Notes to Consolidated Financial Statements
(unaudited)
The accompanying consolidated financial statements have been prepared without audit. In the opinion of management, the accompanying consolidated financial statements contain all adjustments (consisting of only normal recurring accruals and elimination of intercompany balances and transactions) necessary to present fairly the financial position of Bed Bath & Beyond Inc. and subsidiaries (the "Company") as of August 31, 2019 and March 2, 2019 and the results of its operations, shareholders' equity, and comprehensive (loss) income for the three and six months ended August 31, 2019 and September 1, 2018, respectively, and its cash flows for the six months ended August 31, 2019 and September 1, 2018, respectively.
The accompanying unaudited consolidated financial statements are presented in accordance with the requirements for Form 10-Q and consequently do not include all the disclosures normally required by U.S. generally accepted accounting principles ("GAAP"). Reference should be made to Bed Bath & Beyond Inc.'s Annual Report on Form 10-K for the fiscal year ended March 2, 2019 for additional disclosures, including a summary of the Company's significant accounting policies, and to subsequently filed Form 8-Ks.
The consolidated statement of cash flows for the six months ended September 1, 2018 was revised to include restricted cash due to the adoption of the Financial Accounting Standards Board ("FASB") Accounting Standards Update ("ASU") 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash in fiscal 2018.
The Company accounts for its operations as two operating segments: North American Retail and Institutional Sales. The Institutional Sales operating segment, which is comprised of Linen Holdings, does not meet the quantitative thresholds under GAAP and therefore is not a reportable segment. Net sales outside of the U.S. for the Company were not material for the three and six months ended August 31, 2019 and September 1, 2018. As the Company operates in the retail industry, its results of operations are affected by general economic conditions and consumer spending habits.
2) Recent Accounting Pronouncements
In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). This guidance requires an entity to recognize lease liabilities and a right-of-use asset for all leases on the balance sheet and to disclose key information about the entity's leasing arrangements. ASU 2016-02 is effective for annual reporting periods beginning after December 15, 2018, including interim periods within that reporting period, with earlier adoption permitted. In July 2018, the FASB approved an amendment to the new guidance that allows companies the option of using the effective date of the new standard as the initial application (at the beginning of the period in which it is adopted, rather than at the beginning of the earliest comparative period) and to recognize the effects of applying the new ASU as a cumulative effect adjustment to the opening balance sheet or retained earnings.
The Company adopted this accounting standard at the beginning of the first quarter of fiscal 2019 using the new transition election to not restate comparative periods. The Company elected the package of practical expedients upon adoption, which permits the Company to not reassess under the new standard the Company's prior conclusions about lease identification, lease classification and initial direct costs. In addition, the Company elected not to separate lease and non-lease components for all real estate leases and did not elect the hindsight practical expedient. Lastly, the Company elected the short-term lease exception policy, permitting it to exclude the recognition requirements of this standard from leases with initial terms of 12 months or less. Upon adoption, the Company recognized operating lease assets of approximately $2.0 billion and operating lease liabilities of approximately $2.2 billion on its consolidated balance sheet. In addition, upon adoption deferred rent and various lease incentives which were recorded as of March 2, 2019 were reclassified as a component of the right-of-use assets. Upon adoption, the Company recognized a cumulative adjustment decreasing opening retained earnings by approximately $40.7 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.
3) Revenue Recognition
Sales are recognized upon purchase by customers at the Company’s retail stores or upon delivery for products purchased from its websites. The value of point-of-sale coupons and point-of-sale rebates that result in a reduction of the price paid by the customer are recorded as a reduction of sales. Shipping and handling fees that are billed to a customer in a sale transaction are recorded in sales. Taxes, such as sales tax, use tax and value added tax, are not included in sales.
Revenues from gift cards, gift certificates and merchandise credits are recognized when redeemed. Gift cards have no provisions for reduction in the value of unused card balances over defined time periods and have no expiration dates. For the six months ended August 31, 2019, the Company recognized net sales for gift card and merchandise credit redemptions of approximately $81.3 million which were included in merchandise credit and gift card liabilities on the consolidated balance sheet as of March 2, 2019.
Sales returns are provided for in the period that the related sales are recorded based on historical experience. Although the estimate for sales returns has not varied materially from historical provisions, actual experience could vary from historical experience in the future if the level of sales return activity changes materially. In the future, if the Company concludes that an adjustment is required due to material changes in the returns activity, the liability for estimated returns and the corresponding right of return asset will be adjusted accordingly. As of August 31, 2019, the liability for estimated returns of $81.6 million is included in accrued expenses and other current liabilities and the corresponding right of return asset for merchandise of $49.3 million is included in prepaid expenses and other current assets.
The Company sells a wide assortment of domestics merchandise and home furnishings. Domestics merchandise includes categories such as bed linens and related items, bath items and kitchen textiles. Home furnishings include categories such as kitchen and tabletop items, fine tabletop, basic housewares, general home furnishings (including furniture and wall décor), consumables and certain juvenile products. Sales of domestics merchandise and home furnishings accounted for approximately 38.7% and 61.3% of net sales, respectively, for the three months ended August 31, 2019, and approximately 38.6% and 61.4% of net sales, respectively, for the three months ended September 1, 2018. Sales of domestics merchandise and home furnishings accounted for approximately 37.2% and 62.8% of net sales, respectively, for the six months ended August 31, 2019, and approximately 37.3% and 62.7% of net sales, respectively, for the six months ended September 1, 2018.
4) Fair Value Measurements
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e., "the exit price") in an orderly transaction between market participants at the measurement date. In determining fair value, the Company uses various valuation approaches, including quoted market prices and discounted cash flows. The hierarchy for inputs used in measuring fair value maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability developed based on market data obtained from independent sources. Unobservable inputs are inputs that reflect a company's judgment concerning the assumptions that market participants would use in pricing the asset or liability developed based on the best information available under the circumstances. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, an asset or liability must be classified in its entirety based on the lowest level of input that is significant to the measurement of fair value. The fair value hierarchy is broken down into three levels based on the reliability of inputs as follows:
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•
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Level 1 - Valuations based on quoted prices in active markets for identical instruments that the Company is able to access. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these products does not entail a significant degree of judgment.
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•
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Level 2 - Valuations based on quoted prices in active markets for instruments that are similar, or quoted prices in markets that are not active for identical or similar instruments, and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets.
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•
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Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement.
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The Company did not have any financial assets utilizing Level 2 inputs. Financial assets utilizing Level 3 inputs included long term investments in auction rate securities consisting of preferred shares of closed end municipal bond funds (See "Investment Securities," Note 6).
Fair Value of Financial Instruments
The Company's financial instruments include cash and cash equivalents, investment securities, accounts payable, long term debt and certain other liabilities. The Company's investment securities consist primarily of U.S. Treasury securities, which are stated at amortized cost, and auction rate securities, which are stated at their fair value. The book value of the financial instruments, excluding the Company's long term debt, is representative of their fair values. The fair value of the Company's long term debt is approximately $1.146 billion as of August 31, 2019, which is based on quoted prices in active markets for identical instruments (i.e., Level 1 valuation), compared to the carrying value of approximately $1.495 billion.
5) Cash and Cash Equivalents
Included in cash and cash equivalents are credit and debit card receivables from banks, which typically settle within five business days, of $92.7 million and $92.9 million as of August 31, 2019 and March 2, 2019, respectively.
6) Investment Securities
The Company's investment securities as of August 31, 2019 and March 2, 2019 are as follows:
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(in millions)
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August 31, 2019
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March 2, 2019
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Available-for-sale securities:
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Long term
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$
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20.4
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$
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19.9
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Held-to-maturity securities:
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Short term
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—
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485.8
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Total investment securities
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$
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20.4
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$
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505.7
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Auction Rate Securities
As of August 31, 2019 and March 2, 2019, the Company's long term available-for-sale investment securities represented approximately $20.3 million par value of auction rate securities consisting of preferred shares of closed end municipal bond funds, less temporary valuation adjustments of approximately $0.1 million and $(0.4) million, respectively. Since these valuation adjustments are deemed to be temporary, they are recorded in accumulated other comprehensive loss, net of a related tax benefit, and did not affect the Company's net earnings.
U.S. Treasury Securities
As of August 31, 2019, the Company did not hold any short term held-to maturity securities. As of March 2, 2019, the Company’s short term held-to-maturity securities included approximately $485.8 million of U.S. Treasury Bills with remaining maturities of less than one year. These securities are stated at their amortized cost which approximates fair value, which is based on quoted prices in active markets for identical instruments (i.e., Level 1 valuation).
7) Impairment of Long-Lived Assets
The Company reviews long-lived assets for impairment when events or changes in circumstances indicate the carrying value of these assets may exceed their current fair values. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized for the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. The assets and liabilities of a disposal group classified as held for sale would be presented separately in the appropriate asset and liability sections of the balance sheet. In the three and six months ended August 31, 2019, the Company recorded a $28.4 million non-cash pre-tax impairment charge within goodwill and other impairments in the consolidated statement of operations for certain store-level assets, including leasehold improvements, and operating lease assets. There were no impairments to long-lived assets in the three and six months ended September 1, 2018. In the future, if events or market conditions affect the estimated fair value to the extent that a long-lived asset is impaired, the Company will adjust the carrying value of these long-lived assets in the period in which the impairment occurs.
8) Property and Equipment
As of August 31, 2019 and March 2, 2019, included in property and equipment, net is accumulated depreciation of approximately $2.2 billion and $3.5 billion, respectively.
9) Leases
The Company leases retail stores, as well as distribution facilities, offices and equipment, under agreements expiring at various dates through 2041. The leases provide for original lease terms that generally range from 10 to 15 years and most leases provide for a series of five year renewal options, often at increased rents, the exercise of which is at the Company's sole discretion. In recognizing the lease right-of-use assets and lease liabilities, the Company utilizes the lease term for which it is reasonably certain to use the underlying asset, including consideration of options to extend or terminate the lease. Certain leases provide for contingent rents (which are based upon store sales exceeding stipulated amounts and are immaterial for the three and six months ended August 31, 2019 and September 1, 2018), scheduled rent increases and renewal options. The Company is obligated under a majority of the leases to pay for taxes, insurance and common area maintenance charges.
Companies are required 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. The incremental borrowing rate is the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term at an amount equal to the lease payments in a similar economic environment. The Company determined discount rates based on the rates of its unsecured borrowings, which are then adjusted for the appropriate lease term and effects of full collateralization. In determining the Company's operating lease assets and operating lease liabilities, the Company applied these incremental borrowing rates to the minimum lease payments within each lease agreement.
The components of total lease cost for the three and six months ended August 31, 2019, were as follows.
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(in thousands)
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Statement of Operations Location
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Three months ended August 31, 2019
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Six months ended August 31, 2019
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Operating lease cost
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Cost of sales and SG&A
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$
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143,773
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$
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287,673
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Finance lease cost:
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Depreciation of property
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SG&A
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648
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1,296
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Interest on lease liabilities
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Interest expense, net
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2,214
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4,436
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Variable lease cost
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Cost of sales and SG&A
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50,275
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98,170
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Sublease income
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SG&A
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(278
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)
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(556
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)
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Total lease cost
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$
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196,632
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$
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391,019
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As of August 31, 2019, assets and liabilities related to the Company's operating and finance leases are as follows:
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(in thousands)
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Consolidated Balance Sheet Location
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August 31, 2019
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Assets
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Operating leases
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Operating lease assets
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$
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2,012,681
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Finance leases
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Property and equipment, net
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70,583
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Total Lease assets
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$
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2,083,264
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Liabilities
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Current:
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Operating leases
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Current operating lease liabilities
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$
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456,324
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Finance leases
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Accrued expenses and other current liabilities
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1,547
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Noncurrent:
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Operating leases
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Operating lease liabilities
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1,813,015
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Finance leases
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Other liabilities
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103,172
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Total lease liabilities
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$
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2,374,058
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As of August 31, 2019, the Company's lease liabilities mature as follows:
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(in thousands)
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Operating Leases
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Finance Leases
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Fiscal Year:
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Remainder of 2019
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$
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286,430
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$
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5,221
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2020
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576,119
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10,469
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2021
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481,833
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10,434
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2022
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387,133
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10,407
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2023
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294,998
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10,524
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Thereafter
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722,013
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259,584
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Total lease payments
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$
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2,748,526
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$
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306,639
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Less imputed interest
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(479,187
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)
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(201,920
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)
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Present value of lease liabilities
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$
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2,269,339
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$
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104,719
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The Company's lease terms and discount rates are as follows:
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August 31, 2019
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Weighted-average remaining lease term (in years)
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Operating leases
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6.1
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Finance leases
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26.2
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Weighted-average discount rate
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Operating leases
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6.1
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%
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Finance leases
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9.0
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%
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Other information for the Company's leases is as follows:
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(in thousands)
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Six months ended August 31, 2019
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Cash paid for amounts included in the measurement of lease liabilities
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Operating cash flows from operating leases
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$
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271,669
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Operating cash flows from finance leases
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5,160
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Operating lease assets obtained in exchange for new operating lease liabilities
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262,315
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At the beginning of fiscal 2019, the Company adopted ASU2016-02, and as required, the following disclosure is provided for periods prior to adoption. As of March 2, 2019, future minimum lease payments under non-cancelable operating leases were as follows:
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(in thousands)
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Operating Leases
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Fiscal Year:
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2019
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609,613
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2020
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534,055
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2021
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434,908
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2022
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334,587
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2023
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241,863
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Thereafter
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616,170
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Total future minimum lease payments
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2,771,196
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As of March 2, 2019, the capital lease obligations were approximately $3.8 million for which the current and long-term portions were included within accrued expenses and other current liabilities and other liabilities, respectively, in the consolidated balance sheet. Monthly minimum lease payments are accounted for as principal and interest payments. The minimum capital lease payments, including interest, by fiscal year were: $0.9 million in fiscal 2019; $0.8 million in fiscal 2020; $0.7 million in fiscal 2021; $0.6 million in fiscal 2022; $0.6 million in fiscal 2023; and $1.0 million thereafter.
The Company has financing obligations, related to two sale/leaseback agreements, which approximated the discounted fair value of the minimum lease payments, had a residual fair value at the end of the lease term and are being amortized over the term of the respective agreements, including option periods, of 32 and 37 years. As of March 2, 2019, the sale/leaseback financing obligations were approximately $101.7 million, for which the current and long-term portions were included within accrued expenses and other current liabilities and other liabilities, respectively, in the consolidated balance sheet. Monthly lease payments are accounted for as principal and interest payments (at approximate annual interest rates of 7.2% and 10.6%). These sale/leaseback financing obligations, excluding the residual fair value at the end of the lease term, mature as follows: $0.8 million in fiscal 2019; $0.9 million in fiscal 2020; $0.9 million in fiscal 2021; $1.0 million in fiscal 2022; $1.0 million in fiscal 2023; and $75.4 million thereafter.
10) Goodwill and Other Indefinite Lived Intangible Assets
The Company reviews goodwill and other intangibles that have indefinite lives for impairment annually as of the end of the fiscal year or when events or changes in circumstances indicate the carrying value of these assets might exceed their current fair values. Impairment testing is based upon the best information available including estimates of fair value which incorporate assumptions marketplace participants would use in making their estimates of fair value. Significant assumptions and estimates are required, including, but not limited to, projecting future cash flows, determining appropriate discount rates and terminal growth rates, and other assumptions, to estimate the fair value of goodwill and indefinite lived intangible assets. Although the Company believes the assumptions and estimates made are reasonable and appropriate, different assumptions and estimates could materially impact its reported financial results.
Prior to March 2, 2019, the Company had not historically recorded an impairment to its goodwill and other indefinite lived intangible assets. In fiscal 2018, the Company recognized non-cash pre-tax goodwill impairment charges of $285.1 million and $40.1 million for the North American Retail and Institutional Sales reporting units, respectively. As of June 1, 2019, the Company completed a quantitative impairment analysis of goodwill related to its reporting units by comparing the fair value of a reporting unit with its carrying amount. The Company performed a discounted cash flow analysis and market multiple analysis for each reporting unit. Based upon the analysis performed, the Company recognized a non-cash pre-tax goodwill impairment charge of $391.1 million for the North American Retail reporting unit. The non-cash pre-tax impairment charge was primarily the result of a sustained decline in the Company's market capitalization.
Other indefinite lived intangible assets were recorded as a result of acquisitions and primarily consist of tradenames. The Company values its tradenames using a relief-from-royalty approach, which assumes the value of the tradename is the discounted cash flows of the amount that would be paid by a hypothetical market participant had they not owned the tradename and instead licensed the tradename from another company. As of June 1, 2019, for certain other indefinite lived intangible assets, the Company completed a quantitative impairment analysis by comparing the fair value of the tradenames to their carrying value and recognized a non-cash pre-tax tradename impairment charge of $10.2 million, within goodwill and other impairments in the consolidated statement of operations, for certain tradenames. As of August 31, 2019, the Company assessed qualitative factors in order to determine whether any events and circumstances existed which indicated that it was more likely than not that the fair value of these other indefinite lived assets did not exceed their carrying values and concluded no such events or circumstances existed which would require an impairment test be performed. In the future, if events or market conditions affect the estimated fair value to the extent that an asset is impaired, the Company will adjust the carrying value of these assets in the period in which the impairment occurs.
There were no impairments of indefinite lived intangible assets in the three months ended August 31, 2019. Included within other assets in the accompanying consolidated balance sheets as of August 31, 2019 and March 2, 2019, respectively, are $133.6 million and $143.8 million for indefinite lived tradenames and trademarks.
11) Long Term Debt
Senior Unsecured Notes
On July 17, 2014, the Company issued $300 million aggregate principal amount of 3.749% senior unsecured notes due August 1, 2024, $300 million aggregate principal amount of 4.915% senior unsecured notes due August 1, 2034 and $900 million aggregate principal amount of 5.165% senior unsecured notes due August 1, 2044 (collectively, the "Notes"). Interest on the Notes is payable semi-annually on February 1 and August 1 of each year. In fiscal 2018, the Company purchased and retired approximately $4.6 million of senior unsecured notes due August 1, 2024.
The Notes were issued under an indenture (the "Base Indenture"), as supplemented by a first supplemental indenture (together, with the Base Indenture, the "Indenture"), which contains various restrictive covenants, which are subject to important limitations
and exceptions that are described in the Indenture. The Company was in compliance with all covenants related to the Notes as of August 31, 2019.
Revolving Credit Agreement
On November 14, 2017, the Company replaced its existing $250 million five year senior unsecured revolving credit facility agreement with various lenders with a new $250 million five year senior unsecured revolving credit facility agreement ("Revolver") with various lenders maturing November 14, 2022. The new Revolver has essentially the same terms and requirements as the prior revolving credit facility agreement. During the six months ended August 31, 2019, the Company did not have any borrowings under the Revolver.
The Revolver contains customary affirmative and negative covenants and also requires the Company to maintain a maximum leverage ratio. The Company was in compliance with all covenants related to the Revolver as of August 31, 2019.
Deferred financing costs associated with the Notes and the revolving credit facilities of approximately $10.5 million were capitalized. In the accompanying Consolidated Balance Sheets, the deferred financing costs are included in long term debt, net of amortization, for the Notes, and are included in other assets, net of amortization, for the Revolver. These deferred financing costs for the Notes and the Revolver are being amortized over the term of each of the Notes and the term of the Revolver and such amortization is included in interest expense, net in the consolidated statements of operations. Interest expense related to the Notes and the revolving credit facilities, including the commitment fee and the amortization of deferred financing costs, was approximately $18.2 million and $18.3 million for the three months ended August 31, 2019 and September 1, 2018, respectively, and $36.4 million and $36.5 million for the six months ended August 31, 2019 and September 1, 2018, respectively.
Lines of Credit
At August 31, 2019, the Company maintained two uncommitted lines of credit of $100 million each, with expiration dates of February 23, 2020 and August 30, 2020, respectively. These uncommitted lines of credit are currently and are expected to be used for letters of credit in the ordinary course of business. During the first six months of fiscal 2019, the Company did not have any direct borrowings under the uncommitted lines of credit. Although no assurances can be provided, the Company intends to renew both uncommitted lines of credit before the respective expiration dates.
12) Shareholders' Equity
The Company has authorization to make repurchases from time to time in the open market or through other parameters approved by the Board of Directors pursuant to existing rules and regulations.
Between December 2004 and September 2015, the Company's Board of Directors authorized, through several share repurchase programs, the repurchase of $11.950 billion of its shares of common stock. The Company also acquires shares of its common stock to cover employee related taxes withheld on vested restricted stock and performance stock unit awards. In the first six months of fiscal 2019, the Company repurchased approximately 6.7 million shares of its common stock for a total cost of approximately $98.0 million, bringing the aggregate total of common stock repurchased to approximately 217.0 million shares for a total cost of approximately $10.7 billion since the initial authorization in December 2004. The Company has approximately $1.2 billion remaining of authorized share repurchases as of August 31, 2019.
During fiscal 2016, the Company's Board of Directors authorized a quarterly dividend program. During the six months ended August 31, 2019 and September 1, 2018, total cash dividends of $43.4 million were paid, respectively. Subsequent to the end of the second quarter of fiscal 2019, on October 2, 2019, the Company's Board of Directors declared a quarterly dividend of $0.17 per share to be paid on January 14, 2020 to shareholders of record as of the close of business on December 13, 2019. The Company expects to pay quarterly cash dividends on its common stock in the future, subject to the determination by the Board of Directors, based on an evaluation of the Company's earnings, financial condition and requirements, business conditions and other factors.
Cash dividends, if any, are accrued as a liability on the Company's consolidated balance sheets and recorded as a decrease to retained earnings when declared.
13) Stock-Based Compensation
The Company measures all employee stock-based compensation awards using a fair value method and records such expense, net of estimated forfeitures, in its consolidated financial statements. Currently, the Company's stock-based compensation relates to
restricted stock awards, stock options and performance stock units. The Company's restricted stock awards are considered nonvested share awards.
Stock-based compensation expense for the three and six months ended August 31, 2019 was approximately $12.1 million ($8.4 million after tax or $0.07 per diluted share) and approximately $31.4 million ($25.8 million after tax or $0.20 per diluted share), respectively. Stock-based compensation expense for the three and six months ended September 1, 2018 was approximately $13.4 million ($10.2 million after tax or $0.08 per diluted share) and approximately $37.0 million ($26.5 million after tax or $0.19 per diluted share), respectively. In addition, the amount of stock-based compensation cost capitalized for the six months ended August 31, 2019 and September 1, 2018 was approximately $0.5 million and $1.3 million, respectively.
Incentive Compensation Plans
The Company grants awards under the Bed Bath & Beyond 2012 Incentive Compensation Plan (the "2012 Plan") and the Bed Bath & Beyond 2018 Incentive Compensation Plan (the "2018 Plan"), which was adopted by the Company and approved by shareholders in 2018. The 2012 Plan includes an aggregate of 43.2 million common shares authorized for issuance and the 2018 Plan includes an aggregate share reserve of 4.6 million shares of common stock, resulting in a total of 47.8 million shares authorized for issuance under both plans.
The terms of the 2012 Plan and the 2018 Plan are substantially similar and enable the Company to offer incentive compensation through stock options (whether nonqualified stock options or incentive stock options), restricted stock awards, stock appreciation rights, performance awards and other stock based awards, including cash awards. Grants are determined by the Compensation Committee for those awards granted to executive officers and by an appropriate committee for all other awards granted. Stock option grants generally become exercisable in either three or five equal annual installments beginning one year from the date of grant, subject, in general, to the recipient remaining in the Company's service on specified vesting dates. Restricted stock awards generally become vested in five to seven equal annual installments beginning one to three years from the date of grant, subject, in general, to the recipient remaining in the Company's service on specified vesting dates. Performance stock units generally vest over a period of three to four years from the date of grant dependent on the Company's achievement of performance-based tests and subject, in general, to the executive remaining in the Company's service on specified vesting dates.
The Company generally issues new shares for stock option exercises, restricted stock awards and vesting of performance stock units. No grants have been made to date under the 2018 Plan, which expires in May 2028. The 2012 Plan expires in May 2022.
Stock Options
Stock option grants are issued at fair market value on the date of grant and generally become exercisable in either three or five equal annual installments beginning one year from the date of grant, subject, in general, to the recipient remaining in the Company's service on specified vesting dates. Option grants expire eight years after the date of grant. All option grants are nonqualified. As of August 31, 2019, unrecognized compensation expense related to the unvested portion of the Company's stock options was $3.7 million, which is expected to be recognized over a weighted average period of 3.4 years.
The fair value of the stock options granted was estimated on the date of the grant using a Black-Scholes option-pricing model that uses the assumptions noted in the following table.
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Six Months Ended
|
Black-Scholes Valuation Assumptions (1)
|
August 31, 2019
|
|
September 1, 2018
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Weighted Average Expected Life (in years) (2)
|
7.6
|
|
|
6.7
|
|
Weighted Average Expected Volatility (3)
|
39.41
|
%
|
|
34.96
|
%
|
Weighted Average Risk Free Interest Rates (4)
|
2.39
|
%
|
|
2.92
|
%
|
Expected Dividend Yield (5)
|
4.34
|
%
|
|
3.80
|
%
|
(1) Forfeitures are estimated based on historical experience.
(2) The expected life of stock options is estimated based on historical experience.
(3) Expected volatility is based on the average of historical and implied volatility. The historical volatility is determined by observing actual prices of the Company's stock over a period commensurate with the expected life of the awards. The implied volatility represents the implied volatility of the Company's call options, which are actively traded on multiple exchanges, had remaining maturities in excess of twelve months, had market prices close to the exercise prices of the employee stock options and were measured on the stock option grant date.
(4) Based on the U.S. Treasury constant maturity interest rate whose term is consistent with the expected life of the stock options.
(5) Expected dividend yield is estimated based on anticipated dividend payouts.
Changes in the Company's stock options for the six months ended August 31, 2019 were as follows:
|
|
|
|
|
|
|
|
(Shares in thousands)
|
Number of Stock
Options
|
|
Weighted Average
Exercise Price
|
Options outstanding, beginning of period
|
4,395
|
|
|
$
|
47.53
|
|
Granted
|
144
|
|
|
15.68
|
|
Exercised
|
—
|
|
|
—
|
|
Forfeited or expired
|
(2,607
|
)
|
|
53.86
|
|
Options outstanding, end of period
|
1,932
|
|
|
$
|
36.62
|
|
Options exercisable, end of period
|
1,094
|
|
|
$
|
45.83
|
|
The weighted average fair value for the stock options granted during the first six months of fiscal 2019 and 2018 was $4.18 and $4.31, respectively. The weighted average remaining contractual term and the aggregate intrinsic value for options outstanding as of August 31, 2019 was 5.3 years and $0, respectively. The weighted average remaining contractual term for options exercisable as of August 31, 2019 was 4.4 years and the aggregate intrinsic value was $0. There were no stock options exercised during the first six months of fiscal 2019 and 2018.
Restricted Stock
Restricted stock awards are issued and measured at fair market value on the date of grant and generally become vested in five to seven equal annual installments beginning one to three years from the date of grant, subject, in general, to the recipient remaining in the Company's service on specified vesting dates. Vesting of restricted stock is based solely on time vesting. As of August 31, 2019, unrecognized compensation expense related to the unvested portion of the Company's restricted stock awards was $88.4 million, which is expected to be recognized over a weighted average period of 3.9 years.
Changes in the Company's restricted stock for the six months ended August 31, 2019 were as follows:
|
|
|
|
|
|
|
|
(Shares in thousands)
|
Number of Restricted
Shares
|
|
Weighted Average
Grant-Date Fair
Value
|
Unvested restricted stock, beginning of period
|
3,747
|
|
|
$
|
41.73
|
|
Granted
|
880
|
|
|
13.52
|
|
Vested
|
(689
|
)
|
|
50.47
|
|
Forfeited
|
(424
|
)
|
|
36.73
|
|
Unvested restricted stock, end of period
|
3,514
|
|
|
$
|
33.56
|
|
Performance Stock Units
Performance stock units ("PSUs") are issued and measured at fair market value on the date of grant. Vesting of PSUs awarded to certain of the Company's executives is dependent on the Company's achievement of a performance-based test during a one-year period from the date of grant and during a three-year period from the date of grant and, assuming achievement of the performance-based test, time vesting over periods of up to four years, subject, in general, to the executive remaining in the Company's service on specified vesting dates. For awards granted in fiscal 2018 and prior, performance during the three-year period were based on Return on Invested Capital ("ROIC") or a combination of Earnings Before Interest and Taxes ("EBIT") margin and ROIC relative to a peer group. For awards granted in fiscal 2019, performance during a one-year period is based on a one-year Company EBIT goal and performance during the three-year period is based on a three-year cumulative Company EBIT goal and a relative three-year Total Shareholder Return ("TSR") goal relative to a peer group. The PSU awards range from a floor of zero to a cap of 150% of target achievement. PSUs are converted into shares of common stock upon payment following vesting. Upon grant of the PSUs, the Company recognizes compensation expense related to these awards based on the Company's estimate of the percentage of the award that will be achieved. The Company evaluates the estimate on these awards on a quarterly basis and adjusts compensation expense related to these awards, as appropriate. As of August 31, 2019, unrecognized compensation expense related to the unvested portion of the Company's performance stock units was $7.5 million, which is expected to be recognized over a weighted average period of 2.0 years.
The fair value of the PSUs granted in fiscal 2019 for which performance during the three-year period will be based on a relative three-year Total Shareholder Return ("TSR") goal relative to a peer group was estimated on the date of the grant using a Monte Carlo simulation that uses the assumptions noted in the following table.
|
|
|
|
|
Six Months Ended
|
Monte Carlo Simulation Assumptions
|
August 31, 2019
|
Risk Free Interest Rate
|
1.7
|
%
|
Expected Dividend Yield
|
—
|
%
|
Expected Volatility
|
43.40
|
%
|
Expected Term
|
3 years
|
|
Changes in the Company's PSUs for the six months ended August 31, 2019 were as follows:
|
|
|
|
|
|
|
|
(Shares in thousands)
|
Number of Performance
Stock Units
|
|
Weighted Average
Grant-Date Fair
Value
|
Unvested performance stock units, beginning of period
|
2,082
|
|
|
$
|
27.16
|
|
Granted
|
821
|
|
|
11.02
|
|
Vested
|
(557
|
)
|
|
35.09
|
|
Forfeited or performance condition adjustments
|
(173
|
)
|
|
24.87
|
|
Unvested performance stock units, end of period
|
2,173
|
|
|
$
|
19.21
|
|
14) Earnings per Share
The Company presents earnings per share on a basic and diluted basis. Basic earnings per share has been computed by dividing net earnings by the weighted average number of shares outstanding. Diluted earnings per share has been computed by dividing net earnings by the weighted average number of shares outstanding, including the dilutive effect of stock-based awards as calculated under the treasury stock method.
Stock-based awards for the three and six months ended August 31, 2019 of approximately 5.9 million and 6.8 million, respectively, and September 1, 2018 of approximately 7.6 million and 8.1 million, respectively, were excluded from the computation of diluted earnings per share as the effect would be anti-dilutive.
15) Supplemental Cash Flow Information
The Company paid income taxes of $39.6 million and $34.9 million in the first six months of fiscal 2019 and 2018, respectively. In addition, the Company had interest payments of approximately $40.6 million and $40.7 million in the first six months of fiscal 2019 and 2018, respectively.
The Company recorded an accrual for capital expenditures of $19.3 million and $13.8 million as of August 31, 2019 and September 1, 2018, respectively. In addition, the Company recorded an accrual for dividends payable of $25.6 million and $27.0 million as of August 31, 2019 and September 1, 2018, respectively.
16) Restructuring Activities
In the first quarter of fiscal 2019, the Company expensed pre-tax restructuring charges of approximately $3.9 million, related to the realignment of its store management structure to support its customer-focused initiatives and omnichannel growth. These charges primarily were for severance and related costs in conjunction with this realignment. The Company paid $2.6 million of these costs during the six months ended August 31, 2019.
During the second quarter of fiscal 2019, the Company expensed pre-tax restructuring charges of approximately $22.5 million, related to a corporate workforce reduction which impacted the Company's corporate staff, including executive officers, vice presidents, directors, managers, and professional staff and the Company's decision to outsource certain transaction processing functions within the business. These charges were primarily for severance and related costs in conjunction with transformation initiatives. The Company paid $1.0 million of these costs during the three months ended August 31, 2019.
17) Commitments and Contingencies
The District Attorney's office for the County of Ventura, together with District Attorneys for other counties in California (together, the “District Attorneys"), recently concluded an investigation regarding the management and disposal at the Company's stores in California of certain materials that may be deemed hazardous or universal waste under California law. On March 19, 2019, the District Attorneys provided the Company with a settlement demand that included a proposed civil penalty, reimbursement of investigation costs, and certain injunctive relief, including modifications to the Company's existing compliance program, which already includes associate training, on-going review of disposal rules applicable to various product categories, and specialized third-party disposal. The Company is working with the District Attorneys towards a resolution of this matter and has recorded an accrual for the estimated probable loss for this matter as of August 31, 2019 and March 2, 2019. While no assurance can be given as to its ultimate outcome, the Company does not believe that the final resolution of this matter will have a material effect on the Company’s consolidated financial position, results of operations or liquidity.
On April 21, 2019, Warren Eisenberg and Leonard Feinstein transitioned to the role of Co-Founders and Co-Chairmen Emeriti of the Board of Directors of the Company. As a result of this transition, Mr. Eisenberg and Mr. Feinstein ceased to be officers of the Company effective as of April 21, 2019, and became entitled to the payments and benefits provided under their employment agreements that apply in the case of a termination without cause, which generally include continued senior status payments until May 2027 and continued participation for the Co-Founders (and their spouses, if applicable) at the Company's expense in employee plans and programs. In addition, the Co-Founders are entitled to supplemental pension payments specified in their employment agreements until the death of the survivor of the Co-Founder and his spouse, reduced by the continued senior status payments referenced in the foregoing sentence.
Pursuant to their respective restricted stock and performance stock unit agreements, shares of restricted stock and performance-based stock units granted to Messrs. Eisenberg and Feinstein vested upon their resignation as members of the Board of Directors effective May 1, 2019, subject, however, to attainment of any applicable performance goals and the certification of the applicable performance-based tests by the Compensation Committee, as provided under their award agreements.
The Company's Chief Executive Officer ("CEO") departed the Company effective as of May 12, 2019. In accordance with the terms of the CEO's employment and equity award agreements, the CEO was entitled to three times the then-current salary, payable over three years in normal payroll installments, except that any amount due prior to the six months after his departure, will be paid in a lump sum after such six-month period. Such amounts will be reduced by any compensation earned with any subsequent employer or otherwise and will be subject to the CEO's compliance with a one-year non-competition and non-solicitation covenant. Further, as a result of this departure, the time-vesting component of the CEO's equity-based awards accelerated, including (i) stock options (which currently are “underwater”), (ii) PSU awards which had previously met the related performance-based test, had been certified by the Compensation Committee, and remained subject solely to time-vesting, and (iii) PSU awards (assuming target level of performance) which remain subject to attainment of any performance goals and the certification of the applicable performance-based tests by the Compensation Committee, as provided under his award agreements.
The CEO was also party to a supplemental executive retirement benefit agreement (“SERP”) and a related escrow agreement, pursuant to which the CEO was entitled to receive a supplemental retirement benefit as a result of the separation from service from the Company. Pursuant to the SERP, as a result of the separation from service with the Company as of May 12, 2019 being treated as a termination without cause, the CEO is entitled to a lump sum payment equal to the present value of an annual amount equal to 50% of the CEO's annual base salary on the date of termination of employment if such annual amount were paid for a period of 10 years in accordance with the Company’s normal payroll practices, subject to the CEO's timely execution and non-revocation of a release of claims in favor of the Company, which will be paid on the first business day following the six-month anniversary of the CEO's termination of service. Although the SERP provides that the CEO will be protected from any impact resulting from the possible application of Section 409A of the Code to the terms of the SERP due to the complexities surrounding Section 409A, the Company believes that no such payment will be required.
The Company has expensed pre-tax charges related to both the transition of Messrs. Eisenberg and Feinstein to the role of Co-Founders and Co-Chairmen Emeriti of the Board of Directors of the Company and the departure of the Company's CEO of approximately $35.2 million.
In addition, the Company maintains employment agreements with other executives which provide for severance pay.
The Company records an estimated liability related to its various claims and legal actions arising in the ordinary course of business when and to the extent that it concludes a liability is probable and the amount of the loss can be reasonably estimated. Such estimated loss is based on available information and advice from outside counsel, where appropriate. As additional information becomes available, the Company reassesses the potential liability related to claims and legal actions and revises its estimated
liabilities, as appropriate. The Company expects the ultimate disposition of these matters will not have a material adverse effect on the Company’s consolidated financial position, results of operations or liquidity. The Company also cannot predict the nature and validity of claims which could be asserted in the future, and future claims could have a material impact on its earnings.