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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 JUNE 30, 2007
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
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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 August 10,
2007: 30,543,763.
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TARRANT APPAREL GROUP
FORM 10-Q
INDEX
PART I. FINANCIAL INFORMATION
PAGE
------
Item 1. Financial Statements
Consolidated Balance Sheets at June 30, 2007
(unaudited) and December 31, 2006.................................. 2
Consolidated Statements of Operations
for the Three Months and Six Months Ended
June 30, 2007 and June 30, 2006 (unaudited)....................... 3
Consolidated Statements of Cash Flows for
the Six Months Ended June 30, 2007 and
June 30, 2006 (unaudited)......................................... 4
Notes to Consolidated Financial Statements
(unaudited)........................................................ 5
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations .................... 25
Item 3. Quantitative and Qualitative Disclosures
About Market Risk ................................................ 39
Item 4. Controls and Procedures............................................. 39
PART II. OTHER INFORMATION
Item 1. Legal Proceedings................................................... 40
Item 1A. Risk Factors........................................................ 40
Item 6. Exhibits............................................................ 47
SIGNATURES.......................................................... 48
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
DECEMBER 31,
JUNE 30, 2007 2006
------------- -------------
(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents ............................. $ 963,858 $ 904,553
Accounts receivable, net of $1.9 million and $2.1
million allowance for returns, discounts and bad debts
at June 30, 2007 and December 31, 2006, respectively .. 46,789,279 48,079,527
Due from related parties .............................. 4,980,533 3,688,355
Inventory ............................................. 18,221,411 17,774,103
Temporary quota rights ................................ 38,770 32,217
Prepaid expenses ...................................... 1,096,052 1,515,087
Deferred tax assets ................................... 125,401 123,607
Income taxes receivable ............................... 26,267 25,468
------------- -------------
Total current assets ..................................... 72,241,571 72,142,917
Property and equipment, net of $9.5 million and $9.4
million accumulated depreciation at June 30, 2007 and
December 31, 2006, respectively ....................... 1,479,197 1,414,354
Notes receivable - related parties, net of $27.1 million
reserve at June 30, 2007 and December 31, 2006 ........ 14,000,000 14,000,000
Due from related parties ................................. 3,554,117 4,168,205
Equity method investment ................................. 2,277,603 2,151,061
Deferred financing cost, net of $1.4 million and $1.7
million accumulated amortization at June 30, 2007 and
December 31, 2006, respectively ....................... 1,951,043 2,448,526
Other assets ............................................. 220,670 6,223,816
Goodwill, net ............................................ 8,582,845 8,582,845
------------- -------------
Total assets ............................................. $ 104,307,046 $ 111,131,724
============= =============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Short-term bank borrowings ............................ $ 14,841,935 $ 13,696,182
Accounts payable ...................................... 19,011,466 22,685,674
Accrued expenses ...................................... 10,021,269 8,907,658
Derivative liability .................................. -- 195,953
Income taxes .......................................... 18,253,199 16,865,125
Current portion of long-term obligations and factoring
arrangement ......................................... 13,337,908 19,586,565
------------- -------------
Total current liabilities ............................... 75,465,777 81,937,157
Term loan, net of $3.7 million and $4.3 million debt
discount at June 30, 2007 and December 31, 2006,
respectively ........................................... 11,754,274 11,212,724
Other long-term obligations .............................. -- 5,338
------------- -------------
Total liabilities ........................................ 87,220,051 93,155,219
Minority interest in PBG7 ................................ 52,890 54,338
Commitments and contingencies
Shareholders' equity:
Preferred stock, 2,000,000 shares authorized;
no shares at June 30, 2007 and December 31,
2006 issued and outstanding ......................... -- --
Common stock, no par value, 100,000,000 shares
authorized; 30,543,763 shares at June 30, 2007 and
December 31, 2006 issued and outstanding ............ 114,977,465 114,977,465
Warrant to purchase common stock ...................... 7,314,239 7,314,239
Contributed capital ................................... 10,413,586 10,191,511
Accumulated deficit (See Note 12) ..................... (113,602,018) (112,410,363)
Notes receivable from officer/shareholder ............. (2,069,167) (2,150,685)
------------- -------------
Total shareholders' equity .............................. 17,034,105 17,922,167
------------- -------------
Total liabilities and shareholders' equity ............... $ 104,307,046 $ 111,131,724
============= =============
The accompanying notes are an integral part of these
consolidated financial statements
2
TARRANT APPAREL GROUP
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
THREE MONTHS ENDED JUNE 30 SIX MONTHS ENDED JUNE 30
------------------------------ ------------------------------
2007 2006 2007 2006
------------- ------------- ------------- -------------
Net sales .............................. $ 60,100,503 $ 59,082,541 $ 116,207,097 $ 120,343,785
Cost of sales .......................... 47,545,805 46,419,973 91,305,819 95,162,454
------------- ------------- ------------- -------------
Gross profit ........................... 12,554,698 12,662,568 24,901,278 25,181,331
Selling and distribution expenses ...... 3,352,007 2,798,086 6,790,740 5,727,776
General and administrative expenses .... 6,240,358 6,903,093 12,726,954 13,363,236
Royalty expenses ....................... 433,696 352,864 791,428 1,835,809
Terminated acquisition expenses ........ -- -- 2,000,000 --
------------- ------------- ------------- -------------
Income from operations ................ 2,528,637 2,608,525 2,592,156 4,254,510
Interest expense ....................... (1,219,562) (1,945,797) (2,562,886) (3,133,854)
Interest income ........................ 42,857 480,859 87,957 966,202
Interest in income of equity method
investee ............................ 42,793 62,909 126,542 110,322
Other income ........................... 64,748 90,568 152,399 124,373
Adjustment to fair value of derivative . 524 (218,307) 195,953 (218,307)
Other expense .......................... (9,335) (400,000) (11,140) (400,000)
------------- ------------- ------------- -------------
Income before provision for income taxes 1,450,662 678,757 580,981 1,703,246
Provision for income taxes ............. 641,917 60,110 774,084 259,722
Minority interest ...................... 519 (7,363) 1,448 4,131
------------- ------------- ------------- -------------
Net income (loss) ...................... $ 809,264 $ 611,284 $ (191,655) $ 1,447,655
============= ============= ============= =============
Net income (loss ) per share:
Basic ............................... $ 0.03 $ 0.02 $ (0.01) $ 0.05
============= ============= ============= =============
Diluted ............................. $ 0.03 $ 0.02 $ (0.01) $ 0.05
============= ============= ============= =============
Weighted average common and common
equivalent shares:
Basic ............................... 30,543,763 30,543,763 30,543,763 30,378,715
============= ============= ============= =============
Diluted ............................. 30,543,875 30,544,420 30,543,763 30,378,840
============= ============= ============= =============
The accompanying notes are an integral part of these
consolidated financial statements
3
TARRANT APPAREL GROUP
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
SIX MONTHS ENDED JUNE 30,
------------------------------
2007 2006
------------- -------------
Operating activities:
Net income (loss) ......................................... $ (191,655) $ 1,447,655
Adjustments to reconcile net income (loss) to net cash
provided by (used in) Operating activities:
Deferred taxes ......................................... (1,794) (22,414)
Depreciation and amortization of fixed assets .......... 201,339 246,965
Amortization of deferred financing cost ................ 987,036 1,534,973
Adjustment to fair value of derivative ................. (195,953) 218,307
Terminated acquisition expenses ........................ 2,000,000 --
Change in the provision for returns and discounts ...... (204,624) 277,656
Change in the provision for bad debts .................. 40,081 (5,440)
Loss (gain) on sale of fixed assets .................... 6,145 (1,283)
Income from equity method investment ................... (126,542) (110,322)
Minority interest ...................................... (1,448) (4,131)
Stock-based compensation ............................... 321,761 7,054
Changes in operating assets and liabilities:
Accounts receivable .................................. 1,953,928 (5,789,823)
Due to/from related parties .......................... (1,277,229) (121,160)
Inventory ............................................ (447,308) 11,440,735
Temporary quota rights ............................... (6,553) (59,153)
Prepaid expenses ..................................... 418,235 1,353,074
Accounts payable ..................................... (3,674,208) (12,295,638)
Accrued expenses and income tax payable .............. 1,501,684 (518,128)
------------- -------------
Net cash provided by (used in) operating activities .. 1,302,895 (2,401,073)
Investing activities:
Purchase of fixed assets ............................... (272,327) (63,418)
Proceeds from sale of fixed assets ..................... -- 2,800
Due diligence fees in acquisition ...................... (699,764) --
Refund of deposit on acquisition ....................... 4,750,000 --
Distribution from equity method investee ............... -- 67,500
Collection on notes receivable - related parties ....... -- 651,666
Collection of advances from shareholders/officers ...... 81,519 44,522
------------- -------------
Net cash provided by investing activities ............ 3,859,428 703,070
Financing activities:
Short-term bank borrowings, net ........................ 1,145,754 (1,300,390)
Proceeds from long-term obligations .................... 98,640,912 132,805,154
Payment of financing costs ............................. -- (2,231,318)
Repayments of borrowings from convertible debentures ... -- (6,912,626)
Payment of long-term obligations and bank borrowings ... (104,889,684) (120,613,274)
------------- -------------
Net cash provided by (used in) financing activities .. (5,103,018) 1,747,546
------------- -------------
Increase in cash and cash equivalents ..................... 59,305 49,543
Cash and cash equivalents at beginning of period .......... 904,553 1,641,768
------------- -------------
Cash and cash equivalents at end of period ................ $ 963,858 $ 1,691,311
============= =============
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
June 30, 2007, we own 75% of PBG7, LLC ("PBG7"). We previously owned 50.1% of
United Apparel Ventures ("UAV"), which was dissolved on February 27, 2007. The
dissolution of UAV did not have a material impact on our consolidated financial
statements. 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 was 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 merchandisers and department store
chains and branded wholesalers by designing, merchandising, contracting for the
manufacture of, and selling casual apparel for women, men and children under
private label and private brand.
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 generally accepted accounting principles 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, 2006 is derived from
audited financial statements which are included in our Annual Report on Form
10-K for the year ended December 31, 2006, 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.
The preparation of financial statements in conformity with US GAAP
requires management to make estimates and assumptions that affect the amounts
reported in the financial statements and accompanying notes. Significant
estimates used by us in preparation of the consolidated financial statements
include allowance for returns, discounts and bad debts, inventory, notes
receivable - related parties reserve, valuation of long-lived and intangible
assets and goodwill, income taxes, stock options valuation, contingencies and
litigation. Actual results could differ from those estimates.
5
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
LICENSE AGREEMENTS AND ROYALTY EXPENSES
We enter into license agreements from time to time that allow us to use
certain trademarks and trade names on certain of our products. These agreements
require us to pay royalties and marketing fund commitments, generally based on
the sales of such products, and may require guaranteed minimum royalties, a
portion of which may be paid in advance. Our accounting policy is to match
royalty expense with revenue by recording royalties at the time of sale at the
greater of the contractual rate or an effective rate calculated based on the
guaranteed minimum royalty and our estimate of sales during the contract period.
If a portion of the guaranteed minimum royalty is determined not to be
recoverable, the unrecoverable portion is charged to expense at that time. See
Note 15 of the "Notes to Consolidated Financial Statements" regarding various
agreements we have entered into.
Royalty expense in the six months ended June 30, 2007 and 2006 were
$791,000 and $1.8 million, respectively.
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 June 30, 2007 and December 31, 2006, deferred rent of $133,000 and $93,000,
respectively, was recorded under accrued expense in our consolidated financial
statements.
DERIVATIVE ACTIVITIES
WARRANT DERIVATIVES
Statement of Financial Accounting Standards ("SFAS") No. 133
"Accounting for Derivative Instruments and Hedging Activities" requires
measurement of certain derivative instruments at their fair value for accounting
purposes. In determining the appropriate fair value, we use the
Black-Scholes-Merton Option Pricing Formula ("Black-Scholes model"). Derivative
liabilities are adjusted to reflect fair value at each period end, with any
increase or decrease in the fair value being recorded in consolidated statements
of operations as adjustments to fair value of derivatives.
FOREIGN CURRENCY FORWARD CONTRACT
We source our product in a number of countries throughout the world, as
a result, are exposed to movements in foreign currency exchange rates. The
primary purpose of our foreign currency hedging activities is to manage the
volatility associated with foreign currency purchases of materials in the normal
course of business. We utilize derivative financial instruments consisting
primarily of forward currency contracts. These instruments are intended to
protect against exposure related to financing transactions and income from
international operations. We do not enter into derivative financial instruments
for speculative or trading purposes. We enter into certain foreign currency
derivative instruments that do not meet hedge accounting criteria.
SFAS No. 133 requires measurement of certain derivative instruments at
their fair value for accounting purposes. All derivative instruments are
recorded on our balance sheet at fair value; as a result, we mark to market all
derivative instruments. Derivative liabilities are adjusted to reflect fair
value at each period end, with any increase or decrease in the fair value being
recorded in consolidated statements of operations as adjustments to fair value
of derivatives. During 2006, we entered into foreign currency forward contracts
to hedge against the effect of exchange rate fluctuations on cash flows
denominated in foreign currencies and certain inter-company financing
transactions. At June 30, 2007, we had no open foreign exchange forward
contracts. Hedge ineffectiveness resulted in an impact of $196,000 in our
consolidated statements of operations in the six months of 2007.
6
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
ACCOUNTING FOR UNCERTAIN TAX POSITIONS
In June 2006, the FASB issued Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109,"
("FIN 48"). FIN 48 clarifies the accounting for uncertainty in income taxes
recognized in an enterprise's financial statements in accordance with FASB
Statement No. 109, "Accounting for Income Taxes." FIN 48 also prescribes a
recognition threshold and measurement attribute for the financial statement
recognition and measurement of a tax position taken or expected to be taken in a
tax return that results in a tax benefit. Additionally, FIN 48 provides guidance
on de-recognition, income statement classification of interest and penalties,
accounting in interim periods, disclosure, and transition. We adopted the
provisions of FIN 48 on January 1, 2007. As a result of the implementation of
FIN 48, we recognized no material adjustment for unrecognized tax benefits but
reduced retained earnings as of January 1, 2007 by approximately $1 million
attributable to penalties accrued as a component of income tax payable. As of
the date of adoption, our unrecognized tax benefits totaled approximately $8.9
million.
We and several of our subsidiaries file income tax returns in the U.S.,
Hong Kong, Luxembourg, Mexico and various state jurisdictions. We are currently
subject to Internal Revenue Service ("IRS") audit for the years including 1996
through 2002 but are not being audited for state or non-U.S. income tax
examinations for years open in those taxing jurisdictions.
In January 2004, the 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. We are
currently at the appellate level of the IRS and believe the proposed adjustments
made to our federal income tax returns for the years ended 1996 through 2002
will be resolved within the next twelve months and if so, unrecognized tax
benefits related to U.S. tax positions may decrease by up to $6.2 million by
December 31, 2007. 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 under the caption "Income Taxes". 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.
The total unrecognized tax benefits as of January 1, 2007 were $8.9
million, excluding interest, penalties and related income tax benefits and would
be recorded as a component of income tax expense if recognized. We recognize
interest accrued related to unrecognized tax benefits and penalties as a
component of income tax expense. As of January 1, 2007, the accrued interest and
penalties were $8.0 million and $1.2 million, respectively, excluding any
related income tax benefits. As of June 30, 2007, the unrecognized tax benefits
did not change from the date of adoption.
In many cases, the uncertain tax positions are related to tax years
that remain subject to examination by the relevant tax authorities. Federal and
state statutes are open from 1996 through the present period. Hong Kong statutes
are open from 2001, Luxembourg from 2003 and Mexico from 2001.
Certain 2006 amounts have been reclassified to conform to the 2007
presentation.
3. STOCK BASED COMPENSATION
Our Employee Incentive Plan, formerly the 1995 Stock Option Plan (the
"1995 Plan"), authorized the grant of both incentive and non-qualified stock
options to our officers, employees, directors and consultants for shares of our
common stock. As of June 30, 2007, there were outstanding options to purchase a
total of 1,041,000 shares of common stock granted under the 1995 Plan. No
further grants may be made under the 1995 Plan. On May 25, 2006, we adopted the
Tarrant Apparel Group 2006 Stock Incentive Plan (the "2006 Plan"), which
authorizes the issuance of up to 5,100,000 shares of our common stock pursuant
to options or awards granted under the 2006 Plan. As of June 30, 2007, there
were outstanding options to purchase a total of 1,858,000 shares of common
stock, and 3,242,000 shares remained available for issuance pursuant to award
granted under the 2006 Plan. The exercise price of options under the plan must
be equal to 100% of fair
7
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
market value of common stock on the date of grant. The 2006 Plan also permits
other types of awards, including stock appreciation rights, restricted stock and
other performance-based benefits.
On January 1, 2006, we adopted SFAS No. 123 (revised 2004),
"Share-Based Payment," ("SFAS No. 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 No. 123(R)
supersedes our previous accounting under Accounting Principles Board Opinion
("APB") No. 25, "Accounting for Stock Issued to Employees" for periods beginning
in fiscal 2006. In March 2005, the Securities and Exchange Commission issued
Staff Accounting Bulletin ("SAB") No. 107 relating to SFAS No. 123(R). We have
applied the provisions of SAB No. 107 in its adoption of SFAS No. 123(R).
We adopted SFAS No. 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 and six months ended June 30, 2007 and 2006 reflect the
impact of SFAS No. 123(R). SFAS No. 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.
A summary of our stock option activity, and related information for the
year ended December 31, 2006 and the six months ended June 30, 2007 is as
follows:
EMPLOYEES
--------------------------
NUMBER OF EXERCISE
SHARES PRICE
---------- ------------
Options outstanding at December 31, 2005 .......... 6,733,050 $1.39-$45.50
Granted ........................................... 1,233,259 $ 1.84-$1.94
Exercised ......................................... -- --
Forfeited ......................................... (19,650) $1.94-$33.13
Expired ........................................... (273,000) $ 6.75-$7.38
---------- ------------
Options outstanding at December 31, 2006 .......... 7,673,659 $1.39-$45.50
Granted ........................................... 630,000 $ 1.63-$1.99
Exercised ......................................... -- --
Forfeited ......................................... (2,000) $ 18.50
Expired ........................................... (2,000) $ 8.50
---------- ------------
Options outstanding at June 30, 2007 .............. 8,299,659 $1.39-$45.50
We had no stock option outstanding to non-employees as of December 31,
2006 and June 30, 2007.
8
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The following table summarizes information about stock options
outstanding as of December 31, 2006 and June 30, 2007:
WEIGHTED
WEIGHTED AVERAGE
AVERAGE REMAINING
NUMBER OF EXERCISE CONTRACTUAL INTRINSIC
SHARES PRICE LIFE (YEARS) VALUE
---------- -------- ------------ ---------
As of December 31, 2006
Employees - Outstanding .............. 7,673,659 $ 5.52 5.9 $ 0
Employees - Expected to vest ......... 7,579,083 $ 5.57 5.9 $ 0
Employees - Exercisable .............. 6,445,400 $ 6.22 5.3 $ 0
As of June 30, 2007:
Employees - Outstanding .............. 8,299,659 $ 5.24 5.8 $ 0
Employees - Expected to vest ......... 8,156,573 $ 5.30 5.7 $ 0
Employees - Exercisable .............. 6,684,715 $ 6.05 4.9 $ 0
The following table summarizes our non-vested options as of December
31, 2006 and changes during the six months ended June 30, 2007:
WEIGHTED
AVERAGE
NUMBER OF GRANT-DATE
NON-VESTED OPTIONS SHARES FAIR VALUE
------------------------------------------------- ------------ ------------
Non-vested at December 31, 2006 ................. 1,228,259 $ 1.26
Granted ....................................... 630,000 $ 1.28
Vested ........................................ (243,315) $ 1.25
Forfeited ..................................... -- --
------------
Non-vested at June 30, 2007 ..................... 1,614,944 $ 1.27
The following table shows the fair value of each option granted to
employees and directors estimated on the date of grant using the Black-Scholes
model with the following weighted average assumptions used for grants in the six
months ended June 30, 2007 and 2006:
SIX MONTHS ENDED JUNE 30,
-------------------------------
2007 2006
-------------- --------------
Expected dividend ........................... 0.0% 0.0%
Risk free interest rate ..................... 4.49% to 4.67% 5.13%
Expected volatility ......................... 70% 70%
Expected term (in years) .................... 5.75 to 6.18 6.25
9
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Stock-based compensation expense recognized during the period is based
on the value of the portion of share-based payment awards that is ultimately
expected to vest during the period. Stock-based compensation expense recognized
in the consolidated statements of operations for the three months and six months
ended June 30, 2007 and 2006 consisted of compensation expense for the
share-based payment awards granted subsequent to January 1, 2006 based on the
grant date fair value estimated in accordance with the provisions of SFAS No.
123(R). For stock-based payment awards issued to employees and directors,
stock-based compensation is attributed to expense using the straight-line single
option method. As stock-based compensation expense recognized in the
consolidated statements of operations for the three months and six months ended
June 30, 2007 and 2006 is based on awards ultimately expected to vest, it has
been reduced for estimated forfeitures, which we estimate to be 7.7%. SFAS No.
123(R) requires forfeitures to be estimated at the time of grant and revised, if
necessary, in subsequent periods if actual forfeitures differ from those
estimates.
Our determination of fair value of share-based payment awards to
employees and directors on the date of grant using the Black-Scholes model is
affected by our stock price as well as assumptions regarding a number of highly
complex and subjective variables. These variables include, but are not limited
to our expected stock price volatility over the term of the awards. When valuing
awards, we estimate the expected terms using the "safe harbor" provisions
provided in SAB No. 107 and the volatility using historical data. We granted
973,259 shares of stock options to purchase shares of common stock for the six
months ended June 30, 2006. The options granted were fair valued in the
aggregate at $1.2 million or the weighted-average exercise of $1.25 in the six
months ended June 30, 2006. We granted 630,000 shares of options in the six
months ended June 30, 2007. The options granted were fair valued in the
aggregate at $805,000 or the weighted-average exercise of $1.92 in the six
months ended June 30, 2007. The stock-based compensation expense related to
employees or director stock options recognized for the six months ended June 30,
2007 was $322,000, of which $93,000 was recorded under general and
administrative expenses and $229,000 was recorded under selling and distribution
expenses in our consolidated statements of operation. The stock-based
compensation expense related to employees or director stock options recognized
for the six months ended June 30, 2006 was $7,000 which was recorded under
general and administrative expenses in our consolidated statements of operation.
Basic and dilutive income per share for the three months ended June 30, 2007,
and for the three months and six months ended June 30, 2006 was not materially
affected by the additional stock-based compensation recognized. Basic and
dilutive earnings per share for the six months ended June 30, 2007 was decreased
by $0.01 from $0.00 to $(0.01) by the additional stock-based compensation
recognized.
The total intrinsic value of options exercised for the three months and
six months ended June 30, 2007 and 2006 was $0. Cash received from stock options
exercised for the three months and six months ended June 30, 2007 and 2006 was
$0. The total fair value of shares vested for the six months ended June 30, 2007
and 2006 were approximately $304,000 and $0, respectively.
As of June 30, 2007, there was $1.8 million of total unrecognized
compensation cost related to non-vested share-based compensation arrangements
granted under the plans. That cost is expected to be recognized over the
weighted-average period of 2.9 years.
When options are exercised, our policy is to issue previously unissued
shares of common stock to satisfy share option exercises. As of June 30, 2007,
we had 69.5 million shares of authorized, unissued shares of common stock.
4. ACCOUNTS RECEIVABLE
Accounts receivable consists of the following:
JUNE 30, DECEMBER 31,
2007 2006
------------ ------------
U.S. trade accounts receivable ........... $ 3,639,079 $ 2,975,840
Foreign trade accounts receivable ........ 15,694,183 16,986,357
Factored accounts receivable ............. 28,658,895 29,697,935
Other receivables ........................ 709,438 496,253
Allowance for returns, discounts
and bad debts .......................... (1,912,316) (2,076,858)
------------ ------------
$ 46,789,279 $ 48,079,527
============ ============
10
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
5. INVENTORY
Inventory consists of the following:
JUNE 30, 2007 DECEMBER 31, 2006
----------------- -----------------
Raw materials - fabric and trim accessories... $ 3,155,130 $ 3,271,610
Work in process .............................. 13,065 --
Finished goods shipments-in-transit .......... 7,311,640 7,331,422
Finished goods ............................... 7,741,576 7,171,071
----------------- -----------------
$ 18,221,411 $ 17,774,103
================= =================
6. NOTES RECEIVABLE - RELATED PARTY RESERVE
In connection with the sale in 2004 of our assets and real property in
Mexico, the purchasers of the Mexico assets, Solticio, S.A. de C.V.
("Solticio"), and Acabados y Cortes Textiles, S.A. de C.V. ("Acotex"), issued us
unsecured promissory notes of $3,910,000 that mature on November 30, 2007 and
secured promissory notes of $40,204,000 with payments due 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. The secured notes are secured by the real and personal property in Mexico
that we sold to the purchasers. As of September 30, 2006, the outstanding
balance of the notes and interest receivables was $41.1 million prior to the
reserve. Historically, we had placed orders for purchases of fabric from the
purchasers pursuant to the purchase commitment agreement we entered into at the
time of the sale of the Mexico assets, and we had satisfied our payment
obligations for the fabric by offsetting the amounts payable against the amounts
due to us under the notes. However, during the third quarter of 2006, the
purchasers ceased providing fabric and are not currently making payments under
the notes. We further evaluated the recoverability of the notes receivable and
recorded a loss on the notes receivable in the third quarter of 2006 in an
amount equal to the outstanding balance less the value of the underlying assets
securing the notes. The loss was estimated to be approximately $27.1 million,
resulting in a net notes receivable balance at September 30, 2006 of
approximately $14 million. We believe there was no significant change
subsequently on the value of the underlying assets securing the notes;
therefore, we did not have additional reserve after the third quarter of 2006.
We will continue to pursue payment of all amounts under the notes receivable and
believe the remaining $14 million balance at June 30, 2007 is realizable.
On March 21, 2007, our wholly-owned subsidiary, Tarrant Luxembourg
S.a.r.l., entered into a letter agreement with Solticio, Inmobiliaria Cuadros,
S.A. de C.V. ("Inmobiliaria"), and Acotex, (Acotex and together with Solticio
and Inmobiliaria, the "Sellers"), and Tavex Algodonera, S.A. ("Tavex"). On July
19, 2007, the parties amended the letter agreement.
Pursuant to the agreement, as amended, Tavex has the right and option
(but not an obligation), at any time on or prior to September 1, 2007, to pay to
Tarrant Luxembourg an aggregate of U.S. $17.75 million in cash, whereupon, among
other things:
o Tarrant Luxembourg will terminate the Solticio and Acotex
promissory notes described above and release the Sellers from
any further obligations thereunder, and terminate and release
all liens on the collateral securing those notes;
o Tarrant Luxembourg and the Sellers will terminate all other
executory obligations among the parties, including any
obligation of ours to purchase fabric from Soliticio and
Acotex; and
o Tarrant Luxembourg would agree to purchase from Tavex at least
U.S. $1.25 million of fabric prior to the end of 2007, and
Tarrant Luxembourg would deliver a irrevocable letter of
credit for the full purchase price.
11
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Tavex is not obligated to exercise the option and the terms and
conditions of the letter could change prior to the expiration period. During the
option period, we agreed that we would not seek to enforce the Solticio and
Acotex promissory notes, including by taking action with respect to the
collateral, nor would we enter into any agreement with a third party that would
adversely affect Tavex's rights under the agreement.
The Sellers also agreed during the option period, to work exclusively
with Tavex in respect of the payment of the Solticio and Acotex promissory notes
and the other transactions contemplated by the letter agreement, and not to
enter into any agreement with any person other than Tavex with respect to the
payment and/or assignment of the Solticio and Acotex promissory notes and the
transactions contemplated by the agreement.
7. 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 advance in monthly installments during the term of the
agreement. The royalty owed to the licensor in excess of the guaranteed minimum,
if any, is 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. If a portion of the guaranteed minimum royalty is determined not
to be recoverable, the unrecoverable portion is charged to expense at that time.
The guaranteed annual minimum royalty for 2007 is $760,000. At June 30, 2007,
the total commitment on royalties remaining on the term was $8.0 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
locations and is currently available in approximately 600 Macy's stores
nationally. The investment in American Rag CIE, LLC totaling $2.3 million at
June 30, 2007, 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 six month ended
June 30, 2007 was as follows:
Balance as of December 31, 2006 ......................... $ 2,151,061
Share of income ......................................... 126,542
Distribution ............................................ (0)
-----------
Balance as of June 30, 2007 ............................. $ 2,277,603
===========
8. OTHER ASSETS AND WRITE OFF OF ACQUISITION EXPENSES
On December 6, 2006, we entered into a definitive stock and asset
purchase agreement (the "Purchase Agreement") to acquire certain assets and
entities comprising The Buffalo Group. The Buffalo Group designs, imports and
sells contemporary branded apparel and accessories, primarily in Canada and the
United States.
Pursuant to the Purchase Agreement, we and our subsidiaries agreed to
acquire (1) all the outstanding capital stock of four principal operating
subsidiaries of The Buffalo Group - Buffalo Inc., 3163946 Canada Inc., 3681441
Canada Inc. and Buffalo Corporation, and (2) certain assets, consisting
primarily of intellectual property rights and licenses, from The Buffalo Trust,
for a total aggregate purchase price of up to approximately $120 million
consisting of:
o $40 million in cash, subject to reduction prior to closing;
o $15 million in promissory notes that are due and payable in
five equal annual installments beginning on the second
anniversary of the closing date;
12
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
o The issuance to the sellers of 13 million exchangeable shares
of our Canadian subsidiary, which shares will be exchangeable
by the holders into shares of our common stock on a 1-to-1
basis;
o The issuance by us to a trustee of shares of our Series A
Special Voting Preferred Stock that will entitle the sellers
to direct the trustee to vote a number of shares equal to the
number of exchangeable shares of our Canadian subsidiary that
remain outstanding from time to time on all matters on which
our shareholders are entitled to vote;
o Assumption of debt of the entities being acquired by us; and
o Earn-out payments of up to $12 million in the aggregate over a
four year period, contingent upon achievement by the acquired
business of specified earnings targets in years 2007 through
2010.
In addition, we agreed to make a contingent cash payment following the
fifth anniversary of the closing if the average price of our common stock does
not equal or exceed $3.076 within any 10 trading days during the five year
period following the closing of the purchase transaction.
At signing of the Purchase Agreement, we delivered $5.0 million to the
sellers as a deposit against the purchase price payable under the agreement.
On April 19, 2007, we entered into a Mutual Termination and Release
Agreement with The Buffalo Group, pursuant to which we and the other parties to
the Purchase Agreement mutually agreed to terminate the Purchase Agreement. The
parties determined that it was in the mutual best interest of each party to
terminate the proposed agreement. Under the terms of the Mutual Termination and
Release Agreement, Buffalo agreed to return to us $4,750,000 of the $5,000,000
deposit previously provided by us to The Buffalo Group pursuant to the Purchase
Agreement, and the parties have released each other from any claims arising
under or related to the Purchase Agreement. We received $4,750,000 in April
2007. The remaining portion of the deposit of $250,000 and other due diligence
fees incurred in the acquisition process were recorded as terminated acquisition
expenses in the first quarter of 2007.
9. DEBT
Short-term bank borrowings consist of the following:
JUNE 30, 2007 DECEMBER 31, 2006
----------------- -----------------
Import trade bills payable - DBS
Bank and Aurora Capital ................ $ 6,902,696 $ 5,844,887
Bank direct acceptances - DBS Bank ....... 1,939,870 3,368,054
Other Hong Kong credit facilities - DBS
Bank ..................................... 5,999,369 4,483,241
----------------- -----------------
$ 14,841,935 $ 13,696,182
================= =================
Long-term obligations consist of the following:
JUNE 30, 2007 DECEMBER 31, 2006
----------------- -----------------
Equipment financing .................... $ 23,555 $ 38,148
Credit facility - Guggenheim, net ...... 11,754,274 11,212,724
Debt facility and factoring agreement -
GMAC CF .............................. 13,314,353 19,553,755
----------------- -----------------
25,092,182 30,804,627
Less current portion ................... (13,337,908) (19,586,565)
----------------- -----------------
$ 11,754,274 $ 11,218,062
================= =================
IMPORT TRADE BILLS PAYABLE, BANK DIRECT ACCEPTANCES AND OTHER HONG KONG CREDIT
FACILITIES
Since March 2003, DBS Bank (Hong Kong) Limited ("DBS") had made
available a letter of credit facility of up to HKD 20 million (equivalent to US
$2.6 million at June 30, 2007) to our subsidiaries in Hong Kong. This was a
demand
13
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
facility and was 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. In September
2006, a tax loan for HKD 8.438 million (equivalent to US $1.1 million) was also
made available to our Hong Kong subsidiaries and bears interest at the rate
equal to the Hong Kong prime rate plus 1% and are subject to the same security.
It bore interest at 9% per annum at June 30, 2007. As of June 30, 2007, $374,000
was outstanding under this tax loan.
In June 2006, our subsidiaries in Hong Kong, Tarrant Company Limited,
Marble Limited and Trade Link Holdings Limited, entered into a new credit
facility with DBS. Under this facility, we may arrange for letters of credit and
acceptances. The maximum amount our Hong Kong subsidiaries may borrow under this
facility at any time is US $25 million. The interest rate under the letter of
credit facility is equal to the Standard Bills Rate quoted by DBS minus 0.5% if
paid in Hong Kong Dollars, which the interest rate was 8.5% per annum at June
30, 2007, or the Standard Bills Rate quoted by DBS plus 0.5% if paid in any
other currency, which the interest rate was 8.59% per annum at June 30, 2007.
This is a demand facility and is secured by a security interest in all the
assets of the Hong Kong subsidiaries; by a pledge of our office property where
our Hong Kong office is located, which is owned by Gerard Guez and Todd Kay; and
by our guarantee. The DBS facility includes customary default provisions. In
addition, we are subject to certain restrictive covenants, including that we
maintain a specified tangible net worth, and a minimum level of EBITDA at
December 31, 2006, interest coverage ratio, leverage ratio and limitations on
additional indebtedness. We are in the process of revising these covenants for
2007. As of June 30, 2007, $13.9 million was outstanding under this facility. In
addition, $7.8 million of open letters of credit were outstanding and $3.3
million was available for future borrowings as of June 30, 2007.
As of June 30, 2007, the total balance outstanding under the DBS Bank
credit facilities was $13.9 million (classified above as follows: $6.0 million
in import trade bills payable, $1.9 million in bank direct acceptances and $6.0
million in other Hong Kong credit facilities).
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 June 30, 2007, $949,000 was outstanding
under this facility (classified above under import trade bills payable) and
$704,000 of letters of credit was open under this arrangement. We pay a
commission fee of 2.25% on all letters of credits issued under this arrangement.
EQUIPMENT FINANCING
We had three equipment loans outstanding at June 30, 2007. One of these
equipment loans bore interest at 15.8% payable in installments through 2007. The
second loan bears interest at 6.15% payable in installments through 2007 and the
third loan bears interest at 4.75% payable in installments through 2008. As of
June 30, 2007, $24,000 was outstanding under these loans.
DEBT FACILITY AND FACTORING AGREEMENT - GMAC COMMERCIAL FINANCE
On October 1, 2004, we amended and restated our previously existing
credit 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 or (b) $40 million, minus in each case, any amount owed
by us to GMAC CF. 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 might borrow against inventory to the
lesser of $5 million or 50% of the value of eligible inventory. The $5 million
limit was reduced to $4 million on April 1, 2006.
14
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
On June 16, 2006, we expanded our credit facility with GMAC CF by
entering into a new Loan and Security Agreement and amending and restating our
previously existing Factoring Agreement with GMAC CF. UPS Capital Corporation is
also a lender under the Loan and Security Agreement. This is a revolving credit
facility and has a term of 3 years. The amount we may borrow under this credit
facility is determined by a percentage of eligible accounts receivable and
inventory, up to a maximum of $55 million, and includes a letter of credit
facility of up to $4 million. Interest on outstanding amount under this credit
facility is payable monthly and accrues at the rate of the "prime rate" plus
0.5%. Our obligations under the GMAC CF credit facility are secured by a lien on
substantially all our domestic assets, including a first priority lien on our
accounts receivable and inventory. This credit facility contains customary
financial covenants, including covenants that we maintain minimum levels of
EBITDA and interest coverage ratios and limitations on additional indebtedness.
This facility includes customary default provisions, and all outstanding
obligations may become immediately due and payable in the event of a default.
The facility bore interest at 8.75% per annum at June 30, 2007. As of June 30,
2007, we were in violation with the EBITDA covenant and a waiver was obtained on
August 10, 2007. A total of $13.3 million was outstanding with respect to
receivables factored under the GMAC CF facility at June 30, 2007.
CREDIT FACILITY FROM GUGGENHEIM CORPORATE FUNDING LLC AND WARRANTS
On June 16, 2006, we entered into a Credit Agreement with certain
lenders and Guggenheim Corporate Funding LLC ("Guggenheim"), as administrative
agent and collateral agent for the lenders. This credit facility provides for
borrowings of up to $65 million. This facility consists of an initial term loan
of up to $25 million, of which we borrowed $15.5 million at the initial funding,
to be used to repay certain existing indebtedness and fund general operating and
working capital needs. An additional term loan of up to $40 million will be
available under this facility to finance acquisitions acceptable to Guggenheim.
All amounts under the term loans become due and payable in December 2010.
Interest under this facility is payable monthly, with the interest rate equal to
the LIBOR rate plus an applicable margin based on our debt leverage ratio (as
defined in the credit agreement). Our obligations under the Guggenheim credit
facility are secured by a lien on substantially all of our assets and our
domestic subsidiaries, including a pledge of the equity interests of our
domestic subsidiaries and 65% of our Luxembourg subsidiary. This credit facility
contains customary financial covenants, including covenants that we maintain
minimum levels of EBITDA and interest coverage ratios and limitations on
additional indebtedness.
In connection with Guggenheim credit facility, on June 16, 2006, we
issued the lenders under this facility warrants to purchase up to an aggregate
of 3,857,143 shares of our common stock. These warrants have a term of 10 years.
These warrants are exercisable at a price of $1.88 per share with respect to 20%
of the shares, $2.00 per share with respect to 20% of the shares, $3.00 per
share with respect to 20% of the shares, $3.75 per share with respect to 20% of
the shares and $4.50 per share with respect to 20% of the shares. The exercise
prices are subject to adjustment for certain dilutive issuances pursuant to the
terms of the warrants. 357,143 shares of the warrants will not become
exercisable unless and until a specified portion of the initial term loan is
actually funded by the lenders. The warrants were evaluated under SFAS No. 133
and Emerging Issues Task Force ("EITF") No. 00-19, "Accounting for Derivative
Financial Instruments Indexed to, and Potentially Settled in, a Company's Own
Stock" and determined to be a derivative instrument due to certain registration
rights. As such, the warrants excluding the ones not exercisable were valued at
$4.9 million using the Black-Scholes model with the following assumptions:
risk-free interest rate of 5.1%; dividend yields of 0%; volatility factors of
the expected market price of our common stock of 0.70; and contractual term of
ten years. We also paid to Guggenheim 2.25% of the committed principal amount of
the loans which was $563,000 on June 16, 2006. The $563,000 fee paid to
Guggenheim is included in the deferred financing cost, and the value of the
warrants to purchase 3.5 million shares of our common stock of $4.9 million is
recorded as debt discount, both of them are amortized over the life of the loan.
For the six months ended June 30, 2007, $604,000 was amortized.
Durham Capital Corporation ("Durham") acted as our advisor in
connection with the Guggenheim credit facility. As compensation for its
services, we agreed to pay Durham a cash fee in an amount equal to 1% of the
committed principal amount of the loans under the Guggenheim credit facility. As
a result, $250,000 was paid on June 16, 2006. In addition, we issued Durham a
warrant to purchase 77,143 shares of our common stock. This warrant has a term
of 10 years and is exercisable at a price of $1.88 per share, subject to
adjustment for certain dilutive issuances. 7,143 shares of this warrant will not
become exercisable unless and until a specified portion of the initial term loan
is actually funded by the lenders. The warrants were evaluated under SFAS No.
133 and EITF 00-19 and determined to be a derivative instrument due to
15
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
certain registration rights. As such, the warrants excluding the ones not
exercisable were valued at $105,000 using the Black-Scholes model with the
following assumptions: risk-free interest rate of 5.1%; dividend yields of 0%;
volatility factors of the expected market price of our common stock of 0.70; and
contractual term of ten years. The $250,000 fee paid to Durham and the value of
the warrants to purchase 70,000 shares of our common stock of $105,000 is
included in the deferred financing cost, and is amortized over the life of the
loan. For the six months ended June 30, 2007, $39,000 was amortized.
The Guggenheim facility bore interest at 11.82% per annum at June 30,
2007. As of June 30, 2007, we were in violation with the EBITDA covenant and a
waiver was obtained on August 10, 2007. A total of $11.8 million, net of $3.7
million of debt discount, was outstanding under this facility at June 30, 2007.
As of June 30, 2006, the warrants were being accounted for as a
liability pursuant to the provisions of SFAS No. 133 and EITF No. 00-19. This
was because we granted the warrant holders certain registration rights that were
outside our control. In accordance with SFAS No. 133, the warrants were being
valued at each reporting period. Changes in fair value were recorded as
adjustment to fair value of derivative in the statements of operations. The
outstanding warrants were fair valued on June 16, 2006, the date of the
transaction, at $5.0 million and we, in accordance with SFAS No. 133, revaluated
the warrants on June 30, 2006 at the closing stock price on June 30, 2006 to
$5.2 million; as a result, an expense of $218,000 was recorded as an adjustment
to fair value of derivative in the second quarter of 2006 on our consolidated
statements of operations. On August 11, 2006, the registration rights agreement
relating to the warrants was amended to provide that if we were unable to file
or have the registration statement declared effective by the required deadlines,
we would be required to pay the warrant holders cash payments as partial
liquidated damages each month until the registration statement was filed and/or
declared effective. The liquidated damages payable by us to the warrant holders
are limited to 20% of the purchase price of the shares underlying the warrants,
which we determined to be a reasonable discount for restricted stock as compared
to registered stock. As a result of amending the registration rights relating to
the warrants on August 11, 2006, the warrants were reclassified from debt to
equity in accordance with EITF No. 00-19 in the third quarter of 2006. The
outstanding warrants were revaluated on August 11, 2006 at the closing stock
price on August 11, 2006 to $4.5 million; as a result, income of $729,000 was
recorded as an adjustment to fair value of derivative in the third quarter of
2006 on our consolidated statements of operations. As such, a net gain of
$511,000 was recognized in our statements of operations as an adjustment to fair
value of derivative in 2006.
The credit facilities with GMAC CF and Guggenheim include cross-default
clauses subject to certain conditions. An event of default under the GMAC CF
facility would constitute an event of default under the Guggenheim facility
entitling Guggenheim to demand payment in full of all outstanding amounts under
its facility. An event of default under the Guggenheim facility, under
circumstances where Guggenheim has accelerated the debt or has exercised any
other remedy available to Guggenheim which constitutes a Lien Enforcement Action
under its Intercreditor Agreement with GMAC CF, would entitle GMAC CF to demand
payment in full of all outstanding amounts under its debt facilities.
The credit facilities with GMAC CF and Guggenheim prohibit us from
paying dividends or other distributions on our common stock. In addition, the
credit facility with GMAC CF prohibits our subsidiaries that are borrowers under
the facility from paying dividends or other distributions to us, and the credit
facility with DBS prohibits our Hong Kong facilities from paying any dividends
or other distributions or advances to us. We are also restricted in making
advances to and borrowing funds from our subsidiaries under the Guggenheim
credit facility.
10. DERIVATIVES AND OTHER FINANCIAL INSTRUMENTS
We use forward currency contracts to manage risks generally associated
with foreign exchange rate. During 2006, we entered into foreign currency
forward contracts to hedge against the effect of exchange rate fluctuations on
cash flows denominated in foreign currencies and certain inter-company financing
transactions. At June 30, 2007, we had no open foreign exchange forward
contracts. Hedge ineffectiveness resulted in an impact of $196,000 in our
consolidated statements of operations in the six months of June 30, 2007.
16
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
11. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In September 2006, the FASB issued SFAS No. 157, "Fair Value
Measurements". SFAS No. 157 establishes a framework for measuring fair value in
generally accepted accounting principles, and expands disclosures about fair
value measurements. SFAS No. 157 is effective for financial statements issued
for fiscal years beginning after November 15, 2007. We are required to adopt the
provision of SFAS No. 157, as applicable, beginning in fiscal year 2008. We do
not believe the adoption of SFAS No. 157 will have a material impact on our
financial condition or results of operations.
In September 2006, the FASB issued SFAS No. 158, "Employer's Accounting
for Defined Benefit Pension and Other Postretirement Plans-an amendment of FASB
Statements No. 87, 88, 106 and 132(R)". SFAS No. 158 requires us to (a)
recognize a plan's funded status in the statement of financial position, (b)
measure a plan's assets and its obligations that determine its funded status as
of the end of the employer's fiscal year and (c) recognize changes in the funded
status of a defined postretirement plan in the year in which the changes occur
through other comprehensive income. SFAS No. 158 is effective for fiscal years
ending after December 15, 2006. The adoption of SFAS No. 158 did not have a
material impact on our results of operations and financial condition.
In September 2006, the SEC issued SAB No. 108, "Considering the Effects
of Prior Year Misstatements when Quantifying Misstatements in Current Year
Financial Statements", to address diversity in practice in quantifying financial
statement misstatements. SAB No. 108 requires the quantification of
misstatements based on their impact on both the balance sheet and the income
statement to determine materiality. The guidance provides for a one-time
cumulative effect adjustment to correct for misstatements that were not deemed
material under a company's prior approach but are material under the SAB No. 108
approach. SAB No. 108 is effective for fiscal years ending after November 15,
2006. The adoption of SAB 108 did not have a material impact on our results of
operations and financial condition.
In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option
for Financial Assets and Liabilities- Including an amendment of FASB Statement
No. 115". SFAS No. 159 permits entities to choose to measure certain financial
assets and liabilities at fair value (the "fair value option"). Unrealized gains
and losses, arising subsequent to adoption, are reported in earnings. SFAS No.
159 is effective for fiscal years beginning after November 15, 2007. We are
currently assessing the impact of SFAS No. 159 on our results of operations and
financial condition.
12. INCOME TAXES
Our effective tax rate differs from the statutory rate principally due
to the following reasons: (1) a substantial 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; and (2) 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 June 2006, the FASB issued Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109." FIN
48 clarifies the accounting for uncertainty in income taxes recognized in an
enterprise's financial statements in accordance with FASB Statement No. 109,
"Accounting for Income Taxes." FIN 48 also prescribes a recognition threshold
and measurement attribute for the financial statement recognition and
measurement of a tax position taken or expected to be taken in a tax return that
results in a tax benefit. Additionally, FIN 48 provides guidance on
de-recognition, income statement classification of interest and penalties,
accounting in interim periods, disclosure, and transition. We adopted the
provisions of FIN 48 on January 1, 2007. As a result of the implementation of
FIN 48, we recognized no material adjustment for unrecognized tax benefits but
reduced retained earnings as of January 1, 2007 by approximately $1 million
attributable to penalties accrued as a component of income tax payable. As of
the date of adoption, our unrecognized tax benefits totaled approximately $8.9
million.
We and several of our subsidiaries file income tax returns in the U.S.,
Hong Kong, Luxembourg, Mexico and various state jurisdictions. We are currently
subject to an IRS audit for the years including 1996 through 2002 but are not
being audited for state or non-U.S. income tax examinations for years open in
those taxing jurisdictions.
17
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
In January 2004, the 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. We are
currently at the appellate level of the IRS and believe the proposed adjustments
made to our federal income tax returns for the years ended 1996 through 2002
will be resolved within the next twelve months and if so, unrecognized tax
benefits related to U.S. tax positions may decrease by up to $6.2 million by
December 31, 2007. 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 under the caption "Income Taxes". 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.
The total unrecognized tax benefits as of January 1, 2007 were $8.9
million, excluding interest, penalties and related income tax benefits and would
be recorded as a component of income tax expense if recognized. We recognize
interest accrued related to unrecognized tax benefits and penalties as a
component of income tax expense. As of January 1, 2007, the accrued interest and
penalties were $8.0 million and $1.2 million, respectively, excluding any
related income tax benefits. As of June 30, 2007, the unrecognized tax benefits
did not change from the date of adoption.
In many cases, the uncertain tax positions are related to tax years
that remain subject to examination by the relevant tax authorities. Federal and
state statutes are open from 1996 through the present period. Hong Kong statutes
are open from 2001, Luxembourg from 2003 and Mexico from 2001.
13. NET INCOME (LOSS) PER SHARE
Basic and diluted income (loss) per share has been computed in
accordance with SFAS No. 128, "Earnings 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 JUNE 30, SIX MONTHS ENDED JUNE 30,
--------------------------- ----------------------------
2007 2006 2007 2006
------------ ------------ ------------ ------------
Basic EPS Computation:
Numerator .................... $ 809,264 $ 611,284 $ (191,655) $ 1,447,655
Denominator:
Weighted average common shares
outstanding .................. 30,543,763 30,543,763 30,543,763 30,378,715
------------ ------------ ------------ ------------
Basic EPS .................... $ 0.03 $ 0.02 $ (0.01) $ 0.05
============ ============ ============ ============
Diluted EPS Computation:
Numerator .................... $ 809,264 $ 611,284 $ (191,655) $ 1,447,655
Denominator:
Weighted average common share
outstanding .................. 30,543,763 30,543,763 30,543,763 30,378,715
options ...................... 112 657 -- 125
------------ ------------ ------------ ------------
Total shares ................. 30,543,875 30,544,420 30,543,763 30,378,840
------------ ------------ ------------ ------------
Diluted EPS .................. $ 0.03 $ 0.02 $ (0.01) $ 0.05
============ ============ ============ ============
Only 112 shares and 657 shares of outstanding options were included in
the computation of income per share in the three months ended June 30, 2007 and
2006, respectively, as the exercise prices of the remaining shares were greater
than the average market price for the three months ended June 30, 2007 and 2006.
Only 125 shares of outstanding options were included in the computation of
income per share in the six months ended June 30, 2006, as the exercise prices
of the remaining shares were greater than the average market price for the six
months ended June 30, 2006. All options were excluded from the computation of
net loss per share in the six months ended June 30, 2007 as the impact would be
anti-
18
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
dilutive. All warrants were excluded from the computation of net income (loss)
per share in the three months and six months ended June 30, 2007 and 2006, as
the exercise prices of the warrants were greater than the average market price
for the three months and six months ended June 30, 2007 and 2006. The following
table presents potentially dilutive securities that were not included in the
computation of income (loss) per share:
AS OF JUNE 30,
---------------------------------
2007 2006
---------- ----------
Options .......................... 8,299,659 7,694,034
Warrants ......................... 5,931,732 5,931,732
---------- ----------
Total ............................ 14,231,391 13,625,766
========== ==========
14. RELATED PARTY TRANSACTIONS
As of June 30, 2007, related party affiliates were indebted to us in
the amounts of $12.2 million. These include amounts due from Gerard Guez, our
Chairman and Interim Chief Executive Officer. From time to time in the past, we
had advanced funds to, Mr. Guez. These were net advances to Mr. Guez or payments
paid on his behalf before the enactment of the Sarbanes-Oxley Act in 2002. The
promissory note documenting these advances contains a provision that the entire
amount together with accrued interest is immediately due and payable upon our
written demand. The greatest outstanding balance of such advances to Mr. Guez in
the second quarter of 2007 was approximately $2,087,000. At June 30, 2007, the
entire balance due from Mr. Guez totaling $2.1 million has been shown as
reductions to shareholders' equity in the accompanying financial statements. All
amounts due from Mr. Guez bore interest at the rate of 7.75% during the period.
Total interest paid by Mr. Guez was $81,000 and $87,000 for the six months ended
June 30, 2007 and 2006, respectively. Mr. Guez paid expenses on our behalf of
approximately $162,000 and $132,000 for the six months ended June 30, 2007 and
2006, 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.
Azteca Production International, Inc. ("Azteca") is a corporation owned
by the brothers of Gerard Guez, our Chairman and Interim Chief Executive
Officer. We purchased $499,000 and $0 of finished goods, fabric and service from
Azteca and its affiliates in the six months ended June 30, 2007 and 2006,
respectively. Our total sales of fabric and service to Azteca in the six months
ended June 30, 2007 and 2006 were $0 and $9,000, respectively.
At June 30, 2007, Messrs. Guez and Kay beneficially owned 488,400 and
1,003,500 shares, respectively, of common stock of Tag-It Pacific, Inc.
("Tag-It"), collectively representing approximately 8.0% of Tag-It's common
stock. Tag-It is a provider of brand identity programs to manufacturers and
retailers of apparel and accessories. We purchased $140,000 and $202,000 of trim
from Tag-It in the six months ended June 30, 2007 and 2006, respectively. Our
sales of garment accessories to Tag-It were $76,000 and $0 in the six months
ended June 30, 2007 and 2006, respectively.
On September 1, 2006, our subsidiary in Hong Kong, Tarrant Company
Limited, entered into an agreement with Seven Licensing Company, LLC ("Seven
Licensing") to act as its buying agent to source apparel merchandise. Seven
Licensing is beneficially owned by Gerard Guez. Total sales to Seven Licensing
in the six months ended June 30, 2007 were $6.9 million. Net amount due from
these related parties as of June 30, 2007 and December 31, 2006 was $8.1 million
and $7.5 million, respectively.
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, with payments due 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.
As of September 30,
19
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
2006, the outstanding balance of the notes and interest receivables was $41.1
million prior to the reserve. Historically, we had placed orders for purchases
of fabric from the purchasers pursuant to the purchase commitment agreement we
entered into at the time of the sale of the Mexico assets, and we had satisfied
our payment obligations for the fabric by offsetting the amounts payable against
the amounts due to us under the notes. However, during the third quarter of
2006, the purchasers ceased providing fabric and are not currently making
payments under the notes. We further evaluated the recoverability of the notes
receivable and recorded a loss on the notes receivable in the third quarter of
2006 in an amount equal to the outstanding balance less the value of the
underlying assets securing the notes. The loss was estimated to be approximately
$27.1 million, resulting in a notes receivable balance at September 30, 2006 of
approximately $14 million. We believe there was no significant change
subsequently on the value of the underlying assets securing the notes;
therefore, we did not have additional reserve after the third quarter of 2006.
We will continue to pursue payments under the notes receivable and believe the
remaining $14 million balance at June 30, 2007 is realizable. See Note 6 of the
"Notes to Consolidated Financial Statements".
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 did not purchase fabric from Acabados y Terminados in the six
months ended June 30, 2007 and 2006. Net amount due from these parties as of
June 30, 2007 was $159,000.
We lease our executive offices and warehouse in Los Angeles, California
from GET. Additionally, we lease our office space and warehouse in Hong Kong
from Lynx International Limited. GET and Lynx International Limited are each
owned by Gerard Guez, our Chairman and Interim Chief Executive Officer, and Todd
Kay, our Vice Chairman. We paid $563,000 and $538,000 in rent in the six months
ended June 30, 2007 and 2006, respectively, for office and warehouse facilities.
On August 1, 2006, we entered into a lease agreement with GET for the Los
Angeles offices and warehouse, which lease has a term of five years with an
option to renew for an additional five year term. On February 1, 2007, we
entered into a one year lease agreement with Lynx International Limited for our
office space and warehouse in Hong Kong.
On May 1, 2006, we sublet a portion of our executive office in Los
Angeles, California and our sales office in New York to Seven Licensing Company,
LLC for a monthly payment of $25,000 on a month to month basis. Seven Licensing
is beneficially owned by Gerard Guez. We received $150,000 and $50,000 in rental
income from this sublease in the six months ended June 30, 2007 and 2006,
respectively.
At June 30, 2007, we had various employee receivables totaling $235,000
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.
15. COMMITMENTS AND CONTINGENCIES
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 advance in monthly installments during the term of the
agreement. The royalty owed to the licensor in excess of the guaranteed minimum,
if any, is 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. If a portion of the guaranteed minimum royalty is determined not
to be recoverable, the unrecoverable portion is charged to expense at that time.
At June 30, 2007, the total commitment on royalties remaining on the term was
$8.0 million.
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
20
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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. On July 19, 2005, Camuto
Consulting Group replaced J.S. Brand Management as the master licensor. 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. See
Note 17 of the "Notes to Consolidated Financial Statements". The licensor has
refused to accept payments and maintains that the agreement has been terminated.
There have been no sales of new products since the licensor started refusing to
approve products for manufacture and sale. If we are successful in the lawsuit
against the licensor, then we expect to be able to reduce or eliminate these
payment obligations as an offset to damages sustained by us. If we do not
succeed in our claims, we believe we will likely not be required to make the
entire guaranteed payments contemplated under the agreement. As a result, in
2006 and in the first six months of 2007, we did not accrue for the payments of
minimum royalty, sales royalty and advertising commitment of $3.6 million
pursuant to the agreement.
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 are no longer 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.
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 did not
purchase fabric in the six months ended June 30, 2007 and 2006.
On September 1, 2006, our subsidiary in Hong Kong, Tarrant Company
Limited, entered into an agreement with Seven Licensing Company, LLC to act as
its buying agent to source apparel merchandise. Seven Licensing is beneficially
owned by Gerard Guez. Total sales to Seven Licensing in the six months ended
June 30, 2007 were $6.9 million.
21
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
16. 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 two geographic
regions: the United States and Asia. 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 and Asia is presented below. Inter-company
revenues and assets have been eliminated to arrive at the consolidated amounts.
ADJUSTMENTS
AND
UNITED STATES ASIA ELIMINATIONS TOTAL
--------------- --------------- --------------- ---------------
THREE MONTHS ENDED JUNE 30, 2007
Sales .......................... $ 55,694,000 $ 4,407,000 $ -- $ 60,101,000
Inter-company sales ............ -- 36,579,000 (36,579,000) --
--------------- --------------- --------------- ---------------
Total revenue .................. $ 55,694,000 $ 40,986,000 $ (36,579,000) $ 60,101,000
=============== =============== =============== ===============
Income from operations ......... $ 774,000 $ 1,755,000 $ -- $ 2,529,000
=============== =============== =============== ===============
Interest income ................ $ 41,000 $ 2,000 $ -- $ 43,000
=============== =============== =============== ===============
Interest expense ............... $ 1,173,000 $ 47,000 $ -- $ 1,220,000
=============== =============== =============== ===============
Provision for depreciation
and amortization .............. $ 564,000 $ 39,000 $ -- $ 603,000
=============== =============== =============== ===============
Capital expenditures ........... $ 49,000 $ 135,000 $ -- $ 184,000
=============== =============== =============== ===============
THREE MONTHS ENDED JUNE 30, 2006
Sales .......................... $ 58,783,000 $ 300,000 $ -- $ 59,083,000
Inter-company sales ............ -- 31,573,000 (31,573,000) --
--------------- --------------- --------------- ---------------
Total revenue .................. $ 58,783,000 $ 31,873,000 $ (31,573,000) $ 59,083,000
=============== =============== =============== ===============
Income from operations ......... $ 1,462,000 $ 1,147,000 $ -- $ 2,609,000
=============== =============== =============== ===============
Interest income (1) ............ $ 480,000 $ 1,000 $ -- $ 481,000
=============== =============== =============== ===============
Interest expense ............... $ 1,876,000 $ 70,000 $ -- $ 1,946,000
=============== =============== =============== ===============
Provision for depreciation
and amortization .............. $ 1,382,000 $ 27,000 $ -- $ 1,409,000
=============== =============== =============== ===============
Capital expenditures ........... $ 23,000 $ 18,000 $ -- $ 41,000
=============== =============== =============== ===============
SIX MONTHS ENDED JUNE 30, 2007
Sales .......................... $ 107,791,000 $ 8,416,000 $ -- $ 116,207,000
Inter-company sales ............ -- 60,815,000 (60,815,000) --
--------------- --------------- --------------- ---------------
Total revenue .................. $ 107,791,000 $ 69,231,000 $ (60,815,000) $ 116,207,000
=============== =============== =============== ===============
Income from operations ......... $ 220,000 $ 2,372,000 $ -- $ 2,592,000
=============== =============== =============== ===============
Interest income ................ $ 86,000 $ 2,000 $ -- $ 88,000
=============== =============== =============== ===============
Interest expense ............... $ 2,473,000 $ 90,000 $ -- $ 2,563,000
=============== =============== =============== ===============
Provision for depreciation
and amortization .............. $ 1,126,000 $ 62,000 $ -- $ 1,188,000
=============== =============== =============== ===============
Capital expenditures ........... $ 114,000 $ 158,000 $ -- $ 272,000
=============== =============== =============== ===============
Total assets (2) ............... $ 88,543,000 $ 126,168,000 $ (110,404,000) $ 104,307,000
=============== =============== =============== ===============
SIX MONTHS ENDED JUNE 30, 2006
Sales .......................... $ 119,363,000 $ 981,000 $ -- $ 120,344,000
Inter-company sales ............ -- 60,924,000 (60,924,000) --
--------------- --------------- --------------- ---------------
Total revenue .................. $ 119,363,000 $ 61,905,000 $ (60,924,000) $ 120,344,000
=============== =============== =============== ===============
Income from operations ......... $ 1,944,000 $ 2,311,000 $ -- $ 4,255,000
=============== =============== =============== ===============
Interest income (3) ............ $ 965,000 $ 1,000 $ -- $ 966,000
=============== =============== =============== ===============
Interest expense ............... $ 3,006,000 $ 128,000 $ -- $ 3,134,000
=============== =============== =============== ===============
Provision for depreciation
and amortization .............. $ 1,728,000 $ 54,000 $ -- $ 1,782,000
=============== =============== =============== ===============
Capital expenditures ........... $ 32,000 $ 31,000 $ -- $ 63,000
=============== =============== =============== ===============
Total assets (4) ............... $ 136,573,000 $ 115,445,000 $ (106,822,000) $ 145,196,000
=============== =============== =============== ===============
(1) Interest income in the U.S. included $432,000 interest earned from the
notes receivable related to the sale of our fixed assets in Mexico of
which notes are recorded in Luxembourg.
(2) Total assets in the U.S. included $15,973,000 from Luxembourg and
$7,720,000 from Mexico.
22
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
(3) Interest income in the U.S. included $873,000 interest earned from the
notes receivable related to the sale of our fixed assets in Mexico of
which notes are recorded in Luxembourg.
(4) Total assets in the U.S. included $41,586,000 from Luxembourg and
$8,528,000 from Mexico.
17. LITIGATION
JESSICA SIMPSON & CAMUTO CONSULTING GROUP
On or about April 6, 2006, we commenced an action against the licensor
of the Jessica Simpson brands (captioned Tarrant Apparel Group v. Camuto
Consulting Group, Inc., VCJS LLC, With You, Inc. and Jessica Simpson) 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, as
well as fraud against Camuto Consulting. The complaint was amended to add
Vincent Camuto as a defendant and includes nine 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, breach of the
duty of good faith and fair dealing and fraudulent inducement against Camuto
Consulting, a claim against Vincent Camuto individually for fraudulent
inducement, and a claim against With You, Inc. and Ms. Simpson that we are an
intended third party beneficiary of the license between those defendants and
Camuto Consulting. On or about October 30, 2006, Camuto Consulting, VCJS and
Vincent Camuto served their answer to the amended complaint, which included a
counterclaim against us for breach of the sublicense agreement and alleged
damages of no less than $100 million. With You, Inc. and Jessica Simpson also
filed counterclaims against us alleging trademark infringement, unfair
competition and business practices, violation of the right of privacy and other
claims, and seeking injunctive relief and damages in an amount to be determined
but no less than $100 million plus treble and punitive damages. By Order filed
January 17, 2007, the Court granted the motion of With You, Inc. and Ms. Simpson
to discontinue all of Ms. Simpson's counterclaims, and her personal
counterclaims were dismissed with prejudice. With You, Inc.'s counterclaims
remain. Ms. Simpson and With You, Inc. appealed the trial Court's ruling denying
their motion to dismiss the claim against them. The trial Court's determination
was affirmed on appeal in a decision dated May 31, 2007. Accordingly, our claim
against With You, Inc. and Ms. Simpson remains. On or about February 27, 2007,
we served a motion seeking dismissal of two of With You, Inc.'s counterclaims.
With You, Inc. did not oppose the motion and by Order dated March 22, 2007, the
Court granted our motion, dismissing two of With You, Inc.'s counterclaims. On
July 5, 2007, the trial Court denied a motion filed in December 2006 by Camuto
Consulting, VCJS and Vincent Camuto to dismiss our claims for declaratory
judgment seeking a declaration that the sublicense is exclusive and remains in
full force and effect and those aspects of our claims that seek specific
performance. Discovery in the matter has been underway since May 2006. We intend
to continue vigorously to pursue this action and defend the counterclaims.
BAZAK INTERNATIONAL CORPORATION
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. A non-jury trial was held in the United States District Court for
the Southern District of New York beginning on November 27, 2006 and ending on
February 1, 2007. On June 12, 2007, the Court dismissed the case against us.
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.
23
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
18. SUBSEQUENT EVENTS
On July 19, 2007, our wholly-owned subsidiary, Tarrant Luxembourg
S.a.r.l. entered into an amendment to a letter agreement dated March 21, 2007,
with Solticio, S.A. de C.V., Inmobiliaria Cuadros, S.A. de C.V., and Acabados y
Cortes Textiles, S.A. de C.V., and Tavex Algodonera, S.A. Pursuant to the
original letter agreement, Tavex obtained the right and option to pay to Tarrant
Luxembourg an aggregate of U.S. $20 million in cash and promissory notes, in
full satisfaction of all indebtedness owed to Tarrant Luxembourg from the
Sellers, whereupon Tarrant Luxembourg would, among other things, release all
liens it has on certain property owned by the Sellers' in Mexico. The amendment:
(i) extended the period during which Tavex may exercise the option
from July 19, 2007 until September 1, 2007;
(ii) amended the consideration to be paid by Tavex to Tarrant
Luxembourg upon exercise of the option to U.S. $17,750,000
payable in cash concurrently upon exercise of the option; and
(iii) Amended Tarrant Luxembourg's obligation to purchase fabric
from Tavex following exercise of the option, reducing the
purchase commitment to U.S. $1,250,000 in denim fabric that
must be purchased prior to the end of fiscal 2007, and
requiring Tarrant Luxembourg to deliver an irrevocable letter
of credit for the full purchase price.
See Note 6 of the "Notes to Consolidated Financial Statements" for more
information.
24
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
The following management's discussion and analysis should be read
together with the Consolidated Financial Statements of Tarrant Apparel Group and
the "Notes to Consolidated Financial Statements" included elsewhere in this Form
10-Q. This discussion summarizes the significant factors affecting the
consolidated operating results, financial condition and liquidity and cash flows
of Tarrant Apparel Group for the quarterly periods and year to date ended June
30, 2007 and 2006. Except for historical information, the matters discussed in
this management's discussion and analysis of financial condition and results of
operations are forward looking statements that involve risks and uncertainties
and are based upon judgments concerning various factors that are beyond our
control. See "Item 1A. Risk Factors" in Part II of this Form 10-Q.
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 retailers, such as Macy's Merchandising Group, Kohl's,
New York & Co., Mervyn's, Mothers Work, Chico's, Wal-Mart, Charlotte Russe, the
Avenue, Lane Bryant, Sears, and J.C. Penney. Our products are manufactured in a
variety of woven and knit fabrications and include jeans wear, casual pants,
shorts, skirts, dresses, t-shirts, blouses, shirts and other tops and jackets.
Our private brands include American Rag CIE and Alain Weiz.
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
six months of 2007 were $96.1 million compared to $89.7 million in the first six
months of 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 six months of 2007 were $20.1 million
compared to $30.6 million in the first six months of 2006. At June 30, 2007, 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 through
2014, pursuant to which we exclusively distribute our American
Rag CIE brand through Macy's Merchandising Group's national
Department Store organization of more than 600 stores. Net
sales of American Rag CIE branded apparel totaled $19.8
million in the first six months of 2007 compared to $15.5
million in the first six months of 2006.
o ALAIN WEIZ: We have previously sold Alan Weiz apparel
exclusively to Dillard's Department Stores. Net sales of Alain
Weiz branded apparel totaled $3.2 million in the first six
months of 2006. From January 1, 2007, we may sell our licensed
brand "Alain Weiz" to specialty stores and department stores.
There were no sales in the first six months of 2007.
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 did not have any sales of Jessica
Simpson branded apparel after the first quarter of 2006 and do
not anticipate any sales unless and until we are able to
successfully resolve our dispute and retain our rights to
these brands.
25
THE BUFFALO GROUP
On December 6, 2006, we entered into a definitive stock and asset
purchase agreement to acquire certain assets and entities comprising The Buffalo
Group. The Buffalo Group designs, imports and sells contemporary branded apparel
and accessories, primarily in Canada and the United States.
Pursuant to the purchase agreement, we and our subsidiaries agreed to
acquire (1) all the outstanding capital stock of four principal operating
subsidiaries of The Buffalo Group - Buffalo Inc., 3163946 Canada Inc., 3681441
Canada Inc. and Buffalo Corporation, and (2) certain assets, consisting
primarily of intellectual property rights and licenses, from The Buffalo Trust,
for a total aggregate purchase price of up to approximately $120 million. At
signing of the purchase agreement, we delivered $5.0 million to the sellers as a
deposit against the purchase price payable under the agreement.
On April 19, 2007, we entered into a Mutual Termination and Release
Agreement with The Buffalo Group, pursuant to which we and the other parties to
the purchase agreement mutually agreed to terminate the purchase agreement. The
parties determined that it was in the mutual best interest of each party to
terminate the proposed agreement. Under the terms of the Mutual Termination and
Release Agreement, Buffalo agreed to return to us $4,750,000 of the $5,000,000
deposit previously provided by us to The Buffalo Group pursuant to the purchase
agreement, and the parties have released each other from any claims arising
under or related to the purchase agreement. We received $4,750,000 in April
2007. The remaining portion of the deposit of $250,000 and other due diligence
fees incurred in the acquisition process were recorded as terminated acquisition
expenses in the first quarter of 2007.
NOTES RECEIVABLE - RELATED PARTY RESERVE
In connection with the sale in 2004 of our assets and real property in
Mexico, the purchasers of the Mexico assets, Solticio, S.A. de C.V.
("Solticio"), and Acabados y Cortes Textiles, S.A. de C.V. ("Acotex"), issued us
unsecured promissory notes of $3,910,000 that mature on November 30, 2007 and
secured promissory notes of $40,204,000 with payments due 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. The secured notes are secured by the real and personal property in Mexico
that we sold to the purchasers. As of September 30, 2006, the outstanding
balance of the notes and interest receivables was $41.1 million prior to the
reserve. Historically, we had placed orders for purchases of fabric from the
purchasers pursuant to the purchase commitment agreement we entered into at the
time of the sale of the Mexico assets, and we had satisfied our payment
obligations for the fabric by offsetting the amounts payable against the amounts
due to us under the notes. However, during the third quarter of 2006, the
purchasers ceased providing fabric and are not currently making payments under
the notes. We further evaluated the recoverability of the notes receivable and
recorded a loss on the notes receivable in the third quarter of 2006 in an
amount equal to the outstanding balance less the value of the underlying assets
securing the notes. The loss was estimated to be approximately $27.1 million,
resulting in a net notes receivable balance at September 30, 2006 of
approximately $14 million. We believe there was no significant change
subsequently on the value of the underlying assets securing the notes;
therefore, we did not have additional reserve after the third quarter of 2006.
We will continue to pursue payment of all amounts under the notes receivable and
believe the remaining $14 million balance at June 30, 2007 is realizable.
On March 21, 2007, our wholly-owned subsidiary, Tarrant Luxembourg
S.a.r.l., entered into a letter agreement with Solticio, Inmobiliaria Cuadros,
S.A. de C.V., and Acotex, (Acotex and together with Solticio and Inmobiliaria,
the "Sellers"), and Tavex Algodonera, S.A. On July 19, 2007, the parties amended
the letter agreement.
Pursuant to the agreement, as amended, Tavex has the right and option
(but not an obligation), at any time on or prior to September 1, 2007, to pay to
Tarrant Luxembourg an aggregate of U.S. $17.75 million in cash, whereupon, among
other things:
o Tarrant Luxembourg will terminate the Solticio and Acotex
promissory notes described above and release the Sellers from
any further obligations thereunder, and terminate and release
all liens on the collateral securing those notes;
26
o Tarrant Luxembourg and the Sellers will terminate all other
executory obligations among the parties, including any
obligation of ours to purchase fabric from Solticio and
Acotex; and
o Tarrant Luxembourg would agree to purchase from Tavex at least
U.S. $1.25 million of fabric prior to the end of 2007, and
Tarrant Luxembourg would deliver a irrevocable letter of
credit for the full purchase price.
Tavex is not obligated to exercise the option and the terms and
conditions of the letter could change prior to the expiration period. During the
option period, we agreed that we would not seek to enforce the Solticio and
Acotex promissory notes, including by taking action with respect to the
collateral, nor would we enter into any agreement with a third party that would
adversely affect Tavex's rights under the agreement.
The Sellers also agreed during the option period, to work exclusively
with Tavex in respect of the payment of the Solticio and Acotex promissory notes
and the other transactions contemplated by the letter agreement, and not to
enter into any agreement with any person other than Tavex with respect to the
payment and/or assignment of the Solticio and Acotex promissory notes and the
transactions contemplated by the agreement.
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 allowance for returns, discounts
and bad debts, inventory, notes receivable - related parties reserve, valuation
of long-lived and intangible assets and goodwill, income taxes, stock options
valuation, 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, 2006.
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.
27
As of June 30, 2007, the balance in the allowance for returns,
discounts and bad debts reserves was $1.9 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 June 30, 2007, we have a goodwill balance of $8.6 million, and a
net property and equipment balance of $1.5 million.
INCOME TAXES
As part of the process of preparing our consolidated financial
statements, we are 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. We record a valuation allowance to reduce our net
deferred tax assets to the amount that is more likely than not to be realized.
We have 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 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.
In June 2006, the FASB issued Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109." FIN
48 clarifies the accounting for uncertainty in income taxes recognized in an
enterprise's financial statements in accordance with FASB Statement No. 109,
"Accounting for Income Taxes." FIN 48 also prescribes a recognition threshold
and measurement attribute for the financial statement recognition and
measurement of a tax position taken or expected to be taken in a tax return that
results in a tax
28
benefit. Additionally, FIN 48 provides guidance on de-recognition, income
statement classification of interest and penalties, accounting in interim
periods, disclosure, and transition. We adopted the provisions of FIN 48 on
January 1, 2007. As a result of the implementation of FIN 48, we recognized no
material adjustment for unrecognized tax benefits but reduced retained earnings
as of January 1, 2007 by approximately $1 million attributable to penalties
accrued as a component of income tax payable. As of the date of adoption, our
unrecognized tax benefits totaled approximately $8.9 million.
We and several of our subsidiaries file income tax returns in the U.S.,
Hong Kong, Luxembourg, Mexico and various state jurisdictions. We are currently
subject to an IRS audit for the years including 1996 through 2002 but are not
being audited for state or non-U.S. income tax examinations for years open in
those taxing jurisdictions.
In January 2004, the 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. We are
currently at the appellate level of the IRS and believe the proposed adjustments
made to our federal income tax returns for the years ended 1996 through 2002
will be resolved within the next twelve months and if so, unrecognized tax
benefits related to U.S. tax positions may decrease by up to $6.2 million by
December 31, 2007. 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 under the caption "Income Taxes". 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.
The total unrecognized tax benefits as of January 1, 2007 were $8.9
million, excluding interest, penalties and related income tax benefits and would
be recorded as a component of income tax expense if recognized. We recognize
interest accrued related to unrecognized tax benefits and penalties as a
component of income tax expense. As of January 1, 2007, the accrued interest and
penalties were $8.0 million and $1.2 million, respectively, excluding any
related income tax benefits. As of June 30, 2007, the unrecognized tax benefits
did not change from the date of adoption.
In many cases, the uncertain tax positions are related to tax years
that remain subject to examination by the relevant tax authorities. Federal and
state statutes are open from 1996 through the present period. Hong Kong statutes
are open from 2001, Luxembourg from 2003 and Mexico from 2001.
DEBT COVENANTS
Our debt agreements require certain covenants including a minimum level
of EBITDA and specified tangible net worth; and required interest coverage ratio
and leverage ratio as discussed in Note 9 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. As of June
30, 2007, we were in violation of the EBITDA covenant and waivers of the
defaults were obtained in August 2007 from our lenders.
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 11 of the "Notes to Consolidated Financial
Statements."
29
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 JUNE 30, SIX MONTHS ENDED JUNE 30,
---------------------------- -----------------------------
2007 2006 2007 2006
------------ ------------ ------------ ------------
Net sales ................................. 100.0% 100.0% 100.0% 100.0%
Cost of sales ............................. 79.1 78.6 78.6 79.1
------------ ------------ ------------ ------------
Gross profit .............................. 20.9 21.4 21.4 20.9
Selling and distribution expenses ......... 5.6 4.7 5.8 4.8
General and administration expenses ....... 10.4 11.7 11.0 11.1
Royalty expenses .......................... 0.7 0.6 0.7 1.5
Terminated acquisition expenses ........... -- -- 1.7 --
------------ ------------ ------------ ------------
Income from operations .................... 4.2 4.4 2.2 3.5
Interest expense .......................... (2.0) (3.3) (2.2) (2.6)
Interest Income ........................... 0.1 0.8 0.1 0.8
Interest in income of equity method
investee ............................... 0.0 0.1 0.1 0.1
Other income .............................. 0.1 0.2 0.1 0.1
Adjustment to fair value of derivative .... (0.0) (0.4) 0.2 (0.2)
Other expense ............................. (0.0) (0.7) (0.0) (0.3)
------------ ------------ ------------ ------------
Income before taxes ....................... 2.4 1.1 0.5 1.4
Income taxes .............................. 1.1 0.1 0.7 0.2
Minority interest in consolidated
subsidiary ............................. 0.0 0.0 0.0 0.0
------------ ------------ ------------ ------------
Net income (loss) ......................... 1.3% 1.0% (0.2)% 1.2%
============ ============ ============ ============
SECOND QUARTER 2007 COMPARED TO SECOND QUARTER 2006
Net sales increased by $1.0 million, or 1.7%, to $60.1 million in
second quarter of 2007 from $59.1 million in the second quarter of 2006. Sales
of private label in the second quarter of 2007 were $47.9 million compared to
$47.6 million in the same period of 2006. Sales of private brands in the second
quarter of 2007 were $12.2 million compared to $11.4 million in the same period
of 2006 with the increase resulting primarily from increased sales of American
Rag brand to Macy's Merchandising Group in the second quarter of 2007.
Gross profit consists of net sales less product costs, direct labor,
duty, quota, freight in, and brokerage, warehouse handling and markdown. Gross
profit decreased by $108,000 to $12.6 million in the second quarter of 2007 from
$12.7 million in the second quarter of 2006. As a percentage of net sales, gross
profit decreased from 21.4% in the second quarter of 2006 to 20.9% in the second
quarter of 2007. The decrease in gross margin in the second quarter of 2007 was
due primarily to a greater proportion of sales of lower margin products in the
current period.
Selling and distribution expenses increased by $554,000, or 19.8%, to
$3.4 million in the second quarter of 2007 from $2.8 million in the second
quarter of 2006. As a percentage of net sales, these expenses increased to 5.6%
in the second quarter of 2007 from 4.7% in the second quarter of 2006. The
increase in selling and distribution expenses was primarily due to overhead
related to a new label and increased advertising expenses during the second
quarter of 2007.
General and administrative expenses decreased by $663,000, or 9.6%, to
$6.2 million in the second quarter of 2007 from $6.9 million in the second
quarter of 2006. As a percentage of net sales, these expenses decreased to 10.4%
in the second quarter of 2007 from 11.7% in the second quarter of 2006. General
and administrative expenses in the second quarter of 2006 included $284,000 of
expenses of financing cost paid to the placement agent and the remaining value
of the warrants to placement agent and $171,000 of prepayment penalty paid to
the debenture holders as a result of the repayment of the debentures in June
2006, as compared to no such expense in second quarter of 2007.
30
Royalty and marketing allowance expenses increased by $81,000, or
22.9%, to $434,000 in the second quarter of 2007 from $353,000 in the second
quarter of 2006. The increase was primarily due to an increase in sales under
American Rag brand in the second quarter of 2007. As a percentage of net sales,
these expenses increased slightly to 0.7% in the second quarter of 2007 from
0.6% in the second quarter of 2006.
Operating income in the second quarter of 2007 was $2.5 million, or
4.2% of net sales, compared to $2.6 million, or 4.4% of net sales, in the
comparable period of 2006, because of the factors discussed above.
Interest expense decreased by $726,000, or 37.3%, to $1.2 million in
the second quarter of 2007 from $1.9 million in the second quarter of 2006. As a
percentage of net sales, this expense decreased to 2.0% in the second quarter of
2007 from 3.3% in the second quarter of 2006. The decrease in interest expense
was primarily due to expensing $711,000 in the second quarter of 2006 of debt
discount related to the intrinsic value of the conversion option of debentures
and the remaining value of the warrants issued to holders of debentures as a
result of the repayment of the debentures in June 2006, compared to no such
expenses in the second quarter of 2007. Interest income decreased by $438,000,
or 91.1%, to $43,000 in the second quarter of 2007 from $481,000 in the second
quarter of 2006. The decrease in interest income was primarily due to the
interest earned from the notes receivable related to the sale of our fixed
assets in Mexico in the second quarter of 2006, but no such income in the second
quarter of 2007.
Interest in income of equity method investee was $43,000 in the second
quarter of 2007, compared to $63,000 in the second quarter of 2006. Interest in
income of equity method investee represented our 45% share of equity interest in
the owner of the trademark "American Rag CIE" and the operator of American Rag
retail stores. Other income was $65,000 in the second quarter of 2007, compared
to $91,000 in the second quarter of 2006. Other expense was $9,000 in the second
quarter of 2007, compared to $400,000 in the second quarter of 2006.
Loss allocated to minority interest in the second quarter of 2007 was
$1,000, representing the minority partner's share of losses in PBG7. Income
allocated to minority interests in the second quarter of 2006 was $7,000.
FIRST SIX MONTHS OF 2007 COMPARED TO FIRST SIX MONTHS OF 2006
Net sales decreased by $4.1 million, or 3.4%, to $116.2 million in the
first six months of 2007 from $120.3 million in the first six months of 2006.
Sales of private label in the first six months of 2007 were $96.1 million
compared to $89.7 million in the same period of 2006, with the increase
resulting primarily from increased sales to New York & Co and Seven Licensing,
and partially offset by decreased sales to Kohl's in the first six months of
2007. Sales of private brands in the first six months of 2007 were $20.1 million
compared to $30.6 million in the same period of 2006. The decline in private
brands sales is the result of sales of Alain Weiz, Jessica Simpson and House of
Dereon brands in the first six months of 2006, compared to no such sales in the
first six months of 2007, and partially offset by an increase in sales of
American Rag brand to Macy's Merchandising Group in the first six months of
2007.
Gross profit consists of net sales less product costs, direct labor,
duty, quota, freight in, and brokerage, warehouse handling and markdown. Gross
profit decreased by $280,000 to $24.9 million in the first six months of 2007
from $25.2 million in the first six months of 2006. The decrease in gross profit
occurred primarily because of a decrease in sales. As a percentage of net sales,
gross profit increased from 20.9% in the first six months of 2006 to 21.4% in
the first six months of 2007. The increase in gross margin in the current period
is primarily attributable to the absence of sales from the lower margin House of
Dereon and Jessica Simpson brand apparel that were included in the first six
months of 2006.
Selling and distribution expenses increased by $1.1 million, or 18.6%,
to $6.8 million in the first six months of 2007 from $5.7 million in the first
six months of 2006. As a percentage of net sales, these expenses increased from
4.8% for the first six months of 2006 to 5.8% for the first six months of 2007.
The increase in selling and distribution expenses was primarily due to overhead
related to a new label and increased advertising expenses during the first six
months of 2007.
General and administrative expenses decreased by $636,000, or 4.8%, to
$12.7 million in the first six months of 2007 from $13.4 million in the first
six months of 2006. As a percentage of net sales, these expenses
31
decreased to 11.0% in the first six months of 2007 from 11.1% in the first six
months of 2006. General and administrative expenses in the first six months of
2006 included $284,000 of expenses of financing cost paid to the placement agent
and the remaining value of the warrants to placement agent and $171,000 of
prepayment penalty paid to the debenture holders as a result of the repayment of
the debentures in June 2006, as compared to no such expenses in the first six
months of 2007.
Royalty and marketing allowance expenses decreased by $1.0 million, or
56.9%, to $791,000 in the first six months of 2007 from $1.8 million in the
first six months of 2006. As a percentage of net sales, these expenses decreased
to 0.7% in the first six months of 2007 from 1.5% in the first six months of
2006 due to royalties on sales under the licensed Jessica Simpson and Alain Weiz
brands in the first six months of 2006, for which there were no such sales in
the first six months of 2007.
Terminated acquisition expenses in the first six months of 2007 were $2
million, or 1.7% of net sales, compared to no such expense in the first six
months of 2006. These expenses consisted of the non-refunded portion of a
deposit in the amount of $250,000 and other due diligence fees incurred in
connection with the proposed acquisition of The Buffalo Group, which transaction
was mutually terminated on April 19, 2007.
Operating income for the first six months of 2007 was $2.6 million, or
2.2% of net sales, compared to operating income of $4.3 million, or 3.5% of net
sales, in the comparable prior period of 2006 as a result of the factors
discussed above.
Interest expense decreased by $571,000 or 18.2%, to $2.6 million in the
first six months of 2007 from $3.1 million in the first six months of 2006. As a
percentage of net sales, interest expense decreased to 2.2% in the first six
months of 2007 from 2.6% in the first six months of 2006. The decrease was
primarily due to expensing $711,000 in the six months of 2006 of debt discount
related to the intrinsic value of the conversion option of debentures and the
remaining value of the warrants issued to holders of debentures as a result of
the repayment of the debentures in June 2006, but no such expense in the first
six months of 2007. Interest income decreased by $878,000, or 90.9%, to $88,000
in the first six months of 2007 from $966,000 in the first six months of 2006.
The decrease in interest income was primarily due to the interest earned from
the notes receivable related to the sale of our fixed assets in Mexico in the
first six months of 2006, but no such income in the first six months of 2007.
Interest in income of equity method investee was $127,000 in the first
six months of 2007, compared to $110,000 in the first six months of 2006.
Interest in income of equity method investee represented our 45% share of equity
interest in the owner of the trademark "American Rag CIE" and the operator of
American Rag retail stores. Other income was $152,000 in the first six months of
2007, compared to $124,000 in the first six months of 2006. Adjustment to fair
value of derivative was $196,000 in the first six months of 2007, compared to
$(218,000) in the first six months of 2006. Other expense was $11,000 in the
first six months of 2007, compared to $400,000 in the first six months of 2006.
Loss allocated to minority interest in the six months of 2007 was
$1,000, representing the minority partner's share of losses in PBG7. Loss
allocated to minority interest in the first six months of 2006 was $4,000.
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 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
32
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.
As of June 30, 2007, we had $964,000 in cash and cash equivalents as
noted on our consolidated balance sheet and statement of cash flows. This
represented an increase of $59,000 or 6.6% compared to a total of $905,000 as of
December 31, 2006.
Cash flows for the six months ended June 30, 2007 and 2006 were as
follows (dollars in thousands):
CASH FLOWS: 2007 2006
------- -------
Net cash provided by (used in) operating activities .... $ 1,303 $(2,401)
Net cash provided by investing activities .............. $ 3,859 $ 703
Net cash provided by (used in) financing activities .... $(5,103) $ 1,748
During the first six months of 2007, net cash provided by operating
activities was $1.3 million, as compared to net cash used in operating
activities of $2.4 million for the same period in 2006. Net cash provided by
operating activities in the first six months of 2007 resulted primarily from a
net loss of $192,000 and a decrease of accounts payable of $3.7 million offset
by depreciation and amortization expense of $1.2 million and a $2.0 million due
diligence fees expensed in connection with termination of our proposed
acquisition of The Buffalo Group.
During the first six months of 2007, net cash provided by investing
activities was $3.9 million, as compared to net cash provided by investing
activities of $703,000 for the same period in 2006. Net cash provided by
investing activities in the first six months of 2007 resulted primarily from a
return of $4.75 million of deposit offset by approximately $700,000 of due
diligence fees incurred in connection with previously proposed acquisition of
The Buffalo Group.
During the first six months of 2007, net cash used in financing
activities was $5.1 million, as compared to net cash provided by financing
activities of $1.7 million for the same period in 2006. Net cash used in
financing activities in the first six months of 2007 resulted primarily from pay
down of $6.2 million of our long-term bank borrowings offset by $1.1 million net
proceeds from our short-term bank borrowings.
33
CONTRACTUAL OBLIGATIONS AND COMMITMENTS
Following is a summary of our contractual obligations and commercial
commitments available to us as of June 30, 2007 (in millions):
PAYMENTS DUE BY PERIOD
---------------------------------------------------------
Less than Between Between After
CONTRACTUAL OBLIGATIONS Total 1 year 2-3 years 4-5 years 5 years
--------------------------------------- --------- --------- --------- --------- ---------
Long-term debt (1) .................... $ 36.3 $ 16.3 $ 3.7 $ 16.3 $ --
Operating leases ...................... 8.5 1.7 2.6 2.1 2.1
Minimum royalties (2) ................. 14.1 6.9 2.0 2.7 2.5
Purchase commitment ................... 45.4 12.9 10.0 10.0 12.5
--------- --------- --------- --------- ---------
Total Contractual Cash Obligations .... $ 104.3 $ 37.8 $ 18.3 $ 31.1 $ 17.1
(1) Includes interest on long-term debt obligations. Based on outstanding
borrowings as of June 30, 2007, 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 $7.5 million.
(2) Includes minimum royalties of $6.1 million under the agreement with the
licensor of the Jessica Simpson brands.
TOTAL AMOUNT OF COMMITMENT EXPIRATION PER PERIOD
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 .................. $ 80.0 $ 80.0 $ -- $ -- $ --
Letters of credit (within lines of
credit) ....................... $ 25.0 $ 25.0 $ -- $ -- $ --
Total commercial commitments ..... $ 80.0 $ 80.0 $ -- $ -- $ --
Since March 2003, DBS Bank (Hong Kong) Limited had made available a
letter of credit facility of up to HKD 20 million (equivalent to US $2.6 million
at June 30, 2007) to our subsidiaries in Hong Kong. This was a demand facility
and was 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. In September 2006,
a tax loan for HKD 8.438 million (equivalent to US $1.1 million) was also made
available to our Hong Kong subsidiaries and bears interest at the rate equal to
the Hong Kong prime rate plus 1% and are subject to the same security. It bore
interest at 9% per annum at June 30, 2007. As of June 30, 2007, $374,000 was
outstanding under this tax loan.
In June 2006, our subsidiaries in Hong Kong, Tarrant Company Limited,
Marble Limited and Trade Link Holdings Limited, entered into a new credit
facility with DBS. Under this facility, we may arrange for letters of credit and
acceptances. The maximum amount our Hong Kong subsidiaries may borrow under this
facility at any time is US $25 million. The interest rate under the letter of
credit facility is equal to the Standard Bills Rate quoted by DBS minus 0.5% if
paid in Hong Kong Dollars, which the interest rate was 8.5% per annum at June
30, 2007, or the Standard Bills Rate quoted by DBS plus 0.5% if paid in any
other currency, which the interest rate was 8.59% per annum at June 30, 2007.
This is a demand facility and is secured by a security interest in all the
assets of the Hong Kong subsidiaries; by a pledge of our office property where
our Hong Kong office is located, which is owned by Gerard Guez and Todd Kay; and
by our guarantee. The DBS facility includes customary default provisions. In
addition, we are subject to certain restrictive covenants, including that we
maintain a specified tangible net worth, and a minimum level of EBITDA at
December 31, 2006, interest coverage ratio, leverage ratio and limitations on
additional indebtedness. We are in the process of revising these covenants for
2007. As of June 30, 2007, $13.9 million was outstanding under this facility. In
addition, $7.8 million of open letters of credit were outstanding and $3.3
million was available for future borrowings as of June 30, 2007.
On October 1, 2004, we amended and restated our previously existing
credit facility with GMAC Commercial Finance LLC 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
34
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 or (b) $40 million, minus in each case, any amount owed by us to
GMAC CF. 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 might borrow against inventory to the lesser of $5
million or 50% of the value of eligible inventory. The $5 million limit was
reduced to $4 million on April 1, 2006.
On June 16, 2006, we expanded our credit facility with GMAC CF by
entering into a new Loan and Security Agreement and amending and restating our
previously existing Factoring Agreement with GMAC CF. UPS Capital Corporation is
also a lender under the Loan and Security Agreement. This is a revolving credit
facility and has a term of 3 years. The amount we may borrow under this credit
facility is determined by a percentage of eligible accounts receivable and
inventory, up to a maximum of $55 million, and includes a letter of credit
facility of up to $4 million. Interest on outstanding amount under this credit
facility is payable monthly and accrues at the rate of the "prime rate" plus
0.5%. Our obligations under the GMAC CF credit facility are secured by a lien on
substantially all our domestic assets, including a first priority lien on our
accounts receivable and inventory. This credit facility contains customary
financial covenants, including covenants that we maintain minimum levels of
EBITDA and interest coverage ratios and limitations on additional indebtedness.
This facility includes customary default provisions, and all outstanding
obligations may become immediately due and payable in the event of a default.
The facility bore interest at 8.75% per annum at June 30, 2007. As of June 30,
2007, we were in violation with the EBITDA covenant and a waiver was obtained on
August 10, 2007. A total of $13.3 million was outstanding with respect to
receivables factored under the GMAC CF facility at June 30, 2007.
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 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 June 16, 2006, we entered into a Credit Agreement with certain
lenders and Guggenheim Corporate Funding LLC, as administrative agent and
collateral agent for the lenders. This credit facility provides for borrowings
of up to $65 million. This facility consists of an initial term loan of up to
$25 million, of which we borrowed $15.5 million at the initial funding, to be
used to repay certain existing indebtedness and fund general operating and
working capital needs. An additional term loan of up to $40 million will be
available under this facility to finance acquisitions acceptable to Guggenheim.
All amounts under the term loans become due and payable in December 2010.
Interest under this facility is payable monthly, with the interest rate equal to
the LIBOR rate plus an applicable margin based on our debt leverage ratio (as
defined in the credit agreement). Our obligations under the Guggenheim credit
facility are secured by a lien on substantially all of our assets and our
domestic subsidiaries, including a pledge of the equity interests of our
domestic subsidiaries and 65% of our Luxembourg subsidiary. This credit facility
contains customary financial covenants, including covenants that we maintain
minimum levels of EBITDA and interest coverage ratios and limitations on
additional indebtedness.
In connection with Guggenheim credit facility, on June 16, 2006, we
issued the lenders under this facility warrants to purchase up to an aggregate
of 3,857,143 shares of our common stock. These warrants have a term of 10 years.
These warrants are exercisable at a price of $1.88 per share with respect to 20%
of the shares, $2.00 per share with respect to 20% of the shares, $3.00 per
share with respect to 20% of the shares, $3.75 per share with respect to 20% of
the shares and $4.50 per share with respect to 20% of the shares. The exercise
prices are subject to adjustment for certain dilutive issuances pursuant to the
terms of the warrants. 357,143 shares of the warrants will not become
exercisable unless and until a specified portion of the initial term loan is
actually funded by the lenders. The warrants were evaluated under SFAS No. 133
and EITF No. 00-19, "Accounting for Derivative Financial
35
Instruments Indexed to, and Potentially Settled in, a Company's Own Stock" and
determined to be a derivative instrument due to certain registration rights. As
such, the warrants excluding the ones not exercisable were valued at $4.9
million using the Black-Scholes model with the following assumptions: risk-free
interest rate of 5.1%; dividend yields of 0%; volatility factors of the expected
market price of our common stock of 0.70; and contractual term of ten years. We
also paid to Guggenheim 2.25% of the committed principal amount of the loans
which was $563,000 on June 16, 2006. The $563,000 fee paid to Guggenheim is
included in the deferred financing cost, and the value of the warrants to
purchase 3.5 million shares of our common stock of $4.9 million is recorded as
debt discount, both of them are amortized over the life of the loan. For the six
months ended June 30, 2007, $604,000 was amortized.
Durham Capital Corporation acted as our advisor in connection with the
Guggenheim credit facility. As compensation for its services, we agreed to pay
Durham a cash fee in an amount equal to 1% of the committed principal amount of
the loans under the Guggenheim credit facility. As a result, $250,000 was paid
on June 16, 2006. In addition, we issued Durham a warrant to purchase 77,143
shares of our common stock. This warrant has a term of 10 years and is
exercisable at a price of $1.88 per share, subject to adjustment for certain
dilutive issuances. 7,143 shares of this warrant will not become exercisable
unless and until a specified portion of the initial term loan is actually funded
by the lenders. The warrants were evaluated under SFAS No. 133 and EITF 00-19
and determined to be a derivative instrument due to certain registration rights.
As such, the warrants excluding the ones not exercisable were valued at $105,000
using the Black-Scholes model with the following assumptions: risk-free interest
rate of 5.1%; dividend yields of 0%; volatility factors of the expected market
price of our common stock of 0.70; and contractual term of ten years. The
$250,000 fee paid to Durham and the value of the warrants to purchase 70,000
shares of our common stock of $105,000 is included in the deferred financing
cost, and is amortized over the life of the loan. For the six months ended June
30, 2007, $39,000 was amortized.
The Guggenheim facility bore interest at 11.82% per annum at June 30,
2007. As of June 30, 2007, we were in violation with the EBITDA covenant and a
waiver was obtained on August 10, 2007. A total of $11.8 million, net of $3.7
million of debt discount, was outstanding under this facility at June 30, 2007.
The credit facilities with GMAC CF and Guggenheim include cross-default
clauses subject to certain conditions. An event of default under the GMAC CF
facility would constitute an event of default under the Guggenheim facility
entitling Guggenheim to demand payment in full of all outstanding amounts under
its facility. An event of default under the Guggenheim facility, under
circumstances where Guggenheim has accelerated the debt or has exercised any
other remedy available to Guggenheim which constitutes a Lien Enforcement Action
under its Intercreditor Agreement with GMAC CF, would entitle GMAC CF to demand
payment in full of all outstanding amounts under its debt facilities.
The credit facilities with GMAC CF and Guggenheim prohibit us from
paying dividends or other distributions on our common stock. In addition, the
credit facility with GMAC CF prohibits our subsidiaries that are borrowers under
the facility from paying dividends or other distributions to us, and the credit
facility with DBS prohibits our Hong Kong facilities from paying any dividends
or other distributions or advances to us. We are also restricted in making
advances to and borrowing funds from our subsidiaries under the Guggenheim
credit facility.
We had three equipment loans outstanding at June 30, 2007. One of these
equipment loans bore interest at 15.8% payable in installments through 2007. The
second loan bears interest at 6.15% payable in installments through 2007 and the
third loan bears interest at 4.75% payable in installments through 2008. As of
June 30, 2007, $24,000 was outstanding under the three 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 June 30, 2007, $949,000 was outstanding
under this facility and $704,000 of letters of credit was open under this
arrangement. We pay a commission fee of 2.25% on all letters of credits issued
under this arrangement.
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 securities. 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.
36
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.
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. In addition, in July 2004, the IRS initiated an
examination of our Federal income tax return for the year ended December 31,
2002. We are currently at the appellate level of the IRS and believe the
proposed adjustments made to our federal income tax returns for the years ended
1996 through 2002 will be resolved within the next twelve months and if so,
unrecognized tax benefits related to U.S. tax positions may decrease by up to
$6.2 million by December 31, 2007. 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 under the caption "Income Taxes". 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.
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 and warehouse in Los Angeles, California
from GET. Additionally, we leased office space and warehouse in Hong Kong from
Lynx International Limited. GET and Lynx International Limited are each owned by
Gerard Guez, our Chairman and Interim Chief Executive Officer, and Todd Kay, our
Vice Chairman. We believe, at the time the leases were entered into, the rents
on these properties were comparable to then prevailing market rents. We paid
$563,000 and $538,000 in rent in the six months ended June 30, 2007 and 2006,
respectively, for office and warehouse facilities. On August 1, 2006, we entered
into a lease agreement with GET for the Los Angeles offices and warehouse, which
lease has a term of five years with an option to renew for an additional five
year term. On February 1, 2007, we entered into a one year lease agreement with
Lynx International Limited for our office space and warehouse in Hong Kong.
On May 1, 2006, we sublet a portion of our executive office in Los
Angeles, California and our sales office in New York to Seven Licensing Company,
LLC for a monthly payment of $25,000 on a month to month basis. Seven Licensing
is beneficially owned by Gerard Guez. We received $150,000 and $50,000 in rental
income from this sublease in the six months ended June 30, 2007 and 2006,
respectively.
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, with payments due 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.
As of September 30, 2006, the outstanding balance of the notes and interest
receivables was $41.1 million prior to the reserve. Historically, we had placed
orders for purchases of fabric from the purchasers pursuant to the purchase
commitment agreement we entered into at the time of the sale of the Mexico
assets, and we had satisfied our payment obligations for the fabric by
offsetting the amounts payable against the amounts due to us under the notes.
However, during the third quarter of 2006, the purchasers ceased providing
fabric and are not currently making payments under the notes. We further
evaluated the recoverability of the notes receivable and recorded a loss on the
notes receivable in the third quarter of 2006 in an amount equal to the
outstanding balance less the value of the underlying assets securing the notes.
The loss was estimated to be approximately $27.1 million,
37
resulting in a notes receivable balance at September 30, 2006 of approximately
$14 million. We believe there was no significant change subsequently on the
value of the underlying assets securing the notes; therefore, we did not have
additional reserve after the third quarter of 2006. We will continue to pursue
payments under the notes receivable and believe the remaining $14 million
balance at June 30, 2007 is realizable. 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 did not purchase fabric from
Acabados y Terminados in the six months ended June 30, 2007 and 2006. Net amount
due from these parties as of June 30, 2007 was $159,000. See Note 6 of the
"Notes to Consolidated Financial Statements".
From time to time in the past, we had advanced funds to Mr. Guez. These
were net advances to Mr. Guez or payments paid on his behalf before the
enactment of the Sarbanes-Oxley Act in 2002. The promissory note documenting
these advances contains a provision that the entire amount together with accrued
interest is immediately due and payable upon our written demand. The greatest
outstanding balance of such advances to Mr. Guez in the second quarter of 2007
was approximately $2,087,000. At June 30, 2007, the entire balance due from Mr.
Guez totaling $2.1 million is payable on demand and has been shown as reductions
to shareholders' equity in the accompanying financial statements. All amounts
due from Mr. Guez bore interest at the rate of 7.75% during the period. Total
interest paid by Mr. Guez was $81,000 and $87,000 for the six months ended June
30, 2007 and 2006, respectively. Mr. Guez paid expenses on our behalf of
approximately $162,000 and $132,000 for the six months ended June 30, 2007 and
2006, 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.
Azteca Production International, Inc. is a corporation owned by the
brothers of Gerard Guez, our Chairman and Interim Chief Executive Officer. We
purchased $499,000 and $0 of finished goods, fabric and service from Azteca and
its affiliates in the six months ended June 30, 2007 and 2006, respectively. Our
total sales of fabric and service to Azteca in the six months ended June 30,
2007 and 2006 were $0 and $9,000, respectively.
On September 1, 2006, our subsidiary in Hong Kong, Tarrant Company
Limited, entered into an agreement with Seven Licensing Company, LLC to act as
its buying agent to source apparel merchandise. Seven Licensing is beneficially
owned by Gerard Guez. Total sales to Seven Licensing in the six months ended
June 30, 2007 were $6.9 million. Net amount due from these related parties as of
June 30, 2007 and December 31, 2006 was $8.1 million and $7.5 million,
respectively.
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.
38
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. At June 30, 2007, we had no
open foreign exchange forward contracts. 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, 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. As of June 30, 2007, we had $973,000 of fixed-rate borrowings and $42.7
million of variable-rate borrowings outstanding. A one percentage point increase
in interest rates would result in an annualized increase to interest expense of
approximately $0.4 million on our variable-rate borrowings.
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 June 30, 2007, 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
second quarter of 2007 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
During the second quarter ended June 30, 2007, there were no changes in
our internal control over financial accounting that has materially affected, or
is reasonably likely to materially affect, our internal control over financial
reporting.
SARBANES-OXLEY ACT OF 2002 SECTION 404 COMPLIANCE
In 2003, we began our efforts to comply with Section 404 of the
Sarbanes-Oxley Act of 2002 ("SOX 404"), which requires detailed review,
documentation and testing of our internal controls over financial reporting.
This detailed review, documentation and testing includes an assessment of the
risks that could adversely affect the timely and accurate preparation of our
financial statements and the identification of internal controls that are
currently in place to mitigate the risks of untimely or inaccurate preparation
of these financial statements. We will be required to include a report on
management's assessment of internal controls over financial reporting in our
annual report on Form 10-K for the fiscal year ended December 31, 2007.
At the end of 2008, our independent registered public accountants will
be required to audit management's assessment. We are in the process of
performing the system and process documentation, evaluation and testing required
for management to make this assessment and for its independent registered public
accountants to provide their attestation report. We have not completed this
process or its assessment, and this process will require significant amounts of
management time and resources. In the course of evaluation and testing,
management may identify deficiencies that will need to be addressed and
remediated. We have invested significant internal resources and time in the SOX
404 compliance process, and we believe that we are on schedule to comply with
SOX 404.
39
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 (captioned Tarrant Apparel Group v. Camuto
Consulting Group, Inc., VCJS LLC, With You, Inc. and Jessica Simpson) 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, as
well as fraud against Camuto Consulting. The complaint was amended to add
Vincent Camuto as a defendant and includes nine 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, breach of the
duty of good faith and fair dealing and fraudulent inducement against Camuto
Consulting, a claim against Vincent Camuto individually for fraudulent
inducement, and a claim against With You, Inc. and Ms. Simpson that we are an
intended third party beneficiary of the license between those defendants and
Camuto Consulting. On or about October 30, 2006, Camuto Consulting, VCJS and
Vincent Camuto served their answer to the amended complaint, which included a
counterclaim against us for breach of the sublicense agreement and alleged
damages of no less than $100 million. With You, Inc. and Jessica Simpson also
filed counterclaims against us alleging trademark infringement, unfair
competition and business practices, violation of the right of privacy and other
claims, and seeking injunctive relief and damages in an amount to be determined
but no less than $100 million plus treble and punitive damages. By Order filed
January 17, 2007, the Court granted the motion of With You, Inc. and Ms. Simpson
to discontinue all of Ms. Simpson's counterclaims, and her personal
counterclaims were dismissed with prejudice. With You, Inc.'s counterclaims
remain. Ms. Simpson and With You, Inc. appealed the trial Court's ruling denying
their motion to dismiss the claim against them. The trial Court's determination
was affirmed on appeal in a decision dated May 31, 2007. Accordingly, our claim
against With You, Inc. and Ms. Simpson remains. On or about February 27, 2007,
we served a motion seeking dismissal of two of With You, Inc.'s counterclaims.
With You, Inc. did not oppose the motion and by Order dated March 22, 2007, the
Court granted our motion, dismissing two of With You, Inc.'s counterclaims. On
July 5, 2007, the trial Court denied a motion filed in December 2006 by Camuto
Consulting, VCJS and Vincent Camuto to dismiss our claims for declaratory
judgment seeking a declaration that the sublicense is exclusive and remains in
full force and effect and those aspects of our claims that seek specific
performance. Discovery in the matter has been underway since May 2006. We intend
to continue vigorously to pursue this action and defend the counterclaims.
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.
Three customers accounted for approximately 45% of our net sales in
first six months of 2007. 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 except for Macy's Merchandising Group for
American Rag CIE. 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
40
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.
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 pursue 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
41
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.
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. In 2006, quota was
temporarily reinstated for China until 2008 for certain import merchandise
categories. Such disruptions and the temporary measures may continue to affect
us to some extent in the future.
42
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.
We have implemented 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 BUSINESS IS SUBJECT TO RISKS OF OPERATING IN A FOREIGN COUNTRY AND TRADE
RESTRICTIONS.
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;
43
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
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 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. We are currently at the appellate level of the IRS and believe the
proposed adjustments made to our federal income tax returns for the years ended
1996 through 2002 will be resolved within the next twelve months and if so,
unrecognized tax benefits related to U.S. tax positions may decrease by up to
$6.2 million by December 31, 2007. 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 under the caption "Income Taxes". 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.
THE REQUIREMENTS OF THE SARBANES-OXLEY ACT, INCLUDING SECTION 404, ARE
BURDENSOME, AND OUR FAILURE TO COMPLY WITH THEM COULD HAVE A MATERIAL ADVERSE
AFFECT ON OUR BUSINESS AND STOCK PRICE.
Effective internal control over financial reporting is necessary for us
to provide reliable financial reports and effectively prevent fraud. Section 404
of the Sarbanes-Oxley Act of 2002 requires us to evaluate and report on our
internal control over financial reporting beginning with our annual report on
Form 10-K for the fiscal year ending December 31, 2007. Our independent
registered public accounting firm will need to annually attest to our
evaluation, and issue their own opinion on our internal control over financial
reporting beginning with our annual report on Form 10-K for the fiscal year
ending December 31, 2008. We are preparing for compliance with Section 404 by
strengthening, assessing and testing our system of internal control over
financial reporting to provide the basis for our report. The process of
strengthening our internal control over financial reporting and complying with
Section 404 is expensive and time consuming, and requires significant management
attention. We cannot be certain that the measures we will undertake will ensure
that we will maintain adequate controls over our financial processes and
reporting in the future. Failure to implement required controls, or difficulties
encountered in their implementation, could harm our operating results or cause
us to fail to meet our reporting
44
obligations. If we or our auditors discover a material weakness in our internal
control over financial reporting, the disclosure of that fact, even if the
weakness is quickly remedied, could diminish investors' confidence in our
financial statements and harm our stock price. In addition, non-compliance with
Section 404 could subject us to a variety of administrative sanctions, including
the suspension of trading, ineligibility for listing on NASDAQ or one of the
national securities exchanges, and the inability of registered broker-dealers to
make a market in our common stock, which would further reduce our stock price.
INSIDERS OWN A SIGNIFICANT PORTION OF OUR COMMON STOCK, WHICH COULD LIMIT OUR
SHAREHOLDERS' ABILITY TO INFLUENCE THE OUTCOME OF KEY TRANSACTIONS.
As of August 10, 2007, our executive officers and directors and their
affiliates owned approximately 43% of our common stock. Gerard Guez, our
Chairman and Interim Chief Executive Officer, and Todd Kay, our Vice Chairman,
alone own approximately 33% and 8%, respectively, of our common stock at August
10, 2007. 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
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 Global Market, 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.
45
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
------- --------------------------------------------------------------
2.1.2 Mutual Termination and Release Agreement, dated April 19,
2007, by and among Tarrant Apparel Group, 4366883 Canada Inc.,
3681441 Canada Inc., Buffalo Inc., 3163946 Canada Inc.,
Buffalo Corporation, BFL Management Inc. in its capacity as
the sole trustee of The Buffalo Trust and each stockholder of
Target Companies. (Incorporated by reference to Exhibit 2.1 to
the Company's Current Report on Form 8-K filed on April 20,
2007.)
10.19.2 Amendment No. 2 to Loan and Security Agreement, dated May 9,
2007, by and among GMAC Commercial Finance LLC, the Lenders
signatory thereto, Tarrant Apparel Group, Fashion Resource
(TCL), Inc., Tag Mex, Inc., and Private Brands, Inc.
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: August 13, 2007 By: /s/ David Burke
-------------------------------
David Burke,
Chief Financial Officer
Date: August 13, 2007 By: /s/ Gerard Guez
-------------------------------
Gerard Guez,
Interim Chief Executive Officer
48