Cracker Barrel Old Country Store (CBRL) 10-Q2021 Q1 Quarterly report

Cracker Barrel Old Country Store, Inc. and its subsidiaries (collectively, the “Company,” “our” or “we”) are principally engaged in the operation and development in the United States of the Cracker Barrel Old Country Store^® (“Cracker Barrel”) concept.  At October 30, 2020, we operated 663 Cracker Barrel stores in 45 states and 35 Maple Street Biscuit Company (“MSBC”) company-owned locations in seven states.  At October 30, 2020, MSBC had six franchised locations.

All dollar amounts reported or discussed in this Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) are shown in thousands, except per share amounts and certain statistical information (e.g., number of stores).  References to years in MD&A are to our fiscal year unless otherwise noted.

MD&A provides information which management believes is relevant to an assessment and understanding of our consolidated results of operations and financial condition.  MD&A should be read in conjunction with the (i) condensed consolidated financial statements and notes thereto included in this Quarterly Report on Form 10-Q and (ii) audited consolidated financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended July 31, 2020 (the “2020 Form 10-K”).  Except for specific historical information, many of the matters discussed in this report may express or imply projections of items such as revenues or expenditures, estimated capital expenditures, compliance with debt covenants, plans and objectives for future operations, inventory shrinkage, growth or initiatives, expected future economic performance or the expected outcome or impact of pending or threatened litigation. These and similar statements regarding events or results which we expect will or may occur in the future are forward-looking statements that, by their nature, involve risks, uncertainties and other factors which may cause our actual results and performance to differ materially from those expressed or implied by such statements.  All forward-looking information is provided pursuant to the safe harbor established under the Private Securities Litigation Reform Act of 1995 and should be evaluated in the context of these risks, uncertainties and other factors. Forward-looking statements generally can be identified by the use of forward-looking terminology such as “trends,” “assumptions,” “target,” “guidance,” “outlook,” “opportunity,” “future,” “plans,” “goals,” “objectives,” “expectations,” “near-term,” “long-term,” “projection,” “may,” “will,” “would,” “could,” “expect,” “intend,” “estimate,” “anticipate,” “believe,” “potential,” “should,” “projects,” “forecasts” or “continue”  (or the negative or other derivatives of each of these terms) or similar terminology.  We believe the assumptions underlying any forward-looking statements are reasonable; however, any of the assumptions could be inaccurate, and therefore, actual results may differ materially from those projected in or implied by the forward-looking statements.  In addition to the risks of ordinary business operations, and those discussed or described in this report or in information incorporated by reference into this report, factors and risks that may result in actual results differing from this forward-looking information include, but are not limited to risks and uncertainties associated with the novel coronavirus (“COVID-19”) pandemic, including the duration of the COVID-19 pandemic and its ultimate impact on our business, levels of consumer confidence in the safety of dine-in restaurants, restrictions (including occupancy restrictions) imposed by governmental authorities, the effectiveness of cost saving measures undertaken throughout our operations, disruptions to our operations as a result of the spread of COVID-19 in our workforce, and our increased level of indebtedness brought on by additional borrowing necessitated by the COVID-19 pandemic; general or regional economic weakness, and weather on sales and customer travel; discretionary income or personal expenditure activity of our customers; information technology-related incidents, including data privacy and information security breaches, whether as a result of infrastructure failures, employee or vendor errors, or actions of third parties; our ability to identify, acquire and sell successful new lines of retail merchandise and new menu items at our restaurants; our ability to sustain or the effects of plans intended to improve operational or marketing execution and performance; uncertain performance of acquired businesses, strategic investments and other initiatives that we may pursue now or in the future; changes in or implementation of additional governmental or regulatory rules, regulations and interpretations affecting tax, wage and hour matters, health and safety, pensions, insurance or other undeterminable areas; the effects of plans intended to promote or protect our brands and products; commodity price increases; the ability of and cost to us to recruit, train, and retain qualified hourly and management employees; the effects of increased competition at our locations on sales and on labor recruiting, cost, and retention; workers’ compensation, group health and utility price changes; consumer behavior based on negative publicity, changes in consumer health or dietary trends or safety aspects of our food or products or those of the restaurant industry in general, including concerns about outbreaks of infectious disease as well as the possible effects of such events on the price or availability of ingredients used in our restaurants; the effects of our indebtedness and associated restrictions on our financial and operating flexibility and ability to execute or pursue our operating plans and objectives; changes in interest rates, increases in borrowed capital or capital market conditions affecting our financing costs and ability to refinance all or portions of our indebtedness; the effects of business trends on the outlook for individual restaurant locations and the effect on the carrying value of those locations; our ability to retain key personnel; the availability and cost of suitable sites for restaurant development and our ability to identify those sites; our ability to enter successfully into new geographic markets that may be less familiar to us; changes in land, building materials and construction costs; the actual results of pending, future or threatened litigation or governmental investigations and the costs and effects of negative publicity associated with these activities; economic or psychological effects of natural disasters or other unforeseen events such as terrorist acts, social unrest or war and the military or government responses to such events; disruptions to our restaurant or retail supply chain, including as a result of COVID-19; changes in foreign exchange rates affecting our future retail inventory purchases; implementation of new or changes in interpretation of existing accounting principles generally accepted in the United States of America (“GAAP”) and those factors contained in Part I, Item 1A of the 2020 Form 10-K, as well as the factors described under “Critical Accounting Estimates” on pages 29-31 of this report or, from time to time, in our filings with the Securities and Exchange Commission (“SEC”), press releases and other communications.

Readers are cautioned not to place undue reliance on forward-looking statements made in this report because the statements speak only as of the report’s date.  Except as may be required by law, we have no obligation or intention to update or revise any of these forward-looking statements to reflect events or circumstances occurring after the date of this report or to reflect the occurrence of unanticipated events.  Readers are advised, however, to consult any future public disclosures that we may make on related subjects in reports that we file with or furnish to the SEC or in our other public disclosures.

The COVID-19 pandemic continues to negatively impact the Company’s sales and traffic as a result of changes in consumer behavior as well as unprecedented restrictions by federal, state and local governmental authorities and recommendations by public health experts limiting travel, group gatherings and non-essential activities, such as “social distancing” guidance, shelter-in-place orders and limitations on or full prohibitions of dine-in services.  Future consumer behavior and governmental regulations continue to be undeterminable while the COVID-19 pandemic continues to impact local, state, and national health conditions.

Despite the impact of the COVID-19 pandemic, management continues to believe that the Cracker Barrel brand remains one of the strongest and most differentiated brands in the restaurant industry.  Our priorities for 2021 consist of the following:

Management uses a number of key performance measures to evaluate our operational and financial performance, including the following:

The following table highlights our operating results by percentage relationships to total revenue for the quarter ended October 30, 2020 as compared to the same period in the prior year:

Total revenue for the first quarter of 2021 decreased 13.7% as compared to the same period in the prior year.  The total revenue decrease for the first quarter of 2021 was driven by the decline in restaurant guest traffic as a result of restrictions mandated by federal, state and local governments in the United States to mitigate the spread of COVID-19 and the related changes in consumer behavior.

For the first quarter of 2021, our comparable store restaurant sales decreased as a result of an 18.3% decrease in guest traffic decrease partially offset by a 1.9% increase in average check increase (including a 1.0% average menu price increase) as compared to the prior year first quarter.

Our retail sales are made substantially to our restaurant guests.  For the first quarter of 2021 our comparable store retail sales decrease resulted from the guest traffic decline and the impact of the COVID-19 pandemic as compared to the same period in the prior year.

The increase in restaurant cost of goods sold as a percentage of restaurant revenue in the first quarter of 2020 as compared to the same period in the prior year primarily resulted from a shift in purchases to menu items that have a higher cost relative to other menu items,  commodity inflation of 1.9% and higher food waste partially offset by our menu price increase referenced above.  Higher cost menu items and higher food waste accounted for increases of 1.2% and 0.1%, respectively, in restaurant cost of goods sold as a percentage of restaurant revenue for the first quarter of 2021 as compared to the same period in the prior year.

This percentage change resulted from the following:

The decrease in store bonus expense as a percentage of total revenue for the first quarter of 2021 as compared to the same period in the prior year resulted from lower performance against financial objectives for certain components of the incentive plan in the first quarter of 2021 as compared to the same period in the prior year.

The decrease in miscellaneous wages as a percentage of total revenue for the first quarter of 2021 as compared to the same period in the prior year resulted primarily from a reduction in the use of indirect labor hours.

The increase in store hourly labor costs as a percentage of total revenue for the first quarter of 2021 as compared to the same period in the prior year resulted primarily from wage inflation exceeding menu price increases.

The increase in store management compensation as a percentage of total revenue for the first quarter of 2021 as compared to the same period in the prior year was primarily due to the decrease in revenue in the first quarter of 2021 as compared to the same period in the prior year.

Other store operating expenses include all store-level operating costs, the major components of which are utilities, preopening expenses excluding labor, operating supplies, repairs and maintenance, depreciation and amortization, advertising, rent, credit and gift card fees, real and personal property taxes, general insurance and costs associated with our bi-annual manager conference and training event.

The following table highlights other store operating expenses as a percentage of total revenue for the first quarter of 2021 as compared to the same period in the prior year:

The increase in rent expense as a percentage of total revenue for the first quarter of 2021 as compared to the same period in the prior year resulted primarily from the sale and leaseback transaction involving 62 of our owned Cracker Barrel stores completed on August 4, 2020.  The aggregate initial annual rent payment for these properties is approximately $10,393.  Additionally, the related rent expense includes $3,184 recorded in the first quarter of 2021 for the non-cash amortization of the asset recognized from the gain on the Company’s sale and leaseback transactions.  See Note 10 to the Condensed Consolidated Financial Statements for additional information regarding the Company’s sale and leaseback transactions.

The increase in supplies expense as a percentage of total revenue for the first quarter of 2021 as compared to the same period in the prior year resulted primarily from costs associated with the growth in our off-premise business.

The increase in other store expenses as a percentage of total revenue for the first quarter of 2021 as compared to the same period in the prior year resulted primarily from costs associated with the growth in our off-premise business.

The increase in maintenance expense as a percentage of total revenue for the first quarter of 2021 as compared to the same period in the prior year resulted primarily from costs associated with the implementation of technology initiatives to improve the guest experience and the decrease in revenue in the first quarter of 2021 as compared to the prior year period.

The increase in depreciation expense as a percentage of total revenue for the first quarter of 2021 as compared to the same period in the prior year resulted primarily from the decrease in revenue in the first quarter of 2021 as compared to the prior year period partially offset by the decrease in depreciation expense resulting from the August 4, 2020 sale and leaseback transaction and lower spending on capital expenditures..

The increase in advertising expense as a percentage of total revenue for the first quarter of 2021 as compared to the same period in the prior year resulted primarily from higher online media spending and a decrease in revenue in the first quarter of 2021 as compared to the prior year period.

The following table highlights general and administrative expenses as a percentage of total revenue for the first quarter of 2021 as compared to the same period in the prior year:

The increase in general and administrative expenses as a percentage of total revenue in the first quarter of 2021 as compared to the same period in the prior year resulted primarily from expenses related to the proxy contest initiated by affiliates of Sardar Biglari in connection with the Company’s 2020 annual shareholders meeting held on November 19, 2020.

On August 4, 2020, the Company completed a sale and leaseback transaction involving 62 of its owned Cracker Barrel stores and recorded a gain of $217,722 which is recorded in the gain on sale and leaseback transaction line in the Condensed Consolidated Statement of Income in the first quarter of 2021.  See Note 10 to the Condensed Consolidated Financial Statements for additional information regarding this sale and leaseback transaction.

The increase in interest expense for the first quarter of 2021 as compared to the same period in the prior year resulted primarily from higher debt levels caused by our borrowing under our 2019 Revolving Credit Facility in response to the COVID-19 pandemic, higher weighted average interest rates and the nonrecurrence of interest income on Punch Bowl Social (“PBS”) promissory notes written off in the third quarter of 2020.

Our primary sources of liquidity are cash generated from our operations and our borrowing capacity under our 2019 Revolving Credit Facility.  Our internally generated cash, along with cash on hand at July 31, 2020 was sufficient to finance all of our growth, deferred payment of our dividend declared in March 2020 that was originally scheduled to be paid in May 2020 and was subsequently paid in September 2020, working capital needs and other cash payment obligations in the first three months of 2021.  Based on the continued actions taken by management, such as the reduction in operating expenses to reflect reduced operations and sales levels, elimination of non-essential spending, the suspension of current and future dividend payments and share repurchases and the recent completion of sale and leaseback transactions, management expects to meet its obligations over the next twelve months.

Our operating activities provided net cash of $56,991 for the first three months of 2021, representing an increase from the $44,835 net cash provided during the first three months of 2020.  This increase primarily reflected the timing of payments for accounts payable.

On September 5, 2018, we entered into a five-year $950,000 revolving credit facility (“2019 Revolving Credit Facility”).  The 2019 Revolving Credit Facility also contains an option to increase the revolving credit facility by $300,000.  In the fourth quarter of 2020, we borrowed an additional $39,395 under this option for a one-year period.

At October 30, 2020, we had $949,395 of outstanding borrowings under the 2019 Revolving Credit Facility and we had $31,804 of standby letters of credit related to securing reserved claims under our workers’ compensation insurance and our July 29, 2020 and August 4, 2020 sale and leaseback transactions which reduce our borrowing availability under the 2019 Revolving Credit Facility.  At October 30, 2020, we had $8,196 in borrowing availability under our 2019 Revolving Credit Facility.  See Note 5 to our Condensed Consolidated Financial Statements for further information on our long-term debt.

The 2019 Revolving Credit Facility contains customary financial covenants, which include maintenance of a maximum consolidated total leverage ratio and a minimum consolidated interest coverage ratio.  As a result of the negative impact of the COVID-19 pandemic on our financial position and results of operations, we have obtained a waiver for the financial covenants for the fourth quarter of 2020 and the first and second quarters of 2021 (“Covenant Relief Period”).  During this covenant relief period, we are required to maintain liquidity (defined as the availability under the 2019 Revolving Credit Facility plus unrestricted cash and cash equivalents) of at least $140,000. Additionally, during this Covenant Relief Period, our cash payments with respect to capital expenditures may not exceed $60,000 in the aggregate.

Capital expenditures (purchase of property and equipment) net of proceeds from insurance recoveries were $11,214 for the first three months of 2021 as compared to $27,828 for the same period in the prior year.  Our capital expenditures consisted primarily of capital investments for existing stores, new store locations and capital expenditures for strategic initiatives.  The decrease in capital expenditures during the first three months of 2021 as compared to the first three months of 2020 resulted primarily from lower capital expenditures for existing stores as well as our decreases in new store construction, store remodels and other similar expenditures in response to the COVID-19 pandemic.  We estimate that our capital expenditures during 2021 will be approximately $100,000.  This estimate includes the acquisition of sites and construction costs of new Cracker Barrel stores and new MSBC locations that have opened or that we continue to expect to open during 2021, as well as for acquisition and construction costs for store locations that we continue to plan to be opened in 2022.  We intend to fund our capital expenditures with cash generated by operations and cash on hand as the result of borrowings under our 2019 Revolving Credit Facility, as necessary.  See the discussion above under “Borrowing Capacity and Debt Covenants” regarding a debt covenant restriction on our cash payment for capital expenditures.

The proceeds from sale of property and equipment were $149,829 for the first three months of 2021 as compared to $1,534 for the same period in the prior year.  This increase primarily relates to the sale and leaseback transaction entered into on August 4, 2020.  See Note 10 to the Condensed Consolidated Financial Statements for additional information regarding this sale and leaseback transaction.

Effective October 10, 2019, we acquired 100% ownership of MSBC, a breakfast and lunch fast casual concept, for a purchase price of $36,000, of which $32,000 was paid to the sellers in cash with the remaining $4,000 being held as security for the satisfaction of indemnification obligations, if any.  The first installment of $1,500, to be held as security, was paid to the principal seller in the first quarter of 2021, and the remaining amount, if any, will be paid in a final installment to the sellers on the two-year anniversary of closing.  We believe that the investment in MSBC supports our strategic initiative to extend the brand by becoming a market leader in the breakfast and lunch-focused fast casual dining segment of the restaurant industry and by providing a platform for growth.

Effective July 18, 2019, we entered into a strategic relationship with PBS, a food, beverage and entertainment concept, by purchasing a non-controlling interest in the concept.  As part of the transaction, we agreed to fund PBS up to $51,000 through calendar 2020 of which we funded $16,000 during the first quarter of 2020.  During the first quarter of 2020, we recorded a loss related to our equity investment in PBS of $5,980 which was recorded in the net loss from unconsolidated subsidiary line on our Condensed Consolidated Statement of Income.

We believed the investment in PBS provided us with a growth vehicle to deliver additional shareholder value.  However, as a result of the COVID-19 pandemic, PBS Holdco’s wholly-owned subsidiary, PBS BrandCo, LLC (“Brandco”) suspended all operations at each of its 19 locations and laid off substantially all restaurant and corporate employees in the third quarter of 2020.  On March 20, 2020, the primary lender under Brandco’s secured credit facility provided notice of the lender’s intention to foreclose on its collateral interest in Brandco unless we repaid or unconditionally guaranteed the indebtedness.   In keeping with our strategy of concentrating our resources on our core business during the COVID-19 pandemic, and in light of the substantial uncertainties surrounding PBS business coming out of the COVID-19 pandemic, we determined not to invest further resources to prevent foreclosure or otherwise provide additional capital to PBS.  In the third quarter of 2020, we recorded a loss of $132,878, which represented our equity investment in PBS and the principal and accumulated interest under the outstanding unsecured indebtedness of PBS held by the Company.

The 2019 Revolving Credit Facility imposes restrictions on the amount of dividends we are permitted to pay and the amount of shares we are permitted to repurchase.  During the Covenant Relief Period described above, we are subject to restrictions on our ability to pay dividends (other than the deferred dividend payment that we paid on September 2, 2020).  Following the Covenant Relief Period, under the 2019 Revolving Credit Facility, provided there is no default existing and the total of our availability under the 2019 Revolving Credit Facility plus our cash and cash equivalents on hand is at least $100,000 (the “Cash Availability”), we may declare and pay cash dividends on shares of our common stock and repurchase shares of our common stock (1) in an unlimited amount if, at the time the dividend or the repurchase is made, our consolidated total leverage ratio is 3.00 to 1.00 or less and (2) in an aggregate amount not to exceed $100,000 in any fiscal year if our consolidated total leverage ratio is greater than 3.00 to 1.00 at the time the dividend or repurchase is made; notwithstanding (1) and (2), so long as immediately after giving effect to the payment of any such dividends Cash Availability is at least $100,000, we may declare and pay cash dividends on shares of our common stock in an aggregate amount not to exceed in any fiscal year the product of the aggregate amount of dividends declared in the fourth quarter of the immediately preceding fiscal year multiplied by four.

To preserve available cash during the COVID-19 pandemic and in light of the uncertainties as to its duration and economic impact, we deferred payment of the dividend of $1.30 per share declared in the third quarter of 2020 until September 2, 2020 to shareholders of record on August 14, 2020.  Additionally, we have suspended all further dividend payments under the Company’s dividend program until further notice.

In response to the COVID-19 pandemic, we have temporarily suspended all future share repurchases.

During the first three months of 2021, we issued 22,928 shares of our common stock resulting from the vesting of share-based compensation awards. Related tax withholding payments on these share-based compensation awards resulted in a net use of cash of $1,992.

In the restaurant industry, virtually all sales are either for cash or third-party credit or debit card.   Restaurant inventories purchased through our principal food distributor are on terms of net zero days, while restaurant inventories purchased locally are generally financed from normal trade credit.  Because of our retail gift shops, which have a lower product turnover than the restaurant business, we carry larger inventories than many other companies in the restaurant industry.  Retail inventories purchased domestically are generally financed from normal trade credit, while imported retail inventories are generally purchased through wire transfers.  These various trade terms are aided by the rapid turnover of the restaurant inventory.  Employees generally are paid on weekly or semi-monthly schedules in arrears for hours worked except for bonuses that are paid either quarterly or annually in arrears.  Many other operating expenses have normal trade terms and certain expenses, such as certain taxes and some benefits, are deferred for longer periods of time.

We had positive working capital of $380,247 at October 30, 2020 versus positive working capital of $191,956 at July 31, 2020.  The change in working capital from July 31, 2020 to October 30, 2020 primarily resulted from the increase in cash, the decrease in the dividend payable due to the temporary suspension of future dividend payments, lower incentive accruals resulting from the payment of annual and long-term incentive bonuses and the change in retail inventory levels partially offset by the timing of payments for accounts payable.  The increase in cash resulted primarily due to the proceeds received from the sale and leaseback transaction completed on August 4, 2020 and lower payments for annual and long-term incentive bonuses as compared to the prior year.

We have no material off-balance sheet arrangements.

There have been no material changes in our material commitments other than in the ordinary course of business since the end of 2020.  Refer to the sub-section entitled “Material Commitments” under the section entitled “Liquidity and Capital Resources” presented in the MD&A of our 2020 Form 10-K for additional information regarding our material commitments.

See Note 1 to the accompanying Condensed Consolidated Financial Statements for a discussion of recent accounting guidance adopted.  The adopted accounting guidance discussed in Note 1 did not have a significant impact on our consolidated financial position or results of operations.  Regarding the accounting guidance not yet adopted, we are still evaluating the impact of adopting the accounting guidance.

We prepare our Consolidated Financial Statements in conformity with accounting principles generally accepted in the United States of America.  The preparation of these financial statements requires us to make estimates and assumptions about future events and apply judgments that affect the reported amounts of assets, liabilities, revenue, expenses and related disclosures.  We base our estimates and judgments on historical experience, current trends, outside advice from parties believed to be experts in such matters, and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources.  However, because future events and their effects cannot be determined with certainty, actual results could differ from those assumptions and estimates, and such differences could be material.

Our significant accounting policies are discussed in Note 2 to the Consolidated Financial Statements contained in the 2020 Form 10-K.  Judgments and uncertainties affecting the application of those policies may result in materially different amounts being reported under different conditions or using different assumptions.

We assess the impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable.  Recoverability of assets is measured by comparing the carrying value of the asset to the undiscounted future cash flows expected to be generated by the asset.  If the total expected future cash flows are less than the carrying amount of the asset, the carrying value is written down, for an asset to be held and used, to the estimated fair value or, for an asset to be disposed of, to the fair value, net of estimated costs of disposal.  Any loss resulting from impairment is recognized by a charge to income.  Judgments and estimates that we make related to the expected useful lives of long-lived assets and future cash flows are affected by factors such as changes in economic conditions and changes in operating performance.  The accuracy of such provisions can vary materially from original estimates and management regularly monitors the adequacy of the provisions until final disposition occurs.

We have not made any material changes in our methodology for assessing impairments during the first three months of 2021, and we do not believe that there is a reasonable likelihood that there will be a material change in the estimates or assumptions used by us in the future to assess impairment of long-lived assets.  However, if actual results are not consistent with our estimates and assumptions used in estimating future cash flows and fair values of long-lived assets, we may be exposed to losses that could be material.  It is possible that we may recognize impairment as a result of the unknown impacts of the COVID-19 pandemic and our response.

We self-insure a significant portion of our expected workers’ compensation and general liability insurance programs.  We purchase insurance for individual workers’ compensation claims that exceed $250, $750 or $1,000 depending on the state in which the claim originated.  We purchase insurance for individual general liability claims that exceed $500.  We record a reserve for workers’ compensation and general liability for all unresolved claims and for an estimate of incurred but not reported (“IBNR”) claims.  These reserves and estimates of IBNR claims are based upon a full scope actuarial study which is performed annually at the end of our first quarter and is adjusted by the actuarially determined losses and actual claims payments for the fourth quarter.  Additionally, we perform limited scope actuarial studies on a quarterly basis to verify and/or modify our reserves.  The reserves and losses in the actuarial study represent a range of possible outcomes within which no given estimate is more likely than any other estimate.  As such, we record the losses in the lower half of that range and discount them to present value using a risk-free interest rate based on projected timing of payments.  We also monitor actual claims development, including incurrence or settlement of individual large claims during the interim periods between actuarial studies as another means of estimating the adequacy of our reserves.

Our group health plans combine the use of self-insured and fully-insured programs.  Benefits for any individual (employee or dependents) in the self-insured group health program are limited.  We record a liability for the self-insured portion of our group health program for all unpaid claims based upon a loss development analysis derived from actual group health claims payment experience.  Additionally, we record a liability for unpaid prescription drug claims based on historical experience.

Our accounting policies regarding insurance reserves include certain actuarial assumptions and management judgments regarding economic conditions, the frequency and severity of claims and claim development history and settlement practices.  We have not made any material changes in the methodology used to establish our insurance reserves during the first three months of 2021 and do not believe there is a reasonable likelihood that there will be a material change in the estimates or assumptions used to calculate the insurance reserves.  However, changes in these actuarial assumptions, management judgments or claims experience in the future may produce materially different amounts of expense that would be reported under these insurance programs.

Cost of goods sold includes the cost of retail merchandise sold at our stores utilizing the retail inventory method (“RIM”).  Under RIM, the valuation of our retail inventories is determined by applying a cost-to-retail ratio to the retail value of our inventories.  Inherent in the RIM calculation are certain inputs, including initial markons, markups, markdowns and shrinkage, which may significantly impact the gross margin calculation as well as the ending inventory valuation.

Inventory valuation provisions are included for retail inventory obsolescence and retail inventory shrinkage.  Retail inventory is reviewed on a quarterly basis for obsolescence and adjusted as appropriate based on assumptions made by management and judgment regarding inventory aging and future promotional activities.  Retail inventory also includes an estimate of shrinkage that is adjusted upon physical inventory counts.  Annual physical inventory counts are conducted based upon a cyclical inventory schedule.  An estimate of shrinkage is recorded for the time period between physical inventory counts by using a two-year average of the physical inventories’ results on a store-by-store basis.

We have not made any material changes in the methodologies, estimates or assumptions related to our merchandise inventories during the first three months of 2021 and do not believe there is a reasonable likelihood that there will be a material change in the estimates or assumptions in the future.  However, actual obsolescence or shrinkage recorded may produce materially different amounts than we have estimated.

We have ground leases for our leased stores and office space leases that are recorded as operating leases under various non-cancellable operating leases.  Additionally, we lease our retail distribution center, advertising billboards, vehicle fleets, and certain equipment under various non-cancellable operating leases.

We evaluate our leases at contract inception to determine whether we have the right to control use of the identified asset for a period of time in exchange for consideration.  If we determine that we have the right to obtain substantially all of the economic benefit from use of the identified asset and the right to direct the use of the identified asset, we recognize a right-of-use asset and lease liability.  Also, at contract inception, we evaluate our leases to estimate their expected term which includes renewal options that we are reasonably assured that we will exercise, and the classification of the lease as either an operating lease or a finance lease.  Additionally, as our leases do not provide an implicit rate, we use our incremental borrowing rate based on the information available at the time of commencement or modification date in determining the present value of lease payments. Assumptions used in determining our incremental borrowing rate include our implied credit rating and an estimate of secured borrowing rates based on comparable market data. We assess the impairment of the right-of-use asset whenever events or changes in circumstances indicate that the carrying value of the asset may not be recoverable.

Changes in these assumptions and management judgments may produce materially different amounts in the recognition of the right-of-use assets and lease liabilities.  Additionally, any loss resulting from an impairment of the right-of-use assets is recognized by a charge to income, which could be material.

There have been no material changes in our quantitative and qualitative market risks since July 31, 2020.  For a discussion of the Company’s exposure to market risk, refer to the Company’s market risk disclosures set forth in Part II, Item 7A. “Quantitative and Qualitative Disclosures About Market Risk” of the 2020 Form 10-K.

Our management, including our principal executive and principal financial officers, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Exchange Act) as of the end of the period covered by this report.  Based upon this evaluation, our Chief Executive Officer and Chief Financial Officer each concluded that as of October 30, 2020, our disclosure controls and procedures were effective for the purposes set forth in the definition thereof in Exchange Act Rule 13a-15(e).

There have been no material changes in the risk factors previously disclosed in “Item 1A. Risk Factors” of our 2020 Form 10-K.