215  
Costs of sales, including buying and occupancy
    630,853       603,171       337,318       259,536       596,854       604,864       695,872  
Impairment of indefinite-lived intangible assets(a)
          117,584       40,000             40,000              
Selling, general and administrative expenses
    441,875       411,300       214,125       185,225       399,350       452,603       531,101  
                                                         
Total operating expenses
    1,072,728       1,132,055       591,443       444,761       1,036,204       1,057,467       1,226,973  
Operating income (loss)
    (28,375 )     (118,608 )     2,268       20,962       23,230       100,448       90,242  
Interest expense
    26,698       26,928       11,064       761       11,825       316       2,513  
Other income, net(b)
    23,695       3,031       1,919             1,919              
Equity in earnings (losses) of foreign joint ventures
    (1,147 )     (3,413 )     174       (95 )     79       3,590       1,606  
                                                         
Income (loss) from continuing operations before reorganization items and income tax expense
    (32,525 )     (145,918 )     (6,703 )     20,106       13,403       103,722       89,335  
Gain on discharge of liabilities(c)
                      (107,559 )     (107,559 )            
Reorganization costs and expenses, net
                      13,686       13,686       26,871       91,022  
                                                         
Income (loss) from continuing operations before income tax expense (benefit)
    (32,525 )     (145,918 )     (6,703 )     113,979       107,276       76,851       (1,687 )
Income tax expense(d)
    69,193       65,531       14,645       50,402       65,047       36,080       4,803  
                                                         
Income (loss) from continuing operations
    (101,718 )     (211,449 )     (21,348 )     63,577       42,229       40,771       (6,490 )
Income (loss) from discontinued operations, net of tax
          (534 )     (1,440 )     (2,661 )     (4,101 )     2,893       6,171  
                                                         
Net income (loss)
  $ (101,718 )   $ (211,983 )   $ (22,788 )   $ 60,916     $ 38,128     $ 43,664     $ (319 )
                                                         
Basic and Diluted Earnings Per Share Information(e):
                                                       
Loss from continuing operations per share
  $ (3.33 )   $ (7.04 )   $ (0.71 )     n/a       n/a       n/a       n/a  
Loss from discontinued operations per share
  $     $ (0.02 )   $ (0.05 )     n/a       n/a       n/a       n/a  
Net loss per share
  $ (3.33 )   $ (7.06 )   $ (0.76 )     n/a       n/a       n/a       n/a  
Weighted average shares used to complete basic and diluted earnings per share
    30,524,191       30,012,896       29,995,092       n/a       n/a       n/a       n/a  


34


Table of Contents

                                                         
                Successor
    Predecessor
                   
                Six Months
    Six Months
                   
                Ended
    Ended
                   
    Successor
    Successor
    December 31,
    July 2,
    Combined
    Predecessor
    Predecessor
 
    2007     2006     2005     2005     2005     2004     2003  
    ($ in thousands, except per share data)  
 
Operating Information — Unaudited(f):
                                                       
Percentage increase (decrease) in comparable store sales(g)
    4.4 %     (2.0 )%     (6.0 )%     3.4 %     (2.2 )%     (1.7 )%     (5.3 )%
Average sales per square foot
  $ 269     $ 256       n/a       n/a     $ 256     $ 252     $ 245  
Number of retail stores(h):
                                                       
Open at beginning of period
    279       292       279       304       304       330       399  
Opened during the period
    21       16       16             16       7       1  
Closed during the period
    29       29       3       25       28       33       70  
Open at the end of the period
    271       279       292       279       292       304       330  
Number of outlet stores(h):
                                                       
Open at beginning of period
    115       108       103       101       101       103       102  
Opened during the period
    8       8       5       3       8       2       2  
Closed during the period
    3       1             1       1       4       1  
Open at the end of the period
    120       115       108       103       108       101       103  
Total store square footage at end of period (in thousands)
    2,653       2,752       2,897       n/a       2,897       2,960       3,220  
Gross margin
  $ 358,527     $ 353,517     $ 228,161     $ 176,478     $ 404,639     $ 442,875     $ 478,170  
Gross margin%
    36.2 %     37.0 %     40.3 %     40.5 %     40.4 %     42.3 %     40.7 %
Capital expenditures
  $ 56,636     $ 45,814     $ 30,214     $ 8,641     $ 38,855     $ 13,906     $ 6,313  
Depreciation and amortization
  $ 50,333     $ 55,494     $ 26,589     $ 16,171     $ 42,760     $ 41,142     $ 57,339  
 
                                                 
    Successor
    Successor
    Successor
    Successor
    Predecessor
    Predecessor
 
    As of
    As of
    As of
    As of
    As of
    As of
 
    December 29,
    December 30,
    December 31,
    July 2,
    January 1,
    January 3,
 
    2007     2006     2005     2005     2005     2004  
    ($ in thousands)  
 
Balance Sheet Information:
                                               
Net Working Capital
  $ 71,821     $ 105,067     $ 107,297     $ 115,087     $ 112,577     $ 12,805  
Goodwill(a)
  $ 107,748     $ 114,765     $ 220,481     $ 220,481     $ 76,601     $ 76,601  
Trademarks(a)
  $ 185,000     $ 185,000     $ 185,000     $ 225,000     $ 58,756     $ 58,756  
Total assets
  $ 811,432     $ 855,910     $ 1,153,236     $ 1,186,005     $ 591,975     $ 643,137  
Due to (from) Spiegel
  $     $     $     $     $ (37,751 )   $ 90,688  
Total long-term debt(i)
  $ 262,275     $ 274,500     $ 298,500     $ 300,000     $     $  
Stockholders’ equity
  $ 256,272     $ 346,641     $ 545,020     $ 564,900     $ 292,391     $ 248,013  
 
 
(a) In conjunction with our impairment tests of indefinite-lived intangible assets, we recorded an impairment charge of $40 million related to our trademarks during the fourth quarter of 2005 and an impairment charge of $117.6 million related to our goodwill during the third quarter of 2006. See Note 8 to our annual financial statements for more detailed descriptions of the impairment tests performed.
 
(b) Other income, net for fiscal 2007 includes a $10.5 million fair value adjustment related to the embedded derivative associated with our convertible notes we issued in April 2007 and a $9.3 million gain on the sale of our financing receivables in December 2007.
 
(c) In accordance with SOP 90-7, we recorded a net gain of $107.6 million related to the discharge of our liabilities upon our emergence from bankruptcy for the six months ended July 2, 2005.

35


Table of Contents

 
(d) We recorded income tax expense associated with increases to our tax valuation allowances of $27.9 million, $71.3 million and $15.3 million during fiscal 2007, 2006 and 2005, respectively. Additionally, fiscal 2007 included tax expense of $56.6 million related to cash collections and the sale proceeds from our financing receivables, which utilized net operating loss carryforward to offset income tax payments due. See further discussion in Note 14 to our annual financial statements for more detailed descriptions of our tax valuation allowance changes.
 
(e) On June 21, 2005, in connection with the Effective Date of the Plan of Reorganization, we issued 30,000,000 shares of our common stock to certain unsecured creditors of the Debtors. Accordingly, earnings per share data have been included for periods subsequent to July 2, 2005. No earnings per share data have been presented for periods prior to July 2, 2005 because there were no shares outstanding for the combined entity.
 
(f) Represents unaudited financial measures used by our management to assess the performance of our business.
 
(g) Represents increase (decrease) over respective prior year period.
 
(h) Retail and outlet store count data excludes stores related to our discontinued Eddie Bauer Home business.
 
(i) Includes current portion of long-term debt, which totaled $8.0 million as of December 30, 2006, $24.0 million as of December 31, 2005 and $3.0 million as of July 2, 2005. Total long-term debt as of December 29, 2007 includes $66.1 million related to $75 million in convertible notes we issued in April 2007. The $66.1 million carrying value of our convertible notes is net of a $19.6 million discount and includes the fair value of the related embedded derivative of the conversion features of $10.7 million as of December 29, 2007. See further discussion in Note 10 to our annual financial statements for more detailed discussion of the convertible notes and the embedded derivative liability we recorded related to the notes’ conversion features.
 
(j) The Company’s results of operations and financial condition reflected above include the Company’s adoption of SFAS No. 123(R), Share-Based Payment effective July 2, 2005; SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans (an amendment of FASB Statements No. 87, 88, 106, and 132R) effective fiscal 2006; and FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109 effective fiscal 2007.
 
 
The following table sets forth our historical unaudited quarterly comparable sales data (compared to sales of the same quarter the prior year):
 
                                                                                             
Fiscal 2007     Fiscal 2006     Fiscal 2005  
Q4
    Q3     Q2     Q1     Q4     Q3     Q2     Q1     Q4     Q3     Q2     Q1  
 
4.8%         3.4 %     0.9 %     9.5 %     4.6 %     (1.5 )%     (5.9 )%     (10.0 )%     (7.1 )%     (4.3 )%     3.7 %     3.0 %
 
Item 7.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
The information in this Management’s Discussion and Analysis contains certain forward-looking statements, which reflect our current view with respect to future events and financial performance. Any such forward-looking statements are subject to risks and uncertainties that could cause our actual results of operations to differ materially from historical results or current expectations. This discussion and analysis should be read in conjunction with our consolidated and combined financial statements and the related notes included elsewhere in this document.
 
 
 
Eddie Bauer is a specialty retailer that sells mens’ and womens’ outerwear, apparel and accessories for the preeminent, active, outdoor lifestyle. Our primary target customers are women and men who are


36


Table of Contents

30-54 years old with an average annual household income of $75,000. Eddie Bauer is a nationally recognized brand that stands for high quality, innovation, style and customer service. Eddie Bauer was ranked as the number four outerwear brand in a Women’s Wear Daily survey in July 2007, and 27th in a companion Women’s Wear Daily Top 100 Brands survey, also in July 2007.
 
We sell our products through three interdependent sales channels that share product sourcing, design and marketing resources:
 
  •  retail stores, which sell our premium Eddie Bauer merchandise;
 
  •  outlet stores, which sell high quality Eddie Bauer merchandise and inventory overstocks at value or clearance price points; and
 
  •  direct, which consists of our Eddie Bauer catalogs and our website www.eddiebauer.com.
 
In June 2005, we emerged from bankruptcy as a stand-alone company for the first time in 34 years. We are committed to turning our business around and revitalizing Eddie Bauer as a premium quality brand, both by continuing to implement initiatives that we commenced over the past several years and by actively changing initiatives that are not performing up to our expectations.
 
As of December 29, 2007, we operated 391 stores, consisting of 271 retail stores and 120 outlet stores in the U.S. and Canada. During 2007, we had 38.1 million visits to our two websites and circulation of approximately 82.4 million catalogs.
 
We are minority participants in joint venture operations that sell Eddie Bauer branded products through retail and outlet stores, websites and catalogs in Japan and Germany, and we license the Eddie Bauer name to various consumer product manufacturers and other retailers whose products complement our brand image.
 
2007 Business Developments
 
 
In November 2006, we announced that we had entered into a merger agreement with a company owned by affiliates of Sun Capital Partners, Inc. and Golden Gate Capital, under which all of the Company’s outstanding shares of common stock were to be converted into the right to receive $9.25 per share in cash upon closing of the transaction. On February 8, 2007, at a special meeting of our stockholders, an insufficient number of shares were voted in favor of the merger. As a result, we terminated the merger agreement and are now refocused on the long-term effort of rebuilding brand image and increasing our sales per square foot to historic levels. Our results of operations for the first quarter of 2007 were negatively impacted by a $5 million termination fee we were required to pay in accordance with the merger agreement.
 
 
In the first half of 2007, we saw the departure of our Chief Executive Officer and several senior members of management. In conjunction with the CEO’s resignation, we recorded $8.4 million of expense, including $3.2 million of accelerated stock-based compensation expense, during the first quarter of 2007. The Chief Financial Officer had resigned in 2006, and we had yet to hire a replacement. Following the failure to approve the merger, we began recruitment efforts aimed at building a management team to formulate and implement a turnaround of our business. On June 12, 2007, we hired Neil Fiske as Chief Executive Officer and President. In July 2007, we hired a new Senior Vice President of Human Resources. In November 2007 a new Chief Financial Officer, new General Counsel and Senior Vice President of Sourcing and Supply joined the Company, filling the remaining open positions on the management team. Additionally, in February 2008, we appointed a new Senior Vice President of Merchandising. Together with Mr. Fiske, this new team and the existing Senior Vice President of Retail will be instrumental in advancing the initiatives underlying our turnaround plan discussed under “2008 and Beyond: Five Key Initiatives” above.


37


Table of Contents

 
In June 2005, upon our emergence from bankruptcy, the proceeds of a $300 million term loan facility (the “Term Loan”) were paid to certain creditors of Spiegel Corporation. In April 2007, we prepaid $48.8 million and entered into an amended and restated term loan agreement, which reduced the principal balance of the Term Loan to $225 million and extended the maturity date to April 1, 2014. Also in April 2007, we closed our offering of $75 million aggregate principal amount of 5.25% convertible senior notes with a maturity date of April 1, 2014. In December 2007, we prepaid an additional $20 million of the Term Loan principal balance. See further discussion below of our various credit vehicles within “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources”.
 
 
The new management team has set initiatives, formulated strategies to achieve these initiatives, and has begun to take action to implement the initiatives in 2008, with the goal of rebuilding the Eddie Bauer brand as a leader in outerwear and apparel for an active outdoor lifestyle. Given the 12- to 18-month lead time to develop and introduce merchandise into our sales channels, the turnaround of the Eddie Bauer business will be a multi-year effort.
 
Our five key initiatives for 2008 are:
 
  •  clarify the brand position and rebuild brand identity
 
  •  upgrade the quality of the merchandise and align the assortment strategy to the new brand position
 
  •  revamp the creative marketing function and fully exploit our marketing advantage as a direct multi-channel retailer
 
  •  cut costs to become more competitive and profitable
 
  •  realign the organization and build talent to accomplish our goals
 
See “Item 1. Business — 2008 and Beyond: Five Key Initiatives” for an expanded discussion of our key initiatives for 2008.
 
 
In September 2006, we launched our first full-scale customer loyalty program, Eddie Bauer Friends, for Eddie Bauer customers. The loyalty program allows customers in the United States to accrue points that may be redeemed for Eddie Bauer rewards certificates or used toward acquiring special Eddie Bauer merchandise. The full terms and conditions of the loyalty program are available at www.eddiebauerfriends.com. As of December 29, 2007, approximately 2.9 million customers have enrolled in our loyalty program, and approximately 50% of our U.S. net merchandise sales are generated in transactions utilizing a loyalty card. We continue to evaluate the performance of our loyalty program on an on-going basis. We believe that the program will be a valuable tool in driving customer purchases and fostering customer loyalty while facilitating our ability to track and market to our customers.


38


Table of Contents

 
The table below represents our retail and outlet store activity during fiscal 2007 and 2006:
 
                 
    Fiscal 2007     Fiscal 2006  
 
Number of retail stores:
               
Open at beginning of period
    279       292  
Opened during the period
    21       16  
Closed during the period
    29       29  
Open at the end of the period
    271       279  
Number of outlet stores:
               
Open at beginning of period
    115       108  
Opened during the period
    8       8  
Closed during the period
    3       1  
Open at the end of the period
    120       115  
 
The number of stores we ultimately open during any given year will depend on our ability to obtain suitable locations on favorable terms, our working capital, general economic conditions, and the terms of our debt agreements. In addition to closing underperforming stores and opening new stores, our strategy includes “right-sizing” our existing stores, mainly through downsizing and relocations. We are generally satisfied with the retail store prototype size of approximately 5,500 square feet (excluding outlet stores). Currently, approximately 62% of our retail stores fall within 15% of this prototype size. We do not anticipate a significant change in store count over the short term, as we focus on increasing store productivity, as measured by sales per square foot, driven by our branding, merchandising and marketing initiatives. As we improve productivity, we will have the opportunity to develop a longer-term real estate strategy that more appropriately balances our retail and outlet store counts. During 2007, we completed the build-out of our office space at our new leased headquarters in Bellevue, Washington and relocated our headquarters personnel to this new facility.
 
 
Overall, with the exception of certain categories of luxury goods, in 2007 the retail industry experienced slowing sales growth and the need to increase markdowns of goods to move inventory. We believe this slowing was due to a number of factors, including a general lack of consumer confidence in the strength of the U.S. economy during an election year, higher fuel costs which discourage unnecessary shopping trips and depreciation in housing values nationwide. The industry by nature is seasonal, with significant increases in revenues and expenses in the fourth quarter of each year due to holiday purchases. Additional industry factors that may impact our results in fiscal 2008 and beyond include the following:
 
  •  Activewear and outerwear — two categories that we intend to focus on in fiscal 2008 — continue to show sales growth;
 
  •  A shift towards consumers being more willing to purchase either premium apparel at higher prices or value apparel with lower prices, and being less willing to purchase mid-priced apparel;
 
  •  The increased availability of quality, global low-cost sourcing for apparel due to the elimination of import quotas in the U.S., which puts deflationary pressures on pricing and further lowers barriers to entry; and
 
  •  The maturation and fragmentation of the apparel industry by channel of distribution, age, gender, price points and classification, as well as the increase in brand proliferation, especially with the growth of private label brands, will increase competitive pressure on our sales.


39


Table of Contents

 
 
                                                 
    Three
    Three
          Twelve
    Twelve
       
    Months
    Months
          Months
    Months
       
    Ended
    Ended
          Ended
    Ended
       
    December 29.
    December 30,
          December 29,
    December 30,
       
    2007     2006     Change     2007     2006     Change  
    (Unaudited)     (Unaudited)           (Unaudited)     (Unaudited)        
    ($ in thousands)  
 
Net merchandise sales
  $ 377,637     $ 365,177     $ 12,460     $ 989,380     $ 956,688     $ 32,692  
Total revenues
  $ 392,430     $ 381,919     $ 10,511     $ 1,044,353     $ 1,013,447     $ 30,906  
Gross margin
  $ 165,243     $ 164,432     $ 811     $ 358,527     $ 353,517     $ 5,010  
Gross margin%
    43.8 %     45.0 %     (1.2 )%     36.2 %     37.0 %     (0.8 )%
SG&A
  $ 132,517     $ 129,098     $ 3,419     $ 441,875     $ 411,300     $ 30,575  
 
Net merchandise sales for the fourth quarter of 2007 increased $12.5 million, or 3.4%, and comparable store sales increased by 4.8%. Net merchandise sales for fiscal 2007 were up $32.7 million, or 3.4%, compared to the prior year and comparable store sales increased by 4.4%. The increase in our net merchandise sales during the fourth quarter and fiscal 2007 was primarily driven by increases of $9.2 million and $21.5 million in our direct sales in the fourth quarter and full-year periods, respectively, and increases in our retail and outlet stores of $3.3 million and $11.3 million, respectively compared to the prior year fourth quarter and full-year periods. Comparable stores sales increased in our retail stores during the fourth quarter and fiscal 2007 periods by 8.6% and 8.9%, respectively. We believe the quarter-over-quarter and year-over-year increases in net merchandise sales were a result of the following:
 
  •  more focused marketing efforts, both in-store and through our catalogs, with bolder messages on annual events such as our Pant Event, Down Event, “12 Days of Giving” and Ultimate Sale (a biannual event); and
 
  •  targeted merchandising emphasizing fewer colors and styles but rather historically successful merchandise, such as our down outerwear and gift items.
 
We have seen improved results in both our men’s and women’s lines. Customer response to the 2007 merchandise lines were encouraging, as evidenced by increases in comparable store sales of 9.5%, 0.9%, 3.4% and 4.8% in each of the quarters of 2007, respectively. Sales in our direct channel increased (decreased) 16.3%, 6.4%, (0.7%) and 9.7% in each of the quarters of 2007, respectively. The increases in comparable store sales have been in our retail stores, where comparable store sales have increased 16.4%, 4.6%, 8.0% and 8.6% in each of the quarters of 2007, respectively. Comparable store sales in outlet stores have declined; having increased 0.3% in the first quarter and declined 4.5%, 2.8% and 1.9% in the second, third and fourth quarters of 2007, respectively, and 2.3% for the full-year period, as compared to the prior year periods. Although overall units purchased per transaction increased in our outlet stores, a decline in outlet store traffic driven in part by higher fuel costs and in part by consumer concerns over economic issues during 2007, particularly during the fourth quarter, contributed to our decline in outlet store comparable sales. We believe that the decline in outlet store traffic was industry-wide. Outlet store comparable sales declines for Eddie Bauer were also attributed to product mix, which in fiscal 2007 emphasized less seasonal novelties and more wardrobe commodity items.
 
Our gross margin and gross margin percentages for the fourth quarter of 2007 were $165.2 million and 43.8% and $358.5 million and 36.2% for fiscal 2007. These amounts compared to $164.4 million and 45.0% for the fourth quarter of 2006 and $353.5 million and 37.0% for fiscal 2006. Gross margins were negatively impacted in both the fourth quarter and fiscal year 2007 by more in-season markdowns as we sought to increase our sell-through on seasonal inventories. Additionally, our gross margins during the fourth quarter and fiscal 2007 were negatively impacted by higher levels of inventory writedowns and costs associated with our customer loyalty program. These negative impacts to our gross margin were partially offset by a slight decrease in our occupancy costs in both periods.
 
SG&A expenses during the fourth quarter and fiscal 2007 increased by $3.4 million and $30.6 million, respectively, versus the prior year periods. The fourth quarter increase in SG&A expenses primarily reflected


40


Table of Contents

higher advertising and marketing costs. Fiscal 2007 SG&A expenses were negatively impacted by several one-time costs associated with our terminated merger agreement and resignation of our former CEO. See further discussion of our fiscal 2007 versus fiscal 2006 SG&A expenses below under “Results of Operations”. As part of our five key initiatives, we plan to reduce our overall costs, including SG&A expenses, by $25 to $30 million in 2008, and in the first quarter of 2008 have implemented a workforce reduction in corporate support personnel in furtherance of such expense cuts.
 
 
To increase our profitability and generate cash for future growth, we will need to effectively leverage our existing multi-channel infrastructure and increase our productivity, as measured by our comparable store sales and sales per square foot in our retail and outlet stores and through higher year-over-year sales in our direct channel. We believe that the five key initiatives identified above will continue the stronger sales momentum we saw in the fourth quarter of 2007, although weakening of consumer confidence and a general slowing in retail specialty apparel industry growth may impact our ability to increase our sales per square foot and comparable store sales in 2008. Improvement in our gross margins and profitability also depends upon our ability to source our products at cost effective prices, control our transportation and energy costs and reduce our need for inventory markdowns. We have added a new Senior Vice President of Sourcing and Supply to evaluate and improve our sourcing costs and practices, although we do not expect to see any measurable profit improvements in this area until fiscal 2009. Additionally, our ability to control store occupancy and buying costs and efficiently manage our back-end operations and fixed costs will also impact our future gross margins and profitability. As discussed above, we have several initiatives underway to reduce costs and improve efficiency, including efforts to streamline our supply chain and logistics operations. We have already reduced our corporate headcount. We anticipate that these initiatives will reduce our costs of sales and SG&A. Despite our strategy to design products that appeal to our target customers, changes in customer preferences or demand or lack of customer response to these designs could result in increased costs and lower margins if we are required to increase our inventory markdowns or redesign our product offerings. We plan to continue our customer loyalty program during 2008, which will continue to result in revenue impacts, higher cost of sales and put pressure on our gross margin during fiscal 2008. We must continue to make improvements in the merchandise collection and improve our net merchandise sales in order to develop a sustainable trend of improving results.
 
 
The following is a discussion of our results of operations for fiscal 2007, 2006 and 2005. Our historical results for periods prior to July 2, 2005 are not comparable with our results for periods subsequent to July 2, 2005 for several reasons. As discussed above, we applied the fresh start reporting requirements of SOP 90-7 effective July 2, 2005. For fiscal 2005, the results of the Successor for the six months ended December 31, 2005 and the results of the Predecessor for the six months ended July 2, 2005 have been combined for convenience of discussion since separate presentation and discussions of the Predecessor and Successor periods would not be meaningful in terms of operating results or comparisons to other periods. We refer to the combined results collectively as fiscal 2005. Additionally, as mentioned above, in February 2005 we announced our plan to discontinue operating our “Eddie Bauer Home” concept.


41


Table of Contents

Fiscal 2007 Compared to Fiscal 2006
 
 
                         
    Successor
    Successor
       
    Fiscal
    Fiscal
       
    2007     2006     Change  
    (Unaudited)     (Unaudited)        
    ($ in thousands)  
 
Retail & outlet store sales:
                       
Comparable store sales
  $ 591,393     $ 566,451     $ 24,942  
Non-comparable store sales
    120,034       133,693       (13,659 )
                         
Total retail & outlet store sales
    711,427       700,144       11,283  
Direct sales
    277,916       256,463       21,453  
Other merchandise sales
    37       81       (44 )
                         
Net Merchandise Sales
    989,380       956,688       32,692  
Shipping revenues
    34,220       34,022       198  
Licensing revenues
    13,846       15,707       (1,861 )
Foreign royalty revenues
    6,341       6,626       (285 )
Other revenues
    566       404       162  
                         
Net sales and other revenues
    1,044,353       1,013,447       30,906  
                         
Percentage increase (decrease) in comparable store sales
    4.4 %     (2.0 )%     n/a  
 
Net merchandise sales increased $32.7 million, or 3.4%, in fiscal 2007 versus fiscal 2006, which included an increase of $11.3 million, or 1.6%, in our retail and outlet store sales and an increase of $21.5 million, or 8.4%, in our catalog and internet sales. As previously discussed, we believe the year-over-year increase in net merchandise sales was a result of more focused marketing efforts, both in-store and through our catalogs, and targeted merchandising emphasizing historically successful items, with fewer colors and styles. Comparable store sales, which includes sales from both our retail and outlet stores, during fiscal 2007 increased 4.4%, or $24.9 million. Comparable store sales in our retail stores for fiscal 2007 increased 8.9%, or $30.2 million, while comparable store sales in our outlet stores decreased 2.3%, or $5.3 million, versus the prior year period. Comparable store sales in our retail stores for fiscal 2006 decreased 1.2%, or $4.3 million, while comparable store sales in our outlet stores decreased 3.1%, or $7.0 million, versus the prior year period.
 
Non-comparable store sales decreased $13.7 million, or 10.2% during fiscal 2007 versus the prior year period. The decrease in non-comparable store sales was primarily driven by a $41.5 million impact associated with higher sales from closed stores during 2006 versus 2007 and a $5.9 million decrease related to financial adjustments, which primarily includes merchandise purchased through our direct channel that is returned to our stores, adjustments for the accrual we make for returned goods, and the impact of our customer loyalty program as discussed further below. These decreases to our non-comparable sales were partially offset by an increase of $34.0 million in the sales associated with non-comparable stores (sales from retail and outlet stores that have not been open for one complete fiscal year and stores that are expanded or down-sized by more than 30% and have not been in operation in their new configuration for one complete fiscal year) which was attributable to the addition of 21 new retail stores and eight new outlet stores in fiscal 2007 versus 16 new retail stores and eight new outlet stores during fiscal 2006.


42


Table of Contents

 
                         
    Successor
    Successor
       
    Fiscal
    Fiscal
       
    2007     2006     Change  
    (Unaudited)     (Unaudited)        
    ($ in thousands)  
 
Net merchandise sales
  $ 989,380     $ 956,688     $ 32,692  
Cost of sales, including buying and occupancy
  $ 630,853     $ 603,171     $ 27,682  
Gross margin
  $ 358,527     $ 353,517     $ 5,010  
Gross margin as a% of net merchandise sales
    36.2 %     37.0 %     (0.8 )%
 
Our gross margin for fiscal 2007 was $358.5 million, an increase of $5.0 million, or 1.4%, from our fiscal 2006 gross margin of $353.5 million. Our warehousing and distribution expenses (excluding occupancy costs related to our warehouses) and shipping costs are included in selling, general and administrative expenses. As a result, our gross margin and gross margin percentages may not be comparable to those of other retailers. Our warehousing and distribution expenses reflected in selling, general and administrative expenses for fiscal 2007 and 2006 were $30.2 million and $32.5 million, respectively. Our shipping costs reflected in selling, general and administrative expenses for fiscal 2007 and 2006 were $25.4 million and $22.3 million, respectively.
 
We record costs of sales expense and a liability for points earned by the customer, net of estimated breakage, related to our customer loyalty program which we introduced in September 2006. We reduce the liability when a reward certificate is redeemed by the customer and record a reduction in the amount reflected within costs of sales expense and a corresponding reduction to revenue, which therefore has no impact to our gross margin. The net impact of our customer loyalty program for fiscal 2007 was an increase to costs of sales expense of $2.9 million and a reduction to net merchandise sales (including both retail and outlet stores and our direct channel) of $7.7 million. The net impact of our customer loyalty program for fiscal 2006 was an increase of $2.0 million to costs of sales and a reduction to net merchandise sales of $1.0 million. The total reduction to our gross margin from our customer loyalty program for fiscal 2007 and fiscal 2006 was $10.6 million and $3.0 million, respectively. In addition to the impact to our gross margin, we incurred $4.5 million and $2.7 million in fiscal 2007 and 2006, respectively, related to program-related costs which are reflected within our SG&A expenses.
 
The $27.7 million increase in our costs of sales during fiscal 2007 versus the prior year primarily reflected an increase of $21.2 million in our merchandise costs, excluding the impact of the customer loyalty award cost (e.g. the amount we reclassify as a reduction to costs of sales and reduction to revenue when the award is used for a purchase). Merchandise costs increased from the prior year as a result of the corresponding increase in our net merchandise sales and higher inventory markdowns related to excess inventories, particularly in our men’s apparel. Additionally, the total costs of the customer loyalty program, including the award cost, increased $7.6 million due to an increase in customer loyalty program participants and a full year of expense versus fiscal 2006, which included only a partial year of expense as the program was launched in September 2006.
 
Our gross margin percentage declined to 36.2% in fiscal 2007, down from 37.0% in fiscal 2006. The 0.8 percentage point decline in our gross margin percentage was due primarily to a 0.8 percentage point impact associated with our customer loyalty program and a 0.7 percentage point decrease in our merchandise margins driven in part by the higher levels of inventory markdowns in 2007. These decreases to our gross margin percentage were partially offset by a 0.7 percentage point increase in our gross margin associated with the decline in our occupancy costs as a percentage of our net merchandise sales. We expect that gross margin percentages will continue to be impacted by our loyalty program in 2008. We do not expect to see any significant margin impact resulting from initiatives to improve costs associated with sourcing of products until 2009, although we may realize small margin improvements in the fourth quarter of 2008.


43


Table of Contents

 
                         
    Successor
    Successor
       
    Fiscal
    Fiscal
       
    2007     2006     Change  
    (Unaudited)     (Unaudited)        
    ($ in thousands)  
 
Selling, general and administrative expenses (SG&A)
  $ 441,875     $ 411,300     $ 30,575  
SG&A as a% of net merchandise sales
    44.7 %     43.0 %     1.7 %
 
SG&A expenses for fiscal 2007 were $441.9 million, representing an increase of $30.6 million, or 7.4% from the prior year. SG&A expenses as a percentage of net merchandise sales for fiscal 2007 were 44.7%, up from 43.0% in the prior year, primarily as a result of first quarter 2007 non-recurring expenses totaling $16.4 million, which included the $5 million merger termination fee; $8.4 million, including $3.2 million of accelerated stock-based compensation expense, related to the resignation of our former CEO; $1.4 million of legal and other costs related to our terminated merger agreement; and a $1.6 million charge related to a litigation settlement. SG&A expenses as a percentage of net merchandise sales for fiscal 2007 excluding these non-recurring expenses was 43.0%. SG&A expense during fiscal 2006 included non-recurring expenses of $3.1 million related to our terminated merger agreement.
 
SG&A expense during fiscal 2007 also increased versus the prior year period as a result of the following:
 
  •  $6.2 million in increased advertising expenses primarily related to brand advertising, website production and advertising and costs associated with changes to our store signage;
 
  •  $4.0 million in increased incentive plan expenses including guaranteed incentives for our new CEO;
 
  •  $5.2 million in increased professional services costs to support compliance with Sarbanes-Oxley, executive recruiting fees and operations consulting;
 
  •  $3.6 million of increased payroll and benefits costs resulting from an increase in headcount in our corporate offices, higher payroll rates in our stores, and a $0.6 million sign-on bonus for our recently hired CEO;
 
  •  $4.0 million of higher building rent and moving related expenses associated with the move of our corporate campus during 2007;
 
  •  $3.1 million of increased shipping expenses due to an increase in shipping rates combined with more packages shipped due to increased sales and lower average units per package; and
 
  •  $1.8 million increase in program-related costs for our customer loyalty program.
 
These increases in SG&A expense during fiscal 2007 were partially offset by the following:
 
  •  a $3.5 million reduction in stock compensation expenses, excluding the impact of the accelerated expense related to our former CEO’s resignation;
 
  •  a $3.1 million decrease in impairment charges associated with fewer planned store closures;
 
  •  a $2.3 million reduction in our warehousing and distribution costs primarily related to operating efficiencies and reduced headcount;
 
  •  a decrease of $2.7 million related to our depreciation and amortization expenses primarily due to the fair value adjustments we recorded in conjunction with our fresh start accounting that became fully depreciated during mid-2007; and
 
  •  a $1.5 million decrease in our information technology costs.
 
Gift card breakage reduced SG&A expenses for fiscal 2007 and 2006 by $2.2 million and $2.3 million, respectively. We have already implemented a headcount reduction and plan to implement additional measures to reduce SG&A in fiscal 2008, including reductions in professional services fees, reduction in IT spending other than on priority programs, and renegotiating costs associated with our catalogs and loyalty program.


44


Table of Contents

 
                         
    Successor
    Successor
       
    Fiscal
    Fiscal
       
    2007     2006     Change  
    (Unaudited)     (Unaudited)        
    ($ in thousands)  
 
Impairment of indefinite-lived intangible assets
  $     $ 117,584     $ (117,584 )
 
We recorded no impairment charges during fiscal 2007 related to our indefinite-lived assets. See further discussion below under “Results of Operations — Fiscal 2006 Compared to Fiscal 2005” for discussion of the goodwill impairment charge we recorded during fiscal 2006.
 
 
                         
    Successor
    Successor
       
    Fiscal
    Fiscal
       
    2007     2006     Change  
    (Unaudited)     (Unaudited)        
    ($ in thousands)  
 
Equity in earnings (losses) of foreign joint ventures
  $ (1,147 )   $ (3,413 )   $ 2,266  
 
We are a 40% joint venture partner in Germany, and a 30% partner in a joint venture in Japan. Losses of foreign joint ventures for fiscal 2007 of $1.1 million included our share of losses related to Eddie Bauer Germany of $0.9 million and $0.2 million from Eddie Bauer Japan. Losses of foreign joint ventures for fiscal 2006 of $3.4 million included losses related to Eddie Bauer Germany of $4.2 million and earnings from Eddie Bauer Japan of $0.8 million. We recognized equity losses of $0.6 million in fiscal 2007 and $0.7 million in fiscal 2006 (December) from Eddie Bauer Germany’s estimated losses related to a number of store closings. We have received a required one-year notice from our joint venture partner in Eddie Bauer Germany of their decision to terminate the joint venture arrangement, and as a result, the joint venture, together with a companion licensing arrangement, will be terminated in February 2009 unless we successfully conclude ongoing negotiations and enter into an arrangement with a third party to transfer our joint venture interest for an assumption by the third party of future joint venture liabilities. As part of the proposed transaction, we would enter into a licensing arrangement to license our tradename to the new joint venture owner in exchange for specified royalties. Assuming we are not successful in entering into the proposed transaction, we may be liable for additional losses in 2008 arising from severance to employees and termination costs of lease obligations related to the unwinding of the joint venture business.
 
 
                         
    Successor
    Successor
       
    Fiscal
    Fiscal
       
    2007     2006     Change  
    (Unaudited)     (Unaudited)        
    ($ in thousands)  
 
Interest expense
  $ 26,698     $ 26,928     $ (230 )
 
Despite the fact that interest expense remained relatively flat during fiscal 2007 as compared to the prior year, interest expense during fiscal 2007 included $4.5 million of interest associated with the $75 million of convertible notes we issued in April 2007. The $4.5 million of interest expense related to our convertible notes included $1.6 million of discount amortization. Offsetting the increase in interest expense from the convertible notes was a decrease in interest expense of $3.3 million related to our senior term loan due to the lower outstanding principal balance as well as a lower average interest rate resulting from our refinancing. See further description of the refinancing of our term loan and the convertible notes we issued within “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources — Refinancing Transaction” below. Additionally, interest on our revolving line of credit decreased $0.5 million due to lower average outstanding borrowings and a lower average interest rate. During fiscal 2007 and 2006, we capitalized interest of $1.6 million and $0.8 million, respectively.


45


Table of Contents

 
                         
    Successor
    Successor
       
    Fiscal
    Fiscal
       
    2007     2006     Change  
    (Unaudited)     (Unaudited)  
 
Net accretion of financing receivables/payables
  $ 5,531     $ 1,791     $ 3,740  
Gain on fair value adjustment of net financing receivables/payables
          466       (466 )
Gain on sale of net financing receivables/payables
    9,303             9,303  
Loss on extinguishment of debt
    (3,284 )           (3,284 )
Fair value adjustment of convertible note embedded derivative liability
    10,483             10,483  
Interest rate swap gain
    228             228  
Interest income and other
    1,434       774       660  
                         
Other income, net
  $ 23,695     $ 3,031     $ 20,664  
 
Other income, net for fiscal 2007 of $23.7 million included $10.5 million of income associated with the change in fair value of our convertible note embedded derivative liability (see further discussion in “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources — Refinancing Transaction” below); a $9.3 million gain on the sale of our net financing receivables; $5.5 million of net accretion income related to the financing receivables/payables prior to their sale in December 2007; $1.4 million of interest income; and a $0.2 million gain associated with the interest rate swap we terminated in April 2007. These items were partially offset by the $3.3 million loss we recorded related to the extinguishment and refinancing of our senior term loan in April 2007. Other income, net for fiscal 2006 included $1.8 million of net accretion income; a $0.5 million net gain associated with the receivables and liabilities associated with our securitization interests and $0.7 million of interest income. The increase in net accretion income related to our financing receivables/payables in fiscal 2007 versus fiscal 2006 resulted from an increase in actual and projected collections related to financing charges and principal amounts and higher collections of previously written off accounts. See further discussion of the sale of our financing receivables and the gain we recognized during the fourth quarter of 2007 within Note 7 of our audited financial statements included in this document.
 
 
                         
    Successor
    Successor
       
    Fiscal
    Fiscal
       
    2007     2006     Change  
    (Unaudited)     (Unaudited)        
    ($ in thousands)  
 
Income tax expense
  $ 69,193     $ 65,531     $ 3,662  
 
Despite having a pre-tax loss for fiscal 2007, we incurred income tax expense during fiscal 2007 of $69.2 million. The primary differences between our calculated Federal tax benefit of $11.4 million (35% of our pre-tax loss of $32.5 million) and our income tax expense of $69.2 million primarily resulted from tax expense associated with the cash we collected related to our financing receivables, including the cash we collected in December 2007 related to the sale of the receivables, and increases to our valuation allowance requirements associated with our Federal and state NOLs. The cash we collected related to the financing receivables is included in our taxable income; however the majority of the related note payments (equal to 90% of the cash receipts) we made to the creditor’s trust are non-deductible for income tax purposes. The cash collected on the receivables and related sale resulted in Federal tax expense of $56.6 million for fiscal 2007.
 
During the fourth quarter of 2007, we recorded an income tax expense of $26.1 million to increase our valuation allowance related to our Federal NOLs, resulting from several changes in circumstances during 2007. First, we determined that the additional restrictions on Federal NOL utilization under Section 382 resulting from the anticipated change in control upon expiration of the ownership limitations established within


46


Table of Contents

our certification of incorporation were no longer likely to occur. We made this conclusion as a result of the terminated merger agreement which occurred in fiscal 2007. Additionally, we had assumed that our board of directors would lift the ownership restrictions effective January 1, 2008, which did not occur. Accordingly, we used the original Section 382 limitation resulting from the bankruptcy-related ownership change, and no longer assumed a second change in control upon the lapse of the ownership limitations, when determining the valuation allowance required as of December 29, 2007. This change resulted in a higher Section 382 limitation, allowing for increased NOL utilization in the future. Also, in determining the amount of NOL carryforwards that were more likely than not expected to be realized, we determined that we would take into account only our projected taxable income for the next three fiscal years. We changed our assumption related to future years in which we could rely on having taxable income due to our recent history of book losses and taxable losses when excluding the taxable income generated by our financing receivables which we sold in December 2007. Using these assumptions, we estimated that a valuation allowance of $106.3 million was required as of December 29, 2007 related to our Federal NOLs.
 
Also during the fourth quarter of 2007, we recognized $1.8 million of income tax expense related to state NOLs we generated in 2007, which we determined needed a full valuation allowance as we anticipate that these NOLs will expire unused. Additionally, in the course of preparing our 2006 state income tax returns during the fourth quarter of 2007, we received additional information from our prior parent company, Spiegel, related to certain state NOLs that existed as of our fresh start reporting date that we had previously assumed a full valuation allowance against. During the fourth quarter of 2007, we recorded income tax expense and an adjustment to goodwill of $2.7 million for a portion of these NOLs which we utilized during the second half of fiscal 2005 and during fiscal 2006. In accordance with SFAS 109, if a valuation allowance is recognized for some portion or all of an acquired entities’ deferred tax assets for tax operating loss carryforwards at the acquisition date, tax benefits for those items recognized in financial statements for a subsequent year should first be applied to reduce any goodwill related to the acquisition.
 
See “Fiscal 2006 Compared to Fiscal 2005 — Income Tax Expense” below for a discussion of our income tax expense for fiscal 2006.
 
Fiscal 2006 Compared to Fiscal 2005
 
 
                         
    Successor
    Combined
       
    Fiscal
    Fiscal
       
    2006     2005     Change  
    (Unaudited)     (Unaudited)        
    ($ in thousands)  
 
Retail & outlet store sales:
                       
Comparable store sales
  $ 559,549     $ 570,838     $ (11,289 )
Non-comparable store sales
    140,595       162,325       (21,730 )
                         
Total retail & outlet store sales
    700,144       733,163       (33,019 )
Direct sales
    256,463       268,135       (11,672 )
Other merchandise sales
    81       195       (114 )
                         
Net merchandise sales
    956,688       1,001,493       (44,805 )
Shipping revenues
    34,022       35,726       (1,704 )
Licensing revenues
    15,707       15,300       407  
Foreign royalty revenues
    6,626       6,100       526  
Other revenues
    404       815       (411 )
                         
Net sales and other revenues
    1,013,447       1,059,434       (45,987 )
Percentage increase (decrease) in comparable store sales
    (2.0 )%     (2.2 )%     n/a  
 
Net merchandise sales declined $44.8 million, or 4.5%, in fiscal 2006 from fiscal 2005. During fiscal 2006, we experienced declines in both our retail store sales and our direct sales. Comparable store sales during


47


Table of Contents

fiscal 2006 declined 2.0%, or $11.3 million. Comparable store sales in our retail stores for fiscal 2006 decreased 1.2%, or $4.3 million, while comparable store sales in our outlet stores decreased 3.1%, or $7.0 million, versus the prior year period. Non-comparable store sales, which includes sales associated with new, closed and non-comparable remodeled stores, declined $21.7 million, or 1.3%, primarily due to fewer stores open during fiscal 2006 (394 total stores at the end of fiscal 2006 as compared to 400 total stores at the end of fiscal 2005). The decline in net merchandise sales occurred in the first three fiscal quarters of 2006 as a result of the continuation of poor customer response to the significant changes in the merchandise collection first introduced in the fall of fiscal 2005. As of result of the poor sales performance, management took actions to design, source and merchandise products intended to re-capture the interest of our core customer and reverse the downward sales trends. These actions, which began during the fourth quarter of 2005, were undertaken after the poor customer response became clear and the initiatives continued to be implemented through mid-2006 culminating in the introduction of our 2006 Fall/Holiday products beginning during the third quarter of 2006. Improved customer response to this collection resulted in net merchandise sales during the fourth fiscal quarter of 2006 increasing $4.4 million compared to the fourth quarter of fiscal 2005. Net merchandise sales in our retail stores and direct channel were flat with the prior year quarter, while net merchandise sales in our outlet stores increased $4.5 million. Our comparable store sales for the fourth quarter, including our retail and outlet stores, increased 4.6%.
 
During fiscal 2005, overall comparable store sales declined 2.2%, which included comparable store sales declines in our retail and outlet stores of 2.9% and 0.9%, respectively.
 
 
                         
    Successor
    Combined
       
    Fiscal
    Fiscal
       
    2006     2005     Change  
    (Unaudited)     (Unaudited)        
    ($ in thousands)  
 
Net merchandise sales
  $ 956,688     $ 1,001,493     $ (44,805 )
Cost of sales, including buying and occupancy
  $ 603,171     $ 596,854     $ 6,317  
Gross margin
  $ 353,517     $ 404,639     $ (51,122 )
Gross margin as a % of net merchandise sales
    37.0 %     40.4 %     (3.4 )%
 
Our gross margin for fiscal 2006 was $353.5 million, a decrease of $51.1 million, or 12.6%, from our fiscal 2005 gross margin of $404.6 million. As noted above in “Financial Operations Overview”, our warehousing and distribution expenses (excluding occupancy costs related to our warehouses) and shipping costs are included in selling, general and administrative expenses. As a result, our gross margin and gross margin percentages may not be comparable to those of other retailers. Our warehousing and distribution expenses reflected in selling, general and administrative expenses for fiscal 2006 and 2005 were $32.5 million and $37.3 million, respectively. Our shipping costs reflected in selling, general and administrative expenses for fiscal 2006 and 2005 were $22.3 million and $21.6 million, respectively.
 
The $6.3 million increase in our costs of sales during fiscal 2006 versus the prior year primarily reflected increases of $8.8 million, $4.5 million and $1.8 million in our occupancy costs, intangible amortization expense, and buying costs, respectively. These increases were partially offset by an $8.6 million decline in our merchandise costs. The $8.8 million increase in our occupancy expenses resulted primarily from an approximately $3.2 million increase in our rent expense and an approximately $6.1 million increase in the amortization of our leasehold improvements, which included higher amortization expenses associated with the fair value adjustments we recorded to our leasehold improvements as of our fresh start accounting date. The $4.5 million increase in our intangible amortization resulted from the intangible assets related to our customer lists and licensing agreements that we recorded in conjunction with our fresh start accounting effective July 2, 2005. Prior to that date, we did not have any intangible assets that were amortized. Our buying costs increased as a result of higher payroll and employee benefit related expenses. The $8.6 million decline in our merchandise costs resulted primarily from the decrease in our merchandise sales in fiscal 2006 versus fiscal 2005.


48


Table of Contents

Our gross margin percentage declined to 37.0% in fiscal 2006, down from 40.4% in fiscal 2005. The 3.4 percentage point decline in our gross margin percentage was due primarily to increases in our occupancy costs discussed above, which resulted in a 1.6 percentage point decline in our gross margin percentage as a result of lower net merchandise sales in which to absorb our fixed store related costs. Additionally, our merchandise margins decreased 1.1 percentage points as a result of higher markdowns and the customer loyalty program we introduced during the second half of 2006. Lastly, the increases in our intangible amortization expense and buying costs resulted in declines of 0.5 and 0.3 percentage points, respectively, in our gross margin percentage versus fiscal 2005.
 
 
                         
    Successor
    Combined
       
    Fiscal
    Fiscal
       
    2006     2005     Change  
    (Unaudited)     (Unaudited)        
    ($ in thousands)  
 
Selling, general and administrative expenses (SG&A)
  $ 411,300     $ 399,350     $ 11,950  
SG&A as a % of net merchandise sales
    43.0 %     39.9 %     3.1 %
 
SG&A expenses for fiscal 2006 were $411.3 million, representing an increase of $12.0 million, or 3.0% from the prior year. SG&A expenses as a percentage of net merchandise sales for fiscal 2006 were 43.0%, up from 39.9% in the prior year, which reflected both the spreading of our SG&A over our declining merchandise sales and increased expenses as described below. The increase in SG&A expenses for fiscal 2006 versus the prior year primarily resulted from: (i) professional service fees and legal costs of approximately $6.1 million, which included incremental costs related to being a stand-alone company and our exploration of strategic alternatives; (ii) $3.3 million of merger-related expenses; (iii) higher payroll and employee benefits related expenses of approximately $4.3 million; (iv) increased stock compensation expenses of $6.6 million as fiscal 2006 included twelve months of expense versus two months during fiscal 2005; and (v) higher depreciation and amortization of approximately $3.2 million. These increases were partially offset by: (i) an $8.4 million reduction in advertising expenses, including catalog production costs (fewer catalogs produced in fiscal 2006 versus fiscal 2005) and direct mail circulation costs; (ii) an approximately $5.9 million decrease in warehousing and distribution expenses due to consolidation of our distribution facilities; (iii) an approximately $4.9 million reduction in incentive compensation costs; and (iv) an increase of approximately $2.3 million of SG&A costs capitalized into inventory due primarily to higher levels of inventory at the end of fiscal 2006 compared to fiscal 2005. Additionally, fiscal 2005 included $6.2 million of credits associated with adjustments related to pre-bankruptcy petition claims and one-time refund credits. Gift card breakage reduced SG&A expenses for fiscal 2006 and 2005 by $2.3 million and $3.1 million, respectively. The reduction in gift card breakage in fiscal 2006 compared to 2005 was primarily due to fewer gift cards purchased.
 
 
                         
    Successor
    Combined
       
    Fiscal
    Fiscal
       
    2006     2005     Change  
    (Unaudited)     (Unaudited)        
    ($ in thousands)  
 
Impairment of indefinite-lived intangible assets
  $ 117,584     $ 40,000     $ 77,584  
 
Our adoption of fresh start reporting effective July 2, 2005 resulted in the recording of indefinite-lived intangible asset values of $221 million and $225 million for goodwill and trademarks, respectively.
 
During the fourth quarter of fiscal 2005, we completed our annual impairment tests for both goodwill and trademarks in accordance with SFAS No. 142, which resulted in a pretax impairment charge totaling $40 million related to trademarks. The fair value of our trademarks as of the fourth quarter of fiscal 2005 was estimated to be $185 million and was determined using the discounted present value of estimated future cash flows, which was based upon our five-year long-range plan and a terminal value growth rate of 3.5% and a discount rate of 16%. The decline in the fair value of our trademarks since July 2, 2005 was due principally to decreases in projected revenues. The annual impairment review of our goodwill balance as of the fourth


49


Table of Contents

quarter of fiscal 2005 was completed using the two-step approach prescribed in SFAS No. 142 and resulted in no impairment charge.
 
As a result of interactions with our investment bankers, preliminary indications of interest received from various third parties during our publicly announced process of evaluating various strategic alternatives, and the significant decline in our common stock price during the third quarter of 2006, we determined that it was more likely than not that the fair value of our enterprise was below our carrying value. Accordingly, in accordance with SFAS No. 142, we completed impairment tests for our indefinite-lived intangible assets, including our goodwill and trademarks, during the third quarter of 2006.
 
The fair value of our trademarks during the third quarter of 2006 was determined using the discounted present value of estimated future cash flows, which was based upon our five-year long-range plan; a terminal value growth rate of 3.5% and a discount rate of 17.5% and was estimated to be $185 million, equal to their net book value. Accordingly, no impairment charge was recorded during the third quarter of 2006 related to our trademarks.
 
Our enterprise value for purposes of our goodwill impairment test during the third quarter of 2006 was estimated primarily using a discounted cash flow model and was further supported by valuations using market comparables and market transactions for other retail companies and our common stock price. The premise of the discounted cash flow model was based upon our five-year long-range plan related to the future cash flows of our primary assets. The discounted cash flow valuation used a discount rate of 14.5%, which represented our weighted average cost of capital and a terminal value growth rate of 3.5%. In order to assess our fair value in its entirety, following the calculation of the discounted cash flows of our primary assets, the book value of our interest-bearing debt was deducted and the fair values of the assets not contributing to the discounted cash flows of our primary assets, including our NOL carryforwards, were added to derive the fair value of our total net assets. Upon completion of step one of the goodwill impairment test, our estimated enterprise fair value was less than the carrying value of our net book value and long-term debt. Accordingly, we completed step two of the goodwill impairment test, which included comparing the implied fair value of the company with the carrying amount of goodwill. Upon completion of step two of the goodwill impairment test, we recorded an impairment charge of $117.6 million related to our goodwill. The decline in our fair value since our fresh start reporting date of July 2, 2005 was due principally to lower than projected revenues and gross margins.
 
During the fourth quarter of 2006, we completed our annual impairment tests for both our goodwill and trademarks consistent with the testing performed during the third quarter of 2006. We concluded that our enterprise value and the fair value of our trademarks approximated the values as determined during our impairment tests during the third quarter of 2006 as there were no significant changes in our long-range forecast, discount rate or terminal value growth rate. Additionally, our results of operations during the fourth quarter of 2006 were consistent with the long-range plan used during our third quarter impairment review. Our estimated enterprise value as of the fourth quarter of 2006 exceeded our net carrying value and accordingly, we concluded that we passed step one of our goodwill impairment test.
 
Our impairment evaluations during the fourth quarter of 2005 and third and fourth quarters of 2006 included reasonable and supportable assumptions and projections and were based on estimates of projected future cash flows. We experienced lower than anticipated sales during the second half of 2005 and the first three quarters of 2006, indicative of a weaker than expected response by our customers to our merchandise collection. The long-range projections used in our impairment evaluations assume that we will successfully introduce merchandise assortments that appeal to our core customer tastes and preferences and respond to future changes in customer style preferences in a timely and effective manner. These estimates of future cash flows are based upon our experience, historical operations of the stores, catalogs and Internet sites, estimates of future profitability and economic conditions. Future estimates of profitability and economic conditions require estimating such factors as sales growth, employment rates and the overall economics of the retail industry for up to twenty years in the future, and are therefore subject to variability, are difficult to predict and in certain cases, beyond our control. The assumptions utilized by management were consistent with those developed in conjunction with our long-range planning process. If the assumptions and projections underlying these evaluations are not achieved, or should we ultimately adopt and pursue different long-range plans, the


50


Table of Contents

amount of the impairment could be adversely affected. Accordingly, there can be no assurance that there will not be additional impairment charges in the future based on future events and that the additional charges would not have a material adverse impact on our financial position or results of operations.
 
 
                         
    Successor
    Combined
       
    Fiscal
    Fiscal
       
    2006     2005     Change  
    (Unaudited)     (Unaudited)  
    ($ in thousands)  
 
Equity in earnings (losses) of foreign joint ventures
  $ (3,413 )   $ 79     $ (3,492 )
 
Losses of foreign joint ventures for fiscal 2006 of $3.4 million included losses related to Eddie Bauer Germany of $4.2 million and income from Eddie Bauer Japan of $0.8 million. As a result of weak retail sales due partially to a continued poor apparel retail market in Germany, in January 2007 Eddie Bauer Germany made the decision to close all of its retail stores. Eddie Bauer Germany continues to sell its products through its catalogs, website and outlet stores. Equity losses for Eddie Bauer Germany for fiscal 2006 included $0.7 million of losses related to our proportionate share of impairment charges recognized on the write-down of certain of Eddie Bauer Germany’s fixed assets and inventory. Eddie Bauer Germany recorded these impairments during the first quarter of 2007. We reflected these write-downs in our fiscal 2006 equity losses because we determined that these impairments existed as of December 30, 2006. With respect to Eddie Bauer Germany’s fixed assets, we determined that the projected cash flows related to Eddie Bauer Germany’s stores was less than the carrying value of their fixed assets as of December 30, 2006 and accordingly recorded our proportionate share of the fixed asset impairment as of December 30, 2006. With respect to Eddie Bauer Germany’s inventory balance, we determined that a permanent write-down of Eddie Bauer Germany’s inventory to its net realizable value was required as of December 30, 2006. Earnings of foreign joint ventures for fiscal 2005 included losses related to Eddie Bauer Germany of $1.0 million and income from Eddie Bauer Japan of $1.1 million.
 
 
                         
    Successor
    Combined
       
    Fiscal
    Fiscal
       
    2006     2005     Change  
    (Unaudited)     (Unaudited)        
    ($ in thousands)  
 
Interest expense
  $ 26,928     $ 11,825     $ 15,103  
 
Interest expense increased during fiscal 2006 as compared to the prior year primarily as a result of twelve months of interest on our senior secured term loan that we entered into upon our emergence from bankruptcy in late June of 2005 versus six months of interest during fiscal 2005. Interest expense for fiscal 2006 and 2005 also included $2.1 million and $0.6 million, respectively, of interest expense related to our revolving credit facility. During fiscal 2006 and 2005, we capitalized interest of $0.8 million and $0.3 million, respectively.
 
 
                         
    Successor
    Combined
       
    Fiscal
    Fiscal
       
    2006     2005     Change  
    (Unaudited)     (Unaudited)  
    ($ in thousands)  
 
Net accretion of financing receivables/payables
  $ 1,791     $ 873     $ 918  
Gain on fair value adjustment of net financing receivables/payables
    466             466  
Interest rate swap gain
          787       (787 )
Interest income and other
    774       259       515  
                         
Other income, net
  $ 3,031     $ 1,919     $ 1,112  


51


Table of Contents

Other income, net for fiscal 2006 included $1.8 million of net accretion income and a $0.5 million net gain associated with the receivables and liabilities associated with our securitization interests and $0.7 million of interest income. Other income, net for fiscal 2005 included $0.9 million of income associated with the net accretion on the receivables and liabilities associated with our securitization interests, $0.8 million of income associated with derivative income related to our interest rate swap, and $0.2 million of interest income. The increase in net accretion income in fiscal 2006 versus fiscal 2005 resulted from twelve months of accretion versus six months in fiscal 2005 as we recorded the receivables and liabilities related to the securitization interests upon our emergence from bankruptcy. There was no other income reflected during 2006 related to our interest rate swap because we designated the interest rate swap as a cash flow hedge of 50% of our senior secured term loan effective January 1, 2006 and the interest rate swap was determined to be an effective hedge. Accordingly, unrealized gains and losses associated with the hedge were reflected within other comprehensive income during fiscal 2006.
 
 
                         
    Successor
    Combined
       
    Fiscal
    Fiscal
       
    2006     2005     Change  
    (Unaudited)     (Unaudited)        
    ($ in thousands)  
 
Income tax expense
  $ 65,531     $ 65,047     $ 484  
 
Despite having a pre-tax loss for fiscal 2006, we incurred income tax expense of $65.5 million primarily as a result of increases to our valuation allowance requirements, non-deductible impairment charges related to the goodwill impairment we recognized during the third quarter of 2006 and tax expense associated with the non-deductible interest accretion expense on our securitization interest liability. Our income tax expense for fiscal 2006 included $71.3 million of expense to increase our valuation allowance related to our NOLs, of which $23.5 million was recorded during the second quarter, $52.7 million was recorded during the third quarter of 2006 and $4.9 million was reversed during the fourth quarter of 2006. During the second quarter of 2006, we increased our valuation allowance as we reassessed our long-range plan, which resulted in a decrease in our projected taxable income during 2006 and 2007 and an increase in the projected amounts of NOLs expected to expire unused related to this period. The increase to our valuation allowance during the third quarter resulted from a decrease in the estimated annual amount of NOL utilization allowed under Section 382 of the Internal Revenue Code (“IRC”). As discussed above, during the third quarter of 2006, we performed an updated valuation of our enterprise value and concluded that our enterprise value had declined. Because we expected that further restrictions on the utilization of our NOLs would apply to periods subsequent to January 1, 2008 due to the likelihood of a change in ownership after certain trading restrictions on our common stock are lifted, this decline in enterprise value resulted in a decrease in the amount of expected NOL utilization allowed for the years of 2008 through 2023. The lower NOL utilization during this period resulted in an increase in the estimated amount of NOLs that would expire and go unused. Lastly, during the fourth quarter of 2006, we reversed $4.9 million of valuation allowance as our taxable income during the fourth quarter, principally related to collection of our financing receivables, resulted in higher taxable income and higher NOL utilization than previously estimated.
 
Our combined fiscal 2005 effective tax rate of 60.6% was higher than our U.S. Federal statutory tax rate of 35% primarily due to an increase in our valuation allowance requirements, state income taxes, the higher effective tax rate that we incurred on our income generated in Canada, tax expense associated with the accretion on the securitization interest liability and non-deductible reorganization expenses. During the fourth quarter of fiscal 2005, we revised our long range forecast which resulted in a decrease in our estimated taxable income in future years and an increase in the estimated amount of NOLs that would expire and go unused after considering the applicable IRS limitations. These changes resulted in a net $15.3 million increase in our valuation allowance requirement which we recorded during the fourth fiscal quarter of 2005.


52


Table of Contents

Liquidity and Capital Resources
 
Cash Flow Analysis
 
Fiscal 2007, Fiscal 2006 and Fiscal 2005
 
                         
    Successor
    Successor
    Combined
 
    Fiscal
    Fiscal
    Fiscal
 
    2007     2006     2005  
    (Unaudited)  
    ($ in thousands)  
 
Cash flow data:
                       
Net cash provided by operating activities
  $ 39,867     $ 50,424     $ 37,767  
Net cash used in investing activities
  $ (56,248 )   $ (45,452 )   $ (39,179 )
Net cash provided by (used in) financing activities
  $ (10,011 )   $ (26,107 )   $ 68,319  
 
 
Net cash provided by operating activities for fiscal 2007 totaled $39.9 million, compared to $50.4 million for fiscal 2006 and $37.8 million for fiscal 2005. Cash generated from our operations when excluding non-cash income (i.e., fair value adjustment of convertible note liability and net accretion income and gain on the sale of our financing receivables) and non-cash expenses (i.e., depreciation and amortization, non-cash reorganization expenses, losses and impairments of property and equipment, equity in earnings (losses) of joint ventures and deferred income taxes) totaled $0.1 million for fiscal 2007, $35.4 million for fiscal 2006 and $33.6 million for fiscal 2005. The decrease in cash generated from operations when excluding non-cash items in fiscal 2007 versus fiscal 2006 resulted primarily from the $27.4 million decrease in our operating income when excluding the $117.6 million goodwill impairment charge recorded in fiscal 2006. The decline in our operating income in fiscal 2007 versus the prior year was driven primarily by the $30.6 million increase in our SG&A expenses.
 
Changes in our operating assets and liabilities in 2007 resulted in positive cash from working capital of $31.4 million versus $14.5 million in fiscal 2006 and negative cash from working capital of $12.8 million in fiscal 2005. The cash generated from our working capital of $31.4 million in fiscal 2007 resulted primarily from $8.7 million of net cash received related to our receivables and liabilities from securitization interests; $18.7 million of cash generated related to our deferred rent obligations primarily resulting from cash received during fiscal 2007 related to construction allowances; and increases of $4.5 million for both our accrued expenses and accounts payable balances due to timing of payments at year-end. The cash generated from our working capital of $14.5 million for fiscal 2006 resulted primarily from the $11.5 million of net cash received related to our receivables and liabilities from securitization interests and $10.9 million of cash generated related to our deferred rent obligations primarily resulting from cash received during fiscal 2006 related to construction allowances, which were partially offset by $11.6 million of higher inventory levels at the end of fiscal 2006 versus fiscal 2005. Our $12.8 million use of cash related to our working capital during fiscal 2005 resulted primarily from the settlement of our liabilities subject to compromise of $17.4 million in conjunction with our emergence from bankruptcy, which was partially offset by an increase of $7.5 million in our accounts payable balances as of the end of fiscal 2005 versus the prior year end due to the timing of payments.
 
In addition to the cash generated from our working capital in fiscal 2007, we received net cash proceeds of $7.4 million related to the sale of our financing receivables in December 2007. Cash generated from discontinued operations was $0.5 million in fiscal 2006 and $17.0 million in fiscal 2005.
 
 
Net cash used in investing activities for fiscal 2007 totaled $56.2 million compared to $45.5 million and $39.2 million for fiscal 2006 and fiscal 2005, respectively. Our net cash used in investing activities for fiscal 2007 primarily included $56.6 million of capital expenditures related to new store openings and store remodels and capital expenditures related to the move of our corporate headquarters facilities in mid-2007. Our net cash used in investing activities for fiscal 2006 primarily included $45.8 million of capital expenditures related to


53


Table of Contents

new store openings and store remodels and capital expenditures related to our IT systems and corporate facilities. Our net cash used in investing activities for fiscal 2005 primarily included $38.9 million of capital expenditures related to our continuing operations, including $30.2 million during the six months ended December 31, 2005 related to new store openings as well as capital expenditures to convert prior Eddie Bauer Home store locations to Eddie Bauer retail store space. Partially offsetting the cash used for capital expenditures in each fiscal year was the dividends we received from our investment in Eddie Bauer Japan which totaled $0.4 million, $0.4 million, and $0.3 million for fiscal 2007, 2006 and 2005, respectively.
 
 
Net cash used in financing activities for fiscal 2007 totaled $10.0 million and included $80.7 million of repayments of our senior term loan, including $48.8 million in conjunction with our refinancing of the term loan in April 2007, $20 million of voluntary prepayments in December 2007 and $7.7 million of repayments required as a result of the sale of our financing receivables in December 2007. These uses of cash in fiscal 2007 were partially offset by the $71.4 million in net cash proceeds we received from the sale of our $75 million principal convertible notes in April 2007. Net cash used in financing activities for fiscal 2006 totaled $26.1 million, which primarily included $24.0 million of repayments under our senior term loan. Net cash provided by financing activities for fiscal 2005 totaled $68.3 million and included $65.7 million of a net decrease in the receivable due from Spiegel during the six months ended July 2, 2005 and a net increase in our bank overdrafts totaling $4.2 million. The decrease in the receivable due from Spiegel was primarily due to the Predecessor’s income tax expense associated with the gain on the discharge of liabilities related to the emergence from bankruptcy and application of fresh-start reporting. The income tax expense related to this gain was not actually paid or due to be paid. Partially offsetting these sources of cash during 2005 were $1.5 million of repayments of our term loan and $0.2 million of treasury stock repurchased.
 
 
Upon our emergence from bankruptcy, we had $300 million in outstanding debt, which was used to pay certain of the Spiegel creditors during the bankruptcy. As of March 1, 2008 we had $274.0 million in outstanding debt from three credit vehicles, including $194.5 million outstanding on our senior term loan; a revolving loan facility, of which $4.5 million was outstanding as of March 1, 2008; and $75 million in 5.25% senior convertible notes. As of December 29, 2007, we had cash balances of $27.6 million. Our primary source of cash is the cash generated from our operations and borrowings under our revolving credit facility. If sales and operating cash flow do not increase over time, we may not have sufficient capital resources to fund our operating plan, which may result in our need to seek additional sources of liquidity through the sale of assets, the assumption of additional debt or the issuance of equity. There can be no assurance that we would be successful in borrowing additional funds at reasonable rates of interest or issuing equity at a favorable valuation, or at all.
 
 
On June 21, 2005, Eddie Bauer, Inc. executed a loan and security agreement with Bank of America, N.A., General Electric Capital Corporation and The CIT Group/Business Credit, Inc (“Revolving Lenders”). The senior secured revolving credit facility is comprised of a revolving line of credit consisting of revolving loans and letters of credit up to $150 million to fund working capital needs.
 
Advances under the revolving credit facility may not exceed a borrowing base equal to various percentages of Eddie Bauer, Inc.’s eligible accounts receivable balances and eligible inventory, less specified reserves. The revolving credit facility is secured by a first lien on Eddie Bauer, Inc.’s inventory and certain accounts receivable balances and by a second lien on all of Eddie Bauer, Inc.’s other assets other than the Groveport, Ohio facility. The revolving credit facility is guaranteed by Eddie Bauer and certain of its subsidiaries. Our availability under the revolving credit facility was $101.3 million as of December 29, 2007. As of December 29, 2007, we had $8.4 million of letters of credit outstanding and no amounts had been drawn under the revolving credit facility.


54


Table of Contents

Borrowings under the revolving credit facility bear interest at:
 
  •  LIBOR plus 1.25% if the average aggregate outstanding (based upon the preceding calendar month) is less than $75 million; or
 
  •  LIBOR plus 1.50% if the average aggregate outstanding is greater than or equal to $75 million.
 
The weighted average interest rate paid by us on the outstanding revolving credit facility for fiscal 2007 and fiscal 2006 was 6.5% and 7.2%, respectively. In addition, we are required to pay an unused commitment fee of 0.25% per annum on the unused amount, plus a letter of credit fee. The revolving credit facility is scheduled to terminate on June 21, 2010.
 
The agreement requires that at any time the availability under the agreement is less than 10% of the maximum revolver available, we are required to maintain a consolidated fixed charge coverage ratio (as defined therein) of at least 1.25:1.00. The agreement also limits our capital expenditures (net of landlord contributions) to $60 million in 2007 and 2008, and $70 million in 2009 and 2010. Finally, there are additional covenants that restrict us from entering into certain merger, consolidation and sale transactions outside the normal course of business; from making certain distributions or changes in our capital stock; from entering into certain guarantees; from incurring debt and liens subject to limits specified within the agreement; and other customary covenants. As of December 29, 2007, the availability under the agreement was not less than 10% of the maximum revolver available.
 
To facilitate the issuance of our convertible senior notes and the amendment and restatement of our senior secured term loan described below, Eddie Bauer, Inc. executed a First Amendment and Waiver to a loan and security agreement on April 4, 2007 with the Revolving Lenders to specifically permit our issuance of the convertible senior notes described below.
 
 
On June 21, 2005, Eddie Bauer, Inc. entered into a $300 million senior secured term loan agreement (“Prior Term Loan”) with various lenders and JP Morgan Chase Bank, N.A. as administrative agent. In accordance with the Prior Term Loan, we were required to repay $750,000 on a quarterly basis from September 30, 2005 through March 31, 2011, with the remaining balance due upon maturity of the loan on June 21, 2011. The Prior Term Loan was secured by a first lien on certain of our real estate assets and trademarks and by a second lien on all of our other assets. Interest on the Prior Term Loan was calculated as the greater of the prime rate or the Federal funds effective rate plus one-half of one percent plus 2.50% to 3.25% in the case of base rate loans, or LIBOR plus 3.50% to 4.25% in the case of Eurodollar loans, based upon our corporate credit rating issued from time-to-time by Moody’s and Standard & Poor’s, provided that interest on the loan would be increased by 0.50% until the date that the aggregate principal amount of the loans outstanding was less than $225 million as a result of asset sales or voluntary prepayments from operating cash flow.
 
The Prior Term Loan included financial covenants, including a consolidated leverage ratio (as defined therein) and a consolidated fixed charge coverage ratio (as defined therein). In addition to the financial covenants, the agreement limited our capital expenditures (net of landlord contributions) to $45 million in 2007, $60 million in 2008, and $70 million in each of 2009, 2010 and 2011. Finally, there were additional covenants that restricted us from entering into certain merger, consolidation and sale transactions outside the normal course of business; making certain distributions or changes in our capital stock; entering into certain guarantees; incurring debt and liens subject to limits specified within the agreement; and other customary covenants. In April 2006, we requested and received an amendment to the Prior Term Loan that provided a waiver through the first quarter of 2007, of compliance with certain covenants contained in the Prior Term Loan; however, the covenant relief that we obtained would have expired after the first quarter of 2007, resulting in the reestablishment of the original terms related to the financial covenants. As a result of our expectation that we would not meet certain of the financial covenants during 2007, we entered into the refinancing transaction discussed below during April of 2007.


55


Table of Contents

 
On April 4, 2007, Eddie Bauer, Inc. entered into an Amended and Restated Term Loan Agreement with various lenders, Goldman Sachs Credit Partners L.P., as syndication agent, and JPMorgan Chase Bank, N.A., as administrative agent (the “Amended Term Loan Agreement”). The Amended Term Loan Agreement amends the Prior Term Loan. We entered into the Amended Term Loan Agreement as a result of our expectation that we would not meet certain of the financial covenants within our Prior Term Loan during 2007. In connection with the Amended Term Loan Agreement, $48.8 million of the loans were prepaid, reducing the principal balance of the Prior Term Loan from $273.8 million to $225 million. We recognized a loss on extinguishment of debt of $3.3 million in April 2007, which represented the unamortized deferred financing fees of the Prior Term Loan. This loss on extinguishment was reflected within other income, net on our statement of operations during fiscal 2007. We incurred $6.0 million of financing fees related to the Amended Term Loan Agreement and convertible notes issuance (discussed further below), which we capitalized as deferred financing fees. These deferred financing fees are being amortized over the life of the Amended Term Loan Agreement and convertible notes. The Amended Term Loan Agreement extends the maturity date of the Prior Term Loan to April 1, 2014, and amends certain covenants of the Prior Term Loan. As of December 29, 2007, $196.2 million was outstanding under the Amended Term Loan, of which $166.2 million were in Eurodollar loans and $30.0 million were base rate loans. In February 2008, we made an additional prepayment of $1.7 million of proceeds received from the sale of certain financing receivables described in “Footnotes to Financial Statements — Note 7”.
 
Interest under the Amended Term Loan Agreement is calculated as the greater of the prime rate or the Federal funds effective rate plus one-half of one percent plus 2.25% in the case of base rate loans, or LIBOR plus 3.25% for Eurodollar loans. Interest requirements for both base rate loans and Eurodollar loans are reset on a monthly basis. As of December 29, 2007, our amended term loan had an interest rate of LIBOR of 4.83% plus 3.25%, for a total interest rate of 8.08% for Eurodollar loans and an interest rate of prime of 7.25% plus 2.25%, for a total interest rate of 9.50% for base rate loans. Interest is payable quarterly on the last day of each March, June, September and December for base rate loans, and for Eurodollar loans having an interest period of three months or less, the last day of such interest period or for Eurodollar loans having an interest period of longer than three months, each day that is three months after the first day of such interest period.
 
The Amended Term Loan is secured by a first lien on certain real estate assets and trademarks and by a second lien on substantially all of the other assets of the Company, Eddie Bauer, Inc. and its subsidiaries.
 
In accordance with the Amended Term Loan Agreement, we are required to repay $562,500 on a quarterly basis from June 30, 2007 through December 31, 2013, with the remaining balance due upon maturity of the loan on April 1, 2014. The Amended Term Loan Agreement includes mandatory prepayment provisions, including prepayment requirements related to asset sales, future indebtedness, capital transactions, and a requirement that 50% (reduced to 25% if the Company’s consolidated senior secured leverage ratio (as defined therein) on the last day of the relevant fiscal year is not greater than 2.00 to 1.00) of any “excess cash flows,” as defined in the Amended Term Loan Agreement and measured on an annual basis beginning December 31, 2007, be applied to repayment of the loan. In the event we make voluntary prepayments or mandatory prepayments as a result of asset sales or other transactions as specified within the agreement, future principal payments are reduced in accordance with the terms of the Amended Term Loan Agreement. As discussed in Note 7 to our financial statements, we sold our interest in our financing receivables in December 2007. As a result of this asset sale, we were required to use the net cash proceeds from the sale as a payment under our senior term loan. Accordingly, we repaid $7.7 million of the outstanding term loan balance on December 10, 2007. Additionally, we made a voluntary prepayment of $20.0 million on December 27, 2007. As of December 29, 2007, there was no excess cash flow payment requirement as defined within the Amended Term Loan Agreement. In addition, we made a prepayment in February 2008 of $1.7 million of additional proceeds from the sale of the financing receivables. As a result of our prepayments made in December 2007, we are not required to make any of the scheduled repayments under the terms of the Amended Term Loan Agreement and accordingly the remaining balance outstanding under the Amended Term Loan is not required to be repaid until the term loan’s maturity date on April 1, 2014. We are required to make repayments to the Amended


56


Table of Contents

Term Loan resulting from “excess cash flows” and “asset sales”, as such are defined within the Amended Term Loan Agreement.
 
The financial covenants under the Amended Term Loan Agreement include:
 
Our consolidated senior secured leverage ratio calculated on a trailing basis must be equal to or less than:
 
  •  5.75 to 1.00 for the fiscal quarter ending December 31, 2007;
 
  •  5.50 to 1.00 for the fiscal quarters ending March 31, 2008 and June 30, 2008;
 
  •  5.25 to 1.00 for the fiscal quarter ending September 30, 2008;
 
  •  5.00 to 1.00 for the fiscal quarter ending December 31, 2008;
 
  •  4.00 to 1.00 for the fiscal quarters ending March 31, 2009 and June 30, 2009;
 
  •  3.75 to 1.00 for the fiscal quarter ending September 30, 2009;
 
  •  3.50 to 1.00 for the fiscal quarter ending December 31, 2009; and
 
  •  thereafter being reduced on a graduated basis to 2.50 at March 31, 2012 and beyond.
 
In addition, our consolidated fixed charge coverage ratio (as defined therein) calculated on a trailing four fiscal quarter basis must be equal to or greater than:
 
  •  0.75 to 1.00 for the fiscal quarters ending September 29, 2007 and December 31, 2007;
 
  •  0.80 to 1.00 for the fiscal quarter ending March 31, 2008;
 
  •  0.90 to 1.00 for the fiscal quarters ending June 30, 2008 through December 31, 2008; and
 
  •  thereafter increasing on a graduated basis to 1.10 to 1.00 at March 31, 2012 and beyond.
 
Certain of the financial covenants under the Amended Term Loan Agreement are less restrictive than the financial covenants contained within the Prior Term Loan. The Amended Term Loan Agreement also limits our capital expenditures (net of landlord contributions) to $45 million in 2007, $50 million in 2008, $60 million in 2009, and $70 million in 2010 through 2014. As of December 29, 2007, our most recent quarterly compliance reporting date, we were in compliance with the covenants of the Amended Term Loan Agreement.
 
Although our current expectations of future financial performance indicate that we will remain in compliance with these covenants, if actual financial performance does not meet our current expectations and forecasts, we may not remain in compliance with the covenants. We face a number of uncertainties that may adversely affect our ability to generate sales and earnings, including potential weakness in the retail environment in North America, which weakness may negatively affect future retail sales.
 
 
On April 4, 2007, we closed our offering of $75 million aggregate principal amount of convertible senior notes. The convertible notes have a maturity date of April 1, 2014 and pay interest at an annual rate of 5.25% semiannually in arrears on April 1 and October 1 of each year, beginning October 1, 2007 unless earlier redeemed, repurchased or converted. We filed a shelf registration statement in July 2007 under the Securities Act of 1933 relating to the resale of the convertible notes and the common stock to be issued upon conversion of the convertible notes pursuant to a registration rights agreement. The shelf registration statement was declared effective on September 7, 2007.
 
The convertible notes are fully and unconditionally guaranteed by all of our existing and future subsidiaries that are parties to any domestic credit facilities, whether as a borrower, co-borrower or guarantor, including Eddie Bauer, Inc. The convertible notes are unsecured and senior obligations of us and rank equally in right of payment with all existing and future senior unsecured indebtedness and senior in right of payment to any subordinated indebtedness.


57


Table of Contents

The convertible notes are not convertible prior to the termination of our ownership limitations contained in our certificate of incorporation, which will occur not later than January 4, 2009 except upon the occurrence of certain specified corporate transactions, as set forth in the indenture governing the convertible notes. Following the termination of the ownership limitations and prior to April 1, 2013, holders may convert all or a portion of their notes under the following circumstances: (i) during any calendar quarter commencing after June 30, 2007 if the last reported sale price of our common stock is greater than or equal to 120% of the conversion price for at least 20 trading days in the period of 30 consecutive trading days ending on the last trading day of the preceding calendar quarter; (ii) during the five business day period after any 10 consecutive trading-day period (“measurement period”) in which the trading price per $1,000 principal amount of notes for each day in the measurement period was less than 98% of the product of the last reported sale price of our common stock and the conversion rate on such day; or (iii) upon the occurrence of specified corporate transactions, as set forth in the indenture governing the convertible notes. On or after April 1, 2013, holders may convert their notes at any time prior to 5:00 pm, New York City time, on the business day immediately preceding the maturity date. The initial conversion rate, which is subject to adjustment, for the notes was 73.8007 shares per $1,000 principal amount of notes (which represented an initial conversion price of approximately $13.55 per share). Upon conversion, we have the right to deliver, in lieu of shares of common stock, cash or a combination of cash and shares of our common stock, provided that if the notes are converted prior to termination of the ownership limitations, we must pay cash in settlement of the converted notes. A holder will receive cash in lieu of any fractional shares.
 
Upon the occurrence of certain fundamental changes, including certain change of control transactions as set forth in the indenture governing the convertible notes, we will be required to offer to repurchase the convertible notes for cash at 100% of the principal amount thereof plus accrued and unpaid interest and additional interest, if any, to but not including the date of repurchase. In the event of certain events of default under the indenture either the trustee thereunder or the holders of at least 25% in principal amount of the then-outstanding convertible notes may declare 100% of the principal of the convertible notes and accrued and unpaid interest, including additional interest, to be due and payable.
 
As a result of the requirement that we settle any conversion of notes prior to the termination of the ownership limitations contained in our certificate of incorporation in cash, the conversion features contained within the convertible notes are deemed to be an embedded derivative under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”). In accordance with SFAS 133, the embedded derivative related to the conversion features requires bifurcation from the debt component of the convertible notes and a separate valuation. We recognize the embedded derivative as an asset or liability on our balance sheet and measure it at its estimated fair value, and recognize changes in its estimated fair value in other income, net in the period of change.
 
With the assistance of a third party, we estimated the fair value of the embedded derivative primarily using the Black-Scholes model and other valuation methodologies which resulted in an estimated fair value of $21.2 million as of the issuance date for the convertible notes. The estimated fair value of the conversion features is recorded with the convertible note liability on our balance sheet. The estimated fair value of the embedded derivative will be adjusted at each reporting date in the future. We estimated the fair value of the conversion features to be $10.7 million as of December 29, 2007 and accordingly recognized $10.5 million within other income, net during fiscal 2007. The decline in the estimated fair value of our derivative liability since the issuance date for the convertible notes was primarily a result of the decline in our common stock price.
 
As a result of the required bifurcation of the embedded derivative related to the conversion features of the notes under SFAS 133, the carrying value of the convertible notes at issuance was $53.8 million. We are accreting the difference between the face value of the notes and the carrying value, which totaled $21.2 million as of the date of issuance, as a charge to interest expense using the effective interest rate method over the term of the convertible notes. We recognized $1.6 million of discount amortization within interest expense during fiscal 2007, which resulted in an effective interest rate of approximately 11.05% related to the convertible notes.


58


Table of Contents

 
We use derivative instruments primarily to manage exposures to fluctuations in interest rates, to lower our overall costs of financing and to manage the mix of floating- and fixed-rate debt in our portfolio. Our derivative instruments as of December 29, 2007 and December 30, 2006 included an interest rate swap agreement. Additionally, our convertible notes included an embedded derivative as discussed further above. Prior to the amendment of our Prior Term Loan, we had an interest rate swap which totaled $147.8 million as of December 30, 2006. The interest rate swap agreement effectively converted 50% of the outstanding amount under the term loan, which had floating-rate debt, to a fixed-rate by having us pay fixed-rate amounts in exchange for the receipt of the amount of the floating-rate interest payments. Under the terms of the interest rate swap agreement, a monthly net settlement was made for the difference between the fixed rate of 4.665% and the variable rate based upon the monthly LIBOR rate on the notional amount of the interest rate swap. The interest rate swap agreement was designated as a cash flow hedge of the Prior Term Loan, and was scheduled to terminate in conjunction with the termination of the Prior Term Loan in June 2011. On April 4, 2007, we terminated our interest rate swap agreement as a result of our entering into the Amended Term Loan Agreement. Upon termination, we received $1.0 million in settlement of the interest rate swap and recognized a gain of $0.1 million within other income, net on our statement of operations.
 
On April 5, 2007, we entered into a new interest rate swap agreement and designated the new interest rate swap agreement as a cash flow hedge of the Amended Term Loan. The new interest rate swap agreement had a notional amount of $99.3 million as of December 29, 2007. The interest rate swap agreement effectively converts a portion of the outstanding amount under the Amended Term Loan, which has a floating rate of interest, to a fixed-rate by having us pay fixed-rate amounts in exchange for the receipt of the amount of the floating rate interest payments. Under the terms of the interest rate swap agreement, a monthly net settlement is made for the difference between the fixed rate of 5.05% and the variable rate based upon the monthly LIBOR rate on the notional amount of the interest rate swap. No portion of the interest rate swap was excluded from the assessment of the hedge’s effectiveness. Because all critical terms of the derivative hedging instrument and the hedged forecasted transaction were not identical, the interest rate swap did not qualify for the “shortcut method” of accounting as defined in SFAS 133. On a quarterly basis, we assess and measure the effectiveness of the cash flow hedge using the changes in variable cash flows method. In performing our assessment as of December 29, 2007, the fair value of the interest rate swap was determined to be a liability of $4.1 million and the changes in the cash flows of the derivative hedging instrument were within 80 to 125 percent of the opposite change in the cash flows of the hedged forecasted transaction and therefore we concluded that the hedge was highly effective. Accordingly, we recorded the effective portion of the cash flow hedge, which totaled $4.1 million ($2.6 million net of tax) as of December 29, 2007 within other comprehensive loss on our balance sheet. No amount of the cash flow hedge was determined to be ineffective. The amounts reflected in other comprehensive loss will be reclassified into interest expense in the same period in which the hedged debt affects interest expense. We estimate that no amounts will be reclassified into interest expense within the next 12 months. The new interest rate swap agreement is scheduled to terminate in April 2012.
 
Financial Condition
 
 
Our total assets were $811.4 million as of December 29, 2007, down $44.5 million, or 5.2% from December 30, 2006. Current assets as of December 29, 2007 were $274.1 million, down $34.5 million from $308.6 million as of December 30, 2006. The decline in our current assets was driven primarily by a $25.6 million decrease in our cash and cash equivalents (see further discussion above under “Liquidity and Capital Resources — Cash Flow Analysis”) and a $46.0 million decrease in our financing receivables. These decreases were partially offset by $30.9 million of restricted cash as of December 29, 2007. The decline in our financing receivables was due to cash collected from the financing receivables during fiscal 2007 and the sale of the outstanding receivables in December 2007. Thirty percent of the aggregate selling price of the financing receivables, or $34.2 million, is being held in escrow (“holdback”) and will be used to satisfy, if any, (i) purchase price adjustments; (ii) breaches of SAC’s representation and warranties; and (iii) SAC’s obligation


59


Table of Contents

to indemnify the buyers against certain losses or damages. Under the terms of the sale agreement, one-half of the remaining holdback will be paid during the first quarter of 2008 and one-half during the second quarter of 2008. We are required to pay 90% of any holdback received to the Creditor Trust and accordingly we have reflected this amount, which totaled $30.9 million, on our consolidated balance sheet as restricted cash as of December 29, 2007. See further discussion of the cash we collected related to the financing receivables and sale of the outstanding receivables balance in “Footnotes to Financial Statements — Note 7”.
 
Non-current assets as of December 29, 2007 were $537.3 million, down $10.0 million from $547.3 million as of December 30, 2006. The decline in our non-current assets was driven primarily by a $16.0 million decrease in our non-current deferred tax assets as our deferred tax liabilities exceeded our deferred tax assets as of December 29, 2007; an $8.1 million decrease in our other intangible assets due to the amortization recorded during fiscal 2007; and a $7.0 million decrease in our goodwill due to adjustments we recorded to properly reflect our state NOLs as of our fresh start reporting date. These decreases were partially offset by a $17.8 million increase in our property, plant and equipment due to capital expenditures during fiscal 2007.
 
Our total liabilities were $555.2 million as of December 29, 2007, an increase of $45.9 million, or 9.0%, from December 30, 2006. Current liabilities as of December 29, 2007 were $202.3 million, down $1.3 million from $203.6 million as of December 30, 2006. The decline in our current liabilities was driven by a $41.4 million decrease in our current liabilities related to our securitization note as a result of the cash payments and sale of the related financing receivables as discussed further above, which was partially offset by the $30.9 million liability to the Spiegel Creditor Trust we recorded as of December 29, 2007, which reflects the holdback from the sale of the receivables which we will be required to pay to the trust upon our receipt of the holdback during fiscal 2008.
 
Non-current liabilities as of December 29, 2007 were $352.9 million, an increase of $47.2 million from $305.7 million as of December 30, 2006. The increase in our non-current liabilities reflected $66.1 million related to the fair value of our convertible notes we issued in April 2007; $30.5 million of non-current deferred tax liabilities as our deferred tax liabilities exceeded our deferred tax assets as of December 29, 2007; and a $20.2 million increase in our deferred rent obligations primarily due to construction allowances we received from our landlords for leasehold improvements. These increases were partially offset by a $70.3 million decrease in our senior term loan due to the $48.8 million we repaid with the refinancing of the loan in April 2007 and principal payments of $20 million and $7.7 million in December 2007.
 
Our stockholders’ equity as of December 29, 2007 totaled $256.3 million, down $90.4 million from December 30, 2006, driven primarily by our net loss recorded for fiscal 2007.
 
 
Our primary cash requirements for fiscal 2008 are to fund working capital to support anticipated merchandise sales increases; capital expenditures to open new stores and refurbish existing stores; maintain our distribution center and information technology systems; and to make interest payments on our senior term loan and convertible notes. We anticipate that our capital expenditures for 2008 will be approximately $28.7 million (or $24.0 million net of landlord contributions), of which approximately 61% relates to opening and remodeling of stores in accordance with our plans to realign our stores, as compared to capital expenditures of $56.6 million during fiscal 2007, which included capital expenditures related to new store openings, store remodels and capital expenditures related to the move of our corporate headquarters in mid-2007. In 2008, we plan to spend up to an additional $2.5 million to refixture our existing stores to support new merchandise initiatives in outerwear and activewear.
 
We anticipate opening seven new retail and six new outlet stores and closing 24 retail and four outlet stores during fiscal 2008. We finance the opening of the new stores through cash provided by operations and our revolving credit facility. We estimate that capital expenditures to open a store will approximate $1.0 million and $0.6 million per store for retail and outlet stores, respectively. In substantially all instances, this capital investment is funded partially by the landlords of the leased sites. The portion funded by landlords typically ranges from 25% to 50%. Additionally, we expect initial inventory purchases for the new retail and outlet stores to average approximately $0.2 million.


60


Table of Contents

Our liquidity levels and the need to fund our cash requirements through the use of our revolving credit facility will be driven by our net sales and profitability levels, changes in our working capital, the timing of our capital expenditures and by interest payments on our term loan and convertible notes. Cash generated from our net sales and profitability, and somewhat to a lesser extent our changes in working capital, are driven by the seasonality of our business, with a disproportionate amount of net merchandise sales and operating cash flows occurring in the fourth fiscal quarter of each year. Additionally, cash generated from our net sales and profitability are impacted by the levels of and timing of markdowns that we take in order to drive sales. Seasonality also impacts the levels of our working capital, in that we typically experience higher levels of net accounts receivables and sales driven accrued expenses, such as sales and use taxes, sales allowances, and deferred revenues during the fourth quarter of each year. Conversely, we typically experience a decline in both our net accounts receivable and sales driven accrued expenses during the first and second quarters of each year. Additionally, we normally increase our inventory levels during the third quarter in anticipation of higher sales during the third and fourth quarters.
 
We do not anticipate significant cash requirements for U.S. Federal income tax payments during 2008 due to existing, unutilized NOL carryforwards we assumed when Spiegel transferred ownership of its subsidiaries, FSAC and SAC, to us. We do not anticipate paying any dividends on our common stock in the foreseeable future. In addition, covenants in our term loan agreement and revolving credit facility restrict our ability to pay dividends and may prohibit certain other payments.
 
 
                                         
Contractual Obligations
                             
as of December 29,
  Payments Due by Period  
2007
        Less Than
                After
 
(unless otherwise noted)
  Total     1 Year     1-3 Years     3-5 Years     5 Years  
    ($ in thousands)  
 
Long-term debt obligations(1)
  $ 196,162     $     $     $     $ 196,162  
Interest on long-term debt(2)
  $ 97,773     $ 15,374     $ 30,349     $ 31,760     $ 20,290  
Convertible notes(3)
  $ 75,000     $     $     $     $ 75,000  
Interest on convertible notes(3)
  $ 24,970     $ 4,057     $ 7,963     $ 7,963     $ 4,987  
Operating lease obligations(4)
  $ 443,941     $ 75,271     $ 126,629     $ 86,470     $ 155,571  
Purchase obligations(5)
  $ 150,009     $ 150,009     $     $     $  
Other contractual obligations(6)
  $ 10,992     $ 8,924     $ 2,068     $     $  
                                         
Total
  $ 998,847     $ 253,635     $ 167,009     $ 126,193     $ 452,010  
                                         
 
 
(1) Includes payments due under our senior term loan agreement excluding any mandatory prepayment provisions subsequent to December 29, 2007 discussed above under “— Sources of Liquidity — Senior Secured Term Loan.”
 
(2) Represents interest due under our term loan agreement discussed above under “— Sources of Liquidity — Senior Secured Term Loan”. Interest amounts include the impact of the interest rate swap agreement we entered into in April 2007. Interest payments include the assumption of approximately 50% of the outstanding loan at a fixed rate of 8.30% (interest rate swap rate of 5.05% plus margin of 3.25%) and 50% of the outstanding loan using implied forward LIBOR rates based upon Eurodollar futures rates plus a margin of 3.25%. See “— Sources of Liquidity — Interest Rate Swap Agreement” above.
 
(3) Interest and principal payments related to our convertible notes assume no conversion prior to their scheduled maturity date in April 2014. As more fully described above under “Convertible Notes”, the holders of the convertible notes have rights which may cause us to repurchase up to the entire aggregate face amount of the notes then outstanding at certain dates in the future prior to their scheduled maturity date.
 
(4) Includes future minimum lease payments under non-cancelable operating leases for retail stores, corporate headquarters, call center and distribution facilities. Amounts do not include costs for maintenance, common areas or real estate taxes.


61


Table of Contents

 
(5) Includes open purchase orders with vendors for merchandise not yet received or recorded on our balance sheet.
 
(6) Includes facility-related contracts, such as utility and telecommunication services; information technology contracts; printing services; and other miscellaneous business agreements.
 
In addition to the above contractual obligations, we had $8.4 million of letters of credit outstanding as of December 29, 2007 under our revolving credit facility. See further discussion of our letters of credit under “Off-Balance Sheet Arrangements” below.
 
Other Contractual Obligations
 
 
We use a combination of insurance and self-insurance to cover a number of risks, including worker’s compensation, general liability, property and automobile liability and employee-related health care benefits, a portion of which is reimbursed by our employees. Liabilities associated with these risks are estimated in part by considering historical claims experience, demographic factors, severity factors and other actuarial assumptions. We believe that we have taken reasonable steps to ensure that we are adequately accrued for costs incurred related to these programs at December 29, 2007.
 
 
As established in the Plan of Reorganization, we assumed the Spiegel pension and other post-retirement plans as of the effective date of our emergence from bankruptcy. Prior to our emergence from bankruptcy, our employees participated in these plans and our combined financial statements reflected the expense (benefit) and liabilities associated with the portion of these plans related only to our employees. Accordingly, the liabilities associated with these plans, in addition to those liabilities related to our employees that were already reflected on our combined balance sheet, have been reflected in our consolidated balance sheet as of and subsequent to July 2, 2005, our fresh start reporting date. Our funding obligations and liabilities under the terms of the plans are determined using certain actuarial assumptions, including a discount rate and an expected long-term rate of return on plan assets. These assumptions are reviewed and updated annually at the end of each third quarter, which is the period in which we have elected to use as our annual measurement date. The third quarter measurement results are subsequently reflected in our fiscal year end financial statements.
 
Effective December 30, 2006, we adopted SFAS 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans (an amendment of FASB Statements No. 87, 88, 106, and 132R) (“SFAS 158”). SFAS 158 requires companies to (i) recognize in their statement of financial position an asset for a plan’s overfunded status or a liability for a plan’s underfunded status, (ii) measure a plan’s assets and its obligations that determine its funded status as of the end of the employer’s fiscal year and (iii) recognize changes in the funded status of a defined benefit postretirement plan in the year in which the changes occur via reporting them within other comprehensive income. SFAS 158 does not change the amounts recognized in the statement of operations as net periodic benefit cost. The new measurement date requirement will be effective for fiscal years ending after December 15, 2008.
 
We assumed a discount rate of 6.00% for our pension obligation and 6.14% for our other post-retirement obligations, as of September 30, 2007, our most recent measurement date, based upon an analysis of the Moody’s AA corporate bond rate.
 
Our expected long-term rate of return on plan assets assumption for our pension plan was derived from a study conducted by our actuaries and investment managers. The study included a review of anticipated future long-term performance of individual asset classes and consideration of the appropriate asset allocation strategy given the anticipated requirements of the plan to determine the average rate of earnings expected on the funds invested to provide for the pension plan benefits. While the study gives appropriate consideration to recent fund performance and historical returns, the assumption is primarily a long-term, prospective rate. Based upon


62


Table of Contents

the most recent study, we have assumed a long-term return of 8.5% related to our pension assets as of the September 30, 2007 measurement date.
 
As of September 30, 2007, our most recent measurement date, our estimated unfunded pension obligation was approximately $2.1 million and our estimated unfunded obligation related to the assumed post-retirement benefit plans was $8.0 million. We made contributions of $0.6 million and $0.7 million to our post-retirement benefit plans and pension plan, respectively, during fiscal 2007. Our contributions to the post-retirement benefit plans and pension plan are estimated to total $0.6 million and $0, respectively, for fiscal 2008.
 
During 2006, the Pension Protection Act of 2006 was enacted. This regulation has not had a material impact on the funding obligations with respect to our pension and other benefit plans.
 
 
As of December 29, 2007, we had $8.4 million in outstanding stand-by letters of credit. We had no other off-balance sheet financing arrangements as of December 29, 2007. We use stand-by letters of credit to support our worker’s compensation insurance and import customs bond programs. Letters of credit, primarily merchandise vendor letters of credit, are important to our operations because they allow us to have payment on our behalf guaranteed by a bank which then pays the vendor a given amount of money upon presentation of specific documents demonstrating that merchandise has shipped. We subsequently record the payable to the vendor on our balance sheet at the time of merchandise title transfer. We had no merchandise letters of credit outstanding as of December 29, 2007. We are not aware of any material risks to the availability of our letters of credit.
 
 
Historically, our operations have been seasonal, with a disproportionate amount of net merchandise sales occurring in the fourth fiscal quarter, reflecting increased demand during the year-end holiday selling season. During fiscal 2007, the fourth fiscal quarter accounted for approximately 38% of our net merchandise sales. As a result of this seasonality, any factors negatively affecting us during the fourth fiscal quarter of any year, including adverse weather or unfavorable economic conditions, could have a material adverse effect on our financial condition and results of operations for the entire year. The impact of seasonality on results of operations is more pronounced since the level of certain fixed costs, such as occupancy and overhead expenses, do not vary with sales. Our quarterly results of operations also may fluctuate based upon such factors as the timing of certain holiday seasons, the number and timing of new store openings, the amount of net merchandise sales contributed by new and existing stores, the timing and level of markdowns, store closings, refurbishments and relocations, competitive factors, weather and general economic conditions. Accordingly, results for individual quarters are not necessarily indicative of the results to be expected for the entire fiscal year.
 
 
The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities as of the date of the financial statements and revenues and expenses during the periods reported. We base our estimates on historical experience, where applicable and other assumptions that we believe are reasonable under the circumstances. Actual results may differ from our estimates under different assumptions or conditions.
 
There are certain estimates that we believe require significant judgment in the preparation of our financial statements. We consider an accounting estimate to be critical if:
 
  •  It requires us to make assumptions because information was not available at the time or it included matters that were highly uncertain at the time we were making the estimate; and
 
  •  Changes in the estimate or different estimates that we could have selected may have had a material impact on our financial condition or results of operations.


63


Table of Contents

 
We have discussed the development and selection of these critical accounting estimates with the Audit Committee of our board of directors and the Audit Committee has reviewed our disclosure related to them, as presented below.
 
The following represents the nature of and rationale for our critical accounting estimates.
 
Revenue recognition
 
 
Merchandise sales.  We recognize revenues and the related costs of sales related to our store sales at the time of sale when the customer pays for the merchandise. For sales in our direct channels, including our catalog sales and sales through our Internet sites, revenue and the related costs of sales are recognized when the product is estimated to be received by the customer.
 
Sales returns.  We are required to make estimates of future sales returns related to current period sales.
 
Licensing revenues.  We have licensing arrangements with various consumer product manufacturers and other retailers. In certain cases, our licensing revenues are based upon the net sales of the licensed products and therefore we are reliant on the licensee to provide us with their net sales. At times, the net sales information for the licensed products is not available to us prior to the issuance of our financial statements. In these cases, we are required to make an estimate of our licensing revenues.
 
 
Merchandise sales.  In order to properly state our revenues and related costs of sales related to sales in our direct channels, we defer revenue and costs of sales of goods estimated to be in transit to the customer based on our experience of delivery times of the carrier used.
 
Sales returns.  We base our estimates for future sales returns on historical returns experience, taking into consideration current trends.
 
Licensing revenue.  If net sales of the licensed product are not available, we estimate our licensing revenues based upon historical sales experience for the product and by obtaining estimated net sales data from the licensee.
 
 
Merchandise sales.  Our revenue, costs of sales and gross margin would vary if different assumptions were used as to the estimated goods in-transit to the customer. Our average daily sales from our direct channels for fiscal 2007, 2006, and 2005 were $0.8 million, $0.7 million and $0.7 million, respectively.
 
Sales returns.  Our revenue, costs of sales and gross margin would vary if different assumptions were used to estimate our sales returns. Our allowance for sales returns at the end of fiscal 2007 and 2006 were $15.1 million and $15.6 million, respectively.
 
Licensing revenue.  Our revenue related to our licensing agreements would vary if actual net sales for the licensed products turn out to be different than our estimates. Our licensing revenues for fiscal 2007, 2006 and 2005 were $13.8 million, $15.7 million and $15.3 million, respectively.
 
Inventory valuation
 
 
Inventory valuation.  We carry our inventories at the lower of cost or market. Cost is determined by the weighted average cost method and includes certain overhead and internal freight costs capitalized to inventory. Market is determined based upon the estimated net realizable value, which is generally the estimated selling price of the merchandise. We record reserves against our inventory balance for excess and slow moving inventory that are not expected to be sold at or above cost plus cost of disposal and a normal selling margin.


64


Table of Contents

Excess and slow moving inventories are typically disposed of through markdowns, sales in our outlet stores, or through liquidations.
 
 
Inventory valuation.  We base our estimated inventory reserves on historical experience related to the sale and amount of markdowns previously taken on similar categories of inventory, as well as taking into consideration the age of the inventory; inventory levels for the product, including additional outstanding purchase orders; anticipated methods of disposal and new, similar products expected to be sold.
 
 
Inventory valuation.  Our results of operations in future periods could be negatively impacted if we fail to properly estimate the amount of write down of our inventory values. Our inventory valuation reserves at the end of fiscal 2007 and 2006 were $8.8 million and $4.1 million, respectively.
 
Valuation of long-lived assets
 
 
Fair values of property and equipment.  In accordance with Statement of Financial Accounting Standards (SFAS) No. 144, Accounting for the Impairment or Disposal of Long-lived Assets (“SFAS 144”), we review finite-lived long-lived assets, principally consisting of property and equipment and leasehold improvements at our stores, whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. For assets we intend to hold and use, if the total expected future undiscounted cash flows from the asset group is less than the carrying amount of the asset group, an impairment loss is recognized for the difference between the fair value and the carrying value of the asset group. For assets we plan to dispose of, an impairment loss is recognized if the carrying amount of the assets in the disposal group is more than the fair value, net of the costs of disposal. The impairment tests require us to estimate the undiscounted cash flows and fair value of the asset groups.
 
Fair values of indefinite-lived intangible assets.  We review indefinite-lived intangible assets, consisting of our trademarks and goodwill, based upon the requirements of SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS 142”). SFAS 142 requires us to test our goodwill and trademarks for impairment on an annual basis or on an interim basis if an event occurs or circumstances change that would indicate that the intangible asset may be impaired. We perform our annual impairment reviews for goodwill and trademarks during the fourth quarter of each fiscal year. The impairment tests require us to estimate the fair value of our trademarks and our overall business enterprise value.
 
 
Fair values of property and equipment.  When analyzing finite, long-lived assets for potential impairment, significant assumptions are used in determining the undiscounted cash flows of the asset group, including the cash flows attributed to the asset group; future cash flows of the asset group, including estimates of future growth rates; and the period of time in which the assets will be held and used or disposed of. We primarily determine fair values of the asset group using discounted cash flow models. Similar assumptions are used to determine the fair value of the asset group as the assumptions used in the undiscounted cash flow model. In addition, to estimate fair value we are required to estimate the discount rate that incorporates the time value of money and risk inherent in future cash flows.
 
Fair values of indefinite-lived intangible assets.  We estimate the fair value of our trademarks primarily using a discounted cash flow model. We estimate the fair value of our overall business enterprise value using discounted cash flow and market multiple approach models, and also take into consideration our common stock price. Significant assumptions are used when determining the fair values of our trademarks and overall enterprise valuation, including future cash flows of our primary assets; our terminal value growth rates; and our weighted average cost of capital. Additionally, we are required to estimate the fair value of our non-


65


Table of Contents

primary assets, which include our tax net operating losses and foreign joint ventures. Estimates of future cash flows are based upon our experience, historical operations of the stores, catalogs and Internet sites, estimates of future profitability and economic conditions. Future estimates of profitability and economic conditions require estimating such factors as sales growth, employment rates and the overall economics of the retail industry for up to twenty years in the future, and are therefore subject to variability, are difficult to predict and in certain cases, beyond our control.
 
See further discussion of the impairment tests we performed during fiscal 2007 and fiscal 2006 above under “Results of Operations — Impairment of Indefinite-lived Intangible Assets.”
 
 
Fair values of property and equipment and indefinite-lived intangible assets.  The use of different estimates or assumptions within our undiscounted cash flow models could result in cash flows lower than the current carrying values of our asset groups, thereby requiring us to compare the carrying values of the asset groups to their fair value, which may have not been done using different assumptions. The use of different estimates or assumptions within our discounted cash flow models could result in lower fair values of our property and equipment, trademarks, or overall business enterprise value which may result in the need to record further impairment charges, which may not have been done using different assumptions. Lastly, the use of a different method of determining fair value, other than using discounted cash flow and market multiple approach models, could result in lower or higher fair values.
 
Deferred tax valuation allowances
 
 
Upon our emergence from bankruptcy on June 21, 2005, Spiegel transferred ownership of its subsidiaries, FSAC and SAC, to us. Both FSAC and SAC have significant tax NOLs. We are required to estimate the amount of tax valuation allowances to record against these NOLs based upon our assessment of it being more likely than not that these NOLs will expire or go unused.
 
 
In determining the need for tax valuation allowances against our NOLs, we take into consideration current and past operating performance, projections of future operating results and projected taxable income or loss, timing of the reversal of our temporary tax differences, length of the carryback and carryforward periods, and any limitations imposed by the IRC Section 382. Section 382 limits NOL utilization based upon an entity’s estimated enterprise value upon change in control. We estimated our Federal NOLs to be approximately $271 million (tax affected) and our state NOLs to be approximately $19.8 million (tax affected) as of July 2, 2005, our fresh start reporting date. As of our fresh start reporting date, we concluded that it was more likely than not that our state NOLs would expire and go unused. Accordingly, in conjunction with our application of fresh start accounting effective July 2, 2005, a valuation allowance was established for the full estimated value ($19.8 million tax affected) of our state NOLs. As of our fresh start reporting date, we estimated that the full amount of our Federal NOLs would be utilized and accordingly no valuation allowance was established.
 
During the fourth quarter of fiscal 2005, we revised our long range forecast which resulted in a decrease in estimated taxable income in future years and an increase in the amount of Federal NOLs that would have expired and gone unused after considering the Section 382 limitations. These changes resulted in a net $15.3 million increase in the valuation allowance requirement during the six months ended December 31, 2005.
 
During fiscal 2006 we recognized $71.3 million of expense to further increase our valuation allowance related to our NOLs for several reasons. First, we reassessed our long-range plan, which resulted in a decrease in our projected taxable income during 2006 and 2007 and an increase in the projected amounts of NOLs expected to expire unused. Also, we performed an updated valuation of our enterprise value and concluded that our enterprise value had declined. This decline in enterprise value resulted in a decrease in the amount of


66


Table of Contents

expected NOL utilization allowed for the years of 2008 through 2023, and correspondingly, an increase in the estimated amount of NOLs that would have expired and gone unused.
 
During the fourth quarter of 2007, we recorded an income tax expense of $26.1 million to increase our valuation allowance related to our Federal NOLs, resulting from several changes in circumstances during 2007. First, we determined that the additional restrictions on Federal NOL utilization under Section 382 resulting from the anticipated change in control upon expiration of the ownership limitations established within our certification of incorporation were no longer likely to occur. We made this conclusion as a result of the terminated merger agreement which occurred in fiscal 2007. Additionally, we had assumed that our board of directors would lift the ownership restrictions effective January 1, 2008, which did not occur. Accordingly, we used the original Section 382 limitation resulting from the bankruptcy-related ownership change, and no longer assumed a second change in control upon the lapse of the ownership limitations, when determining the valuation allowance required as of December 29, 2007. This change resulted in a higher Section 382 limitation, allowing for increased NOL utilization in the future. Also, in determining the amount of NOL carryforwards that were more likely than not expected to be realized, we determined that we would take into account only our projected taxable income for the next three fiscal years. We changed our assumption related to future years in which we could rely on having taxable income due to our recent history of book losses and taxable losses when excluding the taxable income generated by our financing receivables which we sold in December 2007. Using these assumptions, we estimated that a valuation allowance of $106.3 million was required as of December 29, 2007 related to our Federal NOLs. Our Federal NOLs as of December 29, 2007 were estimated to be approximately $124.9 million (tax affected) and expire in 2021 through 2023.
 
During the fourth quarter of 2007, in the course of preparing our 2006 state income tax returns, we received additional information from our prior parent company, Spiegel, related to certain state NOLs that existed as of our fresh start reporting date, which we had previously assumed a full valuation allowance against. We recorded an adjustment to reduce goodwill by $6.6 million during the fourth quarter which included $2.7 million for NOLs utilized during the second half of fiscal 2005 and during fiscal 2006 (with an offset to income tax expense); $1.5 million for NOLs utilized during fiscal 2007 (which was reflected in the Company’s fiscal 2007 state tax expense); and $2.4 million for state NOLs which will be utilized in future years and not expire unused. These adjustments were recorded as a reduction to goodwill. In accordance with SFAS 109, if a valuation allowance is recognized for some portion or all of an acquired entities’ deferred tax assets for tax operating loss carryforwards at the acquisition date, tax benefits for those items recognized in financial statements for a subsequent year should first be applied to reduce any goodwill related to the acquisition. Additionally, we generated $1.8 million of state NOLs during fiscal 2007 which we provided a full valuation allowance as we expect these state NOLs to expire unused. Our state NOLs as of December 29, 2007 were estimated to be approximately $14.5 million (tax affected), of which we had a valuation allowance of $12.1 million, and expire in 2008 through 2027.
 
 
Different assumptions as to our future profitability and taxable income or loss, including the number of years in which we base our estimate upon, could result in different conclusions as to our need for and the level of our tax valuation allowances related to our NOLs. Additionally, our analysis requires assumptions about the timing and amount of limitations imposed by Section 382 based upon our enterprise value and the potential for additional limitations resulting from the lapse of ownership restrictions within our plan of reorganization. Different estimates in our enterprise value could result in the need for additional valuation allowances. Changes in ownership upon the lapse of the trading restrictions no later than January 4, 2009 and related assumptions may also result in future changes in our valuation allowance requirements. In the future, adjustments to increase or decrease the valuation allowance related to the NOLs may increase or decrease our provision for income taxes and related tax payments which could be materially impacted as these NOLs are realized or expire unused.


67


Table of Contents

Stock Based Compensation
 
 
We account for our stock based compensation in accordance with SFAS No. 123(R), Share Based Payments (“SFAS 123(R)”), which we adopted with our fresh start accounting date of July 2, 2005. Prior to that date, we had no stock based compensation and accordingly, we were not required to select a transition method upon our adoption of SFAS No. 123(R).
 
 
In order to calculate our stock based compensation expense, with the assistance of a third-party, we use the Black-Scholes option pricing model for our time-vested stock options and a Monte-Carlo simulation model for our performance-based stock options, which requires the use of subjective assumptions including:
 
Volatility — This is a measure of the amount by which a stock price has fluctuated or is expected to fluctuate. Due to our limited stock price history, expected volatility is based upon historical and implied volatility for other companies in the retail industry. An increase in the expected volatility will increase stock based compensation expense.
 
Risk-free interest rate — This is the U.S. Treasury yield curve in effect as of the grant date having a term equal to the expected term of the option. An increase in the risk-free interest rate will increase stock based compensation expense.
 
Expected term — This is the period of time over which the options granted are expected to remain outstanding and is based on estimated future exercise behavior. An increase in the expected term will increase stock based compensation expense. We currently estimate the weighted average expected option term for our stock options using the application of the simplified method set out in SEC Staff Accounting Bulletin No. 107 and SAB No. 110. The simplified method defines the life as the average of the contractual term of the options and the weighted average vesting period for all option tranches. We will continue to utilize this simplified method until we have sufficient historical exercise data to provide a reasonable basis to estimate the expected term.
 
Dividend yield — This is assumed to be zero as we do not have plans to pay dividends in the foreseeable future. An increase in the dividend yield will decrease stock based compensation expense.
 
Forfeitures — We estimate forfeitures of stock-based awards based on expected future activity and adjust our forfeiture rate on a quarterly basis as actual forfeitures occur. An increase in forfeitures results in a decrease to stock based compensation expense, which is recognized on a prospective basis over the remaining term of the option grant.
 
 
Different estimates of the above items could result in higher or lower amounts of stock based compensation expense recognized. Our stock based compensation expense for fiscal 2007, 2006 and 2005 was $9.9 million, $10.2 million and $3.6 million, respectively.
 
Valuation of Derivative Instruments
 
 
We value certain embedded features within our convertible notes as derivative liabilities. In accordance with SFAS 133, the embedded derivative must be recorded at fair value and adjusted to fair value each quarter with differences in the fair value from quarter to quarter reflected in our results of operations.


68


Table of Contents

 
We calculate the fair value of our embedded derivative liability associated with the conversion features within our convertible notes primarily using the Black-Scholes option pricing model, which requires the use of subjective assumptions including:
 
Volatility — This is a measure of the amount by which a stock price has fluctuated or is expected to fluctuate. Due to our limited stock price history, expected volatility is based upon historical and implied volatility for other companies in the retail industry in addition to the volatility of our common stock.
 
Risk-free interest rate — This is the U.S. Treasury yield curve in effect as of the end of the quarter having a term equal to the expected term of the conversion option.
 
Expected years to conversion — This is the period of time over which the conversion options within the convertible notes are expected to remain outstanding.
 
 
Different estimates of the above items could result in higher or lower estimates of the fair value of our embedded derivative liability related to the conversion options at the end of each quarter. Accordingly, different fair values could result in increases or decreases in the amounts we recognize within other income, net. We estimated the fair value of the conversion features to be $10.7 million as of December 29, 2007 and accordingly recognized $10.5 million within other income, net during fiscal 2007.
 
 
The rate of inflation over the past several years has not had a significant impact on our sales or profitability.
 
 
See Note 5 to our audited financial statements, which are included in this document, for a discussion of recent accounting pronouncements.
 
Related Party Transactions
 
We had no material related party transactions during fiscal 2007, 2006 or 2005.
 
 
See Note 20 to our audited financial statements, which are included in this document, for a discussion of material events occurring subsequent to December 29, 2007.
 
Item 7A.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
Our primary exposures to market risk relate to interest rates, changes in the value of our common stock and foreign exchange rates. We use certain derivative financial instruments, primarily interest rate swaps, to manage our interest rate risks. We do not use any derivatives to manage our foreign exchange risks. We do not use derivatives for trading purposes, to generate income or to engage in speculative activity.
 
 
We are exposed to interest rate risk associated with our revolving credit facility, the Amended Term Loan Agreement which we entered into in April 2007 and the convertible notes we issued in April 2007.


69


Table of Contents

 
Our revolving credit facility bears interest at variable rates based on LIBOR plus a spread. As of December 29, 2007, our availability was approximately $101.3 million and no amounts had been drawn under the senior secured revolving credit facility.
 
 
On April 4, 2007, we amended and restated the Prior Term Loan. In connection with the amendment and restatement, $48.8 million of the loans were prepaid, reducing the principal balance from $273.8 million to $225 million. As of December 29, 2007, the outstanding amount of our Amended Term Loan totaled $196.2 million; of which $166.2 million were in Eurodollar loans and $30.0 million were base rate loans. Interest on the Amended Term Loan is calculated as the greater of the prime rate or the Federal funds effective rate plus one-half of one percent plus 2.25% in the case of base rate loans, or LIBOR plus 3.25% for Eurodollar loans. Interest requirements for both base rate loans and Eurodollar loans are reset on a monthly basis. As of December 29, 2007, our Amended Term Loan had an interest rate of LIBOR of 4.83% plus 3.25%, for a total interest rate of 8.08% for Eurodollar loans and an interest rate of prime of 7.25% plus 2.25%, for a total interest rate of 9.50% for base rate loans. See “Management’s Discussion and Analysis of Financial Condition — Sources of Liquidity — Refinancing Transaction” for a more detailed description of our Amended Term Loan Agreement.
 
On April 4, 2007, we terminated our interest rate swap agreement that had been designated as a cash flow hedge of Amended Term Loan. We terminated the interest rate swap agreement as a result of the refinancing of our Amended Term Loan on April 4, 2007. Upon termination, we received $1.0 million in settlement of the interest rate swap and recognized a gain of $0.1 million within other income, net. Additionally, on April 5, 2007, we entered into a new interest rate swap agreement and designated the new interest rate swap agreement as a cash flow hedge of our refinanced $225 million Amended Term Loan which we executed on April 4, 2007. The new interest rate swap agreement had a notional amount of $99.3 million as of December 29, 2007 and effectively converts a portion of the outstanding amount under the Amended Term Loan, which has a floating-rate of interest to a fixed-rate by having us pay fixed-rate amounts in exchange for the receipt of the amount of the floating-rate interest payments. Under the terms of the interest rate swap agreement, a monthly net settlement is made for the difference between the fixed rate of 5.05% and the variable rate based upon the monthly LIBOR rate on the notional amount of the interest rate swap. The new interest rate swap agreement is scheduled to terminate in April 2012. Assuming a 10% increase in interest rates, the fair value of the new interest rate swap would be a liability of approximately ($2.6) million at December 29, 2007. Assuming a 10% decrease in interest rates, the fair value of the interest rate swap would be a liability of approximately ($5.6) million at December 29, 2007.
 
 
On April 4, 2007, we closed our offering of $75 million aggregate principal amount of convertible senior notes. The convertible notes have a maturity date of April 1, 2014 and pay interest at an annual rate of 5.25% unless earlier redeemed, repurchased or converted. Generally, the fair market value of fixed interest rate debt will increase as interest rates fall and decrease as interest rates rise.
 
 
Our convertible notes contain certain features that allow the holder to convert their notes into shares of our common stock upon the occurrence of certain conditions. See further discussion above under “Management’s Discussion and Analysis of Financial Condition — Sources of Liquidity — Refinancing Transaction” for a detailed description of the terms of conversion. The fair market value of the convertible notes is subject to market risk due to the convertible feature of the notes. The fair market value of the convertible notes will generally increase as the market price of our common stock increases and decrease as the market price falls.
 
As a result of the requirement that we settle any conversion of notes prior to the termination of the ownership limitations contained in our certificate of incorporation in cash, the conversion features contained


70


Table of Contents

within the convertible notes are deemed to be an embedded derivative under SFAS 133. In accordance with SFAS 133, the embedded derivative related to the conversion features requires bifurcation from the debt component of the convertible notes and a separate valuation. We recognize the embedded derivative as an asset or liability on our balance sheet and measure it at its estimated fair value, and recognize changes in its estimated fair value in other income, net in the period of change. We determine the estimated fair value of the embedded derivative primarily using the Black-Scholes model and other valuation methodologies which resulted in an estimated fair value of $21.2 million as of the issuance date for the convertible notes. The Black-Scholes model and other valuation methodologies are complex and require significant judgments. In applying the Black-Scholes model, changes and volatility in our common stock price and the stock price of other comparable retailers and changes in risk-free interest rates could significantly affect the fair value of this derivative instrument. We estimated the fair value of the conversion features to be $10.7 million as of December 29, 2007 and accordingly recognized $10.5 million within other income, net during fiscal 2007.
 
 
Our foreign currency risks relate primarily to stores that we operate in Canada and with our investments in Japan and Germany, for which we apply the equity method of accounting as we do not control these entities. Additionally, we have foreign currency risks associated with the purchase of merchandise from foreign entities. We believe that the potential exposure from foreign currency risks is not material to our financial condition or results of operations.
 
Item 8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
Information with respect to this item is set forth under Item 15.
 
Item 9.   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
 
None.
 
Item 9A.   CONTROLS AND PROCEDURES
 
 
As of December 29, 2007, the Company’s management, with participation of its Chief Executive Officer and Chief Financial Officer, reviewed and evaluated the effectiveness of the design and operation of the Company’s “disclosure controls and procedures” (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this report (the “Evaluation Date”). Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of the Evaluation Date, the Company’s disclosure controls and procedures are adequate and effective to reasonably assure that material information relating to the Company, including its consolidated subsidiaries, would be communicated to management by others within those entities in a timely manner to allow decisions to be made regarding required disclosure.
 
 
Management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15 (f) under the Securities Exchange Act of 1934. Internal control over financial reporting includes policies and procedures that provide reasonable assurance regarding the accuracy and reliability of financial reporting and the preparation of the Company’s financial statements to accurately and fairly reflect the transactions and dispositions of the Company’s assets; provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles; ensure that receipts and expenditures are being made only in accordance with the authorization of management; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisitions, use or disposition of the Company’s assets that could have a material effect on our financial statements. There are inherent limitations in the effectiveness of internal control over financial reporting, including the possibility that misstatements may not be prevented or


71


Table of Contents

detected. Accordingly, even the most effective internal controls over financial reporting can provide only reasonable assurances with respect to financial statement preparation. Furthermore, the effectiveness of internal controls can change with changes in circumstances.
 
In our report on Form 10-K for the fiscal year ended December 30, 2006, we reported under “Item 9A, Controls and Procedures,” that we had a number of material weaknesses. The identified weaknesses included several clerical errors and accounting errors, primarily related to the recording of complex “fresh start” accounting adjustments required as a result of Eddie Bauer’s emergence from bankruptcy. These errors originally went undetected due to insufficient in-house expertise necessary to provide sufficiently rigorous review. During the year ended December 29, 2007, management completed the corrective action necessary to remediate the material weaknesses discussed in the Form 10-K filed for the year ended December 30, 2006. Corrective action taken to remediate the previously disclosed material weaknesses included: implementing more rigorous financial closing procedures; hiring of qualified accounting and finance personnel with appropriate public company reporting expertise; and engaging external resources and other specialized experts, as needed, to assist management in the preparation of our consolidated financial statements. Management tested the operational effectiveness of the controls implemented to remediate the material weaknesses and has concluded that these controls are effective.
 
Management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework and criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that our internal control over financial reporting was effective as of December 29, 2007.
 
The effectiveness of the Company’s internal control over financial reporting as of December 29, 2007, has been audited by BDO Seidman LLP, an independent registered public accounting firm, as stated in their report which is included herein.
 
 
As disclosed in the Form 8-K filing dated November 13, 2007, the Company’s interim CFO resigned his position effective November 14, 2007. A new CFO was appointed as of the same date and has assumed the internal control duties of the interim CFO. Except as noted above, there have been no significant changes in our internal control over financial reporting during the three months ended December 29, 2007 that have materially affected or are reasonably likely to materially affect, our internal control over financial reporting.


72


Table of Contents

 
Board of Directors and Stockholders
Eddie Bauer Holdings, Inc.
Bellevue, Washington
 
We have audited Eddie Bauer Holdings, Inc.’s internal control over financial reporting as of December 29, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Eddie Bauer Holdings, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying “Item 9A, Management’s Report on Internal Control Over Financial Reporting”. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
 
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
 
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
 
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
In our opinion, Eddie Bauer Holdings, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 29, 2007, based on the COSO criteria.
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Eddie Bauer Holdings, Inc. as of December 29, 2007 and December 30, 2006 and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for the years ended December 29, 2007 and December 30, 2006 and the six month period ended December 31, 2005. We have also audited the accompanying combined statements of operations, stockholders’ equity and comprehensive income (loss) and cash flows of Eddie Bauer Holdings, Inc. and Related Operations (“Predecessor”) for the six month period ended July 2, 2005 and our report dated March 12, 2008 expressed an unqualified opinion thereon.
 
/s/  BDO Seidman, LLP
 
Seattle, Washington
March 12, 2008


73


Table of Contents

Item 9B.   OTHER INFORMATION
 
None.
 
 
Item 10.   DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
 
Except for the code of ethics information below, the information required for this Item will be included in our Proxy Statement relating to our 2008 annual meeting of stockholders, and is incorporated herein by reference. Our Proxy Statement will be filed within 120 days of December 29, 2007, our fiscal year end.
 
We have adopted a written code of ethics, the “Eddie Bauer Code of Business Conduct and Ethics,” that applies to all our employees, managers, officers, executive officers and the board of directors (including non-employee board members to the extent applicable) (collectively, the “Associates”). The code is posted on our website at http://www.eddiebauer.com. We will disclose any changes in or waivers from our code of ethics applicable to any Associate on our website at http://www.eddiebauer.com or by filing a Form 8-K.
 
Item 11.   EXECUTIVE COMPENSATION
 
Information required for this section will be included in our Proxy Statement relating to our 2008 annual meeting of stockholders and is incorporated herein by reference. Our Proxy Statement will be filed within 120 days of December 29, 2007, our fiscal year end.
 
Item 12.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
 
The information required for this Item will be included in our Proxy Statement relating to our 2008 annual meeting of stockholders and is incorporated herein by reference. Our Proxy Statement will be filed within 120 days of December 29, 2007, our fiscal year end.
 
Item 13.   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE
 
Information required for this Item will be included in our Proxy Statement relating to our 2008 annual meeting of stockholders and is incorporated herein by reference. Our Proxy Statement will be filed within 120 days of December 29, 2007, our fiscal year end.
 
Item 14.   PRINCIPAL ACCOUNTING FEES AND SERVICES
 
Information required for this Item will be included in our Proxy Statement relating to our 2008 annual meeting of stockholders and is incorporated herein by reference. Our Proxy Statement will be filed within 120 days of December 29, 2007, our fiscal year end.


74


 

 
 
Item 15.   EXHIBITS, FINANCIAL STATEMENT SCHEDULES
 
(a)   Index to Financial Statements
 
         
    Page
 
Financial Statements
       
    76  
    77  
    78  
    79  
    80  
    82  
    131  
Exhibits required as part of this report are listed in the Exhibit Index.
       


75


Table of Contents

 
 
Board of Directors and Stockholders
Eddie Bauer Holdings, Inc.
Bellevue, Washington
 
We have audited the accompanying consolidated balance sheets of Eddie Bauer Holdings, Inc. (“Successor”) as of December 29, 2007 and December 30, 2006 and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for the years ended December 29, 2007 and December 30, 2006 and the six month period ended December 31, 2005. We have also audited the accompanying combined statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows of Eddie Bauer Inc. and Related Operations (“Predecessor”) for the six month period ended July 2, 2005. In connection with our audits of the consolidated and combined financial statements, we have also audited the accompanying financial statement schedule for the years ended December 29, 2007 and December 30, 2006, and each of the six month periods ended December 31, 2005 and July 2, 2005. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule 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 and financial statement schedule 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, as well as evaluating the overall presentation of the financial statements and financial statement schedule. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the consolidated and combined financial statements referred to above present fairly, in all material respects, the financial position of Eddie Bauer Holdings, Inc. at December 29, 2007 and December 30, 2006, and the results of its operations and its cash flows for the years ended December 29, 2007 and December 30, 2006 and the six month period ended December 31, 2005, and the results of operations and cash flows of Eddie Bauer, Inc. and Related Operations for the six month period ended July 2, 2005 in conformity with accounting principles generally accepted in the United States of America.
 
Also, in our opinion, the financial statement schedule, when considered in relation to the basic consolidated financial statements as a whole, presents fairly, in all material respects, the information set forth therein.
 
As discussed in the notes to the consolidated and combined financial statements, during 2006, the Company adopted SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans and during 2007, the Company adopted FIN 48, Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109.
 
We also have audited in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Eddie Bauer Holdings, Inc.’s internal control over financial reporting as of December 29, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 12, 2008 expressed an unqualified opinion.
 
/s/  BDO Seidman, LLP
 
Seattle, Washington
March 12, 2008


76


Table of Contents

 
EDDIE BAUER HOLDINGS, INC.
 
 
                 
    Successor
    Successor
 
    As of
    As of
 
    December 29,
    December 30,
 
    2007     2006  
    ($ in thousands)  
 
Cash and cash equivalents
  $ 27,596     $ 53,174  
Restricted cash
    30,862        
Accounts receivable, less allowances for doubtful accounts of $983 and $1,274, respectively
    30,122       29,774  
Inventories
    158,223       153,778  
Prepaid expenses
    27,297       23,572  
Financing receivables
          45,978  
Deferred tax assets — current
          2,345  
                 
Total Current Assets
    274,100       308,621  
Property and equipment, net
    195,103       177,344  
Goodwill
    107,748       114,765  
Trademarks
    185,000       185,000  
Other intangible assets, net
    21,668       29,720  
Other assets
    27,813       24,490  
Deferred tax assets — noncurrent
          15,970  
                 
Total Assets
  $ 811,432     $ 855,910  
                 
Trade accounts payable
  $ 45,102     $ 40,092  
Bank overdraft
    12,915       13,622  
Accrued expenses
    107,036       100,460  
Deferred tax liabilities — current
    6,356        
Current liabilities related to securitization note
          41,380  
Current liabilities to Spiegel Creditor Trust
    30,870        
Current portion of long-term debt
          8,000  
                 
Total Current Liabilities
    202,279       203,554  
Deferred rent obligations
    39,118       18,935  
Unfavorable lease obligations, net
    3,693       4,679  
Deferred tax liabilities — noncurrent
    30,490        
Senior term loan
    196,162       266,500  
Convertible note and embedded derivative liability, net of discount of $19,629
    66,113        
Other non-current liabilities
    7,802       270  
Pension and other post-retirement benefit liabilities
    9,503       15,331  
                 
Total Liabilities
    555,160       509,269  
Commitments and Contingencies (See Note 17) 
               
Common stock:
               
$0.01 par value, 100 million shares authorized; 30,672,631 and 30,309,931 shares issued and outstanding as of December 29, 2007 and December 30, 2006, respectively
    307       303  
Treasury stock, at cost
    (157 )     (157 )
Additional paid-in capital
    588,302       578,402  
Accumulated deficit
    (336,818 )     (234,771 )
Accumulated other comprehensive income, net of taxes of $2,848 and $1,759, respectively
    4,638       2,864  
                 
Total Stockholders’ Equity
    256,272       346,641  
                 
Total Liabilities and Stockholders’ Equity
  $ 811,432     $ 855,910  
                 
 
The accompanying notes are an integral part of these consolidated and combined financial statements.


77


Table of Contents

 
EDDIE BAUER HOLDINGS, INC.
 
 
                                   
                Successor
      Predecessor
 
                Six
      Six
 
                Months Ended
      Months Ended
 
    Successor
    Successor
    December 31,
      July 2,
 
    Fiscal 2007     Fiscal 2006     2005       2005  
    ($ in thousands, except per share data)  
Net sales and other revenues
    1,044,353       1,013,447       593,711         465,723  
Costs of sales, including buying and occupancy
    630,853       603,171       337,318         259,536  
Impairment of indefinite-lived intangible assets
          117,584       40,000          
Selling, general and administrative expenses
    441,875       411,300       214,125         185,225  
                                   
Total operating expenses
    1,072,728       1,132,055       591,443         444,761  
Operating income (loss)
    (28,375 )     (118,608 )     2,268         20,962  
Interest expense
    26,698       26,928       11,064         761  
Other income, net
    23,695       3,031       1,919          
Equity in earnings (losses) of foreign joint ventures
    (1,147 )     (3,413 )     174         (95 )
                                   
Income (loss) from continuing operations before reorganization items and income tax expense
    (32,525 )     (145,918 )     (6,703 )       20,106  
Gain on discharge of liabilities
                        (107,559 )
Reorganization costs and expenses, net
                        13,686  
                                   
Income (loss) from continuing operations before income tax expense
    (32,525 )     (145,918 )     (6,703 )       113,979  
Income tax expense
    69,193       65,531       14,645         50,402  
                                   
Income (loss) from continuing operations
    (101,718 )     (211,449 )     (21,348 )       63,577  
Income (loss) from discontinued operations (net of income tax expense (benefit) of $0, $0, $0 and $(1,686), respectively)
          (534 )     (1,440 )       (2,661 )
                                   
Net income (loss)
  $ (101,718 )   $ (211,983 )   $ (22,788 )     $ 60,916  
                                   
Income (loss) per basic and diluted share:
                                 
Loss from continuing operations per share
  $ (3.33 )   $ (7.04 )   $ (0.71 )       n/a  
Loss from discontinued operations per
                                 
share
          (0.02 )     (0.05 )       n/a  
                                   
Net loss per share
  $ (3.33 )   $ (7.06 )   $ (0.76 )       n/a  
Weighted average shares used to compute income (loss) per share:
                                 
Basic
    30,524,191       30,012,896       29,995,092         n/a  
Diluted
    30,524,191       30,012,896       29,995,092         n/a  
 
The accompanying notes are an integral part of these consolidated and combined financial statements.


78


Table of Contents

 
EDDIE BAUER HOLDINGS, INC.
 
 
                                                                                         
                            Common
                                     
    Common
                      Stock
    Common
                               
    Stock
    Common
    Common
          Eddie
    Stock
                               
    Eddie
    Stock
    Stock
    Common
    Bauer,
    Eddie
                      Accumulated
       
    Bauer,
    Eddie
    EBFS
    Stock
    Holdings
    Bauer,
                Retained
    Other
       
    Inc.
    Bauer,
    Inc.
    EBFS
    Inc.
    Holdings
          Additional
    Earnings
    Comprehensive
       
    (# of
    Inc.
    (# of
    Inc.
    (# of
    Inc.
    Treasury
    Paid-In
    (Accumulated
    Income
       
    Shares)     ($)     Shares)     ($)     Shares)     ($)     Stock     Capital     Deficit)     (Loss)     Total  
    ($ in thousands)  
 
Predecessor
                                                                                       
Balances at January 1, 2005
    5,000     $ 500       1,000     $ 100                       $ 261,595     $ 31,437     $ (1,241 )   $ 292,391  
Comprehensive Loss:
                                                                                       
Net loss
                                                    (46,643 )           (46,643 )
Foreign currency translation adjustments, net of income taxes of $126
                                                          97       97