--------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934.
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2006
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934.
FOR THE TRANSITION PERIOD FROM _______________ TO ______________
COMMISSION FILE NUMBER: 0-26006
----------
TARRANT APPAREL GROUP
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
CALIFORNIA 95-4181026
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)
3151 EAST WASHINGTON BOULEVARD
LOS ANGELES, CALIFORNIA 90023
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (323) 780-8250
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 [X] No [_]
Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer or a non-accelerated filer. See definition of
"accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange
Act. Large accelerated filer [ ] Accelerated filer [ ] Non-accelerated filer [X]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Act). Yes [_] No [X]
Number of shares of Common Stock of the Registrant outstanding as of May 12,
2006: 30,543,763.
--------------------------------------------------------------------------------
TARRANT APPAREL GROUP
FORM 10-Q
INDEX
PART I. FINANCIAL INFORMATION
PAGE
------
Item 1. Financial Statements
Consolidated Balance Sheets at March 31, 2006 (unaudited)
and December 31, 2005 (audited).......................... 2
Consolidated Statements of Operations for the Three Months
Ended March 31, 2006 and March 31, 2005 (unaudited)......... 3
Consolidated Statements of Cash Flows for the Three Months
Ended March 31, 2006 and March 31, 2005 (unaudited)...... 4
Notes to Consolidated Financial Statements (unaudited)...... 5
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations .............................. 19
Item 3. Quantitative and Qualitative Disclosures About Market Risk . 31
Item 4. Controls and Procedures..................................... 31
PART II. OTHER INFORMATION
Item 1. Legal Proceedings........................................... 32
Item 1A. Risk Factors................................................ 32
Item 6. Exhibits.................................................... 38
SIGNATURES.................................................. 39
CAUTIONARY LEGEND REGARDING FORWARD-LOOKING STATEMENTS
Some of the information in this Quarterly Report on Form 10-Q may
constitute forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934,
both as amended. These forward-looking statements are subject to various risks
and uncertainties. The forward-looking statements include, without limitation,
statements regarding our future business plans and strategies and our future
financial position or results of operations, as well as other statements that
are not historical. You can find many of these statements by looking for words
like "will", "may", "believes", "expects", "anticipates", "plans" and
"estimates" and for similar expressions. Because forward-looking statements
involve risks and uncertainties, there are many factors that could cause the
actual results to differ materially from those expressed or implied. These
include, but are not limited to, economic conditions. This Quarterly Report on
Form 10-Q contains important cautionary statements and a discussion of many of
the factors that could materially affect the accuracy of Tarrant's
forward-looking statements and such statements and discussions are incorporated
herein by reference. Any subsequent written or oral forward-looking statements
made by us or any person acting on our behalf are qualified in their entirety by
the cautionary statements and factors contained or referred to in this section.
We do not intend or undertake any obligation to update any forward-looking
statements to reflect events or circumstances after the date of this document or
the date on which any subsequent forward-looking statement is made or to reflect
the occurrence of unanticipated events.
1
PART I -- FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
TARRANT APPAREL GROUP
CONSOLIDATED BALANCE SHEETS
MARCH 31, DECEMBER 31,
2006 2005
------------- -------------
(unaudited) (audited)
ASSETS
Current assets:
Cash and cash equivalents ............................. $ 500,636 $ 1,641,768
Accounts receivable, net .............................. 62,370,128 54,598,443
Due from related parties .............................. 3,359,888 3,100,928
Inventory ............................................. 21,836,090 31,628,960
Current portion of notes receivable -- related parties 5,139,387 5,139,387
Prepaid expenses ...................................... 1,264,688 1,292,441
Prepaid royalties ..................................... -- 1,123,531
Income taxes receivable ............................... 25,468 25,468
------------- -------------
Total current assets .................................... 94,496,285 98,550,926
Property and equipment, net of $10.9 million and $10.8
million accumulated depreciation at March 31, 2006
and December 31, 2005, respectively ................. 1,587,822 1,702,840
Notes receivable - related parties, net of current
portion ............................................... 35,834,002 36,268,446
Due from related parties .............................. 3,004,352 2,994,945
Equity method investment .............................. 2,186,278 2,138,865
Deferred financing cost, net of $823,097 and $711,250
accumulated amortization at March 31, 2006 and
December 31, 2005, respectively ..................... 726,939 838,786
Other assets .......................................... 258,062 164,564
Goodwill .............................................. 8,582,845 8,582,845
------------- -------------
Total assets ............................................ $ 146,676,585 $ 151,242,217
============= =============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Short-term bank borrowings ............................ $ 12,479,989 $ 13,833,532
Accounts payable ...................................... 25,888,506 33,278,959
Accrued expenses ...................................... 9,564,188 9,503,806
Income taxes .......................................... 16,795,605 16,828,538
Current portion of long-term obligations and factoring
arrangement ......................................... 39,540,629 36,109,699
------------- -------------
Total current liabilities ............................... 104,268,917 109,554,534
Long-term obligations .................................... 14,774 239,935
Convertible debentures, net .............................. 6,083,539 5,965,098
Deferred tax liabilities ................................. 25,403 47,098
Minority interest ........................................ 63,747 75,241
Shareholders' equity:
Preferred stock, 2,000,000 shares authorized; no shares
at March 31, 2006 and December 31, 2005 issued and
outstanding ......................................... -- --
Common stock, no par value, 100,000,000 shares
authorized; 30,543,763 shares at March 31, 2006 and
30,553,763 shares at December 31, 2005 issued and
outstanding ......................................... 114,977,465 114,977,465
Warrant to purchase common stock ...................... 2,846,833 2,846,833
Contributed capital ................................... 10,004,331 10,004,331
Accumulated deficit ................................... (89,353,243) (90,189,615)
Notes receivable from officer/shareholder ............. (2,255,181) (2,278,703)
------------- -------------
Total shareholders' equity .............................. 36,220,205 35,360,311
------------- -------------
Total liabilities and shareholders' equity .............. $ 146,676,585 $ 151,242,217
============= =============
The accompanying notes are an integral part of these
consolidated financial statements
2
TARRANT APPAREL GROUP
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
THREE MONTHS ENDED MARCH 31,
----------------------------
2006 2005
------------ ------------
Net sales ...................................... $ 61,261,243 $ 44,830,291
Cost of sales .................................. 48,742,481 35,884,573
------------ ------------
Gross profit ................................... 12,518,762 8,945,718
Selling and distribution expenses .............. 2,929,690 2,561,854
General and administrative expenses ............ 6,460,143 5,855,823
Royalty expenses ............................... 1,482,945 294,765
------------ ------------
Income from operations ......................... 1,645,984 233,276
Interest expense ............................... (1,188,056) (813,185)
Interest income ................................ 485,343 553,223
Interest in income of equity method investee ... 47,413 163,311
Other income ................................... 33,806 64,557
Other expense .................................. -- (5,839)
Minority interest .............................. 11,494 --
------------ ------------
Income before provision for income taxes ....... 1,035,984 195,343
Provision for income taxes ..................... 199,612 301,163
------------ ------------
Net income (loss) .............................. $ 836,372 $ (105,820)
============ ============
Net income (loss) per share - Basic ............ $ 0.03 $ (0.00)
Net income (loss) per share -- Diluted ......... $ 0.03 $ (0.00)
============ ============
Weighted average common and common equivalent
shares outstanding:
Basic ....................................... 30,551,207 28,814,763
Diluted ..................................... 30,551,207 28,814,763
============ ============
The accompanying notes are an integral part of these
consolidated financial statements
3
TARRANT APPAREL GROUP
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
THREE MONTHS ENDED MARCH 31,
----------------------------
2006 2005
------------ ------------
Operating activities:
Net income (loss) ..................................... $ 836,372 $ (105,820)
Adjustments to reconcile net income (loss) to net cash
(used in) provided by operating activities:
Deferred taxes ..................................... (21,695) (52,011)
Depreciation and amortization ...................... 372,738 568,165
Provision for returns and discounts ................ 155,978 254,040
Gain on sale of fixed assets ....................... (1,283) (849)
Interest in income of equity method investee ....... (47,413) (163,311)
Minority interest .................................. (11,494) --
Changes in operating assets and liabilities:
Accounts receivable .............................. (7,927,663) (5,777,964)
Due to/from related parties ...................... (268,367) 1,237,215
Inventory ........................................ 9,792,870 866,125
Prepaid expenses ................................. 1,151,283 (1,120,844)
Accounts payable ................................. (7,390,453) (5,867,978)
Accrued expenses and income tax payable .......... 27,449 586,759
------------ ------------
Net cash used in operating activities ............ (3,331,678) (9,576,473)
Investing activities:
Purchase of fixed assets ........................... (22,447) (77,018)
Proceeds from sale of fixed assets ................. 2,800 6,387
Collection on notes receivable, related parties .... 434,444 217,222
Collection of advances from shareholders/officers .. 23,522 2,334,053
------------ ------------
Net cash provided by investing activities ........ 438,319 2,480,644
Financing activities:
Short-term bank borrowings, net .................... 1,652,736 (5,292,126)
Proceeds from long-term obligations ................ 51,911,927 50,602,423
Payment of long-term obligations and bank borrowings (51,812,436) (39,228,376)
------------ ------------
Net cash provided by financing activities ........ 1,752,227 6,081,921
------------ ------------
Decrease in cash and cash equivalents ................. (1,141,132) (1,013,908)
Cash and cash equivalents at beginning of period ...... 1,641,768 1,214,944
------------ ------------
Cash and cash equivalents at end of period ............ $ 500,636 $ 201,036
============ ============
The accompanying notes are an integral part of these
consolidated financial statements
4
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. ORGANIZATION AND BASIS OF CONSOLIDATION
The accompanying financial statements consist of the consolidation of
Tarrant Apparel Group, a California corporation, and its majority owned
subsidiaries located primarily in the U.S., Asia, Mexico, and Luxembourg. At
March 31, 2006, we own 50.1% of United Apparel Ventures ("UAV") and 75% of PBG7,
LLC ("PBG7"). We consolidate these entities and reflect the minority interests
in earnings (losses) of the ventures in the accompanying financial statements.
All inter-company amounts are eliminated in consolidation. The 49.9% minority
interest in UAV is owned by Azteca Production International, a corporation owned
by the brothers of our Chairman and Interim Chief Executive Officer, Gerard
Guez. The 25% minority interest in PBG7 is owned by BH7, LLC, an unrelated
party.
We serve specialty retail, mass merchandise and department store chains
and major international brands by designing, merchandising, contracting for the
manufacture of, and selling casual apparel for women, men and children under
private label. Commencing in 1999, we expanded our operations from sourcing
apparel to sourcing and operating our own vertically integrated manufacturing
facilities. In August 2003, we determined to abandon our strategy of being both
a trading and vertically integrated manufacturing company, and effective
September 1, 2003, we leased and outsourced operation of our manufacturing
facilities in Mexico to affiliates of Mr. Kamel Nacif, a shareholder at the time
of the transaction. In August 2004, we entered into a purchase and sale
agreement to sell these facilities to affiliates of Mr. Nacif, which transaction
was consummated in the fourth quarter of 2004. See Note 13 of the "Notes to
Consolidated Financial Statements".
Historically, our operating results have been subject to seasonal
trends when measured on a quarterly basis. This trend is dependent on numerous
factors, including the markets in which we operate, holiday seasons, consumer
demand, climate, economic conditions and numerous other factors beyond our
control. Generally, the second and third quarters are stronger than the first
and fourth quarters. There can be no assurance that the historic operating
patterns will continue in future periods.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accompanying unaudited financial statements have been prepared in
accordance with accounting principles generally accepted in the United States of
America ("US GAAP") for interim financial information and with the instructions
to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include
all of the information and footnotes required by US GAAP for complete financial
statements. In the opinion of management, all adjustments (consisting of normal
recurring accruals) considered necessary for a fair presentation of the results
of operations for the periods presented have been included.
The consolidated financial data at December 31, 2005 is derived from
audited financial statements which are included in our Annual Report on Form
10-K for the year ended December 31, 2005, and should be read in conjunction
with the audited financial statements and notes thereto. Interim results are not
necessarily indicative of results for the full year.
The accompanying unaudited consolidated financial statements include
all majority-owned subsidiaries in which we exercise control. Investments in
which we exercise significant influence, but which we do not control, are
accounted for under the equity method of accounting. The equity method of
accounting is used when we have a 20% to 50% interest in other entities, except
for variable interest entities for which we are considered the primary
beneficiary under Financial Accounting Standards Board ("FASB") Interpretation
No. 46, "Consolidation of Variable Interest Entities," an interpretation of ARB
No. 51. Under the equity method, original investments are recorded at cost and
adjusted by our share of undistributed earnings or losses of these entities. All
significant inter-company transactions and balances have been eliminated from
the consolidated financial statements.
5
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The preparation of financial statements in conformity with US GAAP
requires management to make estimates and assumptions that 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
revenues and expenses during the reporting period. Significant estimates used by
us in preparation of the consolidated financial statements include: (i)
allowance for returns, discounts and bad debts, (ii) inventory, (iii) valuation
of long lived and intangible assets and goodwill, and (iv) income taxes. Actual
results could differ from those estimates.
ROYALTY EXPENSES
Royalty expenses consist of the royalty payments and marketing fund
commitments according to the various licensing agreements we have entered into.
Royalty expenses are calculated based on certain percentage of net sales. All of
these agreements include minimum royalties. See Note 14 of the "Notes to
Consolidated Financial Statements" regarding various agreements we have entered
into.
DEFERRED RENT PROVISION
When a lease requires fixed escalation of the minimum lease payments,
rental expense is recognized on a straight line basis over the initial term of
the lease, and the difference between the average rental amount charged to
expense and amounts payable under the lease is included in deferred amount. As
of March 31, 2006, deferred rent of $25,000 was recorded under accrued expense
in our consolidated financial statements.
STOCK BASED COMPENSATION
On January 1, 2006, we adopted Statements of Financial Accounting
Standards (SFAS) No. 123 (revised 2004), Share-Based Payment, (SFAS 123(R))
which requires the measurement and recognition of compensation expense for all
share-based payment awards made to employees and directors based on estimated
fair values. SFAS 123(R) supersedes our previous accounting under Accounting
Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees
(APB 25) for periods beginning in fiscal 2006. In March 2005, the Securities and
Exchange Commission issued Staff Accounting Bulletin (SAB) No. 107 (SAB 107)
relating to SFAS 123(R). We have applied the provisions of SAB 107 in its
adoption of SFAS 123(R).
We adopted SFAS 123(R) using the modified prospective transition
method, which requires the application of the accounting standard as of January
1, 2006, the first day of our fiscal year 2006. Our financial statements as of
and for the three months ended March 31, 2006 reflect the impact of SFAS 123(R).
In accordance with the modified prospective transition method, our financial
statements for prior periods have not been restated to reflect, and do not
include, the impact of SFAS 123(R).
The fair value of each option grant is estimated on the date of grant
using the Black-Scholes option-pricing model with the following weighted average
assumptions used for grants in 2005: weighted-average volatility factors of the
expected market price of our common stock of 0.55 for the three months ended
March 31, 2005, weighted-average risk-free interest rates of 4% for the three
months ended March 31, 2005, dividend yield of 0% and weighted-average expected
life of the options of 4 years. These pro forma results may not be indicative of
the future results for the full fiscal year due to potential grants, vesting and
other factors.
The following table illustrates the effect on net loss and loss per
share if we had applied the fair value recognition provisions of SFAS 123 to
stock-based awards granted under our stock option plans for the three months
ended March 31, 2005:
6
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
THREE MONTHS
ENDED
MARCH 31,
2005
-----------
Net loss as reported ............................................ $ (105,820)
Add stock-based employee compensation
charges reported in net loss ................................. --
Pro forma compensation expense, net of tax ...................... (76,509)
-----------
Pro forma net loss .............................................. $ (182,329)
===========
Net loss per share as reported - Basic and Diluted .............. $ (0.00)
Add stock-based employee compensation charges
reported in net loss - Basic and Diluted ........................ --
Pro forma compensation expense per share -
Basic and Diluted ............................................ (0.00)
-----------
Pro forma loss per share - Basic and Diluted .................... $ (0.00)
===========
SFAS 123(R) requires companies to estimate the fair value of
share-based payment awards to employees and directors on the date of grant using
an option-pricing model. The value of the portion of the award that is
ultimately expected to vest is recognized as expense over the requisite service
periods in our consolidated statements of operations. Prior to the adoption of
SFAS 123(R), we accounted for stock-based awards to employees and directors
using the intrinsic value method in accordance with APB 25 as allowed under SFAS
No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION (SFAS 123). Under the intrinsic
value method, no stock-based compensation expense had been recognized in our
consolidated statements of operations for awards to employees and directors
because the exercise price of our stock options equaled the fair market value of
the underlying stock at the date of grant.
We did not have any option granted during the first quarter of 2006. On
September 23, 2005, the Board of Directors approved the acceleration of vesting
of all our unvested stock options. In total, 1.7 million stock options with an
average exercise price of $3.69 and an average remaining contractual life of 7.9
years were subject to this acceleration. The exercise prices and number of
shares subject to the accelerated options were unchanged. The acceleration was
effective as of September 23, 2005. As a result, there was not any options
granted prior to, but not yet vested as of January 1, 2006. There was no
stock-based compensation expense related to employees or directors stock options
recognized during the three months ended March 31, 2006 and 2005.
Certain 2005 amounts have been reclassified to conform to the 2006
presentation.
3. STOCK BASED COMPENSATION
Our Employee Incentive Plan, formerly the 1995 Stock Option Plan, as
amended and restated in May 1999 (the Plan), has authorized the grant of both
incentive and non-qualified stock options to officers, employees, directors and
consultants of the Company for up to 5,100,000 shares (as adjusted for a stock
split effective May 1998) of our common stock. The exercise price of incentive
options must be equal to 100% of fair market value of common stock on the date
of grant and the exercise price of non-qualified options must not be less than
the par value of a share of common stock on the date of grant. The Plan was also
amended to expand the types of awards, which may be granted pursuant thereto to
include stock appreciation rights, restricted stock and other performance-based
benefits. At March 31, 2006, no further options may be granted under the Plan.
In October 1998, we granted 1,000,000 non-qualified stock options not
under the Plan. The options were granted to our Chairman and Vice Chairman at
$13.50 per share, the closing sales price of the common stock on the day of the
grant. The options expire in 2008 and vest over four years. In May 2002, we
granted 3,000,000 non-qualified stock options not under the Plan. The options
were granted to our Chairman, Vice Chairman and Mr. Kamel Nacif at $5.50 per
share, the closing sales price of the common stock on the day of the grant. The
options expire in 2012 and vest over three years. The 1,000,000 stock options
granted to Kamel Nacif were forfeited in 2005. In May 2003, we granted 2,000,000
non-qualified stock options not under the Plan to our Chairman and Vice
Chairman. The options were granted at $3.65 per share, the closing sales price
of the common stock on the day of the grant. The options expire in 2013 and vest
over four years. In December 2003, we granted 400,000 non-qualified stock
options not under the Plan to our President. The options were
7
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
granted at $3.94 per share, the closing sales price of the common stock on the
day of the grant. The options expire in 2013 and vest over four years.
A summary of our stock option activity, and related information for the year
ended December 31, 2005 and the three months ended March 31, 2006 is as follows:
EMPLOYEES
----------------------------
NUMBER OF EXERCISE
SHARES PRICE
------------ ------------
Options outstanding at December 31, 2004 ........ 8,331,962 $1.39-$45.50
Granted ......................................... 42,000 $1.95-$3.68
Exercised ....................................... -- --
Forfeited ....................................... (1,573,300) $1.95-$25.00
Expired ......................................... (67,612) $ 4.50
------------ ------------
Options outstanding at December 31, 2005 ........ 6,733,050 $1.39-$45.50
Granted ......................................... -- --
Exercised ....................................... -- --
Forfeited ....................................... (200) $ 3.60
Expired ......................................... -- --
------------ ------------
Options outstanding at March 31, 2006 ........... 6,732,850 $1.39-$45.50
We had no stock option outstanding to non-employees as of December 31, 2005 and
March 31, 2006.
The following table summarizes information about stock options outstanding as of
December 31, 2005 and March 31, 2006:
WEIGHTED
WEIGHTED AVERAGE
AVERAGE REMAINING
NUMBER OF EXERCISE CONTRACTUAL INTRINSIC
SHARES PRICE LIFE (YEARS) VALUE
--------- --------- --------- ---------
As of December 31, 2005:
Employees - Outstanding ........ 6,733,050 $ 6.25 6.0 $ 12,440
Employees - Exercisable ........ 6,733,050 $ 6.25 6.0 $ 12,440
As of March 31, 2006:
Employees - Outstanding ........ 6,732,850 $ 6.25 5.7 $ 0
Employees - Exercisable ........ 6,732,850 $ 6.25 5.7 $ 0
4. ACCOUNTS RECEIVABLE
Accounts receivable consists of the following:
MARCH 31, DECEMBER 31,
2006 2005
------------ ------------
U.S. trade accounts receivable ................. $ 11,008,456 $ 2,893,217
Foreign trade accounts receivable .............. 18,142,370 19,619,172
Factored accounts receivable ................... 33,877,827 33,222,354
Other receivables .............................. 2,449,203 1,815,450
Allowance for returns, discounts and bad debts . (3,107,728) (2,951,750)
------------ ------------
$ 62,370,128 $ 54,598,443
============ ============
8
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
5. INVENTORY
Inventory consists of the following:
MARCH 31, DECEMBER 31,
2006 2005
----------- -----------
Raw materials - fabric and trim accessories ...... $ 3,824,852 $ 5,079,428
Finished goods shipments-in-transit .............. 7,262,727 8,800,014
Finished goods ................................... 10,748,511 17,749,518
----------- -----------
$21,836,090 $31,628,960
=========== ===========
6. EQUITY METHOD INVESTMENT - AMERICAN RAG
In the second quarter of 2003, we acquired a 45% equity interest in the
owner of the trademark "American Rag CIE" and the operator of American Rag
retail stores for $1.4 million, and our subsidiary, Private Brands, Inc.,
acquired a license to certain exclusive rights to this trademark. We have
guaranteed the payment to the licensor of minimum royalties of $10.4 million
over the initial 10-year term of the agreement. The guaranteed annual minimum
royalty is payable in equal monthly installments during the term of the
agreement. The royalty owed to the licensor in excess of the guaranteed minimum,
if any, are payable no later than 30 days after the end of the preceding full
quarter with the amount for last quarter adjusted based on actual royalties owed
for the year. The minimum royalty paid and expensed for the three month ended
March 31, 2006 was $165,000. At March 31, 2006, the total commitment on
royalties remaining on the term was $8.9 million. Private Brands also entered
into a multi-year exclusive distribution agreement with Macy's Merchandising
Group, LLC ("MMG"), the sourcing arm of Federated Department Stores, to supply
MMG with American Rag CIE, a casual sportswear collection for juniors and young
men. Under this arrangement, Private Brands designs and manufactures American
Rag apparel, which is distributed by MMG exclusively to Federated stores across
the country. Beginning in August 2003, the American Rag collection was available
in approximately 100 select Macy's, the Bon Marche, Burdines, Goldsmith's,
Lazarus and Rich's-Macy's locations. The investment in American Rag CIE, LLC
totaling $2.2 million at March 31, 2006, is accounted for under the equity
method and included in equity method investment on the accompanying consolidated
balance sheets. Income from the equity method investment is recorded in the
United States geographical segment. The change in investment in American Rag
during the three month ended March 31, 2006 was as follows:
Balance as of December 31, 2005 ........... $ 2,138,865
Share of income ........................... 47,413
Distribution .............................. (0)
-----------
Balance as of March 31, 2006 ............. $ 2,186,278
===========
7. DEBT
Short-term bank borrowings consist of the following:
MARCH 31, DECEMBER 31,
2006 2005
----------- -----------
Import trade bills payable - UPS,
DBS Bank and Aurora Capital ............... $ 4,857,531 $ 4,165,306
Bank direct acceptances - UPS and
DBS Bank .................................. 1,368,219 1,471,476
Other Hong Kong credit facilities -
UPS and DBS Bank .......................... 6,254,239 8,196,750
----------- -----------
$12,479,989 $13,833,532
=========== ===========
9
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Long-term obligations consist of the following:
MARCH 31, DECEMBER 31,
2006 2005
------------ ------------
Loan from Max Azria ................ $ 3,006,279 $ --
Equipment financing ................ 34,725 83,206
Term loan - UPS .................... 2,083,333 2,708,333
Debt facility - GMAC CF ............ 34,431,066 33,558,095
------------ ------------
39,555,403 36,349,634
Less current portion ............... (39,540,629) (36,109,699)
------------ ------------
$ 14,774 $ 239,935
============ ============
IMPORT TRADE BILLS PAYABLE, BANK DIRECT ACCEPTANCES AND OTHER HONG KONG CREDIT
FACILITIES
On June 13, 2002, we entered into a letter of credit facility of $25
million with UPS Capital Global Trade Finance Corporation ("UPS"). Under this
facility, we may arrange for the issuance of letters of credit and acceptances.
The facility is collateralized by the shares and debentures of all of our
subsidiaries in Hong Kong. In addition to the guarantees provided by Tarrant
Apparel Group and our subsidiaries, Fashion Resource (TCL) Inc. and Tarrant
Luxembourg Sarl, Gerard Guez, our Chairman and Interim Chief Executive Officer,
also signed a guarantee of $5 million in favor of UPS to secure this facility.
This facility bore interest at 10.75% per annum at March 31, 2006. Under this
facility, we were subject to certain restrictive covenants, including that we
maintain a specified tangible net worth, fixed charge ratio, and leverage ratio.
On June 27, 2005, we amended the letter of credit facility with UPS to extend
the expiration date of the facility from June 30, 2005 to August 31, 2005 and to
reduce the tangible net worth requirement at June 30, 2005. On August 31, 2005,
we amended the letter of credit facility with UPS to further extend the
expiration date of the facility to October 31, 2005, immediately reduce the
maximum amount of borrowings to $14.5 million on September 1, 2005 and further
reduced the maximum amount of borrowing to $14.0 million on October 1, 2005. On
October 31, 2005, we further amended the letter of credit facility with UPS to
extend the expiration date of the facility to January 31, 2006 and amend the
interest rate to "prime rate" plus 3%. The facility amendment also provided for
reduction in the maximum amount of borrowings to $13.5 million commencing on
November 1, 2005, to $13.0 million commencing on December 1, 2005, and to $12.5
million commencing on January 1, 2006. Additionally, Gerard Guez, our Chairman
and Interim Chief Executive Officer, pledged to UPS 4.6 million shares of our
common stock held by Mr. Guez to secure the obligations under the credit
facility. On January 27, 2006, we further amended the letter of credit facility
with UPS to extend the expiration date of the facility from January 31, 2006 to
July 31, 2006. The amendment provides for reduction of the maximum amount of
borrowings under the facility to $12.0 million commencing on April 1, 2006,
$11.5 million commencing on May 1, 2006, $11.0 million commencing on June 1,
2006 and to $10.5 million commencing on July 1, 2006. Under the amended letter
of credit facility, we are subject to restrictive financial covenants of
maintaining tangible net worth of $25 million as of December 31, 2005 and the
last day of each fiscal quarter thereafter. There is also a provision capping
maximum capital expenditures per quarter of $800,000. As of March 31, 2006, we
were in compliance with the covenants. As of March 31, 2006, $8.0 million was
outstanding under this facility with UPS (classified above as follows: $1.8
million in import trade bills payable; $1.4 million in bank direct acceptances
and $4.8 million in other Hong Kong credit facilities) and an additional $2.5
million was available for future borrowings. In addition, $2.0 million of open
letters of credit was outstanding as of March 31, 2006.
Since March 2003, DBS Bank (Hong Kong) Limited (formerly known as Dao
Heng Bank) has made available a letter of credit facility of up to HKD 20
million (equivalent to US $2.6 million) to our subsidiaries in Hong Kong. This
is a demand facility and is secured by the pledge of our office property, which
is owned by Gerard Guez, our Chairman and Interim Chief Executive Officer, and
Todd Kay, our Vice Chairman, and by our guarantee. The letter of credit facility
was increased to HKD 30 million (equivalent to US $3.9 million) in June 2004. As
of March 31, 2006, $2.5 million was outstanding under this facility. In
addition, $1.1 million of open letters of credit was outstanding and $294,000
was available for future borrowings as of March 31, 2006. In October 2005, a tax
loan for HKD 6.233 million (equivalent to US $804,000) was also made available
to our Hong Kong subsidiaries. As of March 31, 2006, $478,000 was outstanding
under this tax loan.
As of March 31, 2006, the total balance outstanding under the DBS Bank
credit facilities was $3.0 million (classified above as follows: $1.6 million in
import trade bills payable, $0 in bank direct acceptances and $1.4 million in
other Hong Kong credit facilities).
10
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
From time to time, we open letters of credit under an uncommitted line
of credit from Aurora Capital Associates which issues these letters of credits
out of Israeli Discount Bank. As of March 31, 2006, $1.5 million was outstanding
under this facility (classified above under import trade bills payable) and $3.2
million of letters of credit were open under this arrangement. We pay a
commission fee of 2.25% on all letters of credits issued under this arrangement.
LOAN FROM MAX AZRIA
On January 19, 2006, we borrowed $4.0 million from Max Azria pursuant
to the terms of a promissory note, which amount bears interest at the rate of
5.5% per annum and is payable in weekly installments of $200,000 beginning on
March 1, 2006. This is an unsecured loan. As of March 31, 2006, $3.0 million was
outstanding under this loan.
EQUIPMENT FINANCING
We had three equipment loans outstanding at December 31, 2005. One of
these equipment loans bore interest at 6% payable in installments through 2009,
which we paid off in January 2006. The second loan bears interest at 15.8%
payable in installment through 2007 and the third loan bears interest at 6.15%
payable in installment through 2007. As of March 31, 2006, $35,000 was
outstanding under the two remaining loans.
TERM LOAN - UPS
On December 31, 2004, our Hong Kong subsidiaries entered into a loan
agreement with UPS pursuant to which UPS made a $5 million term loan, the
proceeds of which were used to repay $5 million of indebtedness owed to UPS
under the letter of credit of facility. The principal amount of this loan is due
and payable in 24 equal monthly installments of approximately $208,333 each,
plus interest equivalent to the "prime rate" plus 2% commencing on February 1,
2005. This facility bore interest at 9.75% per annum at March 31, 2006. On June
27, 2005, we amended the loan agreement with UPS to reduce the tangible net
worth requirement at June 30, 2005. Under the amended loan agreement, we are
subject to restrictive financial covenants of maintaining tangible net worth of
$25 million at December 31, 2005 and the last day of each fiscal quarter
thereafter. There is also a provision capping maximum capital expenditure per
quarter at $800,000. As of March 31, 2006, we were in compliance with the
covenants. As of March 31, 2006, $2.1 million was outstanding. The obligations
under the loan agreement are collateralized by the same security interests and
guarantees provided under our letter of credit facility with UPS. Additionally,
the term loan is secured by two promissory notes payable to Tarrant Luxembourg
Sarl in the amounts of $2,550,000 and $1,360,000 and a pledge by Gerard Guez,
our Chairman and Interim Chief Executive Officer, of 4.6 million shares of our
common stock.
DEBT FACILITY AND FACTORING AGREEMENT - GMAC CF
We were previously party to a revolving credit, factoring and security
agreement (the "Debt Facility") with GMAC Commercial Finance, LLC ("GMAC CF").
This Debt Facility provided a revolving facility of $90 million, including a
letter of credit facility not to exceed $20 million, and was scheduled to mature
on January 31, 2005. The Debt Facility also provided a term loan of $25 million,
which was being repaid in monthly installments of $687,500. The Debt Facility
provided for interest at LIBOR plus the LIBOR rate margin determined by the
Total Leverage Ratio (as defined in the Debt Facility agreements), and was
collateralized by our receivables, intangibles, inventory and various other
specified non-equipment assets. In May 2004, the maximum facility amount was
reduced to $45 million in total and we established new financial covenants with
GMAC CF for the fiscal year of 2004.
On October 1, 2004, we amended and restated the Debt Facility with GMAC
CF by entering into a new factoring agreement with GMAC CF. The amended and
restated agreement (the factoring agreement) extended the expiration date of the
facility to September 30, 2007 and added as parties our subsidiaries Private
Brands, Inc and No! Jeans, Inc. In addition, in connection with the factoring
agreement, our indirect majority-owned subsidiary PBG7, LLC entered into a
separate factoring agreement with GMAC CF. Pursuant to the terms of the
factoring agreement, we and our subsidiaries agree to assign and sell to GMAC
CF, as factor, all accounts which arise from our sale of merchandise or
rendition of service created on a going forward basis. At our request, GMAC CF,
in its discretion, may make advances to us up to the lesser of (a) up to 90% of
our accounts on which GMAC CF has the risk of loss and (b) $40 million, minus in
each case, any amount owed by us to GMAC CF. Pursuant to the terms of the PBG7
factoring agreement, PBG7 agreed to assign and sell to GMAC CF, as factor, all
accounts, which arise from PBG7's sale of merchandise or
11
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
rendition of services created on a going-forward basis. At PBG7's request, GMAC
CF, in its discretion, may make advances to PBG7 up to the lesser of (a) up to
90% of PBG7's accounts on which GMAC CF has the risk of loss, and (b) $5 million
minus in each case, any amounts owed to GMAC CF by PBG7. The facility bore
interest at 7.8256% per annum and the facility under PBG7, LLC bore interest at
8.25% per annum, respectively, at March 31, 2006. Restrictive covenants under
the revised facility include a limit on quarterly capital expenses of $800,000
and tangible net worth of $25 million at December 31, 2005 and at the end of
each fiscal quarter thereafter. As of March 31, 2006, we were in compliance with
the covenants. A total of $29.9 million was outstanding with respect to
receivables factored under the GMAC CF facility at March 31, 2006.
In May 2005, we amended our factoring agreement with GMAC CF to permit
our subsidiaries party thereto and us, to borrow up to the lesser of $3 million
or 50% of the value of eligible inventory. In connection with this amendment, we
granted GMAC CF a lien on certain of our inventory located in the United States.
On January 23, 2006, we further amended our factoring agreement with GMAC CF to
increase the amount we may borrow against inventory to the lesser of $5 million
or 50% of the value of eligible inventory. The $5 million limit will be reduced
to $4 million on April 1, 2006 and will be further reduced to $3 million on July
1, 2006. The maximum borrowing availability under the factoring agreement, based
on the borrowing base formula remains at $40 million. A total of $4.5 million
was outstanding under the GMAC CF facility at March 31, 2006 with respect to
collateralized inventory.
The credit facility with GMAC CF and the credit facility with UPS carry
cross-default clauses. A breach of a financial covenant set by GMAC CF or UPS
constitutes an event of default under the other credit facility, entitling both
financial institutions to demand payment in full of all outstanding amounts
under their respective debt and credit facilities.
8. CONVERTIBLE DEBENTURES AND WARRANTS
On December 14, 2004, we completed a $10 million financing through the
issuance of (i) 6% Secured Convertible Debentures ("Debentures") and (ii)
warrants to purchase up to 1,250,000 shares of our common stock. Prior to
maturity, the investors may convert the Debentures into shares of our common
stock at a price of $2.00 per share. The warrants have a term of five years and
an exercise price of $2.50 per share. The warrants were valued at $866,000 using
the Black-Scholes option valuation model with the following assumptions:
risk-free interest rate of 4%; dividend yields of 0%; volatility factors of the
expected market price of our common stock of 0.55; and an expected life of four
years. The Debentures bear interest at a rate of 6% per annum and have a term of
three years. We may elect to pay interest on the Debentures in shares of our
common stock if certain conditions are met, including a minimum market price and
trading volume for our common stock. The Debentures contain customary events of
default and permit the holder thereof to accelerate the maturity if the full
principal amount together with interest and other amounts owing upon the
occurrence of such events of default. The Debentures are secured by a
subordinated lien on certain of our accounts receivable and related assets. The
closing market price of our common stock on the closing date of the financing
was $1.96. The convertible debenture was thus valued at $8,996,000, resulting in
an effective conversion price of $1.799 per share. The intrinsic value of the
conversion option of $804,000 is being amortized over the life of the loan. The
value of the warrants of $866,000 and the intrinsic value of the conversion
option of $804,000 were netted from the $10 million presented as the convertible
debentures, net on our accompanying balance sheets at December 31, 2004.
The placement agent in the financing, received compensation for its
services in the amount of $620,000 in cash and issuance of five year warrants to
purchase up to 200,000 shares of our common stock at an exercise price of $2.50
per share. The warrants to purchase 200,000 shares of our common stock were
valued at $138,000 using the Black-Scholes option valuation model with the
following assumptions: risk-free interest rate of 4%; dividend yields of 0%;
volatility factors of the expected market price of our common stock of 0.55; and
an expected life of four years. The $620,000 financing cost paid to the
placement agent and the value of the warrants to purchase 200,000 shares of our
common stock of $138,000 are included in the deferred financing cost, net on our
accompanying balance sheets and are amortized over the life of the loan.
In June 2005, holders of our Debentures converted an aggregate of $2.3
million of Debentures into 1,133,687 shares of our common stock. In August 2005,
holders of our Debentures converted an aggregate of $820,000 of Debentures into
410,000 shares of our common stock. The Debentures were converted at the option
of the holders at a price of $2.00 per share. Debt discount of $248,000 related
to the intrinsic value of the conversion option of $804,000 was expensed upon
the conversion. Of the $620,000 financing cost paid to the placement agent,
$191,000 was expensed upon the conversion. The intrinsic value of the
12
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
conversion option, and the value of the warrant amortized in the first three
months of 2006 was $118,000. Total deferred financing cost amortized in the
first three months of 2006 was $47,000. Total interest paid to the holders of
the Debentures in the first three months of 2006 was $104,000. As of March 31,
2006, $6.1 million, net of $829,000 of debt discount, remained outstanding under
the Debentures.
9. EQUITY TRANSACTIONS
In March 2005, in connection with a settlement of a dispute involving a
former employee named Nicolas Nunez, we agreed to compensate Mr. Nunez in the
total amount of $875,000. In April 2005, we issued 195,313 shares of our common
stock (having a value of $375,000) to Mr. Nunez pursuant to the terms of an
agreement and plan of reorganization and paid Mr. Nunez $500,000 in settlement
of all remaining claims by Mr. Nunez against us. In connection with this
settlement, in March 2006, we cancelled 10,000 shares of our common stock
previously issued to him.
10. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing
of Financial Assets" ("SFAS No. 156"), which provides an approach to simplify
efforts to obtain hedge-like (offset) accounting. This Statement amends FASB
Statement No. 140, "Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities", with respect to the accounting for
separately recognized servicing assets and servicing liabilities. The Statement
(1) requires an entity to recognize a servicing asset or servicing liability
each time it undertakes an obligation to service a financial asset by entering
into a servicing contract in certain situations; (2) requires that a separately
recognized servicing asset or servicing liability be initially measured at fair
value, if practicable; (3) permits an entity to choose either the amortization
method or the fair value method for subsequent measurement for each class of
separately recognized servicing assets or servicing liabilities; (4) permits at
initial adoption a one-time reclassification of available-for-sale securities to
trading securities by an entity with recognized servicing rights, provided the
securities reclassified offset the entity's exposure to changes in the fair
value of the servicing assets or liabilities; and (5) requires separate
presentation of servicing assets and servicing liabilities subsequently measured
at fair value in the balance sheet and additional disclosures for all separately
recognized servicing assets and servicing liabilities. SFAS No. 156 is effective
for all separately recognized servicing assets and liabilities as of the
beginning of an entity's fiscal year that begins after September 15, 2006, with
earlier adoption permitted in certain circumstances. The Statement also
describes the manner in which it should be initially applied. We are currently
evaluating the impact of this Statement.
11. INCOME TAXES
Our effective tax rate differs from the statutory rate principally due
to the following reasons: (1) a full valuation allowance has been provided for
deferred tax assets as a result of the operating losses in the United States and
Mexico, since recoverability of those assets has not been assessed as more
likely than not; (2) although we have taxable losses in Mexico, we are subject
to a minimum tax; and (3) the earnings of our Hong Kong subsidiary are taxed at
a rate of 17.5% versus the 35% U.S. federal rate. The impairment charge in
Mexico did not result in a tax benefit due to an increase in the valuation
allowance against the future tax benefit. We believe it is more likely than not
that the tax benefit will not be realized based on our future business plans in
Mexico.
In January 2004, the Internal Revenue Service ("IRS") completed its
examination of our Federal income tax returns for the years ended December 31,
1996 through 2001. The IRS has proposed adjustments to increase our income tax
payable for the six years under examination. In addition, in July 2004, the IRS
initiated an examination of our Federal income tax return for the year ended
December 31, 2002. In March 2005, the IRS proposed an adjustment to our taxable
income of approximately $6 million related to similar issues identified in their
audit of the 1996 through 2001 federal income tax returns. The proposed
adjustments to our 2002 federal income tax return would not result in additional
tax due for that year due to the tax loss reported in the 2002 federal return.
However, it could reduce the amount of net operating losses available to offset
taxes due from the preceding tax years. This adjustment would also result in
additional state taxes and interest. We believe that we have meritorious
defenses to and intend to vigorously contest the proposed adjustments. If the
proposed adjustments are upheld through the administrative and legal process,
they could have a material impact on our earnings and cash flow. We believe we
have provided adequate reserves for any reasonably foreseeable outcome related
to these matters on the consolidated balance sheets included in the consolidated
financial statements under the caption "Income Taxes". The maximum amount of
loss in excess of the amount accrued in the financial statements is $7.7
13
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
million. We do not believe that the adjustments, if any, arising from the IRS
examination, will result in an additional income tax liability beyond what is
recorded in the accompanying consolidated balance sheets.
12. NET INCOME (LOSS) PER SHARE
A reconciliation of the numerator and denominator of basic earnings
(loss) per share and diluted earnings (loss) per share is as follows:
THREE MONTHS ENDED MARCH 31,
----------------------------
Basic EPS Computation: 2006 2005
------------ ------------
Numerator ..................................... $ 836,372 $ (105,820)
Denominator:
Weighted average common shares outstanding .... 30,551,207 28,814,763
Basic EPS ..................................... $ 0.03 $ (0.00)
============ ============
Diluted EPS Computation:
Numerator ..................................... $ 836,372 $ (105,820)
Denominator:
Weighted average common shares outstanding .... 30,551,207 28,814,763
Incremental shares from assumed exercise of
warrants ...................................... -- --
convertible debentures ........................ -- --
options ....................................... -- --
------------ ------------
Total shares .................................. 30,551,207 28,814,763
Diluted EPS ................................... $ 0.03 $ (0.00)
============ ============
Basic and diluted loss per share has been computed in accordance with
SFAS No. 128, "Earnings Per Share".
No shares of outstanding options and warrants were included in the
computation of income per share in the three months ended March 31, 2006 and
2005 as the exercise prices of the remaining shares were greater than the
average market price for the three months ended March 31, 2006 and 2005. All
options, warrants and convertible debentures were excluded from the computation
of net income (loss) per share in the three months ended March 31, 2006 and
2005, as the impact would be anti-dilutive. The effect of applying "IF Converted
Method" to the convertible debenture was anti-dilutive; therefore, it was
excluded from the computation of income per share in the three months ended
March 31, 2006 and 2005. The following table presents outstanding options,
warrants and convertible debentures.
AS OF MARCH 31,
-------------------------
2006 2005
---------- ----------
Options ........................ 6,732,850 6,994,787
Warrants ....................... 2,361,732 2,361,732
Convertible debentures ......... 3,456,313 5,000,000
---------- ----------
Total .......................... 12,550,895 14,356,519
========== ==========
13. RELATED PARTY TRANSACTIONS
As of March 31, 2006, related party affiliates were indebted to us in
the amounts of $8.6 million. These include amounts due from Gerard Guez, our
Chairman and Interim Chief Executive Officer. From time to time in the past, we
borrowed funds from, and advanced funds to, Mr. Guez. The greatest outstanding
balance of such advances to Mr. Guez in the first quarter of 2006 was
approximately $2,279,000. At March 31, 2006, the entire balance due from Mr.
Guez totaling
14
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
$2.3 million is payable on demand and has been shown as reductions to
shareholders' equity in the accompanying financial statements. All advances to,
and borrowings from, Mr. Guez bore interest at the rate of 7.75% during the
period. Total interest paid by Mr. Guez was $44,000 and $74,000 for the three
months ended March 31, 2006 and 2005, respectively. Mr. Guez paid expenses on
our behalf of approximately $67,000 and $108,000 for the three months ended
March 31, 2006 and 2005, respectively, which amounts were applied to reduce
accrued interest and principal on Mr. Guez's loan. These amounts included fuel
and related expenses incurred by 477 Aviation, LLC, a company owned by Mr. Guez,
when our executives used this company's aircraft for business purposes. Since
the enactment of the Sarbanes-Oxley Act in 2002, no further personal loans (or
amendments to existing loans) have been or will be made to our executive
officers or directors.
On July 1, 2001, we formed an entity to jointly market, share certain
risks and achieve economics of scale with Azteca Production International, Inc.
("Azteca"), a corporation owned by the brothers of Gerard Guez, our Chairman and
Interim Chief Executive Officer, called United Apparel Ventures, LLC ("UAV").
This entity was created to coordinate the production of apparel for a single
customer of our branded business. UAV is owned 50.1% by Tag Mex, Inc., our
wholly owned subsidiary, and 49.9% by Azteca. Results of the operation of UAV
have been consolidated into our results since July 2001 with the minority
partner's share of gain and losses eliminated through the minority interest line
in our financial statements. Due to the restructuring of our Mexico operations,
we discontinued manufacturing for UAV customers in the second quarter of 2004.
UAV made purchases from two related parties in Mexico, an affiliate of Azteca
and Tag-It Pacific, Inc.
At March 31, 2006, Messrs. Guez and Kay beneficially owned 590,000 and
1,003,500 shares, respectively, of common stock of Tag-It Pacific, Inc.
("Tag-It"), collectively representing approximately 8.7% of Tag-It Pacific's
common stock. Tag-It is a provider of brand identity programs to manufacturers
and retailers of apparel and accessories. Starting from 1998, Tag-It assumed the
responsibility for managing and sourcing all trim and packaging used in
connection with products manufactured by or on behalf of us in Mexico. Due to
the restructuring of our Mexico operations, Tag-It no longer manages our trim
and packaging requirements. We purchased $97,000 and $0 of trim inventory from
Tag-It in the three months ended March 31, 2006 and 2005, respectively. We
purchased $0 and $135,000 of finished goods and service from Azteca and its
affiliates in the three months ended March 31, 2006 and 2005, respectively. Our
total sales of fabric and service to Azteca in the three months ended March 31,
2006 and 2005 were $9,000 and $63,000, respectively. Pursuant to the operating
agreement for UAV, two and one half percent of gross sales of UAV were paid to
each of the members of UAV as management fees. Net amount due from these related
parties as of March 31, 2006 was $5.6 million.
In August 2004, we entered into an Agreement for Purchase of Assets
with affiliates of Mr. Kamel Nacif, a shareholder at the time of the
transaction, which agreement was amended in October 2004. Pursuant to the
agreement, as amended, on November 30, 2004, we sold to the purchasers
substantially all of our assets and real property in Mexico, including the
equipment and facilities we previously leased to Mr. Nacif's affiliates in
October 2003, for an aggregate purchase price consisting of: a) $105,400 in cash
and $3,910,000 by delivery of unsecured promissory notes bearing interest at
5.5% per annum; and b) $40,204,000, by delivery of secured promissory notes
bearing interest at 4.5% per annum, maturing on December 31, 2005 and every year
thereafter until December 31, 2014. The secured promissory notes are payable in
partial or total amounts anytime prior to the maturity of each note. Included in
the $41.0 million notes receivable - related party on the accompanying balance
sheet as of March 31, 2006 was $1.3 million of Mexico value added taxes on the
real property component of this transaction. Upon consummation of the sale, we
entered into a purchase commitment agreement with the purchasers, pursuant to
which we have agreed to purchase annually over the ten-year term of the
agreement, $5 million of fabric manufactured at our former facilities acquired
by the purchasers at negotiated market prices. We purchased $0 and $840,000 of
fabric from Acabados y Terminados in the three months ended March 31, 2006 and
2005, respectively. Net amount due from these parties as of March 31, 2006 was
$507,000.
We lease our executive offices in Los Angeles, California from GET, a
corporation which is owned by Gerard Guez (our Chairman and Interim Chief
Executive Officer) and Todd Kay (our Vice Chairman). Additionally, we lease our
warehouse and office space in Hong Kong from Lynx International Limited, a Hong
Kong corporation that is owned by Messrs. Guez and Kay. We paid $269,000 and
$255,000 in rent in the three months ended March 31, 2006 and 2005,
respectively, for office and warehouse facilities. Our Los Angeles offices and
warehouse is leased on a month to month basis. On January 1, 2006, we renewed
our lease agreement with Lynx International Limited for our office space in Hong
Kong for one year.
15
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
At March 31, 2006, we had various employee receivables totaling
$273,000 included in due from related parties.
We believe that each of the transactions described above has been
entered into on terms no less favorable to us than could have been obtained from
unaffiliated third parties.
14. COMMITMENTS AND CONTINGENCIES
On January 3, 2005, Private Brands, Inc., our wholly owned subsidiary,
entered into a term sheet exclusive licensing agreement with Beyond Productions,
LLC and Kids Headquarters to collaborate on the design, manufacturing and
distribution of women's contemporary, large sizes and junior apparel bearing the
brand name "House of Dereon", Couture, Kick and Soul. This agreement was a
three-year contract, and providing compliance with all terms of the license, was
renewable for one additional three-year term. The agreement also provided
payment of royalties at the rate of 8% on net sales and 3% on net sales for
marketing fund commitments. In the first quarter of 2005, we advanced $1.2
million as payment for the first year's minimum royalty and marketing fund
commitment. We had applied $34,000 from the above advance against the royalty
and marketing expenses in 2005. In March 2006, we agreed to terminate our
agreement to design, market and sell House of Dereon by Tina Knowles branded
apparel and we agreed to sell all remaining inventory to the licensor or its
designee. As a result, we will no longer be involved in the sales of this
private brand. Prior to December 31, 2005, we had written off the capitalized
balance of $1.2 million related to the first year term of the agreement and
recognized a corresponding loss in 2005.
On October 17, 2004, Private Brands, Inc. entered into an agreement
with J. S. Brand Management to design, manufacture and distribute Jessica
Simpson branded jeans and casual apparel. This agreement has an initial
three-year term, and provided we are in compliance with the terms of the
agreement, is renewable for one additional two-year term. Minimum net sales are
$20 million in year 1, $25 million in year 2 and $30 million in year 3. The
agreement provides for payment of a sales royalty and advertising commitment at
the rate of 8% and 3%, respectively, of net sales, for a total minimum payment
obligation of $8.3 million over the initial term of the agreement. In December
2004, we advanced $2.2 million as payment for the first year's minimum
royalties. We applied $1.1 million from the above advance against the royalty
and marketing expenses in 2005 and $884,000 in the first three months of 2006.
In March 2006, we had written off the capitalized balance of $192,000 and
recognized a corresponding loss. The loss was classified as royalty expense on
our consolidated statements of operations. In March 2006, we became involved in
a dispute with the licensor of the Jessica Simpson brands over our continued
rights to these brands. We are presently in litigation with the licensor.
In the second quarter of 2003, we acquired a 45% equity interest in the
owner of the trademark "American Rag CIE" and the operator of American Rag
retail stores for $1.4 million, and our subsidiary, Private Brands, Inc.,
acquired a license to certain exclusive rights to this trademark. We have
guaranteed the payment to the licensor of minimum royalties of $10.4 million
over the initial 10-year term of the agreement. The guaranteed annual minimum
royalty is payable in equal monthly installments during the term of the
agreement. The royalty owed to the licensor in excess of the guaranteed minimum,
if any, are payable no later than 30 days after the end of the preceding full
quarter with the amount for last quarter adjusted based on actual royalties owed
for the year. At March 31, 2006, the total commitment on royalties remaining on
the term was $8.9 million.
In August 2004, we entered into an Agreement for Purchase of Assets
with affiliates of Mr. Kamel Nacif; a shareholder at the time of the
transaction, with agreement was amended in October 2004. Pursuant to the
agreement, as amended, on November 30, 2004, we sold to the purchasers
substantially all of our assets and real property in Mexico, including the
equipment and facilities we previously leased to Mr. Nacif's affiliates. Upon
consummation of the sale, we entered into a purchase commitment agreement with
the purchasers, pursuant to which we have agreed to purchase annually over the
ten-year term of the agreement, $5 million of fabric manufactured at our former
facilities acquired by the purchasers at negotiated market prices. We purchased
$0 and $840,000 of fabric in the three months ended March 31, 2006 and 2005,
respectively.
16
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
15. OPERATIONS BY GEOGRAPHIC AREAS
Our predominant business is the design, distribution and importation of private
label and private brand casual apparel. Substantially all of our revenues are
from the sales of apparel. We are organized into four geographic regions: the
United States, Asia, Mexico and Luxembourg. We evaluate performance of each
region based on profit or loss from operations before income taxes not including
the cumulative effect of change in accounting principles. Information about our
operations in the United States, Asia, Mexico and Luxembourg is presented below.
Inter-company revenues and assets have been eliminated to arrive at the
consolidated amounts.
ADJUSTMENTS
AND
UNITED STATES ASIA MEXICO LUXEMBOURG ELIMINATIONS TOTAL
------------- ------------- ------------- ------------- ------------- -------------
THREE MONTHS ENDED MARCH 31, 2006
Sales ........................... $ 60,570,000 $ 681,000 $ 10,000 $ -- $ -- $ 61,261,000
Inter-company sales ............. -- 29,351,000 -- -- (29,351,000) --
------------- ------------- ------------- ------------- ------------- -------------
Total revenue ................... $ 60,570,000 $ 30,032,000 $ 10,000 $ -- $ (29,351,000) $ 61,261,000
============= ============= ============= ============= ============= =============
Income (loss) from operations ... $ 571,000 $ 1,164,000 $ (87,000) $ (2,000) $ -- $ 1,646,000
============= ============= ============= ============= ============= =============
Interest income ................. $ 44,000 $ 657,000 $ -- $ 441,000 $ (657,000) $ 485,000
============= ============= ============= ============= ============= =============
Interest expense ................ $ 1,127,000 $ 58,000 $ 3,000 $ 657,000 $ (657,000) $ 1,188,000
============= ============= ============= ============= ============= =============
Provision for depreciation
and amortization ............... $ 346,000 $ 27,000 $ -- $ -- $ -- $ 373,000
============= ============= ============= ============= ============= =============
Capital expenditures ............ $ 9,000 $ 13,000 $ -- $ -- $ -- $ 22,000
============= ============= ============= ============= ============= =============
Total assets .................... $ 111,857,000 $ 120,898,000 $ 14,691,000 $ 211,801,000 $(312,570,000) $ 146,677,000
============= ============= ============= ============= ============= =============
THREE MONTHS ENDED MARCH 31, 2005
Sales ........................... $ 44,600,000 $ 224,000 $ 6,000 $ -- $ -- $ 44,830,000
Inter-company sales ............. -- 26,835,000 -- -- (26,835,000) --
------------- ------------- ------------- ------------- ------------- -------------
Total revenue ................... $ 44,600,000 $ 27,059,000 $ 6,000 $ -- $ (26,835,000) $ 44,830,000
============= ============= ============= ============= ============= =============
Income (loss) from operations ... $ (696,000) $ 1,133,000 $ (204,000) $ -- $ -- $ 233,000
============= ============= ============= ============= ============= =============
Interest income ................. $ 75,000 $ 374,000 $ -- $ 478,000 $ (374,000) $ 553,000
============= ============= ============= ============= ============= =============
Interest expense ................ $ 789,000 $ 24,000 $ -- $ 374,000 $ (374,000) $ 813,000
============= ============= ============= ============= ============= =============
Provision for depreciation
and amortization ............... $ 473,000 $ 24,000 $ 71,000 $ -- $ -- $ 568,000
============= ============= ============= ============= ============= =============
Capital expenditures ............ $ 47,000 $ 24,000 $ -- $ -- $ -- $ 71,000
============= ============= ============= ============= ============= =============
Total assets .................... $ 104,742,000 $ 113,199,000 $ 27,969,000 $ 212,269,000 $(325,490,000) $ 132,689,000
============= ============= ============= ============= ============= =============
17
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
16. LITIGATION
On or about April 6, 2006, we commenced an action against the licensor
of the Jessica Simpson brands in the Supreme Court of the State of New York,
County of New York. The suit named Camuto Consulting Group, Inc., VCJS LLC, With
You, Inc. and Jessica Simpson as defendants, and asserts that the defendants
failed to provide promised support in connection with our sublicense agreement
for the Jessica Simpson brands. The complaint includes eight causes of action,
including two seeking a declaration that the sublicense agreement is exclusive
and remains in full force and effect, as well as claims for breach of contract
by Camuto, breach of the duty of good faith and fair dealing and fraudulent
inducement against Camuto, and a claim against With You, Inc. and Ms. Simpson
that we are an intended third party beneficiary of the licenses between those
defendants and Camuto. On or about April 26, 2006, Camuto served its answer to
our complaint and included a counterclaim against us for breach of the
sublicense agreement and alleging damages of no less than $100 million. On or
about April 17, 2006, Ms. Simpson served a motion seeking dismissal of the cause
of action asserted against her. We intend to vigorously defend Camuto's
counterclaim and vigorously oppose Ms. Simpson's motion.
Shortly before May 2004, Bazak International Corp. commenced an action
against us in the New York County Supreme Court claiming that we breached an
oral contract to sell a quantity of close-out goods, as a consequence of which
Bazak was damaged to the extent of $1.3 million. Bazak International Corp.
claimed that our liability exists under a theory of breach of contract or unjust
enrichment. This case is currently pending in the United States District Court
for the Southern District of New York and is scheduled for trial on December 18,
2006. We will continue to vigorously defend against the breach of contract and
unjust enrichment claim.
From time to time, we are involved in various routine legal proceedings
incidental to the conduct of our business. Our management does not believe that
any of these legal proceedings will have a material adverse impact on our
business, financial condition or results of operations, either due to the nature
of the claims, or because our management believes that such claims should not
exceed the limits of the our insurance coverage.
17. SUBSEQUENT EVENTS
On May 12, 2006, we entered into a commitment letter with Guggenheim
Corporate Funding, LLC with respect to a $65 million credit facility. The
commitment letter contemplates that the credit facility will consist of an
initial term loan of $30 million, which will be used to repay certain existing
indebtedness and fund our general operating and working capital needs, and a
second term loan of $35 million to be used, if at all, to finance acquisitions
acceptable to Guggenheim. The credit facility would be secured by all or
substantially all of our consolidated assets. Completion of the financing is
subject to customary conditions precedent, including, without limitation, the
preparation and execution of definitive loan documents, Guggenheim's completion
and satisfaction with its legal due diligence review of us, obtaining all
necessary consents and other third party approvals, and the preparation and
execution of an inter-creditor agreement between the lenders and our other
lenders.
We are also in negotiations with GMAC CF, UPS and DBS concerning our
credit facilities in effect with these lenders.
On May 1, 2006, we sublet our executive office in Los Angeles,
California and our sales office in New York to Seven Licensing Company, LLC
("Seven Licensing") for a monthly payment of $25,000 on a month to month basis.
Seven Licensing is beneficially owned by Gerard Guez, our Chairman and Interim
Chief Executive Officer.
18
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
BUSINESS OVERVIEW AND RECENT DEVELOPMENTS
We are a design and sourcing company for private label and private
brand casual apparel serving mass merchandisers, department stores, branded
wholesalers and specialty chains located primarily in the United States. Our
major customers include leading retailers, such as Kohl's, Chico's, Macy's
Merchandising Group, Mervyn's, Mothers Work, Sears, Wal-Mart, Dillard's, Lane
Bryant, Lerner New York, the Avenue, and J.C. Penney. Our products are
manufactured in a variety of woven and knit fabrications and include jeans wear,
casual pants, t-shirts, shorts, blouses, shirts and other tops, dresses and
jackets. Our private brands include American Rag Cie, No! Jeans, Alain Weiz,
Gear 7, Souvenir by Cynthia Rowley and brands associated with Jessica Simpson,
which include "JS by Jessica Simpson", "Princy by Jessica Simpson" and "Sweet
Kisses by Jessica Simpson.
PRIVATE LABEL
Private label business has been our core competency for over twenty
years, and involves a one to one relationship with a large, centrally controlled
retailer with whom we can develop product lines that fit with the
characteristics of their particular customer. Private label sales in the first
quarter of 2006 were $42.1 million compared to $33.5 million in the first
quarter of 2005.
The success of our private brands collections has created new
opportunities within the private label business to add value in the development
and marketing of new initiatives for Sears, Mothers Work, Avenue, Chico's, and
other retailers. These initiatives were launched during 2005, and are on track
to be significant growth areas for 2006.
PRIVATE BRANDS
We launched our private brands initiative in 2003, pursuant to which we
acquire ownership of or license rights to a brand name and sell apparel products
under this brand, generally to a single retail company within a geographic
region. Private brands sales in the first quarter of 2006 were $19.2 million
compared to $11.3 million in the first quarter of 2005. At March 31, 2006, we
owned or licensed rights to the following private brands:
o AMERICAN RAG CIE: During the first quarter of 2005, we
extended our agreement with Macy's Merchandising Group for six
years, pursuant to which we exclusively distribute our
American Rag Cie brand through Macy's Merchandising Group's
national Department Store organization of more than 500
stores. Net sales of American Rag Cie branded apparel totaled
$5.3 million in the first quarter of 2006.
o ALAIN WEIZ: We continue to sell Alan Weiz apparel exclusively
to Dillard's Department Stores. Net sales of Alain Weiz
branded apparel totaled $2.0 million in the first quarter of
2006.
o SOUVENIR BY CYNTHIA ROWLEY: We are in discussions with
retailers to identify a potential distribution alliance for
the 2006 fall or holiday season for Souvenir by Cynthia
Rowley.
o GEAR 7: During the fourth quarter of 2005, K-Mart discontinued
sales of Gear 7 products, which resulted in a decline in sales
for this brand in the fourth quarter of 2005. We do not
anticipate sales of Gear 7 branded apparel in 2006.
o JESSICA SIMPSON brands: The JS by Jessica Simpson brand was
originally launched as a denim line with Charming Shoppes. Net
sales of JS by Jessica Simpson and Princy by Jessica Simpson,
which is the department store and better specialty store
brand, totaled $9.7 million in the first quarter of 2006. In
March 2006, we became involved in a dispute with the licensor
of the Jessica Simpson brands over our continued rights to
these brands, and we are presently in litigation with this
licensor. Accordingly, we do not
19
anticipate sales of Jessica Simpson branded apparel after the
first quarter of 2006 unless and until we are able to
successfully resolve our dispute and retain our rights to
these brands.
o HOUSE OF DEREON BY TINA KNOWLES: We began shipping products
for the House of Dereon by Tina Knowles brand in the fourth
quarter of 2005, resulting in net sales of $309,000 in 2005.
In March 2006, we terminated our license agreement for this
brand, and sold our remaining inventory to the licensor or its
designee. Prior to December 31, 2005, we had written off the
capitalized balance of $1.2 million related to the agreement
and recognized a corresponding loss in 2005. Net sales of
House of Dereon by Tina Knowles branded apparel totaled $2.2
million in the first quarter of 2006 which included $1.5
million of sales of inventory to a designee of the licensor.
INTERNAL REVENUE SERVICE AUDIT
In January 2004, the Internal Revenue Service completed its examination
of our Federal income tax returns for the years ended December 31, 1996 through
2001. The IRS has proposed adjustments to increase our income tax payable for
the six years under examination. This adjustment would also result in additional
state taxes and interest. In addition, in July 2004, the IRS initiated an
examination of our Federal income tax return for the year ended December 31,
2002. In March 2005, the IRS proposed an adjustment to our taxable income of
approximately $6 million related to similar issues identified in their audit of
the 1996 through 2001 federal income tax returns. The proposed adjustments to
our 2002 federal income tax return would not result in additional tax due for
that year due to the tax loss reported in the 2002 federal return. However, it
could reduce the amount of net operating losses available to offset taxes due
from the preceding tax years. We believe that we have meritorious defenses to
and intend to vigorously contest the proposed adjustments made to our federal
income tax returns for the years ended 1996 through 2002. If the proposed
adjustments are upheld through the administrative and legal process, they could
have a material impact on our earnings and cash flow. We believe we have
provided adequate reserves for any reasonably foreseeable outcome related to
these matters on the consolidated balance sheets included in the consolidated
financial statements under the caption "Income Taxes". The maximum amount of
loss in excess of the amount accrued in the financial statements is $7.7
million. We do not believe that the adjustments, if any, arising from the IRS
examination, will result in an additional income tax liability beyond what is
recorded in the accompanying consolidated balance sheets.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Management's discussion and analysis of our financial condition and
results of operations are based upon our consolidated financial statements,
which have been prepared in accordance with accounting principles generally
accepted in the United States of America. The preparation of these financial
statements requires us to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenues and expenses, and related disclosures
of contingent assets and liabilities. We are required to make assumptions about
matters, which are highly uncertain at the time of the estimate. Different
estimates we could reasonably have used or changes in the estimates that are
reasonably likely to occur could have a material effect on our financial
condition or result of operations. Estimates and assumptions about future events
and their effects cannot be determined with certainty. On an ongoing basis, we
evaluate estimates, including those related to returns, discounts, bad debts,
inventories, intangible assets, income taxes, and contingencies and litigation.
We base our estimates on historical experience and on various assumptions
believed to be applicable and reasonable under the circumstances. These
estimates may change as new events occur, as additional information is obtained
and as our operating environment changes. In addition, management is
periodically faced with uncertainties, the outcomes of which are not within its
control and will not be known for prolonged period of time.
We believe our financial statements are fairly stated in accordance
with accounting principles generally accepted in the United States of America
and provide a meaningful presentation of our financial condition and results of
operations.
We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our consolidated
financial statements. For a further discussion on the application of these and
other accounting policies, see Note 1 of the "Notes to Consolidated Financial
Statements" included in our Annual Report on Form 10-K for the year ended
December 31, 2005.
20
ACCOUNTS RECEIVABLE--ALLOWANCE FOR RETURNS, DISCOUNTS AND BAD DEBTS
We evaluate the collectibility of accounts receivable and chargebacks
(disputes from the customer) based upon a combination of factors. In
circumstances where we are aware of a specific customer's inability to meet its
financial obligations (such as in the case of bankruptcy filings or substantial
downgrading of credit sources), a specific reserve for bad debts is taken
against amounts due to reduce the net recognized receivable to the amount
reasonably expected to be collected. For all other customers, we recognize
reserves for bad debts and chargebacks based on our historical collection
experience. If our collection experience deteriorates (for example, due to an
unexpected material adverse change in a major customer's ability to meet its
financial obligations to us), the estimates of the recoverability of amounts due
us could be reduced by a material amount.
As of March 31, 2006, the balance in the allowance for returns,
discounts and bad debts reserves was $3.1 million.
INVENTORY
Our inventories are valued at the lower of cost or market. Under
certain market conditions, we use estimates and judgments regarding the
valuation of inventory to properly value inventory. Inventory adjustments are
made for the difference between the cost of the inventory and the estimated
market value and charged to operations in the period in which the facts that
give rise to the adjustments become known.
VALUATION OF LONG-LIVED AND INTANGIBLE ASSETS AND GOODWILL
We assess the impairment of identifiable intangibles, long-lived assets
and goodwill whenever events or changes in circumstances indicate that the
carrying value may not be recoverable. Factors considered important that could
trigger an impairment review include, but are not limited to, the following:
o a significant underperformance relative to expected historical
or projected future operating results;
o a significant change in the manner of the use of the acquired
asset or the strategy for the overall business; or
o a significant negative industry or economic trend.
Effective January 1, 2002, we adopted Statement of Financial Accounting
Standards No. 142, "Goodwill and Other Intangible Assets." According to this
statement, goodwill and other intangible assets with indefinite lives are no
longer subject to amortization, but rather an assessment of impairment applied
on a fair-value-based test on an annual basis or more frequently if an event
occurs or circumstances change that would more likely than not reduce the fair
value of a reporting unit below its carrying amount.
We utilized the discounted cash flow methodology to estimate fair
value. As of March 31, 2006, we have a goodwill balance of $8.6 million, and a
net property and equipment balance of $1.6 million.
INCOME TAXES
As part of the process of preparing our consolidated financial
statements, management is required to estimate income taxes in each of the
jurisdictions in which we operate. The process involves estimating actual
current tax expense along with assessing temporary differences resulting from
differing treatment of items for book and tax purposes. These timing differences
result in deferred tax assets and liabilities, which are included in our
consolidated balance sheet. Management records a valuation allowance to reduce
our net deferred tax assets to the amount that is more likely than not to be
realized. Management has considered future taxable income and ongoing tax
planning strategies in assessing the need for the valuation allowance. Increases
in the valuation allowance result in additional expense to be reflected within
the tax provision in the consolidated statement of operations.
In addition, accruals are also estimated for ongoing audits regarding
U.S. Federal tax issues that are currently unresolved, based on our estimate of
whether, and the extent to which, additional taxes will be due. We
21
routinely monitor the potential impact of these situations and believe that
amounts are properly accrued for. If we ultimately determine that payment of
these amounts is unnecessary, we will reverse the liability and recognize a tax
benefit during the period in which we determine that the liability is no longer
necessary. We will record an additional charge in our provision for taxes in any
period we determine that the original estimate of a tax liability is less than
we expect the ultimate assessment to be. See Note 11 of the "Notes to
Consolidated Financial Statements" for a discussion of current tax matters.
DEBT COVENANTS
Our debt agreements require certain covenants including a minimum level
of net worth as discussed in Note 7 of the "Notes to Consolidated Financial
Statements." If our results of operations erode and we are not able to obtain
waivers from the lenders, the debt would be in default and callable by our
lenders. In addition, due to cross-default provisions in our debt agreements,
substantially all of our long-term debt would become due in full if any of the
debt is in default. In anticipation of us not being able to meet the required
covenants due to various reasons, we either negotiate for changes in the
relative covenants or obtain an advance waiver or reclassify the relevant debt
as current. We also believe that our lenders would provide waivers if necessary.
However, our expectations of future operating results and continued compliance
with other debt covenants cannot be assured and our lenders' actions are not
controllable by us. If projections of future operating results are not achieved
and the debt is placed in default, we would be required to reduce our expenses,
by curtailing operations, and to raise capital through the sale of assets,
issuance of equity or otherwise, any of which could have a material adverse
effect on our financial condition and results of operations.
NEW ACCOUNTING PRONOUNCEMENTS
For a description of recent accounting pronouncements including the
respective expected dates of adoption and effects on results of operations and
financial condition, see Note 10 of the "Notes to Consolidated Financial
Statements."
RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, certain
items in our consolidated statements of operations as a percentage of net sales:
THREE MONTHS ENDED
MARCH 31,
---------------------
2006 2005
-------- --------
Net sales ............................................ 100.0% 100.0%
Cost of sales ........................................ 79.6 80.0
-------- --------
Gross profit ......................................... 20.4 20.0
Selling and distribution expenses
................................................. 4.8 5.7
General and administration
expenses .......................................... 10.5 13.1
Royalty expenses ..................................... 2.4 0.6
-------- --------
Income from operations ............................... 2.7 0.6
Interest expense ..................................... (1.9) (1.8)
Interest income ...................................... 0.8 1.2
Interest in income of equity method
investee .......................................... 0.1 0.4
Other income ......................................... 0.0 0.1
Other expense ........................................ (0.0) (0.0)
Minority interest .................................... 0.0 0.0
-------- --------
Income before taxes .................................. 1.7 0.5
Income taxes ......................................... 0.3 0.7
-------- --------
Net income (loss) .................................... 1.4% (0.2)%
======== ========
FIRST QUARTER 2006 COMPARED TO FIRST QUARTER 2005
Net sales increased by $16.4 million, or 36.7%, to $61.3 million in
first quarter of 2006 from $44.8 million in the first quarter of 2005. Sales of
private label in the first quarter of 2006 were $42.1 million compared to $33.5
million in the same period of 2005, with the increase resulting primarily from
increased sales to Chico's, Mervyn's, Mothers Work and Macy's Merchandising
Group. Sales of private brands in the first quarter of 2006 were $19.2
22
million compared to $11.3 million in the same period of 2005. The sales in the
first quarter of 2006 included sales of Jessica Simpson and House of Dereon,
compared to no such sales in the first quarter of 2005. As described elsewhere
in this report, we will have no further sales of House of Dereon apparel and do
not anticipate further sales of Jessica Simpson apparel in 2006.
Gross profit consists of net sales less product costs, direct labor,
manufacturing overhead, duty, quota, freight in, and brokerage. Gross profit
increased by $3.6 million to $12.5 million in the first quarter of 2006 from
$8.9 million in the first quarter of 2005. The increase in gross profit occurred
primarily because of an increase in sales and gross margin. As a percentage of
net sales, gross profit increased from 20.0% in the first quarter of 2005 to
20.4% in the first quarter of 2006. The improvement in gross margin is primarily
attributable to the improved margins in the private label business due to
expansion of our business to include more knitwear and woven tops at better
margins using private brand product developments. We also experienced lower
margins from sales of House of Dereon apparel during the quarter due to close
out sales resulting from the termination of the House of Dereon license.
Selling and distribution expenses increased by $368,000, or 14.4%, to
$2.9 million in the first quarter of 2006 from $2.6 million in the first quarter
of 2005. As a percentage of net sales, these expenses decreased to 4.8% in the
first quarter of 2006 from 5.7% in the first quarter of 2005 due to the increase
in sales during the first quarter of 2006.
General and administrative expenses increased by $604,000, or 10.3%, to
$6.5 million in the first quarter of 2006 from $5.9 million in the first quarter
of 2005. As a percentage of net sales, these expenses decreased to 10.5% in the
first quarter of 2006 from 13.1% in the first quarter of 2005 due to the
increase in sales during the first quarter of 2006.
Royalty and marketing allowance expenses increased by $1.2 million, or
403.1%, to $1.5 million in the first quarter of 2006 from $295,000 in the first
quarter of 2005. The increase was primarily due to sales under the licensed
Jessica Simpson brands, for which there were no such sales in the first quarter
of 2005. As a percentage of net sales, these expenses increased to 2.4% in the
first quarter of 2006 from 0.6% in the first quarter of 2005.
Operating income in the first quarter of 2006 was $1.6 million, or 2.7%
of net sales, compared to $233,000, or 0.6% of net sales, in the comparable
period of 2005, because of the factors discussed above.
Interest expense increased by $375,000, or 46.1%, to $1.2 million in
the first quarter of 2006 from $813,000 in the first quarter of 2005. As a
percentage of net sales, this expense increased to 1.9% in the first quarter of
2006 from 1.8% in the first quarter of 2005. The increase in interest expense
was primarily due to higher interest rates we paid on our short-term and
long-term debts. Interest income decreased by $68,000 or 12.3%, to $485,000 in
the first quarter of 2005 from $553,000 in the first quarter of 2005. The
interest income was primarily due to the interest earned from the notes
receivable related to the sale of our fixed assets in Mexico. Interest in income
of equity method investee was $47,000 in the first quarter of 2006, compared to
$163,000 in the first quarter of 2005. Other income was $34,000 in the first
quarter of 2006, compared to $65,000 in the first quarter of 2005. Other expense
was $0 in the first quarter of 2006, compared to $6,000 in the first quarter of
2005.
Losses allocated to minority interests in the first quarter of 2006
were $11,000, representing the minority partner's share of losses in PBG7.
Earnings from the equity method investments, UAV and PBG7, totaled approximately
$57,000 for the first quarter of 2005. None of the profit in the equity method
investments was allocated to the minority members in the first quarter of 2005
because we previously absorbed losses in excess of the minority members'
investment.
LIQUIDITY AND CAPITAL RESOURCES
Our liquidity requirements arise from the funding of our working
capital needs, principally inventory, finished goods shipments-in-transit,
work-in-process and accounts receivable, including receivables from our contract
manufacturers that relate primarily to fabric we purchase for use by those
manufacturers. Our primary sources for working capital and capital expenditures
are cash flow from operations, borrowings under our bank and other credit
facilities, issuance of long-term debt, sales of equity and debt securities, and
vendor financing. In the near term, we expect that our operations and borrowings
under bank and other credit facilities will provide sufficient
23
cash to fund our operating expenses, capital expenditures and interest payments
on our debt. In the long-term, we expect to use internally generated funds and
external sources to satisfy our debt and other long-term liabilities.
Our liquidity is dependent, in part, on customers paying on time. Any
abnormal chargebacks or returns may affect our source of short-term funding. Any
changes in credit terms given to major customers may have an impact on our cash
flow. Suppliers' credit is another major source of short-term financing and any
adverse changes in their terms will have negative impact on our cash flow.
Other principal factors that could affect the availability of our
internally generated funds include:
o deterioration of sales due to weakness in the markets in which
we sell our products;
o decreases in market prices for our products;
o increases in costs of raw materials; and
o changes in our working capital requirements.
Principal factors that could affect our ability to obtain cash from
external sources include:
o financial covenants contained in our current or future bank
and debt facilities; and
o volatility in the market price of our common stock or in the
stock markets in general.
Cash flows for the three months ended March 31, 2006 and 2005 were as
follows (dollars in thousands):
CASH FLOWS: 2006 2005
------ ------
Net cash used in operating activities ................ $3,332 $9,576
Net cash provided by investing activities ............ $ 438 $2,481
Net cash provided by financing activities ............ $1,752 $6,082
During the first three months of 2006, net cash used in operating
activities was $3.3 million, as compared to net cash used in operating
activities of $9.6 million for the same period in 2005. Net cash used in
operating activities in the first quarter of 2006 resulted primarily from an
increase of $7.9 million in accounts receivable and a decrease of $7.4 million
in accounts payable, partially offset by income of $836,000 and depreciation and
amortization expense of $373,000 and a decrease in inventory of $9.8 million.
The increase in accounts receivable and decrease in inventory was primarily due
to the increase in sales in the first quarter of 2006, and the decrease in
accounts payable resulted from the pay down of payables.
During the first three months of 2006, net cash provided by investing
activities was $438,000, as compared to net cash provided by investing
activities of $2.5 million in 2005. Net cash provided by investing activities in
the first quarter of 2006 resulted primarily from approximately $434,000 of
collection on notes receivable.
During the first three months of 2006, net cash provided by financing
activities was $1.8 million, as compared to net cash provided by financing
activities of $6.1 million in 2005. Net cash provided by financing activities in
2006 resulted primarily from $1.7 million net proceeds from our short-term bank
borrowings.
24
CONTRACTUAL OBLIGATIONS AND COMMITMENTS
Following is a summary of our contractual obligations and commercial
commitments available to us as of March 31, 2006 (in millions):
PAYMENTS DUE BY PERIOD
----------------------------------------------------
Between Between
CONTRACTUAL OBLIGATIONS Total Less than 2-3 4-5 After
1 year years years 5 years
---------------------------------- -------- -------- -------- -------- --------
Long-term debt(1) ................ $ 39.6 $ 39.6 $ -- $ -- $ --
Convertible debentures, net ...... 6.9 -- 6.9 -- --
Operating leases ................. 6.5 1.1 1.2 1.2 3.0
Minimum royalties ................ 16.9 5.8 4.6 2.2 4.3
Purchase commitment .............. 45.5 6.7 10.0 10.0 18.8
-------- -------- -------- -------- --------
Total Contractual Cash Obligations $ 115.4 $ 53.2 $ 22.7 $ 13.4 $ 26.1
(1) Excludes interest on long-term debt obligations. Based on outstanding
borrowings as of March 31, 2006, and assuming all such indebtedness
remained outstanding and the interest rates remained unchanged, we
estimate that our interest cost on long-term debt would be
approximately $3.5 million.
AMOUNT OF COMMITMENT EXPIRATION PER PERIOD
-------------------------------- ------------- -----------------------------------------------------
TOTAL AMOUNTS
COMMERCIAL COMMITMENTS COMMITTED LESS THAN BETWEEN BETWEEN AFTER
AVAILABLE TO US TO US 1 YEAR 2-3 YEARS 4-5 YEARS 5 YEARS
-------------------------------- ------------- ----------- ----------- ----------- -----------
Lines of credit................. $ 61.4 $ 61.4 $ -- $ -- $ --
Letters of credit (within
lines of credit)............. $ 16.4 $ 16.4 $ -- $ -- $ --
Total commercial commitments.... $ 61.4 $ 61.4 $ -- $ -- $ --
On June 13, 2002, we entered into a letter of credit facility of $25
million with UPS Capital Global Trade Finance Corporation ("UPS"). Under this
facility, we may arrange for the issuance of letters of credit and acceptances.
The facility is collateralized by the shares and debentures of all of our
subsidiaries in Hong Kong. In addition to the guarantees provided by Tarrant
Apparel Group and our subsidiaries, Fashion Resource (TCL) Inc. and Tarrant
Luxembourg Sarl, Gerard Guez, our Chairman and Interim Chief Executive Officer,
also signed a guarantee of $5 million in favor of UPS to secure this facility.
This facility bore interest at 10.75% per annum at March 31, 2006. Under this
facility, we were subject to certain restrictive covenants, including that we
maintain a specified tangible net worth, fixed charge ratio, and leverage ratio.
On June 27, 2005, we amended the letter of credit facility with UPS to extend
the expiration date of the facility from June 30, 2005 to August 31, 2005 and to
reduce the tangible net worth requirement at June 30, 2005. On August 31, 2005,
we amended the letter of credit facility with UPS to further extend the
expiration date of the facility to October 31, 2005, immediately reduce the
maximum amount of borrowings to $14.5 million on September 1, 2005 and further
reduced the maximum amount of borrowing to $14.0 million on October 1, 2005. On
October 31, 2005, we further amended the letter of credit facility with UPS to
extend the expiration date of the facility to January 31, 2006 and amend the
interest rate to "prime rate" plus 3%. The facility amendment also provided for
reduction in the maximum amount of borrowings to $13.5 million commencing on
November 1, 2005, to $13.0 million commencing on December 1, 2005, and to $12.5
million commencing on January 1, 2006. Additionally, Gerard Guez, our Chairman
and Interim Chief Executive Officer, pledged to UPS 4.6 million shares of our
common stock held by Mr. Guez to secure the obligations under the credit
facility. On January 27, 2006, we further amended the letter of credit facility
with UPS to extend the expiration date of the facility from January 31, 2006 to
July 31, 2006. The amendment provides for reduction of the maximum amount of
borrowings under the facility to $12.0 million commencing on April 1, 2006,
$11.5 million commencing on May 1, 2006, $11.0 million commencing on June 1,
2006 and to $10.5 million commencing on July 1, 2006. Under the amended letter
of credit facility, we are subject to restrictive financial covenants of
maintaining tangible net worth of $25 million as of December 31, 2005 and the
last day of each fiscal quarter thereafter. There is also a provision capping
maximum capital expenditures per quarter of $800,000. As of March 31, 2006, we
were in compliance with the covenants. As of March 31, 2006, $8.0 million was
outstanding under this facility with UPS and an additional $2.5 million was
available for future borrowings. In addition, $2.0 million of open letters of
credit was outstanding as of March 31, 2006.
On December 31, 2004, our Hong Kong subsidiaries entered into a loan
agreement with UPS pursuant to which UPS made a $5 million term loan, the
proceeds of which were used to repay $5 million of indebtedness owed to UPS
under the letter of credit of facility. The principal amount of this loan is due
and payable in 24 equal
25
monthly installments of approximately $208,333 each, plus interest equivalent to
the "prime rate" plus 2% commencing on February 1, 2005. This facility bore
interest at 9.75% per annum at March 31, 2006. On June 27, 2005, we amended the
loan agreement with UPS to reduce the tangible net worth requirement at June 30,
2005. Under the amended loan agreement, we are subject to restrictive financial
covenants of maintaining tangible net worth of $25 million at December 31, 2005
and the last day of each fiscal quarter thereafter. There is also a provision
capping maximum capital expenditure per quarter at $800,000. As of March 31,
2006, we were in compliance with the covenants. As of March 31, 2006, $2.1
million was outstanding. The obligations under the loan agreement are
collateralized by the same security interests and guarantees provided under our
letter of credit facility with UPS. Additionally, the term loan is secured by
two promissory notes payable to Tarrant Luxembourg Sarl in the amounts of
$2,550,000 and $1,360,000 and a pledge by Gerard Guez, our Chairman and Interim
Chief Executive Officer, of 4.6 million shares of our common stock.
Since March 2003, DBS Bank (Hong Kong) Limited (formerly known as Dao
Heng Bank) has made available a letter of credit facility of up to HKD 20
million (equivalent to US $2.6 million) to our subsidiaries in Hong Kong. This
is a demand facility and is secured by the pledge of our office property, which
is owned by Gerard Guez, our Chairman and Interim Chief Executive Officer, and
Todd Kay, our Vice Chairman, and by our guarantee. The letter of credit facility
was increased to HKD 30 million (equivalent to US $3.9 million) in June 2004. As
of March 31, 2006, $2.5 million was outstanding under this facility. In
addition, $1.1 million of open letters of credit was outstanding and $294,000
was available for future borrowings as of March 31, 2006. In October 2005, a tax
loan for HKD 6.233 million (equivalent to US $804,000) was also made available
to our Hong Kong subsidiaries. As of March 31, 2006, $478,000 was outstanding
under this tax loan.
On October 1, 2004, we amended and restated our previously existing
debt facility with GMAC Commercial Finance, LLC ("GMAC CF") by entering into a
new factoring agreement with GMAC CF. The amended and restated agreement (the
factoring agreement) extended the expiration date of the facility to September
30, 2007 and added as parties our subsidiaries Private Brands, Inc and No!
Jeans, Inc. In addition, in connection with the factoring agreement, our
indirect majority-owned subsidiary PBG7, LLC entered into a separate factoring
agreement with GMAC CF. Pursuant to the terms of the factoring agreement, we and
our subsidiaries agree to assign and sell to GMAC CF, as factor, all accounts
which arise from our sale of merchandise or rendition of service created on a
going forward basis. At our request, GMAC CF, in its discretion, may make
advances to us up to the lesser of (a) up to 90% of our accounts on which GMAC
CF has the risk of loss and (b) $40 million, minus in each case, any amount owed
by us to GMAC CF. Pursuant to the terms of the PBG7 factoring agreement, PBG7
agreed to assign and sell to GMAC CF, as factor, all accounts, which arise from
PBG7's sale of merchandise or rendition of services created on a going-forward
basis. At PBG7's request, GMAC CF, in its discretion, may make advances to PBG7
up to the lesser of (a) up to 90% of PBG7's accounts on which GMAC CF has the
risk of loss, and (b) $5 million minus in each case, any amounts owed to GMAC CF
by PBG7. The facility bore interest at 7.8256% per annum and the facility under
PBG7, LLC bore interest at 8.25% per annum, respectively, at March 31, 2006.
Restrictive covenants under the revised facility include a limit on quarterly
capital expenses of $800,000 and tangible net worth of $25 million at December
31, 2005 and at the end of each fiscal quarter thereafter. As of March 31, 2006,
we were in compliance with the covenants. A total of $29.9 million was
outstanding with respect to receivables factored under the GMAC CF facility at
March 31, 2006.
In May 2005, we amended our factoring agreement with GMAC CF to permit
our subsidiaries party thereto and us, to borrow up to the lesser of $3 million
or 50% of the value of eligible inventory. In connection with this amendment, we
granted GMAC CF a lien on certain of our inventory located in the United States.
On January 23, 2006, we further amended our factoring agreement with GMAC CF to
increase the amount we may borrow against inventory to the lesser of $5 million
or 50% of the value of eligible inventory. The $5 million limit will be reduced
to $4 million on April 1, 2006 and will be further reduced to $3 million on July
1, 2006. The maximum borrowing availability under the factoring agreement, based
on the borrowing base formula remains at $40 million. A total of $4.5 million
was outstanding under the GMAC CF facility at March 31, 2006 with respect to
collateralized inventory.
The credit facility with GMAC CF and the credit facility with UPS carry
cross-default clauses. A breach of a financial covenant set by GMAC CF or UPS
constitutes an event of default under the other credit facility, entitling both
financial institutions to demand payment in full of all outstanding amounts
under their respective debt and credit facilities.
The amount we can borrow under the new factoring facility with GMAC CF
is determined based on a defined borrowing base formula related to eligible
accounts receivable. A significant decrease in eligible accounts
26
receivable due to the aging of receivables, can have an adverse effect on our
borrowing capabilities under our credit facility, which may adversely affect the
adequacy of our working capital. In addition, we have typically experienced
seasonal fluctuations in sales volume. These seasonal fluctuations result in
sales volume decreases in the first and fourth quarters of each year due to the
seasonal fluctuations experienced by the majority of our customers. During these
quarters, borrowing availability under our credit facility may decrease as a
result of decrease in eligible accounts receivables generated from our sales.
On December 14, 2004, we completed a $10 million financing through the
issuance of (i) 6% Secured Convertible Debentures ("Debentures") and (ii)
warrants to purchase up to 1,250,000 shares of our common stock. Prior to
maturity, the investors may convert the Debentures into shares of our common
stock at a price of $2.00 per share. The warrants have a term of five years and
an exercise price of $2.50 per share. The warrants were valued at $866,000 using
the Black-Scholes option valuation model with the following assumptions:
risk-free interest rate of 4%; dividend yields of 0%; volatility factors of the
expected market price of our common stock of 0.55; and an expected life of four
years. The Debentures bear interest at a rate of 6% per annum and have a term of
three years. We may elect to pay interest on the Debentures in shares of our
common stock if certain conditions are met, including a minimum market price and
trading volume for our common stock. The Debentures contain customary events of
default and permit the holder thereof to accelerate the maturity if the full
principal amount together with interest and other amounts owing upon the
occurrence of such events of default. The Debentures are secured by a
subordinated lien on certain of our accounts receivable and related assets. The
closing market price of our common stock on the closing date of the financing
was $1.96. The convertible debenture was thus valued at $8,996,000, resulting in
an effective conversion price of $1.799 per share. The intrinsic value of the
conversion option of $804,000 is being amortized over the life of the loan. The
value of the warrants of $866,000 and the intrinsic value of the conversion
option of $804,000 were netted from the $10 million presented as the convertible
debentures, net on our accompanying balance sheets at December 31, 2004.
The placement agent in the financing, received compensation for its
services in the amount of $620,000 in cash and issuance of five year warrants to
purchase up to 200,000 shares of our common stock at an exercise price of $2.50
per share. The warrants to purchase 200,000 shares of our common stock were
valued at $138,000 using the Black-Scholes option valuation model with the
following assumptions: risk-free interest rate of 4%; dividend yields of 0%;
volatility factors of the expected market price of our common stock of 0.55; and
an expected life of four years. The $620,000 financing cost paid to the
placement agent and the value of the warrants to purchase 200,000 shares of our
common stock of $138,000 are included in the deferred financing cost, net on our
accompanying balance sheets and are amortized over the life of the loan.
In June 2005, holders of our Debentures converted an aggregate of $2.3
million of Debentures into 1,133,687 shares of our common stock. In August 2005,
holders of our Debentures converted an aggregate of $820,000 of Debentures into
410,000 shares of our common stock. The Debentures were converted at the option
of the holders at a price of $2.00 per share. Debt discount of $248,000 related
to the intrinsic value of the conversion option of $804,000 was expensed upon
the conversion. Of the $620,000 financing cost paid to the placement agent,
$191,000 was expensed upon the conversion. The intrinsic value of the conversion
option, and the value of the warrant amortized in the three months of 2005 was
$118,000. Total deferred financing cost amortized in three months of 2006 was
$47,000. Total interest paid to the holders of the Debentures in the three
months of 2006 was $104,000. As of March 31, 2006, $6.1 million, net of $829,000
of debt discount, remained outstanding under the Debentures.
On January 19, 2006, we borrowed $4.0 million from Max Azria pursuant
to the terms of a promissory note, which amount bears interest at the rate of
5.5% per annum and is payable in weekly installments of $200,000 beginning on
March 1, 2006. This is an unsecured loan. As of March 31, 2006, $3.0 million was
outstanding under this loan.
We had three equipment loans outstanding at December 31, 2005. One of
these equipment loans bore interest at 6% payable in installments through 2009,
which we paid off in January 2006. The second loan bears interest at 15.8%
payable in installment through 2007 and the third loan bears interest at 6.15%
payable in installment through 2007. As of March 31, 2006, $35,000 was
outstanding under the two remaining loans.
From time to time, we open letters of credit under an uncommitted line
of credit from Aurora Capital Associates which issues these letters of credits
out of Israeli Discount Bank. As of March 31, 2006, $1.5 million was outstanding
under this facility (classified above under import trade bills payable) and $3.2
million of letters of
27
credit were open under this arrangement. We pay a commission fee of 2.25% on all
letters of credits issued under this arrangement.
On May 12, 2006, we entered into a commitment letter with Guggenheim
Corporate Funding, LLC with respect to a $65 million credit facility. The
commitment letter contemplates that the credit facility will consist of an
initial term loan of $30 million, which will be used to repay certain existing
indebtedness and fund our general operating and working capital needs, and a
second term loan of $35 million to be used, if at all, to finance acquisitions
acceptable to Guggenheim. The credit facility would be secured by all or
substantially all of our consolidated assets. Completion of the financing is
subject to customary conditions precedent, including, without limitation, the
preparation and execution of definitive loan documents, Guggenheim's completion
and satisfaction with its legal due diligence review of us, obtaining all
necessary consents and other third party approvals, and the preparation and
execution of an inter-creditor agreement between the lenders and our other
lenders.
We are also in negotiations with GMAC CF, UPS and DBS concerning our
credit facilities in effect with these lenders.
We have financed our operations from our cash flow from operations,
borrowings under our bank and other credit facilities, issuance of long-term
debt, and sales of equity and debt security. Our short-term funding relies very
heavily on our major customers, banks, and suppliers. From time to time, we have
had temporary over-advances from our banks. Any withdrawal of support from these
parties will have serious consequences on our liquidity.
From time to time in the past, we borrowed funds from, and advanced
funds to, certain officers and principal shareholders, including Gerard Guez and
Todd Kay. See disclosure under "-Related Party Transactions" below.
The Internal Revenue Service has proposed adjustments to our Federal
income tax returns to increase our income tax payable for the years ended
December 31, 1996 through 2001. This adjustment would also result in additional
state taxes and interest. In addition, in July 2004, the IRS initiated an
examination of our Federal income tax return for the year ended December 31,
2002. In March 2005, the IRS proposed an adjustment to our taxable income of
approximately $6 million related to similar issues identified in their audit of
the 1996 through 2001 federal income tax returns. We believe that we have
meritorious defenses to and intend to vigorously contest the proposed
adjustments made to our federal income tax returns for the years ended 1996
through 2002. If the proposed adjustments are upheld through the administrative
and legal process, they could have a material impact on our earnings and, in
particular, cash flow. We may not have an adequate cash reserve to pay the final
adjustments resulting from the IRS examination. As a result, we may be required
to arrange for payments over time or raise additional capital in order to meet
these obligations. We believe we have provided adequate reserves for any
reasonably foreseeable outcome related to these matters on the consolidated
balance sheets included in the consolidated financial statements under the
caption "Income Taxes." The maximum amount of loss in excess of the amount
accrued in the financial statements is $7.7 million. We do not believe that the
adjustments, if any, arising from the IRS examination, will result in an
additional income tax liability beyond what is recorded in the accompanying
consolidated balance sheets.
We may seek to finance future capital investment programs through
various methods, including, but not limited to, borrowings under our bank credit
facilities, issuance of long-term debt, sales of equity securities, leases and
long-term financing provided by the sellers of facilities or the suppliers of
certain equipment used in such facilities. To date, there is no plan for any
major capital expenditure.
We do not believe that the moderate levels of inflation in the United
States in the last three years have had a significant effect on net sales or
profitability.
RELATED PARTY TRANSACTIONS
We lease our executive offices in Los Angeles, California from GET, a
corporation which is owned by Gerard Guez (our Chairman and Interim Chief
Executive Officer) and Todd Kay (our Vice Chairman), both of which are
significant shareholders. Additionally, we lease our warehouse and office space
in Hong Kong from Lynx International Limited, a Hong Kong corporation that is
owned by Messrs. Guez and Kay. We paid $269,000 and
28
$255,000 in rent in the three months ended March 31, 2006 and 2005,
respectively, for office and warehouse facilities. Our Los Angeles offices and
warehouse is leased on a month to month basis. On January 1, 2006, we renewed
our lease agreement with Lynx International Limited for our office space in Hong
Kong for one year.
In August 2004, we entered into an Agreement for Purchase of Assets
with affiliates of Mr. Kamel Nacif, a shareholder at the time of the
transaction, which agreement was amended in October 2004. Pursuant to the
agreement, as amended, on November 30, 2004, we sold to the purchasers
substantially all of our assets and real property in Mexico, including the
equipment and facilities we previously leased to Mr. Nacif's affiliates in
October 2003, for an aggregate purchase price consisting of: a) $105,400 in cash
and $3,910,000 by delivery of unsecured promissory notes bearing interest at
5.5% per annum; and b) $40,204,000, by delivery of secured promissory notes
bearing interest at 4.5% per annum, maturing on December 31, 2005 and every year
thereafter until December 31, 2014. The secured promissory notes are payable in
partial or total amounts anytime prior to the maturity of each note. Included in
the $41.0 million notes receivable - related party on the accompanying balance
sheet as of March 31, 2006 was $1.3 million of Mexico value added taxes on the
real property component of this transaction. Upon consummation of the sale, we
entered into a purchase commitment agreement with the purchasers, pursuant to
which we have agreed to purchase annually over the ten-year term of the
agreement, $5 million of fabric manufactured at our former facilities acquired
by the purchasers at negotiated market prices. We purchased $0 and $840,000 of
fabric from Acabados y Terminados in the three months ended March 31, 2006 and
2005, respectively. Net amount due from these parties as of March 31, 2006 was
$507,000.
From time to time in the past, we borrowed funds from, and advanced
funds to, Mr. Guez. The greatest outstanding balance of such advances to Mr.
Guez in the first quarter of 2006 was approximately $2,279,000. At March 31,
2006, the entire balance due from Mr. Guez totaling $2.3 million is payable on
demand and has been shown as reductions to shareholders' equity in the
accompanying financial statements. All advances to, and borrowings from, Mr.
Guez bore interest at the rate of 7.75% during the period. Total interest paid
by Mr. Guez was $44,000 and $74,000 for the three months ended March 31, 2006
and 2005, respectively. Mr. Guez paid expenses on our behalf of approximately
$67,000 and $108,000 for the three months ended March 31, 2006 and 2005,
respectively, which amounts were applied to reduce accrued interest and
principal on Mr. Guez's loan. These amounts included fuel and related expenses
incurred by 477 Aviation, LLC, a company owned by Mr. Guez, when our executives
used this company's aircraft for business purposes. Since the enactment of the
Sarbanes-Oxley Act in 2002, no further personal loans (or amendments to existing
loans) have been or will be made to our executive officers or directors.
On July 1, 2001, we formed an entity to jointly market, share certain
risks and achieve economies of scale with Azteca Production International, Inc.
("Azteca"), a corporation owned by the brothers of Gerard Guez, our Chairman,
called United Apparel Ventures, LLC ("UAV"). This entity was created to
coordinate the production of apparel for a single customer of our branded
business. UAV is owned 50.1% by Tag Mex, Inc., our wholly owned subsidiary, and
49.9% by Azteca. Results of the operation of UAV have been consolidated into our
results since July 2001 with the minority partner's share of gain and losses
eliminated through the minority interest line in our financial statements. Due
to the restructuring of our Mexico operations, we discontinued manufacturing for
UAV customers in the second quarter of 2004. UAV made purchases from two related
parties in Mexico, an affiliate of Azteca and Tag-It Pacific, Inc.
At March 31, 2006, Messrs. Guez and Kay beneficially owned 590,000 and
1,003,500 shares, respectively, of common stock of Tag-It Pacific, Inc.
("Tag-It"), collectively representing approximately 8.7% of Tag-It Pacific's
common stock. Tag-It is a provider of brand identity programs to manufacturers
and retailers of apparel and accessories. Starting from 1998, Tag-It assumed the
responsibility for managing and sourcing all trim and packaging used in
connection with products manufactured by or on behalf of us in Mexico. Due to
the restructuring of our Mexico operations, Tag-It no longer manages our trim
and packaging requirements. We purchased $97,000 and $0 of trim inventory from
Tag-It in the three months ended March 31, 2006 and 2005, respectively. We
purchased $0 and $135,000 of finished goods and service from Azteca and its
affiliates in the three months ended March 31, 2006 and 2005, respectively. Our
total sales of fabric and service to Azteca in the three months ended March 31,
2006 and 2005 were $9,000 and $63,000, respectively. Pursuant to the operating
agreement for UAV, two and one half percent of gross sales of UAV were paid to
each of the members of UAV as management fees. Net amount due from these related
parties as of March 31, 2006 was $5.6 million.
29
We believe that each of the transactions described above has been
entered into on terms no less favorable to us than could have been obtained from
unaffiliated third parties. We have adopted a policy that any transactions
between us and any of our affiliates or related parties, including our executive
officers, directors, the family members of those individuals and any of their
affiliates, must (i) be approved by a majority of the members of the Board of
Directors and by a majority of the disinterested members of the Board of
Directors and (ii) be on terms no less favorable to us than could be obtained
from unaffiliated third parties.
30
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
FOREIGN CURRENCY RISK. Our earnings are affected by fluctuations in the
value of the U.S. dollar as compared to foreign currencies as a result of doing
business in foreign jurisdictions. As a result, we bear the risk of exchange
rate gains and losses that may result in the future. At times we use forward
exchange contracts to reduce the effect of fluctuations of foreign currencies on
purchases and commitments. These short-term assets and commitments are
principally related to trade payables positions. We do not utilize derivative
financial instruments for trading or other speculative purposes. We actively
evaluate the creditworthiness of the financial institutions that are counter
parties to derivative financial instruments, and we do not expect any counter
parties to fail to meet their obligations.
INTEREST RATE RISK. Because our obligations under our various credit
agreements bear interest at floating rates (primarily prime rates), we are
sensitive to changes in prevailing interest rates. Any major increase or
decrease in market interest rates that affect our financial instruments would
have a material impact on earning or cash flows during the next fiscal year.
Our interest expense is sensitive to changes in the general level of
U.S. interest rates. In this regard, changes in U.S. interest rates affect
interest paid on our debt. A majority of our credit facilities are at variable
rates.
ITEM 4. CONTROLS AND PROCEDURES.
EVALUATION OF CONTROLS AND PROCEDURES
Members of the our management, including our Chief Executive Officer
and Chief Financial Officer have evaluated the effectiveness of our disclosure
controls and procedures, as defined by paragraph (e) of Exchange Act Rules
13a-15 or 15d-15, as of March 31, 2006, the end of the period covered by this
report. Members of the our management, including our Chief Executive Officer and
Chief Financial Officer, also conducted an evaluation of our internal control
over financial reporting to determine whether any changes occurred during the
further quarter of 2006 that have materially affected, or are reasonably likely
to materially affect, our internal control over financial reporting. Based upon
that evaluation, the Chief Executive Officer and Chief Financial Officer
concluded that our disclosure controls and procedures are effective.
CHANGES IN CONTROLS AND PROCEDURES
There were no significant changes in our internal controls or in other
factors that could significantly affect internal controls, known to the Chief
Executive Officer or the Chief Financial Officer during the first quarter of
2006.
31
PART II -- OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
On or about April 6, 2006, we commenced an action against the licensor
of the Jessica Simpson brands in the Supreme Court of the State of New York,
County of New York. The suit named Camuto Consulting Group, Inc., VCJS LLC, With
You, Inc. and Jessica Simpson as defendants, and asserts that the defendants
failed to provide promised support in connection with our sublicense agreement
for the Jessica Simpson brands. The complaint includes eight causes of action,
including two seeking a declaration that the sublicense agreement is exclusive
and remains in full force and effect, as well as claims for breach of contract
by Camuto, breach of the duty of good faith and fair dealing and fraudulent
inducement against Camuto, and a claim against With You, Inc. and Ms. Simpson
that we are an intended third party beneficiary of the licenses between those
defendants and Camuto. On our about April 26, 2006, Camuto served its answer to
our complaint and included a counterclaim against us for breach of the
sublicense agreement and alleging damages of no less than $100 million. On or
about April 17, 2006, Ms. Simpson served a motion seeking dismissal of the cause
of action asserted against her. We intend to vigorously defend Camuto's
counterclaim and vigorously oppose Ms. Simpson's motion.
From time to time, we are involved in various routine legal proceedings
incidental to the conduct of our business. Our management does not believe that
any of these legal proceedings will have a material adverse impact on our
business, financial condition or results of operations, either due to the nature
of the claims, or because our management believes that such claims should not
exceed the limits of the our insurance coverage.
ITEM 1A. RISK FACTORS.
This Quarterly Report on Form 10-Q contains forward-looking statements,
which are subject to a variety of risks and uncertainties. Our actual results
could differ materially from those anticipated in these forward-looking
statements as a result of various factors, including those set forth below.
RISKS RELATED TO OUR BUSINESS
WE DEPEND ON A GROUP OF KEY CUSTOMERS FOR A SIGNIFICANT PORTION OF OUR SALES. A
SIGNIFICANT ADVERSE CHANGE IN A CUSTOMER RELATIONSHIP OR IN A CUSTOMER'S
FINANCIAL POSITION COULD HARM OUR BUSINESS AND FINANCIAL CONDITION.
Four customers accounted for approximately 49% of our net sales in
first three months of 2006. We believe that consolidation in the retail industry
has centralized purchasing decisions and given customers greater leverage over
suppliers, like us, and we expect this trend to continue. If this consolidation
continues, our net sales and results of operations may be increasingly sensitive
to deterioration in the financial condition of, or other adverse developments
with, one or more of our customers.
While we have long-standing customer relationships, we generally do not
have long-term contracts with them. Purchases generally occur on an
order-by-order basis, and relationships exist as long as there is a perceived
benefit to both parties. A decision by a major customer, whether motivated by
competitive considerations, financial difficulties, and economic conditions or
otherwise, to decrease its purchases from us or to change its manner of doing
business with us, could adversely affect our business and financial condition.
In addition, during recent years, various retailers, including some of our
customers, have experienced significant changes and difficulties, including
consolidation of ownership, increased centralization of purchasing decisions,
restructurings, bankruptcies and liquidations.
These and other financial problems of some of our retailers, as well as
general weakness in the retail environment, increase the risk of extending
credit to these retailers. A significant adverse change in a customer
relationship or in a customer's financial position could cause us to limit or
discontinue business with that customer, require us to assume more credit risk
relating to that customer's receivables, limit our ability to collect amounts
related to previous purchases by that customer, or result in required prepayment
of our receivables securitization arrangements, all of which could harm our
business and financial condition.
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FAILURE OF THE TRANSPORTATION INFRASTRUCTURE TO MOVE SEA FREIGHT IN ACCEPTABLE
TIME FRAMES COULD ADVERSELY AFFECT OUR BUSINESS.
Because the bulk of our freight is designed to move through the West
Coast ports in predictable time frames, we are at risk of cancellations and
penalties when those ports operate inefficiently creating delays in delivery. We
experienced such delays from June 2004 until November 2004, and we may
experience similar delays in the future especially during peak seasons.
Unpredictable timing for shipping may cause us to utilize air freight or may
result in customer penalties for late delivery, any of which could reduce our
operating margins and adversely affect our results of operations.
UNPREDICTABLE DELAYS AS THE RESULT OF INCREASED AND INTENSIFIED CUSTOMS
ACTIVITY.
U.S. Customs has stepped up efforts to scrutinize imports from Hong
Kong in order to verify all details of shipments under the OPA rules allowing
certain processes to be performed in China without shipping under China country
of origin documentation. Such "detentions" are unpredictable and cause serious
interruption of normally expected freight movement timetables.
THE OUTCOME OF LITIGATION IN WHICH WE ARE INVOLVED IS UNPREDICTABLE AND AN
ADVERSE DECISION IN ANY SUCH MATTER COULD HAVE A MATERIAL ADVERSE AFFECT ON OUR
FINANCIAL POSITION AND RESULTS OF OPERATIONS.
We are currently in litigation with the licensors of the Jessica
Simpson brands regarding our rights to sell apparel under these brands. See Part
II of this report, Item 1 "Legal Proceedings" for a detailed description of this
lawsuit. The licensor has filed a counterclaim against us seeking damage. These
claims may divert financial and management resources that would otherwise be
used to benefit our operations. Although we believe that we have meritorious
defenses to the claims made against us, and intend to contest the lawsuit
vigorously, no assurances can be given that the results of these matters will be
favorable to us. An adverse resolution of any of these lawsuits could have a
material adverse affect on our financial position and results of operations.
Additionally, we have incurred significant legal fees in this litigation, and
unless the case is settled, we will continue to incur additional legal fees in
increasing amounts as the case accelerates to trial.
FAILURE TO MANAGE OUR GROWTH AND EXPANSION COULD IMPAIR OUR BUSINESS.
Since our inception, we have experienced periods of rapid growth. No
assurance can be given that we will be successful in maintaining or increasing
our sales in the future. Any future growth in sales will require additional
working capital and may place a significant strain on our management, management
information systems, inventory management, sourcing capability, distribution
facilities and receivables management. Any disruption in our order processing,
sourcing or distribution systems could cause orders to be shipped late, and
under industry practices, retailers generally can cancel orders or refuse to
accept goods due to late shipment. Such cancellations and returns would result
in a reduction in revenue, increased administrative and shipping costs and a
further burden on our distribution facilities.
OUR OPERATING RESULTS MAY FLUCTUATE SIGNIFICANTLY.
We have experienced, and expect to continue to experience, substantial
variations in our net sales and operating results from quarter to quarter. We
believe that the factors which influence this variability of quarterly results
include the timing of our introduction of new product lines, the level of
consumer acceptance of each new product line, general economic and industry
conditions that affect consumer spending and retailer purchasing, the
availability of manufacturing capacity, the seasonality of the markets in which
we participate, the timing of trade shows, the product mix of customer orders,
the timing of the placement or cancellation of customer orders, the weather,
transportation delays, the occurrence of charge backs in excess of reserves and
the timing of expenditures in anticipation of increased sales and actions of
competitors. Due to fluctuations in our revenue and operating expenses, we
believe that period-to-period comparisons of our results of operations are not a
good indication of our future performance. It is possible that in some future
quarter or quarters, our operating results will be below the expectations of
securities analysts or investors. In that case, our stock price could fluctuate
significantly or decline.
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WE DEPEND ON OUR COMPUTER AND COMMUNICATIONS SYSTEMS.
As a multi-national corporation, we rely on our computer and
communication network to operate efficiently. Any interruption of this service
from power loss, telecommunications failure, weather, natural disasters or any
similar event could have a material adverse affect on our business and
operations. Additionally, hackers and computer viruses have disrupted operations
at many major companies. We may be vulnerable to similar acts of sabotage, which
could have a material adverse effect on our business and operations.
WE MAY REQUIRE ADDITIONAL CAPITAL IN THE FUTURE.
We may not be able to fund our future growth or react to competitive
pressures if we lack sufficient funds. Currently, we believe we have sufficient
cash on hand and cash available through our bank credit facilities, issuance of
long-term debt and equity securities, and proceeds from the exercise of stock
options to fund existing operations for the foreseeable future. However, in the
future we may need to raise additional funds through equity or debt financings
or collaborative relationships. This additional funding may not be available or,
if available, it may not be available on economically reasonable terms. In
addition, any additional funding may result in significant dilution to existing
shareholders. If adequate funds are not available, we may be required to curtail
our operations or obtain funds through collaborative partners that may require
us to release material rights to our products.
OUR BUSINESS IS SUBJECT TO RISKS ASSOCIATED WITH IMPORTING PRODUCTS.
Substantially all of our import operations are subject to tariffs
imposed on imported products, safeguards and growth targets imposed by trade
agreements. In addition, the countries in which our products are manufactured or
imported may from time to time impose additional new duties, tariffs or other
restrictions on our imports or adversely modify existing restrictions. Adverse
changes in these import costs and restrictions, or our suppliers' failure to
comply with customs or similar laws, could harm our business. We cannot assure
that future trade agreements will not provide our competitors with an advantage
over us, or increase our costs, either of which could have an adverse effect on
our business and financial condition.
Our operations are also subject to the effects of international trade
agreements and regulations such as the North American Free Trade Agreement, and
the activities and regulations of the World Trade Organization. Generally, these
trade agreements benefit our business by reducing or eliminating the duties
assessed on products manufactured in a particular country. However, trade
agreements can also impose requirements that adversely affect our business, such
as limiting the countries from which we can purchase raw materials and setting
duties or restrictions on products that may be imported into the United States
from a particular country. In addition, the World Trade Organization may
commence a new round of trade negotiations that liberalize textile trade by
further eliminating or reducing tariffs. The elimination of quotas on World
Trade Organization member countries in 2005 has resulted in explosive growth in
textile imports from China, and subsequent safeguard measures including embargo
of certain China country of origin products. Actions taken to avoid these
measures caused disruption, and a negative impact on margins. Such disruption
may continue to affect us to some extent in the future.
OUR DEPENDENCE ON INDEPENDENT MANUFACTURERS REDUCES OUR ABILITY TO CONTROL THE
MANUFACTURING PROCESS, WHICH COULD HARM OUR SALES, REPUTATION AND OVERALL
PROFITABILITY.
We depend on independent contract manufacturers to secure a sufficient
supply of raw materials and maintain sufficient manufacturing and shipping
capacity in an environment characterized by declining prices, labor shortage,
continuing cost pressure and increased demands for product innovation and
speed-to-market. This dependence could subject us to difficulty in obtaining
timely delivery of products of acceptable quality. In addition, a contractor's
failure to ship products to us in a timely manner or to meet the required
quality standards could cause us to miss the delivery date requirements of our
customers. The failure to make timely deliveries may cause our customers to
cancel orders, refuse to accept deliveries, impose non-compliance charges
through invoice deductions or other charge-backs, demand reduced prices or
reduce future orders, any of which could harm our sales, reputation and overall
profitability. We do not have material long-term contracts with any of our
independent contractors and any of these contractors may unilaterally terminate
their relationship with us at any time. To the extent we are not able to secure
or maintain relationships with independent contractors that are able to fulfill
our requirements, our business would be harmed.
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We have initiated a factory compliance agreement with our suppliers,
and monitor our independent contractors' compliance with applicable labor laws,
but we do not control our contractors or their labor practices. The violation of
federal, state or foreign labor laws by one of the our contractors could result
in our being subject to fines and our goods that are manufactured in violation
of such laws being seized or their sale in interstate commerce being prohibited.
From time to time, we have been notified by federal, state or foreign
authorities that certain of our contractors are the subject of investigations or
have been found to have violated applicable labor laws. To date, we have not
been subject to any sanctions that, individually or in the aggregate, have had a
material adverse effect on our business, and we are not aware of any facts on
which any such sanctions could be based. There can be no assurance, however,
that in the future we will not be subject to sanctions as a result of violations
of applicable labor laws by our contractors, or that such sanctions will not
have a material adverse effect on our business and results of operations. In
addition, certain of our customers, require strict compliance by their apparel
manufacturers, including us, with applicable labor laws and visit our facilities
often. There can be no assurance that the violation of applicable labor laws by
one of our contractors will not have a material adverse effect on our
relationship with our customers.
OUR DEPENDENCE ON THIRD PARTIES FOR BRANDED APPAREL PRODUCTS REDUCES
OUR ABILITY TO CONTROL THE MARKETING PROCESS, WHICH COULD HARM OUR SALES,
REPUTATION AND OVERALL PROFITABILITY.
For certain branded apparel lines, in particular celebrity brands, we
depend on the cooperation and efforts of the celebrity personality and/or master
licensor to support our design and marketing efforts for apparel products. A
celebrity's failure to adequately support our marketing efforts could adversely
affect the sales for new products and lines. In addition, we are subject to the
terms of our agreements with the master licensor for licensed brands, and our
rights to exploit certain brands may therefore be limited. Further, we may, from
time to time, become involved in disputes with the master licensor with respect
to our contractual relationship. To the extent we are not able to receive
adequate support from the master licensor and/or celebrity or maintain good
working relationships with master licensors, our business would be harmed.
OUR BUSINESS IS SUBJECT TO RISKS OF OPERATING IN A FOREIGN COUNTRY AND TRADE
RESTRICTIONS.
Approximately 90% of our products were imported from outside the U.S.
in fiscal 2005. We are subject to the risks associated with doing business in
foreign countries, including, but not limited to, transportation delays and
interruptions, political instability, expropriation, currency fluctuations and
the imposition of tariffs, import and export controls, other non-tariff barriers
and cultural issues. Any changes in those countries' labor laws and government
regulations may have a negative effect on our profitability.
RISK ASSOCIATED WITH OUR INDUSTRY
OUR SALES ARE HEAVILY INFLUENCED BY GENERAL ECONOMIC CYCLES.
Apparel is a cyclical industry that is heavily dependent upon the
overall level of consumer spending. Purchases of apparel and related goods tend
to be highly correlated with cycles in the disposable income of our consumers.
Our customers anticipate and respond to adverse changes in economic conditions
and uncertainty by reducing inventories and canceling orders. As a result, any
substantial deterioration in general economic conditions, increases in interest
rates, acts of war, terrorist or political events that diminish consumer
spending and confidence in any of the regions in which we compete, could reduce
our sales and adversely affect our business and financial condition.
OUR BUSINESS IS HIGHLY COMPETITIVE AND DEPENDS ON CONSUMER SPENDING PATTERNS.
The apparel industry is highly competitive. We face a variety of
competitive challenges including:
o anticipating and quickly responding to changing consumer
demands;
o developing innovative, high-quality products in sizes, colors
and styles that appeal to consumers of varying age groups and
tastes;
o competitively pricing our products and achieving customer
perception of value; and
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o the need to provide strong and effective marketing support.
WE MUST SUCCESSFULLY GAUGE FASHION TRENDS AND CHANGING CONSUMER PREFERENCES TO
SUCCEED.
Our success is largely dependent upon our ability to gauge the fashion
tastes of our customers and to provide merchandise that satisfies retail and
customer demand in a timely manner. The apparel business fluctuates according to
changes in consumer preferences dictated in part by fashion and season. To the
extent we misjudge the market for our merchandise; our sales may be adversely
affected. Our ability to anticipate and effectively respond to changing fashion
trends depends in part on our ability to attract and retain key personnel in our
design, merchandising and marketing staff. Competition for these personnel is
intense, and we cannot be sure that we will be able to attract and retain a
sufficient number of qualified personnel in future periods.
OUR BUSINESS IS SUBJECT TO SEASONAL TRENDS.
Historically, our operating results have been subject to seasonal
trends when measured on a quarterly basis. This trend is dependent on numerous
factors, including the markets in which we operate, holiday seasons, consumer
demand, climate, economic conditions and numerous other factors beyond our
control. There can be no assurance that our historic operating patterns will
continue in future periods as we cannot influence or forecast many of these
factors.
OTHER RISKS RELATED TO AN INVESTMENT IN OUR COMMON STOCK
THE ULTIMATE RESOLUTION OF THE INTERNAL REVENUE SERVICE'S EXAMINATION OF OUR TAX
RETURNS MAY REQUIRE US TO INCUR AN EXPENSE BEYOND WHAT HAS BEEN RESERVED FOR ON
OUR BALANCE SHEET OR MAKE CASH PAYMENTS BEYOND WHAT WE ARE THEN ABLE TO PAY.
In January 2004, the Internal Revenue Service proposed adjustments to
increase our federal income tax payable for the years ended December 31, 1996
through 2001. This adjustment would also result in additional state taxes,
penalties and interest. In addition, in July 2004, the IRS initiated an
examination of our Federal income tax return for the year ended December 31,
2002. In March 2005, the IRS proposed an adjustment to our taxable income of
approximately $6 million related to similar issues identified in their audit of
the 1996 through 2001 federal income tax returns. We believe that we have
meritorious defenses to and intend to vigorously contest the proposed
adjustments made to our federal income tax returns for the years ended 1996
through 2002. If the proposed adjustments are upheld through the administrative
and legal process, they could have a material impact on our earnings and cash
flow. We believe we have provided adequate reserves for any reasonably
foreseeable outcome related to these matters on the consolidated balance sheets
included in the Consolidated Financial Statements. The maximum amount of loss in
excess of the amount accrued in the financial statements is $7.7 million. If the
amount of any actual liability, however, exceeds our reserves, we would
experience an immediate adverse earnings impact in the amount of such additional
liability, which could be material. Additionally, we anticipate that the
ultimate resolution of these matters will require that we make significant cash
payments to the taxing authorities. Presently we do not have sufficient cash or
borrowing ability to make any future payments that may be required. No assurance
can be given that we will have sufficient surplus cash from operations to make
the required payments. Additionally, any cash used for these purposes will not
be available for other corporate purposes, which could have a material adverse
effect on our financial condition and results of operations.
INSIDERS OWN A SIGNIFICANT PORTION OF OUR COMMON STOCK, WHICH COULD LIMIT OUR
SHAREHOLDERS' ABILITY TO INFLUENCE THE OUTCOME OF KEY TRANSACTIONS.
As of March 31, 2006, our executive officers and directors and their
affiliates owned approximately 43% of the outstanding shares of our common
stock. Gerard Guez, our Chairman and Interim Chief Executive Officer, and Todd
Kay, our Vice Chairman, alone own approximately 33.1% and 8.4%, respectively, of
the outstanding shares of our common stock at March 31, 2006. Accordingly, our
executive officers and directors have the ability to affect the outcome of, or
exert considerable influence over, all matters requiring shareholder approval,
including the election and removal of directors and any change in control. This
concentration of ownership of our common stock could have the effect of delaying
or preventing a change of control of us or otherwise discouraging or preventing
a potential acquirer from attempting to obtain control of us. This, in turn,
could have a negative effect on the market
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price of our common stock. It could also prevent our shareholders from realizing
a premium over the market prices for their shares of common stock.
WE HAVE ADOPTED A NUMBER OF ANTI-TAKEOVER MEASURES THAT MAY DEPRESS THE PRICE OF
OUR COMMON STOCK.
Our shareholders rights plan, our ability to issue additional shares of
preferred stock and some provisions of our articles of incorporation and bylaws
could make it more difficult for a third party to make an unsolicited takeover
attempt of us. These anti-takeover measures may depress the price of our common
stock by making it more difficult for third parties to acquire us by offering to
purchase shares of our stock at a premium to its market price without approval
of our board of directors.
OUR STOCK PRICE HAS BEEN VOLATILE.
Our common stock is quoted on the NASDAQ National Market System, and
there can be substantial volatility in the market price of our common stock. The
market price of our common stock has been, and is likely to continue to be,
subject to significant fluctuations due to a variety of factors, including
quarterly variations in operating results, operating results which vary from the
expectations of securities analysts and investors, changes in financial
estimates, changes in market valuations of competitors, announcements by us or
our competitors of a material nature, loss of one or more customers, additions
or departures of key personnel, future sales of common stock and stock market
price and volume fluctuations. In addition, general political and economic
conditions such as a recession, or interest rate or currency rate fluctuations
may adversely affect the market price of our common stock.
In addition, the stock market in general has experienced extreme price
and volume fluctuations that have affected the market price of our common stock.
Often, price fluctuations are unrelated to operating performance of the specific
companies whose stock is affected. In the past, following periods of volatility
in the market price of a company's stock, securities class action litigation has
occurred against the issuing company. If we were subject to this type of
litigation in the future, we could incur substantial costs and a diversion of
our management's attention and resources, each of which could have a material
adverse effect on our revenue and earnings. Any adverse determination in this
type of litigation could also subject us to significant liabilities.
ABSENCE OF DIVIDENDS COULD REDUCE OUR ATTRACTIVENESS TO YOU.
Some investors favor companies that pay dividends, particularly in
general downturns in the stock market. We have not declared or paid any cash
dividends on our common stock. We currently intend to retain any future earnings
for funding growth, and we do not currently anticipate paying cash dividends on
our common stock in the foreseeable future. Additionally, we cannot pay
dividends on our common stock unless the terms of our bank credit facilities and
outstanding preferred stock, if any, permit the payment of dividends on our
common stock. Because we may not pay dividends, your return on this investment
likely depends on your selling our stock at a profit.
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ITEM 6. EXHIBITS.
EXHIBIT
NUMBER DESCRIPTION
------- -----------------------------------------------------
10.8.2 Amendment to Factoring Agreement dated as of January
23, 2006 by and among GMAC Commercial Finance LLC and
Tarrant Apparel Group, Fashion Resource (TCL), Inc.,
TAG Mex, Inc., United Apparel Ventures, LLC, Private
Brands, Inc. and NO! Jeans, Inc.
10.16.24 Sixteenth Deed of Variation to Syndicated Letter of
Credit Facility effective as of January 31, 2006
among Tarrant Company Limited, Marble Limited and
Trade Link Holdings Limited and UPS Capital Global
Trade Finance Corporation.
10.34 Promissory Note in the principal amount of $4,000,000
dated as of January 19, 2006, issued by Tarrant
Apparel Group in favor of Max Azria.
31.1 Certificate of Chief Executive Officer pursuant to
Rule 13a-14(a) under the Securities and Exchange Act
of 1934, as amended.
31.2 Certificate of Chief Financial Officer pursuant to
Rule 13a-14(a) under the Securities and Exchange Act
of 1934, as amended.
32.1 Certificate of Chief Executive Officer pursuant to
Rule 13a-14(b) under the Securities and Exchange Act
of 1934, as amended.
32.2 Certificate of Chief Financial Officer pursuant to
Rule 13a-14(b) under the Securities and Exchange Act
of 1934, as amended.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
TARRANT APPAREL GROUP
Date: May 15, 2006 By: /s/ Corazon Reyes
-------------------------------
Corazon Reyes,
Chief Financial Officer
Date: May 15, 2006 By: /s/ Gerard Guez
-------------------------------
Gerard Guez,
Interim Chief Executive Officer
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