RUE Rue21, Inc. (MM)

NOTE 1 — Organization and Basis of Presentation

rue21, inc. and subsidiaries (the Company or rue21) is a specialty retailer of girls and guys apparel and accessories with 959, 877 and 834 stores as of August 3, 2013, February 2, 2013 and July 28, 2012, respectively, in various strip centers, regional malls and outlet centers throughout the United States. Sales are generally transacted for cash or checks and through the acceptance of third-party credit and debit cards.

The consolidated financial statements include all of the accounts of the Company and its wholly-owned subsidiaries, r services, llc and rue services corporation. All intercompany transactions and balances have been eliminated in consolidation. At August 3, 2013, the Company operated in one reportable segment.

In the opinion of management, the unaudited consolidated financial statements include all adjustments, consisting of only normal recurring adjustments, necessary for the fair statement of consolidated financial position, results of operations, and cash flows for the interim periods presented. The accompanying unaudited consolidated financial statements have been prepared by the Company, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosure normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) have been condensed or omitted pursuant to such rules and regulations, although the Company believes that the disclosures made are adequate to ensure that the information presented is not misleading. Accordingly, these unaudited consolidated financial statements and related notes should be read in conjunction with the consolidated financial statements and notes thereto for the fiscal year ended February 2, 2013 included in the Company’s Annual Report on Form 10-K.

The results of operations for the current and prior periods are not necessarily indicative of the operating results for the full fiscal year.

Merger

On May 23, 2013, we entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Rhodes Holdco, Inc., a Delaware corporation (“Parent”), and Rhodes Merger Sub, a newly formed Delaware corporation and a wholly owned subsidiary of Parent (“Merger Sub”), providing for the merger (the “Merger”) of Merger Sub with and into the Company, with the Company surviving the Merger as a wholly owned subsidiary of Parent. Parent and Merger Sub are affiliates of Apax Partners L.P. (“Apax”). The merger consideration is $42.00 per share in cash, without interest. The transaction will be supported through financing to be obtained by affiliates of Apax.

Under the Merger Agreement, each share of the Company’s common stock issued and outstanding immediately prior to the effective time of the Merger (other than (i) shares owned by Parent, Merger Sub, or any other direct or indirect wholly owned subsidiary of Parent and shares owned by the Company or any direct or indirect wholly owned subsidiary of the Company and, in each case, not held on behalf of third parties, (ii) shares as otherwise agreed to in writing before the effective time of the Merger between Parent or its affiliates and the holder of such shares and (iii) shares owned by stockholders who have not voted in favor of adoption of the Merger Agreement or consented thereto in writing and who have properly demanded and not withdrawn a demand for appraisal with respect to such shares under Delaware law) will be converted into the right to receive $42.00 per share in cash, without interest.

The Merger is subject to the approval by (i) at least a majority of all outstanding shares of common stock and (ii) a majority of the then-outstanding shares not beneficially owned, directly or indirectly, by Parent, Merger Sub, certain Apax entities, SKM Equity Fund II, L. P. and SKM Investment Fund II (together, the “SKM Funds”) or certain other specified parties, receipt of regulatory approvals, and other customary closing conditions, including, among others, the absence of any order, judgment, injunction, award, decree or writ restraining, enjoining, prohibiting or otherwise preventing consummation of the Merger. The Company has received notice from the Federal Trade Commission granting early termination of the mandatory waiting period under the Hart-Scott Rodino Antitrust Improvements Act of 1976, as amended, receipt of which was a condition to consummation of the proposed Merger.

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Under the terms of the Merger Agreement, the Company and its advisors were permitted to actively solicit and negotiate alternative acquisition proposals from third parties during a “go-shop” period that began on May 23, 2013 and expired at 11:59 p.m. EDT on July 2, 2013. With the expiration of the “go-shop” period, the Company is now subject to customary “non-solicitation” provisions that limit its ability to solicit, encourage, discuss or negotiate alternative acquisition proposals from third parties or to provide non-public information to third parties. These non-solicitation provisions are subject to a “fiduciary out” provision that allows the Company to provide non-public information and participate in discussions and negotiations with respect to certain unsolicited written acquisition proposals and to terminate the Merger Agreement and enter into an alternative acquisition agreement with respect to a superior proposal in compliance with the terms of the Merger Agreement.

Concurrently with the execution and delivery of the Merger Agreement, the SKM Funds, which collectively own approximately 30% of the outstanding shares of the Company entered into a support agreement with the Company and Apax to vote their shares in favor of the transaction with Apax (the “Support Agreement”). Pursuant to the terms of the Support Agreement, if the agreement with Apax is terminated and the Company terminates the Merger Agreement to accept an all-cash superior proposal of at least $42.00 per share, the SKM Funds have agreed to vote their shares in favor of such superior proposal on the same pro rata basis as unaffiliated stockholders (although SKM Funds can choose to vote all, or an amount between the applicable pro rata proportion and all of their shares in favor of a superior proposal).

The proposed Merger is expected to close before the end of the 2013 calendar year, subject to approval by the majority of stockholders unaffiliated with the SKM funds as well as customary closing conditions.

The Merger Agreement and the above summary of certain of its terms have been included to provide you with information regarding the terms of the Merger Agreement. Factual disclosures about us contained in this report may supplement, update or modify the factual disclosures about us contained in the Merger Agreement and described in this summary. The representations, warranties and covenants made in the Merger Agreement by us, Parent and Merger Sub were qualified and subject to important limitations agreed to by us, Parent and Merger Sub in connection with negotiating the terms of the Merger Agreement. In particular, in your review of the representations and warranties contained in the Merger Agreement and described in the above summary, it is important to bear in mind that the representations and warranties were negotiated with the principal purposes of establishing the circumstances in which a party to the Merger Agreement may have the right not to close the Merger if the representations and warranties of the other party prove to be untrue due to a change in circumstance or otherwise, and allocating risk between the parties to the Merger Agreement, rather than establishing matters as facts. The representations and warranties may also be subject to a contractual standard of materiality different from those generally applicable to stockholders and reports and documents filed with the SEC and in some cases were qualified by disclosures that were made by each party to the other, which disclosures are not reflected in the Merger Agreement. Moreover, information concerning the subject matter of the representations and warranties, which do not purport to be accurate as of the date of this report, may have changed since the date of the Merger Agreement and subsequent developments or new information qualifying a representation or warranty may have been included in this report.

For further information on the Merger, the Merger Agreement and related agreements, please refer to the Current Report on Form 8-K filed on May 24, 2013. The foregoing descriptions of the Merger Agreement and Support Agreement are subject to, and qualified in their entirety by, the full text of those agreements as attached as Exhibits 2.1 and 10.1 respectively to the Form 8-K filed on May 24, 2013, each of which is incorporated by reference herein.

NOTE 2 — Summary of Significant Accounting Policies

Fiscal Year

The Company’s fiscal year is 52 or 53 weeks ending on the Saturday nearest to January 31 of the following year. As used herein, the “second quarter of 2013” and the “second quarter of 2012” refer to the thirteen week periods ending August 3, 2013 and July 28, 2012, respectively. “Year-to-date 2013” and “Year-to-date 2012” refer to the twenty-six week periods ending August 3, 2013 and July 28, 2012, respectively.

Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of net sales and expenses during the reporting period. Actual results could differ from those estimates. On an ongoing basis, management reviews its estimates based on currently available information. Changes in facts and circumstances may result in revised estimates.

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Seasonality

Our operations are seasonal in nature and consist of two principal selling seasons: Spring (the first and second quarters) and Fall (the third and fourth quarters). Generally, our highest sales volume occurs in the fourth quarter, which includes the holiday selling season. Accordingly, cash requirements are highest in the third quarter as our inventories build in advance of the holiday season. In addition, our quarterly results can be affected by the timing of new store openings and store closings, the amount of sales contributed by new and existing stores and the timing of certain holidays.

Recent Accounting Standards

The FASB issues Accounting Standards Updates (ASU) to amend the authoritative literature in Accounting Standards Codification (ASC). There are no ASUs during the current period that (i) provide supplemental guidance, (ii) are technical corrections, (iii) are not applicable to the Company or (iv) are expected to have a significant impact on the Company.

Stock options to purchase 296,365 and 386,453 shares of common stock during the second quarter of 2013 and Year-to-date 2013, respectively, and 974,742 and 946,687 shares of common stock for the second quarter of 2012 and Year-to-date 2012, respectively, were outstanding, but were not included in the computation of weighted average diluted common share amounts as the effect of doing so would have been anti-dilutive.

NOTE 4 — Stock-Based Compensation

On June 7, 2013, the Company’s stockholders approved the Amended and Restated 2009 Omnibus Incentive Plan (the 2009 Plan) pursuant to which key employees, officers, and directors shall be eligible to receive grants of stock options, stock appreciation rights, restricted stock, restricted stock units or performance awards to purchase or receive, as applicable, up to an aggregate of 5,626,000 shares of common stock based on eligibility, vesting, and performance standards established by the board of directors. Stock options granted are generally exercisable ratably over three or four years, subject to certain employment terms and conditions. The stock options generally expire ten years from the date of grant.

Effective May 15, 2003, the Company adopted the 2003 Ownership Incentive Plan (the 2003 Plan) pursuant to which key employees, officers, and directors were eligible to receive options to purchase common stock for an aggregate of up to 19.8% of the number of shares of the common stock outstanding upon adoption of the 2003 Plan based on eligibility, vesting, and performance standards established by the board of directors. Upon adopting the 2009 Plan, the Company discontinued use of the 2003 Plan and no further equity awards have been or will be made under the 2003 Plan.

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The Company recognized $2.7 million and $5.5 million in compensation expense related to stock-based compensation during the second quarter of 2013 and Year-to-date 2013, respectively, and $3.2 million and $5.1 million in compensation expense related to stock-based compensation for the second quarter of 2012 and Year-to-date 2012, respectively. As of August 3, 2013, the Company had 3,889,455 shares available for equity grants.

Stock Options

The following table represents stock option activity during the Year-to-date 2013 period.

There were no stock options granted in the second quarter of 2013.The weighted average fair value of stock options at the grant date was $14.08 during Year-to-date 2013, and $14.35 and $13.71 during the second quarter of 2012 and Year-to-date 2012, respectively. The intrinsic value of options exercised was $2.2 million and $2.7 million during the second quarter of 2013 and Year-to-date 2013, respectively and $0.7 million and $1.0 million for the second quarter of 2012 and Year-to-date 2012, respectively. All outstanding vested options are currently exercisable as of August 3, 2013.

The fair value of stock options was estimated at the date of grant using a Black-Scholes option pricing model with the following range of assumptions:

Fair Value of stock options

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As of August 3, 2013, there was $6.8 million of unrecognized compensation expense related to non-vested stock option awards that is expected to be recognized over a weighted-average period of 1.05 years. The total fair value of shares vested during the second quarter of 2013 and Year-to-date 2013 was $0.6 million and $3.9 million respectively, and $1.7 million and $3.4 million for the second quarter of 2012 and Year-to-date 2012, respectively.

Restricted Stock Units

Time-based restricted stock unit awards vest generally over three years.

Performance-based stock unit awards either vest evenly over three years or cliff vest if the performance goal is achieved in the first year period. The level of goal achievement, if any, will determine the number of shares that may be received.

The following table summarizes information regarding non-vested outstanding restricted stock units as of August 3, 2013:

As of August 3, 2013, there was $10.2 million of unrecognized compensation expense related to non-vested restricted stock unit awards that is expected to be recognized over a weighted-average period of 1.30 years. The total fair value of shares vested during the second quarter of 2013 and Year-to-date 2013 was $0.4 million and $3.0 million respectively, and $1.4 million and $1.4 million, respectively, during the second quarter of 2012 and Year-to-date 2012 period.

As of August 3, 2013, there was $6.4 million of unrecognized compensation expense related to non-vested performance share unit awards that is expected to be recognized if achievement of performance goals becomes probable or as the service period is fulfilled.

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In accordance with the FASB’s authoritative guidance related to the impairment or disposal of long-lived assets, impairment losses may be recorded on long-lived assets used in operations when events and circumstances indicate that the assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amounts of those assets. If such a condition occurs, the assets are adjusted to their estimated fair value, which is determined based upon prices for similar assets. Impairment charges are recorded in selling, general, and administrative expense in the accompanying Consolidated Statements of Income.

NOTE 6 — Fair Value

The FASB’s authoritative guidelines require the categorization of assets and liabilities into three levels based upon the assumptions (inputs) used to price the assets or liabilities. Level 1 provides the most reliable measure of fair value, whereas Level 3 generally requires significant management judgment. The three levels are defined as follows:

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In accordance with ASC 820, the following tables represent the fair value hierarchy for the Company’s financial assets (cash equivalents) measured at fair value on a recurring basis as of August 3, 2013 and July 28, 2012:

NOTE 7— Income Taxes

The provision for income taxes is based on the current estimate of the annual effective tax rate and is adjusted as necessary for discrete events occurring in a particular period. The effective income tax rate for the second quarter of 2013 was 36.8% as compared to 33.8% for the second quarter of 2012. The higher effective income tax rate was the result of a higher effective state income tax rate and lower federal tax credits as compared to the prior year. The Company classifies interest and penalties as an element of tax expense. The amount of tax related interest and penalties for the second quarter of 2013 and 2012, respectively, was not material.

The Year-to-date 2013 effective income tax rate was 36.3% as compared to 35.6% for the Year-to-date 2012 period. The higher effective income tax rate was due to a higher effective state tax income rate and lower federal income tax credits as compared to the prior year.

The Company recognizes income tax liabilities related to unrecognized tax benefits in accordance with FASB’s authoritative guidance related to uncertain tax positions and adjusts these liabilities when its judgment changes as a result of the evaluation of new information. The Company does not anticipate any significant changes to the unrecognized tax benefits recorded at the consolidated balance sheet date within the next 12 months.

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NOTE 8 — Stock Repurchase Program

On May 24,2012, rue21’s board of directors authorized a stock repurchase program granting the Company authority to repurchase up to $50 million of the Company’s common stock. On March 21, 2013, the authorization was increased by $25 million for a total authorization of $75 million. Under the stock repurchase program, the Company may repurchase shares in the open market or through privately negotiated transactions. During the second quarter of 2013 and second quarter of 2012, the Company repurchased 92,300 and 495,900 shares, respectively, of its common stock on the open market at an average price of $34.00 and $26.05, respectively for an aggregate cost of $3.1 million and $12.9 million, respectively. During the Year-to-date 2013 and Year-to-date 2012, the Company repurchased 444,003 and 495,900 shares, respectively, of its common stock on the open market at an average price of $30.57 and $26.05, respectively for an aggregate cost of $13.6 million and $12.9 million, respectively. The Company has not purchased any stock through privately negotiated transactions. As of May 23, 2013, the Company suspended its stock repurchase program.

In addition to the shares of common stock we purchased under our stock repurchase program, during second quarter of 2013 and second quarter 2012, we withheld 990 and 11,280 shares from employees for the payment of taxes, respectively, not in excess of the minimum statutory withholding requirements, in connection with the vesting of shared-based payments. During Year-to-date 2013 and Year-to-date 2012, we withheld 41,613 and 11,351 shares from employees for the payment of taxes, respectively, in connection with the vesting of shared-based payments. The aforementioned shares have been recorded as treasury stock.

NOTE 9 — Commitments and Contingencies

The Company is subject to various proceedings, lawsuits, disputes, and claims arising in the ordinary course of our business. Many of these actions raise complex factual and legal issues and are subject to uncertainties. Actions filed against us from time to time include commercial, intellectual property, customer, and employment actions, including class action lawsuits. The plaintiffs in some actions seek unspecified damages or injunctive relief, or both. Actions are in various procedural stages, and some are covered in part by insurance. We cannot predict with assurance the outcome of actions brought against us. Accordingly, adverse developments, settlements, or resolutions may occur and negatively impact income in the quarter of such development, settlement, or resolution. If a potential loss arising from these lawsuits, claims and pending actions is probable and reasonably estimable, we record the estimated liability based on circumstances and assumptions existing at the time.

On May 30, 2013, the Southeastern Pennsylvania Transportation Authority, on behalf of itself and a putative class of public stockholders of the Company, filed a complaint in the Court of Chancery in the State of Delaware against the Company, the directors of the Company, Apax and several funds affiliated with Apax (collectively hereafter, “Apax”) and Apax-affiliated entities participating in the proposed Merger pursuant to the Merger Agreement (the “Apax Entities”). The complaint alleged, among other things, that the Company and its directors breached their fiduciary duties to the Company’s public stockholders by authorizing the Merger for inadequate consideration, without a reasonable independent process and without a fair opportunity to seek and secure the best sale price for stockholders; that Apax, Apax affiliated members of the Company’s board of directors and the Company’s chief executive officer breached their duty of loyalty and entire fairness to the Company through causing or supporting the Merger which plaintiff alleged does not include a fair price and was not the result of fair dealing; and that the Apax Entities aided and abetted the other defendants’ alleged breaches of fiduciary duty. The plaintiff was seeking, among other things, a judgment determining that the action is a proper class action and that the plaintiff is a proper class representative; to enjoin the defendants from taking steps to implement the acquisition of the Company at a price that is not fair and equitable and under terms presently proposed; to rescind the Merger (or awarding damages to the class) in the event of its consummation prior to the entry of final judgment; to enjoin any material transactions or changes to the Company’s business and assets until a proper process is conducted to evaluate strategic alternatives; and the award of compensatory damages and fees, expenses and costs of attorneys and experts. The suit was dismissed without prejudice on July 30, 2013, with each party bearing its own costs.

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