DBI

Business Context and Reporting Period

Company: DSW Inc. (Designer Brands Inc.)
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: October 28, 2006 (Third Quarter of Fiscal 2006)
Business Overview: DSW is a leading U.S. specialty branded footwear retailer operating 215 DSW stores and 225 leased shoe departments for retailers including Stein Mart, Gordmans, and Filene's Basement. The company operates in two segments: DSW Stores and Leased Departments.

Key Financial Metrics

Note: The company has no direct borrowings outstanding under its $150 million secured revolving credit facility. Letters of credit outstanding totaled $15.8 million.

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 9.9% ($30.0 million) in the quarter and 10.4% ($89.7 million) for the nine-month period compared to the prior year. Comparable store sales improved 2.6% in the quarter and 3.0% for the nine months.
• Profitability Expansion: Gross margin expanded to 29.7% (quarter) and 29.2% (nine months) from 27.5% and 28.1% respectively in the prior year, driven by increased initial markups, reduced markdown rates, and lower warehouse expenses.
• Net Income Surge: Net income increased 46.7% in the quarter and 80.0% for the nine months. The nine-month increase was significantly aided by the absence of a $6.5 million charge recorded in the prior year related to a credit card data theft incident.
• Interest Income: Net interest income was $1.6 million for the quarter and $4.9 million for the nine months, a reversal from net interest expense in the prior year due to the repayment of intercompany debt and investment of IPO proceeds.
• Store Count: The company opened 20 new DSW stores and added 21 new leased departments during the nine-month period.

Guidance, Outlook, Risks, and Unusual Items

• Capital Expenditures: Management expects annual capital expenses to reach approximately $40 million for the fiscal year, driven by new store openings, the Stein Mart expansion (102 additional locations), and a new corporate headquarters lease ($10 million expected in Q4).
• Expansion Strategy: Plans to open approximately 30 new stores per year for the next four fiscal years.
• Legal Contingencies (Data Theft): The company is involved in class action lawsuits and an FTC consent order regarding a 2005 credit card data theft. The estimated exposure ranges from $6.5 million to $9.5 million. An accrual of $3.1 million remained as of October 28, 2006. No fines were paid under the FTC order.
• Related Party Transactions: DSW remains dependent on Retail Ventures, Inc. (RVI) for shared services (IT, logistics, payroll). RVI owns approximately 63.1% of DSW's outstanding shares. RVI issued Premium Income Exchangeable Securities (PIES) that are mandatorily exchangeable for DSW Class A shares, which could impact stock price volatility.
• Accounting Changes: The company adopted SFAS No. 123R (Share-Based Payment) effective January 29, 2006, resulting in the recognition of stock-based compensation expense of $2.7 million for the nine months ended October 28, 2006.

Investor Verification Checklist

• Related Party Dependence: Verify the terms and duration of the Shared Services Agreement with Retail Ventures, Inc., and the potential costs of transitioning these services in-house.
• Legal Exposure: Monitor the status of the class action lawsuits and the final resolution of the FTC consent order regarding the 2005 data breach to assess if the $3.1 million accrual is sufficient.
• Capital Allocation: Confirm the execution of the $10 million corporate headquarters lease and the timeline for the 102 new Stein Mart locations to ensure capital expenditure forecasts are met.
• PIES Impact: Assess the potential dilution or market pressure from the Retail Ventures PIES exchangeable securities maturing in 2011.
• Inventory Management: Review inventory turnover and markdown rates given the aggressive expansion and the reliance on the retail inventory method for valuation.