DBI

Business Context and Reporting Period

Company: DSW Inc. (formerly a subsidiary of Retail Ventures Inc., now publicly traded on NYSE as "DSW").
Reporting Period: Quarterly period ended October 29, 2005 (Third Quarter of Fiscal 2005).
Business Overview: DSW operates 197 company-owned stores and supplies leased shoe departments for non-affiliated retailers (Stein Mart, Gordmans, Filene's Basement, Frugal Fannie's). The company sells better-branded footwear and accessories.
Key Event: DSW completed its Initial Public Offering (IPO) on July 5, 2005, raising approximately $285.8 million in net proceeds, which were used to repay intercompany debt and fund working capital.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 15.2% ($39.8 million) for the quarter and 17.9% ($130.9 million) for the nine-month period compared to the prior year. Comparable store sales improved 3.5% for the quarter and 3.7% for the nine-month period.
• Margin Compression: Gross profit margin decreased from 29.5% to 27.5% (quarter) and 29.1% to 28.1% (nine months). This was driven by increased markdowns, higher occupancy expenses due to new store openings, and a higher mix of leased shoe department sales which carry higher occupancy costs.
• Profitability: Net income increased 15.6% for the quarter and 3.8% for the nine-month period. Operating profit margins declined slightly due to the gross margin compression, partially offset by operating expense leverage.
• Liquidity: Cash and equivalents surged from $8.3 million to $57.1 million, primarily due to IPO proceeds. Net working capital increased by $86.9 million.
• Debt Structure: Following the IPO, DSW repaid $196.6 million in intercompany indebtedness to its former parent, Retail Ventures Inc. (RVI), and entered into a new $150 million secured revolving credit facility with no outstanding borrowings as of the period end.

Guidance, Risks, and Unusual Items

• Data Breach Contingency: The company disclosed a theft of credit card and purchase information affecting approximately 1.4 million cards and 96,000 checks between November 2004 and February 2005. DSW accrued a $6.5 million charge in the first quarter of fiscal 2005. The estimated potential exposure ranges from $6.5 million to $9.5 million. The company is cooperating with the FTC and has entered a proposed consent order requiring a comprehensive information security program.
• Accounting Standards: DSW is evaluating the impact of SFAS No. 123R (Share-Based Payment), with adoption delayed until the beginning of fiscal 2006. Pro forma net income would be lower if fair value accounting were applied currently.
• Outlook: Management plans to open approximately 30 new stores per year for the next four fiscal years. Capital expenditures are expected to be funded by operating cash flows and the new revolving credit facility.
• Risks: Key risks include the ability to open profitable new stores, vendor relationships, fashion trends, competition, and the potential for additional legal proceedings related to the data breach.

Investor Verification Checklist

• Data Breach Exposure: Verify if the $6.5 million reserve is sufficient given the potential exposure range up to $9.5 million and any new legal developments.
• Post-IPO Debt Covenants: Review the restrictive covenants in the new $150 million secured revolving credit facility, specifically the fixed charge coverage ratio test triggered if borrowing exceeds 90% capacity.
• Comparable Store Sales: Monitor the sustainability of the 3.5% comparable store sales growth, noting the decline in the accessories category (-9.4% for the quarter).
• Inventory Valuation: Assess the $18.6 million inventory reserve and the impact of markdowns on future gross margins.
• Related Party Transactions: Confirm the terms of the shared services agreement with RVI and the classification of receivables/payables with affiliates post-IPO.