ETHAN ALLEN INTERIORS INC.
Management's Discussion and Analysis of Financial Condition and Results of
Operations ("MD&A") is designed to provide a reader of our financial statements
with a narrative from the perspective of our management on our financial
condition, results of operations, liquidity and certain other factors that may
affect our future results.
The MD&A is based upon, and should be read in conjunction with, our Consolidated Financial Statements and related Notes included under Item 8 of this Annual Report on Form 10-K.
Executive Overview Who We Are. Founded in 1932 and incorporated inDelaware in 1989, Ethan Allen is a leading interior design company and manufacturer and retailer of quality home furnishings. We are vertically integrated from design through delivery, affording our clientele a value proposition of style, quality and price. We offer complementary interior design service to our clients and sell a full range of furniture products and decorative accents through ethanallen.com and a network of approximately 300 design centers inthe United States and abroad. The design centers represent a mix of independent licensees and our own Company-operated retail segment. We own and operate nine manufacturing facilities, including three manufacturing plants, one sawmill, one rough mill and a lumberyard inthe United States and two manufacturing plants inMexico and one manufacturing plant inHonduras . Approximately 75% of our products are made in our North American plants. Business Model. Our business model is to maintain continued focus on (i) capitalizing on the strength of our interior design consultants in our retail design centers, (ii) investing in new technologies across key aspects of our vertically integrated business, (iii) utilizing ethanallen.com as a key marketing tool to drive traffic to our design centers, (iv) communicating our messages with strong advertising and marketing campaigns, and (v) leveraging the benefits of our vertical integration by maintaining a strong manufacturing capacity inNorth America .
Our competitive advantages arise from:
? providing fashionable high-quality products of the finest craftsmanship;
? offering complimentary design service through our motivated interior designer
network-wide;
? offering a wide array of custom products across our upholstery, case goods,
and accent product categories;
? use of technology in all aspects of the business; and
? leveraging our vertically integrated structure.
Our strategy has been to position Ethan Allen as a preferred brand offering
complimentary design service together with products of superior style, quality
and value to provide consumers with a comprehensive, one-stop shopping solution
for their home furnishing and interior design needs. In carrying out our
strategy, we continue to expand our reach to a broader consumer base through a
diverse selection of attractively priced products, designed to complement one
another, reflecting current fashion trends in home decorating. We continuously
monitor changes in home fashion trends through attendance at international
industry events and fashion shows, internal market research, and regular
communication with our retailers and design center design consultants who
provide valuable input on consumer trends. We believe that the observations and
input gathered enable us to incorporate appropriate style details into our
products to react quickly to changing consumer tastes.
Ongoing Evolution and Transformation. Our product offerings continue to evolve
and transform to meet the changing demands and tastes of our customers. We
refreshed approximately 70% of our entire product line over the past three
years. During fiscal 2020, we further strengthened our offerings with new
products including Lucy, a mid-century modern inspired upholstery collection
that launched very successfully, and Farmhouse, a country cottage inspired
furniture collection that just recently launched to strong reviews. Prior to
that, in fiscal 2019, we introduced our Relaxed Modern product line, a casual,
livable, inspired by nature, transitional design made of mixed materials as well
as expanded our Home & Garden collection. Our contract sales, including sales to
the GSA, hospitality and other commercial businesses, also continue to grow and
the GSA has become one of our ten largest customers. Our marketing programs
during the year were strong. In the second quarter we launched a marketing
program featuring a membership with special saving opportunities. In the third
quarter, with the effects of the pandemic accelerating, we pivoted our marketing
messaging to our core values centered on our quality and service, including
offering the opportunity for our customers to shop safely by appointment
in-store or online. We also implemented marketing geared to drive customers to
our online channels and to interact with our designers virtually, and as a
result, we have seen our internet business double during the past three months.
We plan for our marketing programs going forward to continue to focus on our
core values and the in-store or virtual professional services of our interior
design professionals.
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ETHAN ALLEN INTERIORS INC. AND SUBSIDIARIES Business Update Related to Impact of COVID-19. The ongoing COVID-19 health crisis continues to pose significant and widespread risk to our business as well as to the business environment and the markets in which we operate our business. We have already experienced significant disruption to our business as a result of the rapid development of the COVID-19 pandemic. The immediate impact from this global health crisis has been both direct in terms of disruption in numerous aspects of our business operations, including a 50.2% reduction in revenues during the fourth quarter, the furlough of approximately 70% of our global workforce onApril 1, 2020 , elimination of non-essential operating expenses which led to a 42.8% decline in expenses in the past three months and the borrowing of$100 million under our revolving credit facility as well as indirect in terms of the adverse effect on overall economic conditions. The magnitude and duration of the negative impact to our business from the COVID-19 pandemic cannot be predicted with certainty. In response to the COVID-19 pandemic, we have taken actions to tightly manage costs, working capital and capital expenditures to preserve the Company's financial health. We will continue to monitor the impact of COVID-19 on the Company's business, results of operations, financial position and cash flows. When the public health crisis posed by COVID-19 first broke out, we announced immediate actions to mitigate the impact, including temporary closures of our Company-operated retail design centers inNorth America , effectiveMarch 19, 2020 . As sales continued to decline, we also had to institute a number of measures to mitigate expenses and reduce costs. OnApril 1, 2020 , we announced our action plan in response to the COVID-19 health crisis. Measures taken included, among other things, the temporary closure of design centers and manufacturing facilities, the furlough of 70% of our global workforce, the decision by our CEO to temporarily forego his salary throughJune 30, 2020 , a temporary reduction in salaries of up to 40% for all senior management and up to 20% for other salaried employees throughJune 30, 2020 , a temporary reduction of 50% in the cash compensation of the Company's directors throughJune 30, 2020 , the elimination of all non-essential operating expenses, a delay of capital expenditures, the temporary suspension of the regular quarterly dividend and temporarily halted our share repurchase program. These efforts may not be sufficient to offset anticipated declines in revenue resulting from the persistent crisis and may negatively affect our ability to fully resume operations. In an effort to mitigate the impacts of the ongoing COVID-19 pandemic, we have also taken various actions to preserve our liquidity. As previously announced, inMarch 2020 , the Company drew down$100 million under our revolving credit facility and subsequently repaid$50 million inJune 2020 . As a result of the drawdown, we had an outstanding cash and cash equivalents balance of$72.3 million as ofJune 30, 2020 . Additionally, we reduced or stopped discretionary spending across all areas of the business. We have also negotiated alternative terms for lease payments and reduced merchandise purchases as we further manage to lower inventory carrying levels. The Company has planned reduced capital expenditures in fiscal 2021 as compared to the previous fiscal year with a primary focus on critical activities, such as maintenance capital and necessary technology investments. At this time, we believe that we have sufficient liquidity on hand to continue business operations and service our debt obligations during this volatile period. If the Company experienced another significant reduction in revenues, we would have additional alternatives to maintain liquidity, including further decreases in capital expenditures and cost reductions as well adjustments to our capital allocation policy. To date, we have halted our share repurchase program but reinstated our temporarily suspended quarterly dividend. Refer to the Liquidity and Capital Resources section for additional information. The global scale and scope of COVID-19 is unknown, and the duration of the business disruption and related financial impact cannot be reasonably estimated at this time. The extent to which the ongoing COVID-19 pandemic impacts our results will depend on future developments that are highly uncertain and cannot be predicted. For more information, refer to Item 1A, Risk Factors. Fiscal 2020 Financial Year in Review.(1) The impact of the COVID-19 crisis, which accelerated during our fiscal third quarter and caused the temporary closing of all of our North American design centers and most of our manufacturing inMarch 2020 and through most of our fourth quarter, had a significant negative impact on our fiscal 2020 financial results. Consolidated net sales were 21.0% lower in fiscal 2020 compared to the prior year. Net sales decreased by 23.5% within the wholesale segment and by 21.5% in the retail segment. Consolidated international net sales for fiscal 2020 decreased$17.0 million primarily due to lower sales toChina and inCanada . Our adjusted gross margin expanded 60 basis points to 55.7% due to improved retail price optimization and increased wholesale contract business partially offset by plant shutdowns from COVID-19. Adjusted operating income, which excludes pre-tax charges from restructuring initiatives, asset impairments and other corporate actions in both periods presented, decreased 69.0% in fiscal 2020 compared with a year ago primarily due to the$156.8 decline in consolidated net sales partially offset by a higher adjusted gross margin and a 12.6% decrease in adjusted operating expenses. The full year fiscal 2020 effective income tax rate was 37.3% compared with 24.1% in the prior year primarily due to recording a valuation allowance on deferred tax assets. Adjusted diluted EPS was$0.52 compared with$1.56 in the prior year. This decrease was primarily from net sales being negatively impacted as a result of the COVID-19 pandemic partially offset by expense management. As ofJune 30, 2020 , our balance sheet remains strong with cash and cash equivalents of$72.3 million and inventory of$126.1 million . During fiscal 2020, we generated$52.7 million of cash from operating activities, which provided us the ability to pay$21.5 million in regular quarterly cash dividends and repurchase$24.3 million in shares under our existing share repurchase program. Furthermore, we elected to draw down$100.0 million on our credit facility during fiscal 2020 to increase our cash position as a precautionary measure and to preserve financial flexibility in consideration of the disruption and uncertainty surrounding the ongoing COVID-19 pandemic. We subsequently repaid$50.0 million in June using available cash on hand, which leaves$50.0 million of outstanding borrowings on our balance sheet as ofJune 30, 2020 .
(1) Refer to the Regulation G Reconciliation of Non-GAAP Financial Measures
section within this MD&A for the reconciliation of
financial metrics.
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ETHAN ALLEN INTERIORS INC. AND SUBSIDIARIES Optimization of Manufacturing and Logistics. During the fourth quarter of fiscal 2019, we initiated restructuring plans to consolidate our manufacturing and logistics operations as part of an overall strategy to maximize production efficiencies and maintain our competitive advantage. We permanently ceased operations at ourPassaic, New Jersey property and ceased using most of ourOld Fort, North Carolina case goods manufacturing operations, which we transferred to our other existing case goods operations. We completed this optimization project in fiscal 2020 as we converted theOld Fort facility into a distribution center and expanded our existingMaiden, North Carolina manufacturing campus while finalizing severance and other exit costs. In connection with these initiatives, we recorded pre-tax restructuring and other exit charges totaling$2.1 million , consisting of$1.3 million in abnormal manufacturing variances associated with thePassaic andOld Fort facilities,$0.8 million in employee severance and other payroll and benefit costs and$0.7 million in other exit costs partially offset by$0.7 million in gains from the sale of property, plant and equipment held at ourOld Fort facility. As part of our optimization plans, we also completed the sale of ourPassaic property inSeptember 2019 to an independent third party and received$12.4 million in cash less certain adjustments, including$0.9 million in selling and other closing costs. As a result of the sale, we recognized a pre-tax gain of$11.5 million in fiscal 2020. Retail Segment Restructuring and Impairment Charges. During fiscal 2020 we recorded$7.7 million of restructuring and impairment charges within the retail segment. Approximately$5.2 million was an impairment charge for long-lived assets held at a number of our retail design centers. An additional$2.5 million represented remaining contractual obligations under leased space that was exited during fiscal 2020. Inventory Write-downs. During fiscal 2020 we recorded a non-cash charge of$4.1 million related to the write-down and disposal of certain slow moving and discontinued inventory items, which was due to actual demand and forecasted market conditions for these inventory items being less favorable than originally estimated. Of the total inventory write-down,$3.5 million related to slow moving finished goods with the remaining$0.6 million consisting of raw materials that were disposed. CARES Act. OnMarch 27, 2020 , the Coronavirus Aid, Relief, and Economic Security Act (the "CARES Act") was signed into law. The CARES Act provides numerous tax provisions and other stimulus measures, including temporary suspension of certain payment requirements for the employer-paid portion of social security taxes, the creation of certain refundable employee retention credits, and technical corrections from prior tax legislation for tax depreciation of certain qualified improvement property. We elected to defer the employer-paid portion of social security taxes beginning with pay dates on and afterMarch 12, 2020 . We recorded an estimate for refundable employee retention credits for eligible wages paid to employees affected by the cessation of our operations. We also recorded additional employee retention credits during the fourth quarter of 2020 for additional wages paid, primarily for health care benefits paid for employees furloughed in fiscal 2020. Leases. We adopted Accounting Standards Update 2016-02, Leases (Topic 842), as ofJuly 1, 2019 using the modified retrospective method and have not restated comparative periods. Upon adoption, we recognized operating lease assets of$129.7 million and operating lease liabilities of$149.7 million on our consolidated balance sheet. In addition,$20.0 million of deferred rent and various lease incentives, which were reflected as other long-term liabilities as ofJune 30, 2019 , were reclassified as a component of the right-of-use assets upon adoption. We also recognized a cumulative adjustment as ofJuly 1, 2019 , which decreased opening retained earnings by$1.6 million due to the impairment of certain right-of-use assets. The adoption of the new standard did not have a material impact on the consolidated statements of operations or cash flows during fiscal 2020. 29
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ETHAN ALLEN INTERIORS INC. AND SUBSIDIARIES Key Operating Metrics
A summary of our key operating metrics is presented in the following table ($ in millions, except per share amounts).
Fiscal Year Ended June 30,
2020 % of Sales % Chg 2019 % of Sales % Chg 2018 % of Sales % Chg
Net sales $ 589.8 100.0 % (21.0 %) $ 746.7 100.0 % (2.6 %) $ 766.8 100.0 % 0.4 %
Gross profit $ 323.1 54.8 % (21.1 %) $ 409.5 54.8 % (1.6 %) $ 416.0 54.2 % (0.9 %)
Adjusted gross
profit(1) $ 328.6 55.7 % (20.2 %) $ 411.5 55.1 % (1.1 %) $ 416.0 54.2 % (2.4 %)
Operating
income $ 14.6 2.5 % (56.9 %) $ 33.9 4.5 % (30.5 %) $ 48.9 6.4 % (15.7 %)
Adjusted
operating
income(1) $ 17.1 2.9 % (69.0 %) $ 55.1 7.4 % 9.8 % $ 50.1 6.5 % (22.8 %)
Net income $ 8.9 1.5 % (65.4 %) $ 25.7 3.4 % (29.3 %) $ 36.4 4.7 % 0.5 %
Adjusted net
income(1) $ 13.5 2.3 % (67.5 %) $ 41.6 5.6 % 11.6 % $ 37.3 4.9 % (8.2 %)
Diluted EPS $ 0.34 (64.6 %) $ 0.96 (27.3 %) $ 1.32 2.3 %
Adjusted
diluted EPS(1) $ 0.52 (66.7 %) $ 1.56 15.6 % $ 1.35 (6.9 %)
Cash flow from
operating
activities $ 52.7 (4.6 %) $ 55.2 30.0 % $ 42.5 (46.0 %)
(1) Refer to the Regulation G Reconciliation of Non-GAAP Financial Measures
section within this MD&A for the reconciliation of
financial metrics.
The components of consolidated net sales and operating income (loss) by business segment are presented in the following table ($ in millions):
Fiscal Year Ended June 30,
2020 2019 2018
Net sales
Wholesale segment $ 337.9 $ 441.6 $ 475.7
Retail segment 462.8 589.8 587.5
Elimination of intersegment sales (210.9 ) (284.7 ) (296.4 )
Consolidated net sales $ 589.8 $ 746.7 $ 766.8
Operating income (loss):
Wholesale segment $ 33.1 $ 42.4 $ 48.5
Retail segment (21.4 ) (10.5 ) (1.7 )Elimination of intercompany profit(1) 2.9 2.0 2.1 Consolidated operating income
$ 14.6 $ 33.9 $ 48.9
(1) Represents the change in wholesale profit contained in the retail segment
inventory existing at the end of the period.
A summary by segment changes from the applicable periods in the preceding fiscal year is presented in the following table:
Fiscal Year Ended June 30,
2020 2019 2018
Wholesale segment:
Net sales (23.5 %) (7.2 %) 4.9 %
Operating income (22.1 %) (12.4 %) (9.4 %)
Wholesale orders (17.9 %) (10.8 %) 5.8 %
Retail segment:
Net sales (21.5 %) 0.4 % (2.7 %)
Operating income (103.4 %) (505.8 %) (245.1 %)
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ETHAN ALLEN INTERIORS INC. AND SUBSIDIARIES
The following table shows selected design center location information.
Fiscal 2020 Fiscal 2019
Independent Company- Independent Company-
retailers operated Total retailers operated Total
Retail Design Center
activity:
Balance at July 1 158 144 302 148 148 296
New locations 13 9 22 21 3 24
Closures (10 ) (10 ) (20 ) (9 ) (9 ) (18 )
Transfers (1 ) 1 - (2 ) 2 -
Balance at June 30 160 144 304 158 144 302
Relocations (in new
and closures) 1 7 8 - 3 3
Retail Design Center geographic
locations:
United States 35 138 173 40 138 178
Canada - 6 6 - 6 6
China 107 - 107 100 - 100
Other Asia 11 - 11 11 - 11
Europe 1 - 1 1 - 1
Middle East 6 - 6 6 - 6
Total 160 144 304 158 144 302
Results of Operations
For an understanding of the significant factors that influenced our financial
performance in fiscal 2020 compared with fiscal 2019, the following discussion
should be read in conjunction with the consolidated financial statements and
related notes presented under Item 8 in this Annual Report on Form 10-K ($ in
millions, except per share amounts).
Fiscal 2020 Compared to Fiscal 2019
Consolidated net sales for fiscal 2020 were$589.8 million , a decrease of 21.0% compared with the same prior year period. Net sales decreased by 23.5% within the wholesale segment and by 21.5% in the retail segment. International sales decreased$17.0 million primarily related to lower sales toChina and inCanada . Consolidated net sales were 21.0% lower in the current year primarily due to the disruptions in the market caused by the ongoing COVID-19 pandemic and lower written orders when a new marketing program featuring a membership was just getting underway. Partially offsetting these declines was growth in contract sales, which grew 31.6%. The year over year increase in contract sales was attributable to continued growth in sales from the GSA contract. Wholesale net sales decreased 23.5% to$337.9 million primarily due to a 33.3% decrease in sales to the Company's North American retail network and a 38.3% decrease in international sales. Our international net sales to independent retailers was 5.7% of our wholesale net sales compared to 7.0% last year. Wholesale net sales were significantly impacted in fiscal 2020 due to COVID-19-related disruptions and a new marketing program featuring a membership, which caused a dip in orders and subsequent shipments during this marketing transition period. Prior toMarch 2020 , wholesale net sales were improving sequentially each month as customer demand increased. However, due to the disruptions caused by COVID-19 design center and manufacturing plant closings, net shipments decreased 52.0% in the fourth quarter of fiscal 2020, leading to the full fiscal year decrease in net sales of 23.5%. Partially offsetting the net sales decline was growth in our contract sales, which grew 31.6%. This increase was attributable to continued growth in sales from the GSA contract. Wholesale orders booked, which represents orders booked through all of our channels, were down 17.9% in fiscal 2020 compared with last fiscal year. Wholesale orders from our North American retail network declined 30.5% while orders fromChina dropped 37.9% from a year ago mainly due to COVID-19 stay-at-home orders, the imposition of tariffs byChina and the economic uncertainty surrounding the international trade disputes. Excluding orders fromChina , our total wholesale orders decreased 17.0%, primarily as the result of the closing of our retail design centers and manufacturing operations for multiple months. These decreases were partially offset by continued growth in our contract business, including the GSA contract. While wholesale orders decreased 17.9% from a year ago, the Company realized sequential improvement in orders each month during the fourth quarter of fiscal 2020, with June orders increasing by 17% year over year. We are focused on our short-term ability to return our wholesale production and shipping to the levels that are necessary to properly service our customers. 31 --------------------------------------------------------------------------------
ETHAN ALLEN INTERIORS INC. AND SUBSIDIARIES Retail net sales from Company-operated design centers decreased 21.5% to$462.8 million . There was a 21.4% decrease in net sales inthe United States , while sales from our Canadian design centers decreased 26.0%. These decreases were primarily due to the temporary closing of our North American design centers for almost three months during fiscal 2020 due to COVID-19, and lower written orders in the second quarter when a new marketing program featuring a membership was just getting underway ahead of the COVID-19 pandemic. In response to COVID-19, we temporarily closed all of our retail design centers inNorth America , effectiveMarch 19, 2020 . We gradually began reopening our design centers in May and as ofJune 30, 2020 , have reopened all of our Company-operated retail design centers, including 14% open by appointment only. We continued to generate written business through virtual appointments while our design centers were closed. However, the level of new business was significantly lower due to economic uncertainty as people sheltered at home. There were 144 Company-operated design centers at the end of fiscal 2020, the same number we ended last year with. We continue to relocate and open new locations while closing older locations. During fiscal 2020, we relocated seven Company-operated design centers, acquired one from an independent retailer and opened two new locations. Gross profit decreased 21.1% to$323.1 million compared with the prior year period due to sales declines within both the wholesale and retail segments. Retail sales, as a percentage of total consolidated sales, were 78.5% in the current year and 79.0% in the prior year. Wholesale gross profit was negatively impacted by lower sales volumes combined with a reduction in gross margin due to plant shutdowns related to the ongoing COVID-19 pandemic. Retail gross profit was lower due to a 21.5% reduction in net shipments partially offset by a higher gross margin. Fiscal 2020 adjusted gross margin was 55.7% compared with 55.1% a year ago. This increase was primarily due to improved retail price optimization and increased wholesale contract business. Restructuring charges negatively impacted the fiscal 2020 consolidated gross margin by 90 basis points compared with 30 basis points a year ago. Operating expenses decreased to$308.5 million compared with$375.5 million in the prior year period. The 17.9% decrease was due to lower selling costs, a reduction in general and administrative expenses and a gain of$11.5 million from the sale of thePassaic property during fiscal 2020. Retail selling expenses were lower due to reduced volume of shipments, less designer selling expenses and lower compensation due to headcount reductions. Wholesale selling costs were down due to a reduction in advertising spend and lower compensation costs. General and administrative expenses decreased due to lower compensation costs coupled with lower depreciation, occupancy costs and regional management charges. Restructuring and impairment charges incurred during fiscal 2020 was a benefit of$3.0 million compared to a charge of$18.7 million last year. Operating income totaled$14.6 million compared with$33.9 million for the prior year period. The decrease in operating income was driven by the$156.8 decline in consolidated net sales partially offset by a 17.9% decrease in operating expenses. Adjusted operating income in fiscal 2020 was$17.1 million compared with$55.1 million last year. Wholesale operating income totaled$33.1 million , or 9.8% of net sales, as compared to$42.5 million at 9.6% of net sales in the prior year. The 22.1% decrease was primarily due to the 23.5% decrease in wholesale net sales and a 130 basis point reduction in gross margin partially offset by operating expense reductions of 28.4% from the gain on the sale of thePassaic property, COVID-19 related plant closings and actions taken to control and minimize expenditures. The decrease in gross margin was largely due to plant shutdowns from COVID-19. Retail operating loss was$21.4 million , or 4.6% of sales for fiscal 2020, compared to a loss of$10.5 million , or 1.8% of sales, for fiscal 2019. The retail operating margin decreased to -4.6% from -1.8% due to the$127.0 million reduction in net sales partially offset by a 160 basis point improvement in gross margin and a 14.2% decrease in operating expenses from lower selling, administrative, occupancy and regional management costs. Retail restructuring and impairment charges lowered retail operating income by$7.7 million during fiscal 2020 compared to$12.3 million a year ago. Income tax expense was$5.3 million for fiscal 2020 compared with$8.2 million a year ago. The effective tax rate for fiscal 2020 includes a provision for income taxes on the current year's income including federal, state, foreign and local income taxes, tax and interest expense on various uncertain tax positions, and tax expense on the establishment and maintenance of a valuation allowance on Retail deferred tax assets, partially offset by the reversal of various uncertain tax positions. The effective tax rate for the prior fiscal year includes a provision for income taxes on that year's income, tax expense on the establishment and maintenance of a valuation allowance on Canadian deferred tax assets and tax and interest expense on uncertain tax position, partially offset by the reversal of and recognition of various uncertain tax positions. Income tax expense was$2.9 million lower in fiscal 2020 compared with a year ago primarily due to the$19.7 million decrease in income before income taxes partially offset by a higher effective tax rate. The fiscal 2020 effective rate increased to 37.3% compared with 24.1% in the prior year primarily due to a valuation allowance on deferred tax assets. We recorded a valuation allowance during the fourth quarter of fiscal 2020 in the amount of$2.5 million on the deferred tax assets. 32
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ETHAN ALLEN INTERIORS INC. AND SUBSIDIARIES Net income was$8.9 million compared with$25.7 million for the prior year, which resulted in$0.34 per diluted share compared to$0.96 in the prior year period. Fiscal 2020 restructuring and impairment charges along with other corporate actions during the year totaled$4.6 million (net of tax), which lowered diluted EPS by$0.18 . Fiscal 2019 was negatively impacted by restructuring and impairment charges combined with other corporate actions of$15.9 million (net of tax), which lowered diluted EPS by$0.60 . Adjusted diluted EPS of$0.52 in the current year represents a decrease of 66.7% over the prior year of$1.56 . Lower net income and diluted EPS was primarily from net sales being negatively impacted from the COVID-19 pandemic partially offset by expense management.
Fiscal 2019 Compared to Fiscal 2018
For a comparison of our results of operations for the fiscal years endedJune 30, 2019 and 2018, see Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, of our Annual Report on Form 10-K for the fiscal year endedJune 30, 2019 , filed with theSEC onAugust 9, 2019 .
Regulation G Reconciliations of Non-GAAP Financial Measures
To supplement the financial measures prepared in accordance with generally
accepted accounting principles in
These non-GAAP measures are derived from the consolidated financial statements but are not presented in accordance withU.S. GAAP. We believe these non-GAAP measures provide a meaningful comparison of our results to others in our industry and our prior year results. Investors should consider these non-GAAP financial measures in addition to, and not as a substitute for, our financial performance measures prepared in accordance withU.S. GAAP. Moreover, these non-GAAP financial measures have limitations in that they do not reflect all the items associated with the operations of the business as determined in accordance withU.S. GAAP. Other companies may calculate similarly titled non-GAAP financial measures differently than we do, limiting the usefulness of those measures for comparative purposes.
Despite the limitations of these non-GAAP financial measures, we believe these adjusted financial measures and the information they provide are useful in viewing our performance using the same tools that management uses to assess progress in achieving our goals. Adjusted measures may also facilitate comparisons to our historical performance.
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The following tables below show a reconciliation of non-GAAP financial measures
used in this filing to the most directly comparable
(in thousands, except per share data) Fiscal Year Ended June
30,
2020 2019 % Change
Consolidated Adjusted Gross Profit / Gross Margin
GAAP Gross profit $ 323,132 $ 409,491 (21.1 %)
Adjustments (pre-tax) * 5,423 1,994
Adjusted gross profit *$ 328,555 $ 411,485 (20.2 %) Adjusted gross margin * 55.7 %
55.1 %
Adjusted Operating Income / Operating Margin GAAP Operating income$ 14,644 $ 33,947 (56.9 %) Adjustments (pre-tax) * 2,428
21,104
Adjusted operating income *$ 17,072 $ 55,051 (69.0 %) Consolidated Net sales$ 589,837 $ 746,684 (21.0 %) GAAP Operating margin 2.5 % 4.5 % Adjusted operating margin * 2.9 % 7.4 % Consolidated Adjusted Net Income / Adjusted Diluted EPS GAAP Net income$ 8,900 $ 25,698 (65.4 %) Adjustments, net of tax * 4,612 15,934 Adjusted net income$ 13,512 $ 41,632 (67.5 %) Diluted weighted average common shares 26,069 26,751 GAAP Diluted EPS $ 0.34 $ 0.96 (64.6 %) Adjusted diluted EPS * $ 0.52 $ 1.56 (66.7 %)
Wholesale Adjusted Operating Income / Adjusted Operating Margin Wholesale GAAP operating income
$ 33,106 $ 42,481 (22.1 %) Adjustments (pre-tax) * (5,794 )
8,498
Adjusted wholesale operating income *
(46.4 %)
Wholesale net sales $ 337,948 $ 441,551 (23.5 %)
Wholesale GAAP operating margin 9.8 % 9.6 %
Adjusted wholesale operating margin * 8.1 % 11.5 %
Retail Adjusted Operating Income / Adjusted Operating Margin
Retail GAAP operating income (loss)
(103.4 %)
Adjustments (pre-tax) * 8,222 12,606
Adjusted retail operating income (loss) *
nm
Retail net sales $ 462,800 $ 589,829 (21.5 %)
Retail GAAP operating margin (4.6 %) (1.8 %)
Adjusted retail operating margin * (2.9 %) 0.4 %
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ETHAN ALLEN INTERIORS INC. AND SUBSIDIARIES
* Adjustments to reported U.S. GAAP financial measures including gross profit
and margin, operating income and margin, net income, and diluted EPS have been
adjusted by the following:
(in thousands) Fiscal Year Ended June 30,
2020 2019
Inventory write-downs and additional reserves
(wholesale) $ 4,107 $ -
Manufacturing overhead costs and other (wholesale) 1,316 1,994
Adjustments to gross profit$ 5,423
Inventory write-downs and additional reserves (wholesale)$ 4,107 $ - Optimization of manufacturing and logistics (wholesale) 2,147
8,324
Gain on sale ofPassaic, New Jersey property (wholesale) (11,497 ) - Employee retention credit (wholesale) (1,177 ) - Severance and other professional fees (wholesale) 626 174 Retail acquisition costs, severance and other charges (retail) 553 556
Impairment of long-lived assets and lease exit costs (retail)
7,669 12,050
Adjustments to operating income$ 2,428 $ 21,104 Adjustments to income before income taxes$ 2,752 $ 21,104 Related income tax effects on non-recurring items(1) (674 ) (5,170 ) Income tax expense from valuation allowance 2,534 - Adjustments to net income$ 4,612 $ 15,934
(1) Calculated using a tax rate of 24.5% in all periods presented.
Liquidity AtJune 30, 2020 , we held cash and equivalents of$72.3 million compared with$20.8 million atJune 30, 2019 . Our principal sources of liquidity include cash and cash equivalents, cash flow from operations and amounts available under our credit facility. Cash and cash equivalents aggregated to 11.6% of our total assets atJune 30, 2020 , compared with 4.1% of our total assets a year ago. Our cash and cash equivalents increased$51.5 million during fiscal 2020 due to net borrowings on our revolving credit facility of$50.0 million , net cash provided by operating activities of$52.7 million and net proceeds from the sale of ourPassaic property of$11.7 million , partially offset by$24.3 million in share repurchases,$21.5 million in dividend payments,$15.7 million of capital expenditures and$1.3 million from retail acquisitions. A summary of net cash provided by (used in) operating, investing and financing activities for each of the last three fiscal years is provided below (in millions): Fiscal Year Ended June 30, 2020 2019 2018 Operating activities Net income $ 8.9 $ 25.7 $ 36.4 Non-cash operating lease cost 32.0 - - Other non-cash items, including depreciation and amortization 22.6 37.0 20.6 Restructuring payments (9.1 ) (2.5 ) - Change in working capital (1.7 ) (5.0 ) (14.5 ) Total provided by operating activities $ 52.7 $ 55.2 $ 42.5 Investing activities Capital expenditures $ (15.7 ) $ (9.1 )$ (12.5 ) Acquisitions, net of cash acquired (1.4 ) (0.5 ) (6.3 ) Proceeds from the disposal of property, plant and equipment 12.4 - 0.3 Other investing activities 0.1 0.1 0.3 Total (used in) investing activities $ (4.6 ) $ (9.5 )$ (18.2 ) Financing activities Borrowings from revolving credit facility $ 100.0 $ 16.0 $ - Payments on borrowings (50.0 ) (16.0 ) (13.8 ) Purchases and retirements of company stock (24.3 ) - (23.1 ) Payment of cash dividends (21.5 ) (47.0 ) (29.5 ) Other financing activities (0.5 ) (0.3 ) (0.5 ) Total provided by (used in) financing activities $ 3.7$ (47.3 ) $ (66.9 ) 35
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ETHAN ALLEN INTERIORS INC. AND SUBSIDIARIES Cash Provided By (Used in) Operating Activities. Fiscal 2020 cash generated from operations totaled$52.7 million , a decrease of$2.5 million from the prior year primarily due to higher restructuring payments made in connection with our previously announced optimization of manufacturing and logistics activities as well as other exit costs partially offset by improved working capital changes. The change in working capital was primarily due to higher retail customer deposits, a reduction in inventory levels from the concerted effort to minimize carrying costs, improved receivable collections and the deferral and abatement of$2.7 million in retail design center rent. These cash flow benefits were partially offset by the timing of accounts payable and accrued expenses. As a result of fiscal 2020 adoption of the new leasing standard, we now report non-cash operating lease costs as a non-cash adjustment to reconcile to net income while our monthly lease payments are reported as a reduction to operating lease liabilities within working capital. Restructuring payments included$2.5 million in severance,$1.3 million of manufacturing overhead costs and$5.3 million in other exit and relocation payments. Cash Provided by (Used in) Investing Activities. Fiscal 2020 cash used in investing activities was$4.6 million , a decrease from$9.5 million last year due to cash proceeds of$12.4 million received from the sale of thePassaic property and other manufacturing equipment partially offset by higher capital expenditures and design center acquisitions. Cash paid to acquire design centers from our independent retailers in arm's length transactions totaled$1.4 million during fiscal 2020 compared with$0.5 million a year ago. Capital expenditures were$15.7 million , an increase of$6.6 million compared with$9.1 million spent a year ago. In fiscal 2020, approximately 53% of our total capital expenditures related to opening new and relocating design centers in desirable locations, updating existing design center presentations and floor plans and opening new home delivery centers. The remaining 47% was capital expenditures incurred in connection with the previously announced optimization project as well as investments in additional technology to improve existing workflows. Cash Provided By (Used in) Financing Activities. Fiscal 2020 total cash provided by financing activities was$3.7 compared with cash used of$47.3 million in the prior year comparable period. The significant increase in cash provided by financing activities was due to borrowings of$100.0 million under our revolving credit facility inMarch 2020 and a decrease in cash dividends paid due to a special dividend paid in the prior year. Cash dividends paid in fiscal 2020 totaled$21.5 million compared with$47.0 million in the prior year due to the$1.00 per share or$26.7 million special cash dividend paid in the prior year. We had suspended our regular quarterly cash dividend as ofApril 28, 2020 , due to the COVID-19 impact. However, onAugust 4, 2020 , our Board of Directors reinstated the regular quarterly cash dividend. Our policy is to issue quarterly dividends, and we expect to continue to declare and pay comparable quarterly dividends for the foreseeable future, business conditions permitting. These positive cash flow items were partially offset by the partial repayment of outstanding debt and share repurchases in the current fiscal year. InJune 2020 we repaid 50% or$50.0 million of our outstanding borrowings using available cash on hand. In addition, we repurchased 1,538,363 shares under our existing share repurchase program at an average price of$15.81 per share for a total cash outflow of$24.3 million during fiscal 2020. We believe our liquidity (cash on hand, cash flow from operating activities and amounts available under our credit facility), will be sufficient to fund our operations, including changes in working capital, necessary capital expenditures, fiscal 2021 contractual obligations as presented in our contractual obligations table and other financing activities, as they occur, for at least the next 12 months. During the period of uncertainty and volatility related to the COVID-19 pandemic, we will continue to monitor our liquidity. Included in our cash and cash equivalents atJune 30, 2020 , is$3.4 million held by foreign subsidiaries, a portion of which we have determined to be indefinitely reinvested. For a discussion of our liquidity and capital resources as of and our cash flow activities for the fiscal year endedJune 30, 2019 and 2018, see Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, of our Annual Report on Form 10-K for the fiscal year endedJune 30, 2019 , filed with theSEC onAugust 9, 2019 . Capital Resources Capital Expenditures. Capital expenditures in fiscal 2020 were$15.7 million compared with$9.1 million in the prior year period. The increase of$6.6 million from the prior year related primarily to incremental spending on retail design center improvements and completion of our optimization project. In fiscal 2020, approximately 53% of our total capital expenditures related to opening new and relocating design centers in desirable locations, updating existing design center presentations and floor plans and opening new retail home delivery centers. The remaining 47% was primarily capital expenditures incurred in connection with our optimization project as we converted theOld Fort, North Carolina facility into a distribution center and expanded our existingMaiden, North Carolina manufacturing campus. In fiscal 2019, approximately 65% of our total capital expenditures were within the retail segment. We have no material contractual commitments outstanding for future capital expenditures. We anticipate that cash from operations will be sufficient to fund future capital expenditures. 36
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ETHAN ALLEN INTERIORS INC. AND SUBSIDIARIES Capital Needs. DuringDecember 2018 we entered into a five-year,$165 million senior secured revolving credit facility, which amended and restated the previously existing facility. DuringMarch 2020 , we borrowed a total of$100 million under the credit facility and byJune 30, 2020 had repaid$50 million from available cash. Prior to March, there were no borrowings outstanding under the credit facility. The outstanding borrowings of$50 million bear a weighted average interest rate of 1.7%, which is equal to the one-month LIBOR rate plus a spread using a debt leverage pricing grid. Interest on the borrowings outstanding is payable monthly in arrears and the principal balance is payable on the maturity date ofDecember 21, 2023 . We are in compliance with all covenants under the agreement as ofJune 30, 2020 . The credit facility will mature inDecember 2023 . We elected to draw down on the credit facility to increase our cash position as a precautionary measure and to preserve financial flexibility in consideration of the disruption and uncertainty surrounding the ongoing COVID-19 pandemic. The outstanding borrowings of$50 million are reported as Long-term debt within the consolidated balance sheet atJune 30, 2020 .
To partially fund the special cash dividend paid to shareholders in
For a detailed discussion of revolving credit facility, our debt obligations and timing of our related cash payments see Note 11 to the consolidated financial statements included under Part II, Item 8 of this Annual Report on Form 10-K.
Letters of Credit. At
Total availability under the revolving credit facility was$58.9 million atJune 30, 2020 and$158.9 million atJune 30, 2019 . At bothJune 30, 2020 and 2019, respectively, we were in compliance with all the covenants under the revolving credit facility. For a discussion of our liquidity and capital resources as of and our cash flow activities for the fiscal year endedJune 30, 2019 and 2018, see Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, of our Annual Report on Form 10-K for the fiscal year endedJune 30, 2019 , filed with theSEC onAugust 9, 2019 . Share Repurchase Program OnJanuary 13, 2020 , our Board of Directors authorized an increase in the aggregate share repurchase authorization under our existing multi-year share repurchase program (the "Share Repurchase Program") to 3,000,000 shares. We repurchased 1,538,363 shares under the program during fiscal 2020 at an average price of$15.81 per share. There were no share repurchases under the program during fiscal 2019. As ofApril 1, 2020 , as part of our COVID-19 action plan, we temporarily halted our share repurchase program. AtJune 30, 2020 , we had a remaining Board authorization to repurchase 2,007,364 shares of our common stock pursuant to our program. Contractual Obligations Fluctuations in our operating results, levels of inventory on hand, the degree of success of our accounts receivable collection efforts, the timing of tax and other payments, as well as necessary capital expenditures to support growth of our operations will impact our liquidity and cash flows in future periods. The effect of our contractual obligations on our liquidity and capital resources in future periods should be considered in conjunction with the factors mentioned here. As ofJune 30, 2020 , we had total contractual obligations of$233.4 million , an increase from$207.0 million a year ago. As disclosed earlier in the Capital Resources section of this MD&A, we borrowed$100.0 million under our revolving credit facility during the third quarter of fiscal 2020, of which we repaid$50.0 million during June. The principal loan balance of$50.0 million remains outstanding as ofJune 30, 2020 and is payable on the maturity date ofDecember 21, 2023 . Our operating lease obligations decreased from$169.9 million last year to$149.7 million atJune 30, 2020 due to monthly lease payments made to landlords and the exiting of certain retail leased spaces during fiscal 2020 partially offset by new leases and modifications entered into throughout the fiscal year. 37
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ETHAN ALLEN INTERIORS INC. AND SUBSIDIARIES
The following table summarizes our significant contractual obligations as of
June 30, 2020 and the corresponding impact that these obligations will have on
our liquidity and cash flows in future periods (in millions):
Payments Due by Period
Less than 1-3 4-5 More than
Total 1 Year Years Years 5 Years
Operating leases(1) $ 149.7 $ 32.1 $ 49.0 $ 29.4 $ 39.1
Financing leases(2) 0.6 0.5 0.1 - -
Long-term debt(3) 50.0 - - 50.0 -
Purchase obligations(4) 32.9 30.9 2.0 - -
Other long-term liabilities 0.2 - - - 0.2
Total contractual obligations(5)
(1) We enter into operating leases in the normal course of business. Most lease
arrangements provide us with the option to renew the leases at defined terms.
The table above includes future obligations for renewal options that are
reasonably certain to be exercised and are included in the measurement of the
lease liability. Amounts above do not include future lease payments under
leases that have not commenced or estimated contingent rent due under
operating and finance leases. For more information on our operating leases,
see Note 6, Leases, in the notes to the Consolidated Financial Statements
included in Item 8 of this Annual Report on Form 10-K.
(2) Financing lease obligations include all future payment obligations under a
lease classified as a financing lease pursuant to FASB ASU 2016-02.
(3) Debt obligations mean all payment obligations under long-term borrowings. As
of
revolving credit facility. Further discussion of our contractual obligations
associated with long-term debt can be found in Note 11, Debt, in the notes to
the Consolidated Financial Statements included in Item 8 of this Annual
Report on Form 10-K.
(4) Purchase obligations are defined as agreements that are enforceable and
legally binding that specify all significant terms, including fixed or
minimum quantities to be purchased; fixed, minimum or variable price
provisions; and the approximate timing of the transaction. We do, in the
normal course of business, regularly initiate purchase orders for the
procurement of (i) selected finished goods sourced from third-party
suppliers, (ii) lumber, fabric, leather and other raw materials used in
production, and (iii) certain outsourced services. All purchase orders are
based on current needs and are fulfilled by suppliers within short time
periods. At
goods and services totaled
year. Other purchase commitments included within this table represent payment
due for other services such as telecommunication, computer-related software,
royalties, web development, insurance and other maintenance contracts.
(5) Non-current income taxes payable of
liabilities of
uncertainty regarding the timing of future payments. We do not expect that
the net liability for uncertain income tax positions will significantly
change within the next 12 months. The remaining balance will be settled or
released as tax audits are effectively settled, statutes of limitation
expire, or other new information becomes available.
We believe that our cash flow from operations, together with our other available
sources of liquidity, will be adequate to make all required payments of
principal and interest on our debt, to permit anticipated capital expenditures,
and to fund working capital and other cash requirements. As of June 30, 2020 , we
had working capital of $91.0 million compared to $93.5 million at June 30, 2019
and a current ratio of 1.65 at June 30, 2020 compared to 1.76 a year ago.
Off-Balance Sheet Arrangements and Other Commitments and Contingencies
Except as indicated below, we do not utilize or employ any off-balance sheet arrangements, including special-purpose entities, in operating our business. As such, we do not maintain any (i) retained or contingent interests, (ii) derivative instruments (other than as specified below), or (iii) variable interests which could serve as a source of potential risk to our future liquidity, capital resources and results of operations. We may, from time to time in the ordinary course of business, provide guarantees on behalf of selected affiliated entities or become contractually obligated to perform in accordance with the terms and conditions of certain business agreements. The nature and extent of these guarantees and obligations may vary based on our underlying relationship with the benefiting party and the business purpose for which the guarantee or obligation is being provided. The only such program in place at bothJune 30, 2020 and 2019, respectively, was for our legacy consumer credit program described below. Ethan Allen Consumer Credit Program. During the fourth quarter of fiscal 2019, we launched a new consumer credit program utilizing a non-related third-party financial institution, which replaced the previous program agreement and legacy consumer credit program that was terminated onJuly 31, 2019 . Our new Ethan Allen Platinum consumer credit program, designed to make the Ethan Allen brand accessible to everyone, had a successful national launch and should continue to attract both new prospects and returning clients. Financing offered through this program is administered by a third-party financial institution and is granted to our clients on a non-recourse basis to the Company. 38 --------------------------------------------------------------------------------
ETHAN ALLEN INTERIORS INC. AND SUBSIDIARIES Product Warranties. Our products, including our case goods, upholstery and home accents, generally carry explicit product warranties and are provided based on terms that are generally accepted in the industry. All our domestic independent retailers are required to enter into and perform in accordance with the terms and conditions of a warranty service agreement. We record provisions for estimated warranty and other related costs at time of sale based on historical warranty loss experience and make periodic adjustments to those provisions to reflect actual experience. On rare occasion, certain warranty and other related claims involve matters of dispute that ultimately are resolved by negotiation, arbitration or litigation. In certain cases, a material warranty issue may arise which is beyond the scope of our historical experience. We provide for such warranty issues as they become known and are deemed to be both probable and estimable. It is reasonably possible that, from time to time, additional warranty and other related claims could arise from disputes or other matters beyond the scope of our historical experience. As ofJune 30, 2020 and 2019, our product warranty liability totaled$0.9 million and$1.6 million , respectively. Dividends For the full fiscal 2020 year, we paid a total of$0.82 per share in cash dividends for an aggregate total of$21.5 million . In the prior year, total dividends paid were$47.0 million , which included a$1.00 per share special cash dividend totaling$26.7 million , paid inJanuary 2019 . With our dividends, we have returned$134.6 million to shareholders over the past five years. At the quarterly Board of Directors meeting held onApril 28, 2020 , our Board temporarily suspended the Company's regular quarterly cash dividend due to the COVID-19 impact. However, onAugust 4, 2020 , our Board of Directors reinstated the regular quarterly cash dividend and declared a regular quarterly cash dividend of$0.21 per share, which will be payable to shareholders of record as ofOctober 8, 2020 and will be paid onOctober 22, 2020 . Our Board of Directors met with management to review the effects of the COVID-19 pandemic on the business and determined that it was appropriate to return capital to shareholders in the form of a quarterly cash dividend equal to the pre-COVID-19 level of$0.21 per share. We will continue to monitor the pace of business as it relates to future dividends and any future cash dividends will depend on our earnings, capital requirements, financial condition and other factors considered relevant by us, subject to final determination by our Board of Directors. [[Image Removed]] Foreign Currency Foreign Currency Exposure. Foreign currency exchange risk is primarily limited to our operation of Ethan Allen operated retail design centers located inCanada and our manufacturing plants inMexico andHonduras , as substantially all purchases of imported parts and finished goods are denominated inU.S. dollars. The financial statements of these foreign locations are translated intoU.S. dollars using period-end rates of exchange for assets and liabilities and average rates for the period for revenues and expenses. Translation gains and losses that arise from translating assets, liabilities, revenues and expenses of foreign operations are recorded in accumulated other comprehensive (loss) income as a component of shareholders' equity. Foreign exchange gains or losses resulting from market changes in the value of foreign currencies did not have a material impact during any of the fiscal periods presented in this Annual Report on Form 10-K. Impact of Inflation. We believe any inflationary impact on our product and operating costs during the past three fiscal years was offset by our ability to create operational efficiencies, seek lower cost alternatives and raise selling prices. 39
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ETHAN ALLEN INTERIORS INC. AND SUBSIDIARIES
Critical Accounting Estimates
We prepare our consolidated financial statements in conformity withU.S. GAAP. In some cases, these principles require management to make difficult and subjective judgments regarding uncertainties and, as a result, such estimates and assumptions may significantly impact our financial results and disclosures. We consider an accounting estimate to be critical if: (i) the accounting estimate requires us to make assumptions about matters that were highly uncertain at the time the accounting estimate was made, and (ii) changes in the estimate that are reasonably likely to occur from period to period, or use of different estimates that we reasonably could have used in the current period, would have a material impact on our financial condition or results of operations. We base our estimates on currently known facts and circumstances, prior experience and other assumptions we believe to be reasonable. We use our best judgment in valuing these estimates and may, as warranted, use external advice. Actual results could differ from these estimates, assumptions, and judgments and these differences could be significant. We make frequent comparisons throughout the year of actual experience to our assumptions to reduce the likelihood of significant adjustments and will record adjustments when differences are known.
The following critical accounting estimates affect our consolidated financial statements.
Goodwill and Intangible Assets. We review the carrying value of our goodwill and other intangible assets with indefinite lives at least annually, during the fourth quarter, or more frequently if an event occurs or circumstances change, for possible impairment. For impairment testing, goodwill has been assigned to our wholesale reporting unit. We may elect to evaluate qualitative factors to determine if it is more likely than not that the fair value of a reporting unit or fair value of indefinite lived intangible assets is less than its carrying value. If the qualitative evaluation indicates that it is more likely than not that the fair value of a reporting unit or indefinite lived intangible asset is less than its carrying amount, a quantitative impairment test is required. Alternatively, we may bypass the qualitative assessment for a reporting unit or indefinite lived intangible asset and directly perform the quantitative assessment. The quantitative impairment test involves estimating the fair value of each reporting unit and indefinite lived intangible asset and comparing these estimated fair values with the respective reporting unit or indefinite lived intangible asset carrying value. If the carrying value of a reporting unit exceeds its fair value, an impairment loss will be recognized in an amount equal to such excess, limited to the total amount of goodwill allocated to the reporting unit. If the carrying value of an individual indefinite lived intangible asset exceeds its fair value, such individual indefinite lived intangible asset is written down by an amount equal to such excess. Estimating the fair value of reporting units and indefinite lived intangible assets involves the use of significant assumptions, estimates and judgments with respect to a number of factors, including sales, gross margin, general and administrative expenses, capital expenditures, EBITDA and cash flows, the selection of an appropriate discount rate, as well as market values and multiples of earnings and revenue of comparable public companies. To evaluate goodwill, the Company estimates the fair value of the reporting units using a combination of Market and Income approaches. The Market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities (including a business). In the Market approach, the "Guideline Company " method is used, which focuses on comparing the Company's risk profile and growth prospects to reasonably similar publicly traded companies. Key assumptions used for theGuideline Company method include multiples for revenues, EBITDA and operating cash flows, as well as consideration of control premiums. The selected multiples are determined based on public furniture companies within our peer group, and if appropriate, recent comparable transactions are also considered. Control premiums are determined using recent comparable transactions in the open market. Under the Income approach, a discounted cash flow method is used, which includes a terminal value, and is based on management's forecasts and budgets. The long-term terminal growth rate assumptions reflect our current long-term view of the market in which we compete. Discount rates use the weighted average cost of capital for companies within our peer group, adjusted for specific company risk premium factors. We also annually evaluate whether our trade name continues to have an indefinite life. Our trade name is reviewed for impairment annually in the fourth quarter and may be reviewed more frequently if indicators of impairment are present. Conditions that may indicate impairment include, but are not limited to, a significant adverse change in customer demand or business climate that could affect the value of an asset, a product recall or an adverse action or assessment by a regulator. Factors used in the valuation of intangible assets with indefinite lives include, but are not limited to, management's plans for future operations, recent results of operations and projected future cash flows. The fair value of our trade name, which is the Company's only indefinite lived intangible asset other than goodwill, is valued using the relief-from-royalty method. Significant factors used in the trade name valuation are rates for royalties, future revenue growth and a discount factor. Royalty rates are determined using an average of recent comparable values, review of the operating margins and consideration of the specific characteristics of the trade name. Future growth rates are based on the Company's perception of the long-term values in the market in which we compete, and the discount rate is determined using the weighted average cost of capital for companies within our peer group, adjusted for specific company risk premium factors. 40 --------------------------------------------------------------------------------
ETHAN ALLEN INTERIORS INC. AND SUBSIDIARIES Impairment of Long-lived Assets. The recoverability of long-lived assets is evaluated for impairment whenever events or changes in circumstances indicate that we may not be able to recover the carrying amount of an asset or asset group. Conditions that may indicate impairment include, but are not limited to, a significant adverse change in customer demand or business climate that could affect the value of an asset, change in the intended use of an asset, a product recall or an adverse action or assessment by a regulator. If the sum of the estimated undiscounted future cash flows over the remaining life of the primary asset is less than the carrying value, we recognize a loss equal to the difference between the carrying value and the fair value, usually determined by the estimated discounted cash flow analysis or independent third-party appraisal of the asset or asset group. While determining fair value requires a variety of input assumptions and judgment, we believe our estimates of fair value are reasonable. The asset group is defined as the lowest level for which identifiable cash flows are available and largely independent of the cash flows of other groups of assets, which for our retail segment is the individual design center while for our wholesale segment, it is the individual manufacturing plant. For retail design center level long-lived assets, expected cash flows are determined based on our estimate of future net sales, margin rates and expenses over the remaining expected terms of the leases. Inventories. Inventories (finished goods, work in process and raw materials) are stated at the lower of cost, determined on a first-in, first-out basis, and net realizable value. Cost is determined based solely on those charges incurred in the acquisition and production of the related inventory (i.e. material, labor and manufacturing overhead costs). We estimate an inventory reserve for excess quantities and obsolete items based on specific identification and historical write-downs, taking into account future demand and market conditions. Our inventory reserves contain uncertainties that require management to make assumptions and to apply judgment regarding a number of factors, including market conditions, the selling environment, historical results and current inventory trends. We adjust our inventory reserves for net realizable value and obsolescence based on trends, aging reports, specific identification and estimates of future retail sales prices. If actual demand or market conditions change from our prior estimates, we adjust our inventory reserves accordingly throughout the period. We have not made any material changes to our assumptions included in the calculations of the lower of cost or net realizable value reserves during the periods presented. Lease Accounting. We implemented ASU 2016-02, Leases (Topic 842), in the first quarter of fiscal 2020. Critical accounting estimates and judgments made in applying ASU 2016-02 relate to how the Company determines the reasonably certain lease term, the incremental borrowing rate and fair market value of the underlying asset. In recognizing the lease right-of-use assets and lease liabilities, we utilize the lease term for which we are reasonably certain to use the underlying asset, including consideration of options to extend or terminate the lease. At lease commencement, we evaluate whether we are reasonably certain to exercise available options based on consideration of a variety of economic factors and the circumstances related to the leased asset. Factors considered include, but are not limited to, (i) the contractual terms compared to estimated market rates, (ii) the uniqueness or importance of the asset or its location, (iii) the potential costs of obtaining an alternative asset, (iv) the potential costs of relocating or ceasing use of the asset, including the consideration of leasehold improvements and other invested capital, and (v) any potential tax consequences. The determination of the reasonably certain lease term affects the inclusion of rental payments utilized in the incremental borrowing rate calculations and the results of the lease classification test. The reasonably certain lease term may materially impact our financial position related to certain design centers which typically have greater lease payments. Although the above factors are considered in our analysis, the assessment involves subjectivity considering our strategy, expected future events and market conditions. While we believe our estimates and judgments in determining the lease term are reasonable, future events may occur which may require us to reassess this determination. ASU 2016-02 requires companies to use the rate implicit in the lease whenever that rate is readily determinable and if the interest rate is not readily determinable, then a lessee may use its incremental borrowing rate. As most of our leases do not include an implicit interest rate, we determine the discount rate for each lease based upon the incremental borrowing rate ("IBR") in order to calculate the present value of the lease liability at the commencement date. The IBR is computed as the rate of interest that we would have to pay to (i) borrow on a collateralized basis (ii) over a similar term (iii) an amount equal to the total lease payments (iv) in a similar economic environment. As we do not have any outstanding public debt, we estimated the incremental borrowing rate based on our estimated credit rating and available market information. The incremental borrowing rate is subsequently reassessed upon a modification to the lease agreement. In the case an interest rate is implicit in a lease we will use that rate as the discount rate for that lease. The lease term for all of our lease arrangements include the noncancelable period of the lease plus, if applicable, any additional periods covered by an option to extend the lease that is reasonably certain to be exercised by the Company. Some of our leases contain variable lease payments based on a Consumer Price Index or percentage of sales, which are excluded from the measurement of the lease liability. 41 --------------------------------------------------------------------------------
ETHAN ALLEN INTERIORS INC. AND SUBSIDIARIES
Refer to Note 6, Leases, for further details on the adoption of ASU 2016-02.
Income Taxes. We are subject to income taxes inthe United States and other foreign jurisdictions. Our tax provision is an estimate based on our understanding of laws in Federal, state and foreign tax jurisdictions. These laws can be complicated and are difficult to apply to any business, including ours. The tax laws also require us to allocate our taxable income to many jurisdictions based on subjective allocation methodologies and information collection processes. We use the asset and liability method to account for income taxes. We recognize deferred tax assets and liabilities based on the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. We measure deferred tax assets and liabilities using enacted tax rates in effect for the year in which we expect to recover or settle those temporary differences. When we record deferred tax assets, we are required to estimate, based on forecasts of taxable earnings in the relevant tax jurisdiction, whether we are more likely than not to recover them. In making judgments about realizing the value of our deferred tax assets, we consider historic and projected future operating results, the eligible carry-forward period, tax law changes and other relevant considerations. The Company evaluates, on a quarterly basis, uncertain tax positions taken or expected to be taken on tax returns for recognition, measurement, presentation, and disclosure in its financial statements. If an income tax position exceeds a 50% probability of success upon tax audit, based solely on the technical merits of the position, the Company recognizes an income tax benefit in its financial statements. The tax benefits recognized are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. The liability associated with an unrecognized tax benefit is classified as a long-term liability except for the amount for which a cash payment is expected to be made or tax positions settled within one year. Business Insurance Reserves. We have insurance programs in place to cover workers' compensation and health care benefits under certain employee benefit plans provided by the Company. The insurance programs, which are funded through self-insured retention, are subject to various stop-loss limitations. We accrue estimated losses using actuarial models and assumptions based on historical loss experience. Although we believe that the insurance reserves are adequate, the reserve estimates are based on historical experience, which may not be indicative of current and future losses. In addition, the actuarial calculations used to estimate insurance reserves are based on numerous assumptions, some of which are subjective. We adjust insurance reserves, as needed, in the event that future loss experience differs from historical loss patterns.
Significant Accounting Policies
See Note 3, Summary of Significant Accounting Policies, in the notes to our consolidated financial statements included under Part II, Item 8, for a full description of our significant accounting policies.
Recent Accounting Pronouncements
See Note 3, Summary of Significant Accounting Policies, in the notes to our consolidated financial statements included under Part II, Item 8, for a full description of recent accounting pronouncements, including the expected dates of adoption, which we include here by reference. Business Outlook Fiscal 2020 saw unprecedented disruption around the world as a result of the rapid spread of COVID-19. Economies throughout the world have been severely disrupted by the effects of the quarantines, business closures and the reluctance or inability of individuals to leave their homes as a result of the outbreak of COVID-19. In addition, the capital markets have been impacted and our efforts to raise necessary capital in the future could be adversely impacted by the outbreak of the virus and we cannot forecast with any certainty when the disruptions caused by it will cease to impact our business and the results of our operations. As of the date of the filing of this report, we are gratified with the work and focus of our teams during this crisis and have operated with the foremost focus on safety of our associates and clients. We have been able to bring many previously furloughed associates back and our action plan helped us end the year with strong liquidity. We gradually began reopening our design centers beginning inMay 2020 and as ofJune 30, 2020 , reopened all of our Company-operated retail design centers, including 14% open by appointment only. We resumed production in our North American manufacturing plants during the end of fiscal 2020, some in a limited capacity, and expect to work through existing order backlog and ramp up to full production during the first half of fiscal 2021. Our distribution centers are fully open and our retail home delivery centers are making home deliveries. As we move forward, we will continue to focus on our advantages, including a strong retail network, the personal service of our interior design professionals, our vertical structure whereby 75% of products are made in our North American workshops and increasing the use of technology in all aspects of our enterprise, while also maintaining our focus on strong governance and social responsibility. 42
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ETHAN ALLEN INTERIORS INC. AND SUBSIDIARIES Our strong network of North American interior design consultants continue to create design solutions that best satisfy our customer's needs and are able to work with clients in-person or virtually. We believe changes in consumer spending and new habits being formed as a result of social distancing and sheltering in place, will create opportunities for our brand. Now more than ever, home is a haven, and we are here to help the customer reimagine their homes. We continue to generate business through virtual and in-person appointments and by interacting virtually with our customers through Live Chat online. Our design consultants, are available to work with customers in-store and virtually utilizing technology, including the Ethan Allen inHome augmented reality app, the 3D room planner tool,Skype and FaceTime. We plan to further invest in our digital footprint, including our website, in order to enhance our customer experience. We are also continually improving our customers' journey from the time they land on our website to their visit to one of our design centers to the delivery of their purchase via our white glove home delivery service. We view the combination of online traffic and design center traffic in a holistic fashion whereby our customer generally experiences our brand on our website before visiting a design center in person. Our online traffic continues to increase each year and our marketing teams remain focused on enhancing our digital outreach strategies to further drive more traffic and keep our brand relevant in today's social media oriented world.
We are also making good progress with our new products including Lucy, a mid-century modern inspired upholstery collection that recently launched successfully, and Farmhouse, a country cottage inspired furniture collection that is just now launching in two phases scheduled over the next few months.
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