UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

☒ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended August 1, 2021

or

☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                to         

Registrant’s telephone number, including area code: (888) 636-1223

Not applicable

(Former name, former address and former fiscal year, if changed since last report)

Securities registered pursuant to Section 12(b) of the Act:

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. ☒ Yes ☐ No

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files) ☒ Yes ☐ No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act ☐

Indicate by check mark whether the Registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act). Yes ☐ No ☒

As of September 7, 2021, there were 15,118,514 shares of common stock, $0.00001 par value per share, outstanding.

THE LOVESAC COMPANY

FORM 10-Q

INDEX TO QUARTERLY REPORT ON FORM 10-Q

AUGUST 1, 2021

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and other legal authority, which statements may involve substantial risk and uncertainties. Forward-looking statements generally relate to future events or our future financial or operating performance. In some cases, you can identify forward-looking statements because they contain words such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “could,” “intends,” “target,” “projects,” “contemplates,” “believes,” “estimates,” “predicts,” “potential,” or “continue” or the negative of these words or other similar terms or expressions that concern our expectations, strategy, plans, or intentions.

You should not place undue reliance on forward looking statements. We cannot assure you that the events and circumstances reflected in the forward-looking statements will be achieved or occur at all or on a specified timeframe. The cautionary statements set forth in this Quarterly Report on Form 10-Q, including in Part I – Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations, and elsewhere, identify important factors which you should consider in evaluating our forward-looking statements. These factors include, among other things:

We caution you that the foregoing list may not contain all the forward-looking statements made in this Quarterly Report on Form 10-Q.

You should not rely upon forward-looking statements as predictions of future events. We have based the forward-looking statements contained in this Quarterly Report on Form 10-Q primarily on our current expectations and projections about future events and trends that we believe may affect our business, financial condition, results of operations, and prospects. The outcome of the events described in these forward-looking statements is subject to risks, uncertainties, and other factors described in the sections entitled “Risk Factors” and in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our most recent Annual Report on Form 10-K filed with the Securities and Exchange Commission and in this Quarterly Report on Form 10-Q. Moreover, we operate in a very competitive and rapidly changing environment. New risks and uncertainties emerge from time to time, and it is not possible for us to predict all risks and uncertainties that could have an impact on the forward-looking statements contained in this Quarterly Report on Form 10-Q. We cannot assure you that the results, events, and circumstances reflected in the forward-looking statements will be achieved or occur at all or on a specified timeline, and actual results, events, or circumstances could differ materially from those described in the forward-looking statements.

The forward-looking statements made in this Quarterly Report on Form 10-Q relate only to events as of the date on which the statements are made. We undertake no obligation to update any forward-looking statements made in this Quarterly Report on Form 10-Q to reflect events or circumstances after the date of this Quarterly Report on Form 10-Q or to reflect new information or the occurrence of unanticipated events, except as required by law. We may not actually achieve the plans, intentions, or expectations disclosed in our forward-looking statements, and you should not place undue reliance on our forward-looking statements. Our forward-looking statements do not reflect the potential impact of any future acquisitions, mergers, dispositions, joint ventures, or investments we may make.

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements.

THE LOVESAC COMPANY

CONDENSED CONSOLIDATED BALANCE SHEETS

The accompanying notes are an integral part of these condensed consolidated financial statements.

THE LOVESAC COMPANY

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

THE LOVESAC COMPANY

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY 

FOR THE THIRTEEN AND TWENTY-SIX WEEKS ENDED AUGUST 1, 2021 AND AUGUST 2, 2020

(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

THE LOVESAC COMPANY

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

THE LOVESAC COMPANY

CONDENSED CONSOLIDATED NOTES TO FINANCIAL STATEMENTS

FOR THE THIRTEEN AND TWENTY-SIX WEEKS ENDED AUGUST 1, 2021 AND AUGUST 2, 2020

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our unaudited condensed consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the fiscal year ended January 31, 2021. As discussed in the section titled “Forward-Looking Statements,” the following discussion and analysis contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. Factors that could cause or contribute to these differences include, but are not limited to, those identified in the Forward-Looking Statements section herein and set forth below and those discussed in the sections titled “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our most recent report on Form 10-K filed with the Securities and Exchange Commission.

We operate on a 52- or 53-week fiscal year that ends on the Sunday closest to February 1. Each fiscal year generally is comprised of four 13-week fiscal quarters, although in the years with 53 weeks, the fourth quarter represents a 14-week period.

Overview

We are a technology driven company that designs, manufactures and sells unique, high quality furniture derived through our proprietary “Designed for Life” approach which results in products that are built to last a lifetime and designed to evolve as our customers’ lives do. Our current product offering is comprised of modular couches called Sactionals, premium foam beanbag chairs called Sacs, and their associated home decor accessories. Innovation is at the center of our design philosophy with all of our core products protected by a robust portfolio of utility patents. We market and sell our products primarily online directly at www.lovesac.com, supported by direct-to-consumer touch-feel points in the form of our own showrooms as well as through shop-in-shops and online pop-up-shops with third party retailers. We believe that our ecommerce centric approach, coupled with our ability to deliver our large, upholstered products through express couriers, is unique to the furniture industry.

Impact of COVID-19

In March 2020, the World Health Organization declared the outbreak of COVID-19 as a global pandemic and, in the following weeks, the U.S. federal, state and local governments issued lockdown orders and related safety measures impacting the operations of our showrooms and consumer demand. Although there has been a general improvement in conditions, there continues to be significant uncertainties around the scope and severity of the pandemic, its impact on the global economy, including supply chains, and other business disruptions that may impact our operating results and financial condition. We continue to follow the guidance issued by federal, state and local governments and health organizations and have taken measures to protect the safety of our associates and customers.

While the COVID-19 pandemic led to shifts in the way in which we operated in fiscal 2021, we continued to serve our customers through our online channels as our products can be easily configured, shopped online and delivered quickly in a touchless way, coupled with consumers’ demand for home related products and solutions. In fiscal 2022, our showroom sales have increased, including sales from shop-in-shop and pop-up-shops, and our internet sales have decreased demonstrating a customer shift back to in-store purchases. As our showrooms are now fully reopened, we continue to experience growth as our net sales increased $69.0 million, or 59.4%, to $185.4 million for the twenty-six weeks ended August 1, 2021, compared to $116.3 million for the twenty-six weeks ended August 2, 2020. Retail sales drove an increase of $80.6 million, or 260.3%, to $111.6 million for the twenty-six weeks ended August 1, 2021 compared to $31.0 million for the twenty-six weeks ended August 2, 2020. The increase in retail sales over the prior year period was mainly due to the limited showroom operations related to COVID-19 in the prior year period, which more than offset the decrease in our internet sales (sales made directly to customers through our ecommerce channel) of $21.5 million, or 28.2% in the twenty-six weeks ended August 1, 2021. New customers increased by 9.6% for the twenty-six weeks ended August 1, 2021 as compared to 52.5% for the twenty-six weeks ended August 2, 2020 due to large number of new internet customers acquired related to the Heroes campaign and the temporary closures of some showroom locations.

Product Overview

Our products serve as a set of building blocks that can be rearranged, restyled and re-upholstered with any new setting, mitigating constant changes in fashion and style. They are built to last and evolve throughout a customer’s life.

Sales Channels

We offer our products through an omni-channel platform that provides a seamless and meaningful experience to our customers online and in-store. Our distribution strategy allows us to reach customers through four distinct, brand-enhancing channels.

SELECTED CONDENSED CONSOLIDATED FINANCIAL INFORMATION

The following tables present our summary condensed consolidated financial and other data as of and for the periods indicated. The condensed consolidated statement of operations data and the condensed consolidated statement of cash flow data for the thirteen and twenty-six weeks ended August 1, 2021 and August 2, 2020 and the summary condensed consolidated balance sheet data as of August 1, 2021, are derived from our unaudited condensed consolidated financial statements included elsewhere in this Quarterly Report filed on Form 10-Q and have been prepared on the same basis as the audited condensed consolidated financial statements.

The summarized financial information presented below is derived from and should be read in conjunction with our audited condensed consolidated financial statements including the notes to those financial statements and our unaudited condensed consolidated financial statements including the notes to those financial statements both of which are included elsewhere in this Quarterly Report filed on Form 10-Q along with the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Our historical results are not necessarily indicative of our future results.

These Non-GAAP Measures should not be considered as alternatives to net income (loss) or net income (loss) per share as a measure of financial performance, cash flows from operating activities as a measure of liquidity, or any other performance measure derived in accordance with GAAP. They should not be construed as an inference that our future results will be unaffected by unusual or non-recurring items. Additionally, our Non-GAAP Measures are not intended to be measures of free cash flow for management’s discretionary use, as they do not consider certain cash requirements such as tax payments and debt service requirements and certain other cash costs that recur in the future. Our Non-GAAP Measures contain certain other limitations, including the failure to reflect our cash expenditures, cash requirements for working capital needs and cash costs to replace assets being depreciated and amortized. In addition, our Non-GAAP Measures exclude certain non-recurring and other charges.

In the future, we may incur expenses that are the same as or similar to some of the adjustments in our Non-GAAP Measures. Our presentation of our Non-GAAP Measures should not be construed to imply that our future results will be unaffected by any such adjustments. Management compensates for these limitations by relying primarily on our GAAP results and by using our Non-GAAP Measures as supplemental information. Our Non-GAAP Measures are not necessarily comparable to other similarly titled captions of other companies due to different methods of calculation.

Reconciliation of Non-GAAP Financial Measures

The following provides a reconciliation of Net income (loss) to EBITDA and Adjusted EBITDA for the periods presented:

How We Assess the Performance of Our Business

We consider a variety of financial and operating measures, including the following, to evaluate our business, measure our performance, identify trends affecting our business, formulate business plans, and make strategic decisions.

Net Sales

Net sales reflect our sale of merchandise plus shipping and handling revenue less returns and discounts. Sales made at Company operated showrooms, including shop-in-shops and pop-up shops, and via the web are recognized in accordance with the guidance set forth in ASC 606, which is typically at the point of transference of title when the goods are shipped.

Gross Profit

Gross profit is equal to our net sales less cost of merchandise sold. Gross profit as a percentage of our net sales is referred to as gross margin. In September 2018, the Office of the U.S. Trade Representative began imposing a 10 percent ad valorem duty on a subset of products imported from China, inclusive of various furniture product categories. In September 2019, the Office of U.S. Trade Representative imposed an additional 15 percent ad valorem duty on products imported from China.

Selling, General and Administrative Expenses

Selling, general and administrative expenses include all operating costs, other than advertising and marketing expense, not included in cost of merchandise sold. These expenses include all payroll and payroll-related expenses; showroom expenses, including occupancy costs related to showroom operations, such as rent and common area maintenance; occupancy and expenses related to many of our operations at our headquarters, including utilities, equity-based compensation, financing related expense and public company expenses. Selling, general and administrative expenses as a percentage of net sales is usually higher in lower volume quarters and lower in higher volume quarters because a significant portion of the costs are relatively fixed.

Our recent revenue growth has been accompanied by increased selling, general and administrative expenses. The most significant components of these increases are payroll and rent costs. We expect these expenses, as well as rent expense associated with the opening of new showrooms, to increase as we grow our business. We expect to leverage total selling, general and administrative expenses as a percentage of sales as sales volumes continue to grow. We expect to continue to invest in infrastructure to support the Company’s growth. These investments will lessen the impact of expense leveraging during the period of investment with the greater impact of expense leveraging happening after the period of investment. However, total selling, general and administrative expenses generally will leverage during the periods of investments with the most deleverage occurring in the first three quarters of the fiscal year, and the greatest leverage occurring in the fourth quarter.

Advertising and Marketing Expense

Advertising and marketing expense include digital, social, and traditional advertising and marketing initiatives that cover all of our business channels. Advertising and marketing expense is expected to continue to increase as a percentage to sales as we continue to invest in advertising and marketing which has accelerated sales growth.

Basis of Presentation and Results of Operations

The following table sets forth, for the periods presented, our condensed consolidated statement of operations data as a percentage of total revenues:

Thirteen weeks ended August 1, 2021 Compared to the Thirteen weeks ended August 2, 2020

Net sales

Net sales increased $40.5 million, or 65.4%, to $102.4 million in the thirteen weeks ended August 1, 2021 as compared to $61.9 million in the thirteen weeks ended August 2, 2020. The increase in overall net sales was driven by our Showroom and Other channel sales, partially offset by the decrease in Internet sales. New customers increased by 16.5% in the thirteen weeks ended August 1, 2021 as compared to 47.8% in the thirteen weeks ended August 2, 2020 driven by the successful Heroes’ campaign. We had 123 and 97 showrooms as of August 1, 2021 and August 2, 2020, respectively. We opened 7 additional showrooms, and we did not close or remodel any showrooms in the thirteen weeks ended August 1, 2021, as compared to opening 8 additional showrooms, closing 2 showrooms and remodeling 1 showroom in the thirteen weeks ended August 2, 2020. Showroom sales increased $49.7 million, or 387.1%, to $62.6 million in the thirteen weeks ended August 1, 2021 as compared to $12.9 million in the thirteen weeks ended August 2, 2020. This increase was due in large part to comparable sales increase of $40.3 million, or 290.9%, to $54.1 million in the thirteen weeks ended August 1, 2021, compared to $13.8 million in the thirteen weeks ended August 2, 2020, related to higher point of sales transactions with lower promotional discounting. Point of sales transactions represent orders placed through our showrooms which does not always reflect the point at which control transfers to the customer, which occurs upon shipment being confirmed. See Note 12 to the condensed consolidated financial statements. We believe point of sales transactions is a more accurate way to measure showroom performance and how our showroom associates are incentivized. Retail sales per selling square foot increased $418, or 215.6%, to $611 in the thirteen weeks ended August 1, 2021 as compared to $194 in the thirteen weeks ended August 2, 2020. Total number of units sold at point of transaction increased by approximately 222.6% driven by higher comparable sales. The increase in comparable sales, retail sales per selling square foot and total number of units sold over prior years is the result of limited showroom operations due to COVID-19 in the prior year period. Internet sales (sales made directly to customers through our ecommerce channel) decreased $16.6 million, or 36.0%, to $29.5 million in the thirteen weeks ended August 1, 2021 as compared to $46.1 million in the thirteen weeks ended August 2, 2020. The decrease in Internet sales was due primarily to the shift of sales into the internet channel in prior year as a result of the limited showroom operations due to COVID-19. Other sales, which include pop-up-shop sales and shop-in-shop sales increased $7.4 million, or 243.4%, to $10.4 million in the thirteen weeks ended August 1, 2021 as compared to $3.0 million in the thirteen weeks ended August 2, 2020. This increase was due to hosting 1 additional temporary online pop-up-shop on Costco.com compared to the prior year period and sales increase from shop-in-shop locations that were closed in the prior year period due to COVID-19.

Gross profit

Gross profit increased $28.0 million, or 90.1%, to $59.0 million in the thirteen weeks ended August 1, 2021 from $31.1 million in the thirteen weeks ended August 2, 2020. Gross margin increased to 57.6% of net sales in the thirteen weeks ended August 1, 2021 from 50.1% of net sales in the thirteen weeks ended August 2, 2020. The increase in gross margin percentage of 749 basis points was primarily driven by an increase of approximately 506 basis points due to lower promotional discounting, continuing vendor negotiations to assist with the mitigation of tariffs and continued shift of products from China to Vietnam, Malaysia, and Indonesia. Distribution expenses improved by 243 basis points over the prior year due to higher leverage of 793 basis points in warehousing and distribution costs, partially offset by the increase in inbound freight of 550 basis points due to escalating inbound container costs as well as some shift of inventory purchases back to China, which are impacted by the 25% tariff rate to help alleviate container congestion coming from our other overseas vendors.

Selling, general and administrative expenses

Selling, general and administrative expenses increased $12.0 million, or 51.3%, to $35.4 million in the thirteen weeks ended August 1, 2021 as compared to $23.4 million in the prior year period. The increase in selling, general and administrative expenses was primarily related to an increase in employment costs, overhead expenses, rent, and selling related expenses. Employment costs increased by $6.9 million driven by an increase in new hires and variable compensation. Rent increased by $2.4 million related to our net addition of 26 showrooms. Selling related expenses increased $1.7 million due to an increase of $1.9 million in credit card fees related to the increase in sales, partially offset by a decrease of $0.2 million due to a lower fee structure relating to online pop-up shops at Costco.com. Overhead expenses increased $1.0 million consisting of an increase of $0.6 million in equity-based compensation related to an option trigger event that caused an acceleration of the recognition of stock option equity compensation expense, an increase of $0.4 million in infrastructure investments, and an increase of $0.1 million in travel expenses, partially offset by a decrease of $0.1 million in insurance expenses.

Selling, general and administrative expenses were 34.5% of net sales in the thirteen weeks ended August 1, 2021 as compared to 37.7% of net sales in the thirteen weeks ended August 2, 2020. The decrease in selling, general and administrative expenses of 3.2% of net sales was primarily due to higher leverage within infrastructure investments, rent, insurance and selling related expenses, partially offset by deleverage in employment costs, equity-based compensation, and travel. The deleverage in certain expenses relate to the investments we are making into the business that were put on hold in the prior year relating to COVID-19 financial resilience measures and the acceleration of stock compensation expense related to stock options vesting as a required market condition was achieved in the thirteen weeks ended August 1, 2021.

Advertising and Marketing

Advertising and marketing expenses increased $5.9 million, or 81.9%, to $13.0 million for the thirteen weeks ended August 1, 2021 as compared to $7.2 million in the thirteen weeks ended August 2, 2020. The majority of the increase in advertising and marketing dollars relates to the reinstatement of marketing spends as showroom locations are fully open in the current period versus the limited showroom operations due to COVID-19 in the prior year period. The investment by quarter may vary greatly. Advertising and marketing expenses were 12.7% of net sales in the thirteen weeks ended August 1, 2021 as compared to 11.6% of net sales in the thirteen weeks ended August 2, 2020. The majority of the increase in advertising and marketing as a percent of net sales is related to increased media activities and higher media costs compared to the COVID-19 related marketing environment in the prior year period.

Depreciation and amortization expenses

Depreciation and amortization expenses increased $0.1 million, or 3.8%, to $1.6 million in the thirteen weeks ended August 1, 2021 as compared to $1.5 million in the thirteen weeks ended August 2, 2020. The increase in depreciation and amortization expense principally relates to capital investments for new and remodeled showrooms.

Interest (expense) income, net

 Interest expense, net which is less than $0.1 million principally relates to the interest expense related to unused line fees and amortization of deferred financing fees on the asset-based loan with a slight offset of interest earned on the Company’s cash and cash equivalents balances for the thirteen weeks ended August 1, 2021. The increase in net interest expense from prior year was the result of a decrease in interest rates being earned on the Company’s cash and cash equivalents during the thirteen weeks ended August 1, 2021 as compared to the same period in the prior year.

Provision for income taxes

Income tax provision was less than 0.60% and 0.06% of sales for the thirteen weeks ended August 1, 2021 and August 2, 2020, respectively.

Twenty-six weeks ended August 1, 2021 Compared to the Twenty-six weeks ended August 2, 2020

Net sales

Net sales increased $69.0 million, or 59.4%, to $185.4 million in the twenty-six weeks ended August 1, 2021 as compared to $116.3 million in the twenty-six weeks ended August 2, 2020. The increase in overall net sales was driven by our Showroom sales, Other sales and partially offset by a decrease in our Internet Sales. New customers increased by 9.6% in the twenty-six weeks ended August 1, 2021 as compared to 52.5% in the twenty-six weeks ended August 2, 2020 driven by the successful Heroes’ campaign in the second quarter. We had 123 and 97 showrooms as of August 1, 2021 and August 2, 2020, respectively. We opened 15 additional showrooms and did not permanently close or remodel any showrooms in the twenty-six weeks ended August 1, 2021. Showroom sales increased $80.6 million, or 260.3%, to $111.6 million in the twenty-six weeks ended August 1, 2021 as compared to $31.0 million in the twenty-six weeks ended August 2, 2020, related to higher point of sales transactions with lower promotional discounting. This increase was due in large part to our comparable showroom point of sales transaction increase of $67.0 million, or 235.3%, to $95.4 million in the twenty-six weeks ended August 1, 2021 as compared to $28.5 million in the twenty-six weeks ended August 2, 2020. Point of sales transactions represent orders placed through our showrooms which does not always reflect the point at which control transfers to the customer, which occurs upon shipment being confirmed. See Note 12 to the condensed consolidated financial statements. We believe point of sales transactions is a more accurate way to measure showroom performance and how our showroom associates are incentivized. Retail sales per selling square foot increased $768, or 178.5%, to $1,198 in the twenty-six weeks ended August 1, 2021 as compared to $430 in the twenty-six weeks ended August 2, 2020. Total number of units sold at point of transaction increased by approximately 179.5%. The increase in comparable point of sales transactions, retail sales per selling square foot and number of units sold for the twenty-six week ended was principally driven by the limited showroom operations due to COVID-19 in the prior year period. Internet sales (sales made directly to customers through our ecommerce channel) decreased $21.5 million, or 28.2%, to $54.7 million in the twenty-six weeks ended August 1, 2021 as compared to $76.1 million in the twenty-six weeks ended August 2, 2020. The decrease in Internet sales was due primarily to the shift of sales into the internet channel in prior year as a result of the limited showroom operations due to COVID-19. Other sales, which include pop-up-shop sales and shop-in-shop sales, increased $9.9 million, or 107.7%, to $19.1 million in the twenty-six weeks ended August 1, 2021 as compared to $9.2 million in the twenty-six weeks ended August 2, 2020. This increase was due to hosting 2 additional temporary online pop-up-shops on Costco.com compared to the prior year period and sales increase from shop-in-shop locations that were closed in the prior year period due to COVID-19.

Gross profit

Gross profit increased $46.8 million, or 80.2%, to $105.1 million in the twenty-six weeks ended August 1, 2021 from $58.3 million in the twenty-six weeks ended August 2, 2020. Gross margin increased to 56.7% of net sales in the twenty-six weeks ended August 1, 2021 from 50.2% of net sales in the twenty-six weeks ended August 2, 2020. The increase in gross margin percentage of 655 basis points was primarily driven by an increase of approximately 457 basis points due to lower promotional discount, continuing vendor negotiations to assist with the mitigation of tariffs and continued shift of products from China to Vietnam, Malaysia, and Indonesia. Distribution expenses improved by 198 basis points over the prior year due to higher leverage of 945 basis points in warehousing and distribution costs, partially offset by the increase in inbound freight of 747 basis points due to escalating inbound container costs as well as some shift of inventory purchases back to China, which are impacted by the 25% tariff rate to help alleviate container congestion coming from our other overseas vendors. 

Selling, general and administrative expenses

Selling, general and administrative expenses increased $16.9 million, or 34.3%, to $66.1 million in the twenty-six weeks ended August 1, 2021 as compared to $49.2 million in twenty-six weeks ended August 2, 2020. The increase in selling, general and administrative expenses was primarily related to an increase in employment costs, rent, overhead expenses, and selling related expenses. Employment costs increased by $9.9 million driven by an increase in new hires and variable compensation. Rent increased by $3.9 million related to our net addition of 26 showrooms. Overhead expenses increased $1.7 million consisting of an increase of $1.4 million in infrastructure investments and an increase of $0.3 million in equity-based compensation. Selling related expenses increased $1.4 million due to an increase of $2.8 million in credit card fees, partially offset by a decrease of $1.4 million in due to a lower fee structure in for online pop-up-shop sales at Costco.com.

Selling, general and administrative expenses were 35.7% of net sales in the twenty-six weeks ended August 1, 2021 as compared to 42.3% of net sales in the twenty-six weeks ended August 2, 2020. The decrease in selling, general and administrative expenses of 6.6% of net sales was primarily due to higher leverage within infrastructure investments, selling related expenses, rent, insurance, equity-based compensation and travel.

Advertising and Marketing

Advertising and marketing expenses increased $8.4 million, or 54.4%, to $23.7 million in the twenty-six weeks ended August 1, 2021 as compared to $15.4 million in the twenty-six weeks ended August 2, 2020. The majority of the increase in advertising and marketing dollars relates to the reinstatement of marketing spends as showroom locations are fully open in the current period versus the limited showroom operations due to COVID-19 in the prior year period. The investment by quarter may vary greatly. Advertising and marketing expenses were 12.8% of net sales in the twenty-six weeks ended August 1, 2021 as compared to 13.2% of net sales in the twenty-six weeks ended August 2, 2020. The majority of the decrease in advertising and marketing as a percent of net sales is primarily due to improved performance in our media activities which has driven an increase in net sales, higher Sactional sales mix and higher average selling price.

Depreciation and amortization expenses

Depreciation and amortization expenses increased $0.8 million, or 26.5%, to $4 million in the twenty-six weeks ended August 1, 2021 as compared to $3.2 million in the twenty-six weeks ended August 2, 2020. The increase in depreciation and amortization expense principally relates to capital investments for new and remodeled showrooms.

Interest income (expense), net

Interest expense, net which is less than $0.1 million principally relates to the interest expense related to unused line fees and amortization of deferred financing fees on the asset-based loan with a slight offset of interest earned on the Company’s cash and cash equivalents balances for the twenty-six weeks ended August 1, 2021. The increase in net interest expense from prior year was the result of a decrease in interest rates being earned on the Company’s cash and cash equivalents during the twenty-six weeks ended August 1, 2021 as compared to the same period in the prior year.

Provision for income taxes

Income tax provision was less than 0.40% and 0.06% of sales for the twenty-six weeks ended August 1, 2021 and August 2, 2020, respectively.

Liquidity and Capital Resources

General

Our business relies on cash flows from operations, our revolving line of credit (see “Revolving Line of Credit” below) and securities issuances as our primary sources of liquidity. Our primary cash needs are for advertising and marketing, inventory, payroll, showroom rent, capital expenditures associated with opening new showrooms and updating existing showrooms, as well as infrastructure and information technology. The most significant components of our working capital are cash and cash equivalents, inventory, accounts receivable, accounts payable and other current liabilities and customer deposits. Borrowings generally increase in our third fiscal quarter as we prepare for the holiday selling season, which is in our fourth fiscal quarter. We believe that cash expected to be generated from operations, the availability under our revolving line of credit and our existing cash balances are sufficient to meet working capital requirements and anticipated capital expenditures for at least the next 12 months.

Cash Flow Analysis

A summary of operating, investing, and financing activities during the periods indicated are shown in the following table:

Net Cash Provided By Operating Activities

Cash from operating activities consists primarily of net income(loss) adjusted for certain non-cash items, including depreciation and amortization, loss on disposal of property and equipment, equity-based compensation, deferred rent, and non-cash interest expense and the effect of changes in working capital and other activities.

In the twenty-six weeks ended August 1, 2021, net cash provided by operating activities was $0.8 million and consisted of changes in operating assets and liabilities of ($25.1) million, net income of $10.5 million, and adjustments to reconcile net income to cash provided by operating activities of $15.4 million. Working capital and other activities consisted primarily of increases in inventory of $24.6 million, trade accounts receivable of $2.9 million, and customer deposits of $7.4 million, and accounts payable and accrued expenses of $2.8 million, partially offset by decreases in prepaid expenses and other current assets of $0.5 million and operating lease liabilities of $8.4 million.

In the twenty-six weeks ended August 2, 2020, net cash provided by operating activities was $12.1 million and consisted of changes in operating assets and liabilities of $14.4 million, a net loss of $9.5 million, and adjustments to reconcile net loss to cash used in operating activities of $7.2 million. Working capital and other activities consisted primarily of decreases in prepaid expenses of $2.4 million and accounts receivable of $1.0 million and increases in accounts payable and accrued expenses of $8.2 million and customer deposits of $7.4 million, partially offset by an increase in inventory of $4.6 million.

Net Cash Used In Investing Activities

Investing activities consist primarily of investment in supply chain and systems infrastructure and capital expenditures related to new showroom openings and the remodeling of existing showrooms.

For the twenty-six weeks ended August 1, 2021, capital expenditures were $7.4 million as a result of investments in new and remodeled showrooms and intangibles such as patents and trademarks.

For the twenty-six weeks ended August 2, 2020, capital expenditures were $5.3 million as a result of investments in new and remodeled showrooms and intangibles such as patents and trademarks offset by proceeds from disposal of property and equipment.

Net Cash Used In Financing Activities

Financing activities consist primarily of the proceeds from stock offerings and taxes paid for the net settlement of equity awards.

For the twenty-six weeks ended August 1, 2021, net cash used in financing activities was $3.3 million, due mostly to taxes paid for net share settlement of $3.4 million offset by proceeds from the exercise of warrants of $0.1 million. For the twenty-six weeks ended August 2, 2020, net cash used in financing activities was $0.5 million, due mostly to taxes paid for net share settlement of $0.5 million.

Revolving Line of Credit

On February 6, 2018, we entered into a five-year, secured revolving credit facility with Wells Fargo Bank, National Association (“Wells”). The credit facility permits borrowings of up to $25.0 million, subject to borrowing base and availability restrictions. For additional information regarding our line of credit with Wells, see Note 7 to our condensed consolidated financial statements. As of August 1, 2021, the Company’s borrowing availability under the line of credit with Wells was $22.5 million. As of August 1, 2021, there were $115 borrowings outstanding on this line of credit related to line of credit fees.

Severance Contingency

The Company has various employment agreements with its senior level executives. A number of these agreements have severance provisions, ranging from 12 to 18 months of salary, in the event those associates are terminated without cause. The total amount of exposure to the Company under these agreements was $4.7 million at August 1, 2021 if all executives with employment agreements were terminated without cause and the full amount of severance was payable.

Off Balance Sheet Arrangements

We have no material off balance sheet arrangements as of August 1, 2021, except for employment agreements entered in the ordinary course of business.

Critical Accounting Policies and Estimates

The discussion and analysis of financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in conformity with GAAP. Certain accounting policies and estimates are particularly important to the understanding of our financial position and results of operations and require the application of significant judgment by our management or can be materially affected by changes from period to period in economic factors or conditions that are outside of our control. As a result, they are subject to an inherent degree of uncertainty. In applying these policies, management uses their judgment to determine the appropriate assumptions to be used in the determination of certain estimates. Those estimates are based on our historical operations, our future business plans and projected financial results, the terms of existing contracts, observance of trends in the industry, information provided by our customers and information available from other outside sources, as appropriate. Please see Note 1 to our consolidated financial statements included in the Annual Report on Form 10-K filed on April 14, 2021 for a complete description of our significant accounting policies. There have been no material changes to the significant accounting policies during the twenty-six weeks ended August 1, 2021.

Recent Accounting Pronouncements

Refer to Note 2, Recent Accounting Pronouncements, contained in the Condensed Consolidated Notes to Financial Statements in Item 1 of Part 1 of this Quarterly Report on Form 10-Q for a full description of the recent accounting pronouncements and our expectation of their impact, if any, on our results of operations and financial condition.

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

In the normal course of business, we are exposed to a variety of risks, including fluctuations in interest rates that could affect our financial position and results of operations.

Interest Rate Risk

Debt

Interest rate risk exists primarily through our borrowing activities. We use U.S. dollar denominated borrowings to fund our working capital and investment needs. It is anticipated that the fair market value of any future debt under the line of credit will continue to be immaterially affected by fluctuations in interest rates and we do not believe that the value of such debt would be significantly impacted by current market events. Under the line of credit, the Company may elect that revolving loans bear interest at a rate per annum equal to the base rate plus the applicable margin or the LIBOR rate plus the applicable margin. The applicable margin is based on tier’s relating to the quarterly average excess availability. The tiers range from 2.00% to 2.25%. We currently do not engage in any interest rate hedging activity and we have no intention of doing so in the foreseeable future. A hypothetical 100 basis point change (up or down) in the one-month LIBOR rate would not have a material effect on our condensed consolidated results of operations.