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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 SEPTEMBER 30, 2006
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934.
FOR THE TRANSITION PERIOD FROM _____________ TO
COMMISSION FILE NUMBER: 0-26006
----------
TARRANT APPAREL GROUP
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
CALIFORNIA 95-4181026
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)
3151 EAST WASHINGTON BOULEVARD
LOS ANGELES, CALIFORNIA 90023
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (323) 780-8250
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer or a non-accelerated filer. See definition of
"accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange
Act. Large accelerated filer [ ] Accelerated filer [ ] Non-accelerated filer [X]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Act). Yes [_] No [X]
Number of shares of Common Stock of the Registrant outstanding as of November
10, 2006: 30,543,763.
--------------------------------------------------------------------------------
TARRANT APPAREL GROUP
FORM 10-Q
INDEX
PART I. FINANCIAL INFORMATION
PAGE
----
Item 1. Financial Statements
Consolidated Balance Sheets at September 30, 2006 (unaudited)
and December 31, 2005............................................. 2
Consolidated Statements of Operations for the Three Months
and Nine Months Ended September 30, 2006 and September 30, 2005
(unaudited)....................................................... 3
Consolidated Statements of Cash Flows for the Nine Months
Ended September 30, 2006 and September 30, 2005 (unaudited)....... 4
Notes to Consolidated Financial Statements (unaudited)............ 5
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations ........................................ 24
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.......................................................... 46
SIGNATURES........................................................ 47
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
SEPTEMBER 30, DECEMBER 31,
2006 2005
------------- -------------
(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents ................................ $ 976,481 $ 1,641,768
Accounts receivable, net ................................. 46,175,909 54,598,443
Due from related parties ................................. 3,918,287 3,100,928
Inventory ................................................ 20,455,702 31,628,960
Temporary quota rights ................................... 111,207 --
Current portion of notes receivable -- related parties ... -- 5,139,387
Prepaid expenses ......................................... 1,219,895 1,292,441
Prepaid royalties ........................................ -- 1,123,531
Income taxes receivable .................................. 25,468 25,468
------------- -------------
Total current assets ....................................... 72,882,949 98,550,926
Property and equipment, net of $11.0 million and $10.8
million accumulated depreciation at September 30, 2006
and December 31, 2005, respectively ................... 1,477,101 1,702,840
Notes receivable - related parties, net of current
portion, and net of $27.1 million reserve at
September 30, 2006 .................................... 14,000,000 36,268,446
Due from related parties ................................. 2,213,416 2,994,945
Equity method investment ................................. 2,174,380 2,138,865
Deferred financing cost, net of $1.5 million and $711,250
accumulated amortization at September 30, 2006 and
December 31, 2005, respectively ....................... 2,654,952 838,786
Other assets ............................................. 507,379 164,564
Goodwill ................................................. 8,582,845 8,582,845
------------- -------------
Total assets ............................................... $ 104,493,022 $ 151,242,217
============= =============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Short-term bank borrowings ............................... $ 12,534,937 $ 13,833,532
Accounts payable ......................................... 18,195,022 33,278,959
Accrued expenses ......................................... 9,777,354 9,503,806
Income taxes ............................................. 17,035,409 16,828,538
Current portion of long-term obligations and factoring
arrangement ........................................... 19,769,030 36,109,699
------------- -------------
Total current liabilities .................................. 77,311,752 109,554,534
Term loan, net .............................................. 10,941,948 --
Other long-term obligations ................................. 26,380 239,935
Convertible debentures, net ................................. -- 5,965,098
Deferred tax liabilities .................................... 39,025 47,098
------------- -------------
Total liabilities .......................................... 88,319,105 115,806,665
Minority interest in consolidated subsidiary ................ 57,469 75,241
Commitment and Contingencies
Shareholders' equity:
Preferred stock, 2,000,000 shares authorized; no shares
at September 30, 2006 and December 31, 2005 issued
and outstanding ....................................... -- --
Common stock, no par value, 100,000,000 shares authorized;
30,543,763 shares at September 30, 2006 and 30,553,763
shares at December 31, 2005 issued and outstanding .... 114,977,465 114,977,465
Warrants to purchase common stock ........................ 7,314,239 2,846,833
Contributed capital ...................................... 10,101,151 10,004,331
Accumulated deficit ...................................... (114,094,373) (90,189,615)
Notes receivable from officer/shareholder ................ (2,182,034) (2,278,703)
------------- -------------
Total shareholders' equity ................................. 16,116,448 35,360,311
------------- -------------
Total liabilities and shareholders' equity ................. $ 104,493,022 $ 151,242,217
============= =============
The accompanying notes are an integral part of these consolidated financial
statements
2
TARRANT APPAREL GROUP
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------------ ------------------------------
2006 2005 2006 2005
------------- ------------- ------------- -------------
Net sales .................................. $ 54,645,223 $ 69,566,080 $ 174,989,008 $ 164,934,075
Cost of sales .............................. 42,844,174 55,020,926 138,006,628 129,988,823
------------- ------------- ------------- -------------
Gross profit ............................... 11,801,049 14,545,154 36,982,380 34,945,252
Selling and distribution expenses .......... 2,568,038 2,846,445 8,295,815 7,812,476
General and administrative expenses ........ 6,551,393 7,398,722 19,914,629 20,270,148
Royalty expenses ........................... 263,583 1,288,634 2,099,392 2,181,325
Loss on notes receivable - related parties . 27,137,297 -- 27,137,297 --
------------- ------------- ------------- -------------
Income (loss) from operations .............. (24,719,262) 3,011,353 (20,464,753) 4,681,303
Interest expense ........................... (1,562,426) (1,301,271) (4,696,279) (3,400,081)
Interest income ............................ 165,399 505,913 1,131,601 1,575,727
Interest in income (loss) of equity method
investee ................................ (7,307) 129,587 103,015 475,947
Other income ............................... 109,093 38,589 233,466 277,947
Adjustment to fair value of derivative ..... 729,394 -- 511,087 --
Other expense .............................. -- (228) (400,000) (559)
Minority interest in consolidated subsidiary 13,641 (163,576) 17,772 (163,576)
------------- ------------- ------------- -------------
Income (loss) before provision for income
taxes ................................... (25,271,468) 2,220,367 (23,564,091) 3,446,708
Provision for income taxes ................. 80,946 517,950 340,667 979,272
------------- ------------- ------------- -------------
Net income (loss) .......................... $ (25,352,414) $ 1,702,417 $ (23,904,758) $ 2,467,436
============= ============= ============= =============
Net income (loss) per share:
Basic ................................... $ (0.83) $ 0.06 $ (0.78) $ 0.08
============= ============= ============= =============
Diluted ................................. $ (0.83) $ 0.06 $ (0.78) $ 0.08
============= ============= ============= =============
Weighted average common and common
equivalent shares:
Basic ................................... 30,543,763 30,365,502 30,546,217 29,451,054
============= ============= ============= =============
Diluted ................................. 30,543,763 30,785,797 30,546,217 29,517,251
============= ============= ============= =============
The accompanying notes are an integral part of these consolidated financial
statements
3
TARRANT APPAREL GROUP
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
NINE MONTHS ENDED SEPTEMBER 30,
------------------------------
2006 2005
------------- -------------
Operating activities:
Net income (loss) ......................................... $ (23,904,758) $ 2,467,436
Adjustments to reconcile net income to net cash provided by
(used in) operating activities:
Deferred taxes ......................................... (8,073) (61,551)
Depreciation and amortization .......................... 2,383,897 1,738,937
Adjustment to fair value of derivative ................. (511,087) --
Loss on notes receivable - related parties ............. 27,137,297 --
Compensation expense related to stock option ........... -- 38,740
Provision for returns and discounts .................... 318,208 372,805
Gain on sale of fixed assets ........................... (2,054) (113,968)
Interest in income of equity method investee ........... (103,015) (475,947)
Minority interest in consolidated subsidiary ........... (17,772) 163,577
Stock-based compensation ............................... 96,820 --
Changes in operating assets and liabilities:
Accounts receivable .................................. 7,288,752 (27,473,378)
Due to/from related parties .......................... (35,830) 1,982,152
Inventory ............................................ 11,173,258 (6,819,037)
Temporary quota rights ............................... (111,207) --
Prepaid expenses ..................................... 1,196,077 54,471
Accounts payable ..................................... (15,083,937) 3,634,123
Accrued expenses and income tax payable .............. 480,420 1,689,190
------------- -------------
Net cash provided by (used in) operating activities .. 10,296,996 (22,802,450)
Investing activities:
Purchase of fixed assets ............................... (130,177) (452,930)
Proceeds from sale of fixed assets ..................... 4,707 119,506
Distribution from equity method investee ............... 67,500 216,000
Collection on notes receivable, related parties ........ 1,086,111 977,500
Collection of advances from shareholders/officers ...... 96,669 2,456,334
------------- -------------
Net cash provided by investing activities ............ 1,124,810 3,316,410
Financing activities:
Short-term bank borrowings, net ........................ (1,298,595) (2,536,215)
Proceeds from long-term obligations .................... 183,669,591 167,099,510
Payment of financing costs ............................. (2,821,647) --
Repayments of borrowings from convertible debentures ... (6,912,626) --
Payment of long-term obligations and bank borrowings ... (184,723,816) (144,655,258)
------------- -------------
Net cash (used in) provided by financing activities .. (12,087,093) 19,908,037
------------- -------------
Increase (decrease) in cash and cash equivalents .......... (665,287) 421,997
Cash and cash equivalents at beginning of period .......... 1,641,768 1,214,944
------------- -------------
Cash and cash equivalents at end of period ................ $ 976,481 $ 1,636,941
============= =============
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
September 30, 2006, we own 50.1% of United Apparel Ventures ("UAV") and 75% of
PBG7, LLC ("PBG7"). We consolidate these entities and reflect the minority
interests in earnings (losses) of the ventures in the accompanying financial
statements. All inter-company amounts are eliminated in consolidation. The 49.9%
minority interest in UAV is owned by Azteca Production International, a
corporation owned by the brothers of our Chairman and Interim Chief Executive
Officer, Gerard Guez. The 25% minority interest in PBG7 is owned by BH7, LLC, an
unrelated party.
We serve specialty retail, mass merchandise and department store chains
and major international brands by designing, merchandising, contracting for the
manufacture of, and selling casual apparel for women, men and children under
private label. Commencing in 1999, we expanded our operations from sourcing
apparel to sourcing and operating our own vertically integrated manufacturing
facilities. In August 2003, we determined to abandon our strategy of being both
a trading and vertically integrated manufacturing company, and effective
September 1, 2003, we leased and outsourced operation of our manufacturing
facilities in Mexico to affiliates of Mr. Kamel Nacif, a shareholder at the time
of the transaction. In August 2004, we entered into a purchase and sale
agreement to sell these facilities to affiliates of Mr. Nacif, which transaction
was consummated in the fourth quarter of 2004. See Note 14 of the "Notes to
Consolidated Financial Statements".
Historically, our operating results have been subject to seasonal
trends when measured on a quarterly basis. This trend is dependent on numerous
factors, including the markets in which we operate, holiday seasons, consumer
demand, climate, economic conditions and numerous other factors beyond our
control. Generally, the second and third quarters are stronger than the first
and fourth quarters. There can be no assurance that the historic operating
patterns will continue in future periods.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accompanying unaudited financial statements have been prepared in
accordance with accounting principles generally accepted in the United States of
America ("US GAAP") for interim financial information and with the instructions
to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include
all of the information and footnotes required by US GAAP for complete financial
statements. In the opinion of management, all adjustments (consisting of normal
recurring accruals) considered necessary for a fair presentation of the results
of operations for the periods presented have been included.
The consolidated financial data at December 31, 2005 is derived from
audited financial statements which are included in our Annual Report on Form
10-K for the year ended December 31, 2005, and should be read in conjunction
with the audited financial statements and notes thereto. Interim results are not
necessarily indicative of results for the full year.
The accompanying unaudited consolidated financial statements include
all majority-owned subsidiaries in which we exercise control. Investments in
which we exercise significant influence, but which we do not control, are
accounted for under the equity method of accounting. The equity method of
accounting is used when we have a 20% to 50% interest in other entities, except
for variable interest entities for which we are considered the primary
beneficiary under Financial Accounting Standards Board ("FASB") Interpretation
No. 46, "Consolidation of Variable Interest Entities," an interpretation of ARB
No. 51. Under the equity method, original investments are recorded at cost and
adjusted by our share of undistributed earnings or losses of these entities. All
significant inter-company transactions and balances have been eliminated from
the consolidated financial statements.
5
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
The preparation of financial statements in conformity with US GAAP
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Significant estimates used by
us in preparation of the consolidated financial statements include: (i)
allowance for returns, discounts and bad debts, (ii) inventory, (iii) notes
receivable - related parties reserve, (iv) valuation of long lived and
intangible assets and goodwill, (v) income taxes, and (vi) stock options
valuation. Actual results could differ from those estimates.
ROYALTY EXPENSES
Royalty expenses consist of the royalty payments and marketing fund
commitments according to the various licensing agreements we have entered into.
Royalty expenses are calculated based on certain percentage of net sales. Some
of these agreements include minimum royalties. See Note 15 of the "Notes to
Consolidated Financial Statements" regarding various agreements we have entered
into.
DEFERRED RENT PROVISION
When a lease requires fixed escalation of the minimum lease payments,
rental expense is recognized on a straight line basis over the initial term of
the lease, and the difference between the average rental amount charged to
expense and amounts payable under the lease is included in deferred amount. As
of September 30, 2006, deferred rent of $71,000 was recorded under accrued
expense in our consolidated financial statements.
VALUATION OF DERIVATIVE INSTRUMENTS
Statements 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 (the "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.
STOCK-BASED COMPENSATION
On January 1, 2006, we adopted Statements of Financial Accounting
Standards (SFAS) No. 123 (revised 2004), "Share-Based Payment," ("SFAS 123(R)")
which requires the measurement and recognition of compensation expense for all
share-based payment awards made to employees and directors based on estimated
fair values. SFAS 123(R) supersedes our previous accounting under Accounting
Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to
Employees" ("APB 25") for periods beginning in fiscal 2006. In March 2005, the
Securities and Exchange Commission issued Staff Accounting Bulletin (SAB) No.
107 ("SAB 107") relating to SFAS 123(R). We have applied the provisions of SAB
107 in our adoption of SFAS 123(R).
We adopted SFAS 123(R) using the modified prospective transition
method, which requires the application of the accounting standard as of January
1, 2006, the first day of our fiscal year 2006. Our financial statements as of
and for the nine months ended September 30, 2006 reflect the impact of SFAS
123(R). In accordance with the modified prospective transition method, our
financial statements for prior periods have not been restated to reflect, and do
not include, the impact of SFAS 123(R). Stock-based compensation expense
recognized under SFAS 123(R) during the three months and nine months ended
September 30, 2006 was $90,000 and $97,000. Basic and dilutive earnings per
share for the three months and nine months ended September 30, 2006 were not
affected by the additional stock-based compensation recognized.
The fair value of each option granted to employees and directors is
estimated on the date of grant using the Black-Scholes option-pricing model with
the following weighted average assumptions used for grants in 2006 and 2005:
weighted-average volatility factors of the expected market price of our common
stock of 0.70 and 0.55 for the three months ended September 30, 2006 and 2005,
weighted-average risk-free interest rates of 5.075% and 4% for the three months
ended September 30, 2006 and 2005, dividend yield of 0% for the three months
6
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
ended September 30, 2006 and 2005, and weighted-average expected life of the
options of 6.25 years and 4 years for the three months ended September 30, 2006
and 2005.
The following table illustrates the effect on net loss and net loss per
share if we had applied the fair value recognition provisions of SFAS 123 to
stock-based payment awards granted under our stock option plans for the three
and nine months ended September 30, 2005:
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
2005 2005
------------- -------------
Net income as reported .......................... $ 1,702,417 $ 2,467,436
Add stock-based employee compensation charges
reported in net income ....................... 38,740 38,740
Pro forma compensation expense, net of tax ...... (3,248,221) (4,298,193)
------------- -------------
Pro forma net loss .............................. $ (1,507,064) $ (1,792,017)
============= =============
Net income per share as reported - Basic ........ $ 0.06 $ 0.08
Add stock-based employee compensation charges
reported in net income--Basic ................ -- --
Pro forma compensation expense per share - Basic (0.11) (0.14)
------------- -------------
Pro forma net loss per share - Basic ............ $ (0.05) $ (0.06)
============= =============
Net income per share as reported -Diluted ....... $ 0.06 $ 0.08
Add stock-based employee compensation charges
reported in net income - Diluted ............. -- --
Pro forma compensation expense per share -Diluted (0.11) (0.14)
------------- -------------
Pro forma net loss per share -Diluted ........... $ (0.05) $ (0.06)
============= =============
SFAS 123(R) requires companies to estimate the fair value of
share-based payment awards to employees and directors on the date of grant using
an option-pricing model. The value of the portion of the award that is
ultimately expected to vest is recognized as expense over the requisite service
periods in our consolidated statements of operations. Prior to the adoption of
SFAS 123(R), we accounted for stock-based payment awards to employees and
directors using the intrinsic value method in accordance with APB 25 as allowed
under SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123").
Under the intrinsic value method, no stock-based compensation expense had been
recognized in our consolidated statements of operations for awards to employees
and directors because the exercise price of our stock options equaled the fair
market value of the underlying stock at the date of grant.
On September 23, 2005, the Board of Directors approved the acceleration
of vesting of all our unvested stock options, including those not issued under
the plan; see Note 3 of the "Notes to Consolidated Financial Statements." In
total, 1.7 million stock options with an average exercise price of $3.69 and an
average remaining contractual life of 7.9 years were subject to this
acceleration. The exercise prices and number of shares subject to the
accelerated options were unchanged. The acceleration was effective as of
September 23, 2005. As a result, there were no stock options granted prior to,
but not yet vested as of January 1, 2006. There was no stock-based compensation
expense related to employees or directors stock options recognized during the
three months and nine months ended September 30, 2005.
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 nine
months of 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 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, which is
consistent with how the prior-period pro-formas were provided. As stock-based
compensation expense recognized in the consolidated statements of operations for
the three months and nine months ended September 30, 2006 is based on awards
ultimately expected to vest, it has been reduced for estimated forfeitures which
we estimate to be 7.7%. SFAS 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. In our pro-forma information for the
periods prior to fiscal 2006, we accounted for forfeitures as they occurred.
7
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Our determination of fair value of share-based payment awards to
employees and directors on the date of grant using the Black-Scholes model,
which 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 its expected terms using the "safe harbor"
provisions provided in SAB 107 and its volatility using historical data. We
granted options to purchase 260,000 and 1,233,259 shares of common stock,
respectively, during the three months and nine months of 2006. The options
granted were fair valued in the aggregate at $341,000 or $1.31 per share during
the third quarter of 2006. The options granted were fair valued in the aggregate
at $1.6 million or the weighted-average exercise price of $1.86 during the nine
months ended September 30, 2006. The stock-based compensation expense related to
employees or director stock options recognized during the three months and nine
months ended September 30, 2006 was $90,000 and $97,000, respectively.
Certain 2005 amounts have been reclassified to conform to the 2006
presentation.
3. STOCK-BASED COMPENSATION
Our Employee Incentive Plan, formerly the 1995 Stock Option Plan (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 September 30, 2006, there were outstanding options to
purchase a total of 1,319,000 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 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 September 30, 2006, there were
outstanding options to purchase a total of 1,228,000 shares of common stock, and
3,872,000 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 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.
In October 1998, we granted 1,000,000 non-qualified stock options
outside of the plan. The options were granted to our Chairman and Vice Chairman
at $13.50 per share, the closing sales price of the common stock on the day of
the grant, expire in 2008 and vested over four years. In May 2002, we granted
3,000,000 non-qualified stock options outside of the plan. Theses options were
granted to our Chairman, Vice Chairman and Mr. Kamel Nacif at $5.50 per share,
the closing sales price of the common stock on the day of the grant, expire in
2012 and vested over three years. The 1,000,000 stock options granted to Kamel
Nacif were forfeited in 2005. In May 2003, we granted 2,000,000 non-qualified
stock options outside of the plan to our Chairman and Vice Chairman. These
options were granted at $3.65 per share, the closing sales price of the common
stock on the day of the grant, expire in 2013 and initially provided for vesting
over four years. In December 2003, we granted 400,000 non-qualified stock
options outside of the plan to one of our employees. The options were granted at
$3.94 per share, the closing sales price of the common stock on the day of the
grant, expire in 2013 and initially provided for vesting over four years.
8
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
A summary of our stock option activity, and related information for the
year ended December 31, 2005 and the nine months ended September 30, 2006 is as
follows:
EMPLOYEES
----------------------------
NUMBER OF EXERCISE
SHARES PRICE
---------- ------------
Options outstanding at December 31, 2004 ...... 8,331,962 $1.39-$45.50
Granted ....................................... 42,000 $1.95-$3.68
Exercised ..................................... -- --
Forfeited ..................................... (1,573,300) $1.95-$25.00
Expired ....................................... (67,612) $ 4.50
---------- ------------
Options outstanding at December 31, 2005 ...... 6,733,050 $1.39-$45.50
Granted ....................................... 1,233,259 $1.84-$1.94
Exercised ..................................... -- --
Forfeited ..................................... (19,450) $1.94-$33.13
Expired ....................................... -- --
---------- ------------
Options outstanding at September 30, 2006 ..... 7,946,859 $1.39-$45.50
We had no stock option outstanding to non-employees as of December 31,
2005 and September 30, 2006.
The following table summarizes information about stock options
outstanding and exercisable as of December 31, 2005 and September 30, 2006:
WEIGHTED
AVERAGE
WEIGHTED REMAINING
AVERAGE CONTRACTUAL
NUMBER OF EXERCISE LIFE INTRINSIC
SHARES PRICE (YEARS) VALUE
--------- --------- --------- ---------
As of December 31, 2005:
Employees - Outstanding ........ 6,733,050 $ 6.25 6.0 $ 12,440
Employees - Expected to vest ... 6,733,050 $ 6.25 6.0 $ 12,440
Employees - Exercisable ........ 6,733,050 $ 6.25 6.0 $ 12,440
As of September 30, 2006:
Employees - Outstanding ........ 7,946,859 $ 5.56 6.0 $ 0
Employees - Expected to vest ... 7,852,283 $ 5.61 5.9 $ 0
Employees - Exercisable ........ 6,718,600 $ 6.24 5.3 $ 0
The total intrinsic value of options exercised during 2005 was $0. Cash
received from stock options exercised during 2005 was $0. The total fair value
of shares vested during the years ended December 31, 2003, 2004 and 2005, were
approximately $2.8 million, $4.3 million, and $5.7 million, respectively.
As of September 30, 2006, there was $1.4 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 3.7 years.
When options are exercised, our policy is to issue previously un-issued
shares of common stock to satisfy share option exercises. As of September 30,
2006, we had 69.5 million shares of un-issued shares of common stock.
9
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
4. ACCOUNTS RECEIVABLE
Accounts receivable consists of the following:
SEPTEMBER 30, DECEMBER 31,
2006 2005
------------ ------------
U.S. trade accounts receivable ................. $ 4,236,436 $ 2,893,217
Foreign trade accounts receivable .............. 12,943,876 19,619,172
Factored accounts receivable ................... 31,278,819 33,222,354
Other receivables .............................. 979,850 1,815,450
Allowance for returns, discounts and bad debts . (3,263,072) (2,951,750)
------------ ------------
$ 46,175,909 $ 54,598,443
============ ============
5. INVENTORY
Inventory consists of the following:
SEPTEMBER 30, DECEMBER 31,
2006 2005
------------ ------------
Raw materials - fabric and trim accessories ...... $ 3,896,436 $ 5,079,428
Finished goods shipments-in-transit .............. 7,648,321 8,800,014
Finished goods ................................... 8,910,945 17,749,518
------------ ------------
$ 20,455,702 $ 31,628,960
============ ============
6. EQUITY METHOD INVESTMENT - AMERICAN RAG
In the second quarter of 2003, we acquired a 45% equity interest in the
owner of the trademark "American Rag CIE" and the operator of American Rag
retail stores for $1.4 million, and our subsidiary, Private Brands, Inc.,
acquired a license to certain exclusive rights to this trademark. We have
guaranteed the payment to the licensor of minimum royalties of $10.4 million
over the initial 10-year term of the agreement. The guaranteed annual minimum
royalty is payable in equal monthly installments during the term of the
agreement. The royalty owed to the licensor in excess of the guaranteed minimum,
if any, 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. The guaranteed annual minimum royalty for 2006 is $661,000. The
minimum royalty paid and expensed for the three months and nine months ended
September 30, 2006 was $165,000 and $496,000, respectively. At September 30,
2006, the total commitment on royalties remaining on the term was $8.6 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. In June 2006, we signed a guarantee of certain liabilities of
American Rag CIE to California United Bank to the aggregate amount equal at all
times to the lesser of (A) 45% of the aggregate amount of the outstanding
liabilities and (B) $675,000. Upon execution of the guarantee, we re-evaluated
our investment under the provisions of FIN 46. In our analysis, we determined
that consolidation under FIN 46 was still not appropriate. The investment in
American Rag CIE, LLC totaling $2.2 million at September 30, 2006, is accounted
for under the equity method and included in equity method investment on the
accompanying consolidated balance sheets. Income from the equity method
investment is recorded in the United States geographical segment. The change in
investment in American Rag during the nine months ended September 30, 2006 was
as follows:
Balance as of December 31, 2005 ..... $ 2,138,865
Share of income...................... 103,015
Distribution......................... (67,500)
-------------
Balance as of September 30, 2006.... $ 2,174,380
=============
10
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
7. 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 issued us unsecured promissory notes
of $3,910,000 that mature on November 30, 2007 and secured promissory notes of
$40,204,000 that mature on December 31, 2014 and 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 were $41.1 million prior to the reserve. Historically, we
have 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 have satisfied our payment obligations for the fabric by
offsetting the amounts payable against the amounts due to us under the notes.
However, the purchasers have recently 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 a 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 will continue to pursue payment of all amounts
under the notes receivable and believe the remaining $14 million balance at
September 30, 2006 is realizable. The entire reserve was recorded in the
Luxembourg geographic reporting segment.
8. DEBT
Short-term bank borrowings consist of the following:
SEPTEMBER 30, DECEMBER 31,
2006 2005
----------- -----------
Import trade bills payable - UPS, DBS
Bank and Aurora Capital ................... $ 4,651,308 $ 4,165,306
Bank direct acceptances - UPS and DBS
Bank ...................................... 3,839,388 1,471,476
Other Hong Kong credit facilities -
UPS and DBS Bank .......................... 4,044,241 8,196,750
----------- -----------
$12,534,937 $13,833,532
=========== ===========
Long-term obligations consist of the following:
SEPTEMBER 30, DECEMBER 31,
2006 2005
------------ ------------
Equipment financing ...................... 46,331 83,206
Term loan - UPS .......................... -- 2,708,333
Debt facility - GMAC CF .................. 19,749,079 33,558,095
Credit facility - Guggenheim, net ........ 10,941,948 --
------------ ------------
30,737,358 36,349,634
Less current portion ..................... (19,769,030) (36,109,699)
------------ ------------
$ 10,968,328 $ 239,935
============ ============
IMPORT TRADE BILLS PAYABLE, BANK DIRECT ACCEPTANCES AND OTHER HONG KONG CREDIT
FACILITIES
On June 13, 2002, we entered into a letter of credit facility of $25
million with UPS Capital Global Trade Finance Corporation ("UPS"). Under this
facility, we could arrange for the issuance of letters of credit and
acceptances. The facility was collateralized by the shares and debentures of all
of our subsidiaries in Hong Kong. In addition to the guarantees provided by us
and our subsidiaries, Fashion Resource (TCL) Inc. and Tarrant Luxembourg Sarl,
Gerard Guez, our Chairman and Interim Chief Executive Officer, also signed a
guarantee of $5 million in favor of UPS to secure this facility. Under this
facility, we were subject to certain restrictive covenants, including that we
maintain a specified tangible net worth, fixed charge ratio, and leverage ratio.
Additionally, Gerard Guez, our Chairman and Interim Chief Executive Officer,
pledged to UPS 4.6 million shares of our common stock held by Mr. Guez to secure
the obligations under the credit facility. On June 9, 2006, we completed the
pay-off of all remaining amounts due under the letter of credit facility with
UPS. As a result of the payment of these obligations, the letter of credit
facility was terminated and all collateral released. There was no prepayment
penalty under this arrangement. As of September 30, 2006, $0 was outstanding
under this facility with UPS.
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) to our subsidiaries in Hong Kong. This was a demand facility and
11
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
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 October 2005, a
tax loan for HKD 6.233 million (equivalent to US $804,000) 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 9.25% per annum at September 30, 2006. As of September 30, 2006,
$70,000 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 8.75% per annum at
September 30, 2006, or the Standard Bills Rate quoted by DBS plus 0.5% if paid
in any other currency, which the interest rate was 8.6% per annum at September
30, 2006. 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, our
Chairman and Interim Chief Executive Officer, and Todd Kay, our Vice Chairman
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. As of September 30, 2006, $12.3 million was outstanding
under this facility. In addition, $4.7 million of open letters of credit was
outstanding and $8.0 million was available for future borrowings as of September
30, 2006.
As of September 30, 2006, the total balance outstanding under the DBS
credit facilities was $12.4 million (classified above as follows: $4.5 million
in import trade bills payable, $3.8 million in bank direct acceptances and $4.1
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 September 30, 2006, $164,000 was outstanding
under this facility (classified above under import trade bills payable) and $1.0
million of letters of credit were open under this arrangement. We pay a
commission fee of 2.25% on all letters of credits issued under this arrangement.
LOAN FROM MAX AZRIA
On January 19, 2006, we borrowed $4.0 million from Max Azria pursuant
to the terms of a promissory note, which amount bore interest at the rate of
5.5% per annum and was payable in weekly installments of $200,000 beginning on
March 1, 2006. This was an unsecured loan. We paid off the remaining balance of
this loan in July 2006. As of September 30, 2006, $0 was outstanding under this
loan.
EQUIPMENT FINANCING
We had three equipment loans outstanding at December 31, 2005. One of
these equipment loans bore interest at 6% payable in installments through 2009,
which we paid off in January 2006. The second loan bears interest at 15.8%
payable in installment through 2007 and the third loan bears interest at 6.15%
payable in installment through 2007. In August 2006, we entered into a new auto
loan that bears interest at 4.75% payable in installment through 2008. As of
September 30, 2006, $46,000 was outstanding under the three remaining loans.
TERM LOAN - UPS
On December 31, 2004, our Hong Kong subsidiaries entered into a loan
agreement with UPS pursuant to which UPS made a $5 million term loan, the
proceeds of which were used to repay $5 million of indebtedness owed to UPS
under the letter of credit of facility. The principal amount of this loan was
due and payable in 24 equal monthly installments of approximately $208,333 each,
plus interest equivalent to the "prime rate" plus 2% commencing on February 1,
2005. Under the amended loan agreement, we were subject to restrictive financial
covenants of maintaining tangible net worth of $25 million at December 31, 2005
12
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
and the last day of each fiscal quarter thereafter. There was also a provision
capping maximum capital expenditure per quarter at $800,000. The obligations
under the loan agreement were collateralized by the same security interests and
guarantees provided under our letter of credit facility with UPS. Additionally,
the term loan was secured by two promissory notes payable to Tarrant Luxembourg
Sarl in the amounts of $2,550,000 and $1,360,000 and a pledge by Gerard Guez,
our Chairman and Interim Chief Executive Officer, of 4.6 million shares of our
common stock. On June 9, 2006, we completed the pay-off of all remaining amounts
due under the term loan agreement with UPS. As a result of the payment of these
obligations, the term loan agreement was terminated and all collateral released.
There was no prepayment penalty under this arrangement.
DEBT FACILITY AND FACTORING AGREEMENT - GMAC CF
On October 1, 2004, we amended and restated our previously existing
credit facility with GMAC Commercial Finance Credit, LLC ("GMAC CF") by entering
into a new factoring agreement with GMAC CF. The amended and restated agreement
(the factoring agreement) extended the expiration date of the facility to
September 30, 2007 and added as parties our subsidiaries Private Brands, Inc and
No! Jeans, Inc. In addition, in connection with the factoring agreement, our
indirect majority-owned subsidiary PBG7, LLC entered into a separate factoring
agreement with GMAC CF. Pursuant to the terms of the factoring agreement, we and
our subsidiaries agree to assign and sell to GMAC CF, as factor, all accounts
which arise from our sale of merchandise or rendition of service created on a
going forward basis. At our request, GMAC CF, in its discretion, may make
advances to us up to the lesser of (a) up to 90% of our accounts on which GMAC
CF has the risk of loss and (b) $40 million, minus in each case, any amount owed
by us to GMAC CF. In May 2005, we amended our factoring agreement with GMAC CF
to permit our subsidiaries party thereto and us, to borrow up to the lesser of
$3 million or 50% of the value of eligible inventory. In connection with this
amendment, we granted GMAC CF a lien on certain of our inventory located in the
United States. On January 23, 2006, we further amended our factoring agreement
with GMAC CF to increase the amount we may borrow against inventory to the
lesser of $5 million or 50% of the value of eligible inventory. The $5 million
limit 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 amounts 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 September 30, 2006. As of
September 30, 2006, we were in violation with the EBITDA covenant and a waiver
was obtained during the default. A total of $19.7 million was outstanding with
respect to receivables factored under the GMAC CF facility at September 30,
2006.
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
13
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
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 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 $4.9 million using the Black-Scholes option valuation 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. As of September 30, 2006, $352,000 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 Capital 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 Capital 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 option valuation 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 Capital 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. As of September 30, 2006, $23,000 was amortized.
The Guggenheim facility bore interest at 12.33% per annum at September
30, 2006. As of September 30, 2006, we were in violation with the EBITDA
covenant and a waiver was obtained during the default. A total of $10.9 million,
net of $4.6 million of debt discount, was outstanding under this facility at
September 30, 2006.
As of June 30, 2006, the warrants were being accounted for as a
liability pursuant to the provisions of 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" ("EITF 00-19").
This is because we granted the warrant holders certain registration rights that
are outside our control. In accordance with SFAS No. 133, the warrants are being
valued at each reporting period. Changes in fair value are 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 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 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 form debt to equity in accordance with
EITF 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
14
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
$4.5 million; as a result, income of $729,000 was recorded as an adjustment to
fair value of derivative on our consolidated statements of operations.
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.
9. CONVERTIBLE DEBENTURES AND WARRANTS
On December 14, 2004, we completed a $10 million financing through the
issuance of (i) 6% Secured Convertible Debentures ("Debentures") and (ii)
warrants to purchase up to 1,250,000 shares of our common stock. Prior to
maturity, the investors may convert the Debentures into shares of our common
stock at a price of $2.00 per share. The warrants have a term of five years and
an exercise price of $2.50 per share. The warrants were valued at $866,000 using
the Black-Scholes option valuation model with the following assumptions:
risk-free interest rate of 4%; dividend yields of 0%; volatility factors of the
expected market price of our common stock of 0.55; and an expected life of four
years. The Debentures bear interest at a rate of 6% per annum and have a term of
three years. We may elect to pay interest on the Debentures in shares of our
common stock if certain conditions are met, including a minimum market price and
trading volume for our common stock. The Debentures contain customary events of
default and permit the holder thereof to accelerate the maturity if the full
principal amount together with interest and other amounts owing upon the
occurrence of such events of default. The Debentures are secured by a
subordinated lien on certain of our accounts receivable and related assets. The
closing market price of our common stock on the closing date of the financing
was $1.96. The Debentures were thus valued at $8,996,000, resulting in an
effective conversion price of $1.799 per share. The intrinsic value of the
conversion option of $804,000 was being amortized over the life of the loan. The
value of the warrants of $866,000 and the intrinsic value of the conversion
option of $804,000 were netted from the $10 million presented as the convertible
debentures, net on our accompanying balance sheets at December 31, 2004.
The placement agent in the financing, received compensation for its
services in the amount of $620,000 in cash and issuance of five year warrants to
purchase up to 200,000 shares of our common stock at an exercise price of $2.50
per share. The warrants to purchase 200,000 shares of our common stock were
valued at $138,000 using the Black-Scholes option valuation model with the
following assumptions: risk-free interest rate of 4%; dividend yields of 0%;
volatility factors of the expected market price of our common stock of 0.55; and
an expected life of four years. The financing cost paid to the placement agent
of $620,000, and the value of the warrants to purchase 200,000 shares of our
common stock of $138,000 were included in the deferred financing cost, net on
our accompanying balance sheets and was amortized over the life of the loan.
In June 2005, holders of our Debentures converted an aggregate of $2.3
million of Debentures into 1,133,687 shares of our common stock. In August 2005,
holders of our Debentures converted an aggregate of $820,000 of Debentures into
410,000 shares of our common stock. The Debentures were converted at the option
of the holders at a price of $2.00 per share. Debt discount of $248,000 related
to the intrinsic value of the conversion option of $804,000 was expensed upon
the conversion. Of the $620,000 financing cost paid to the placement agent,
$191,000 was expensed upon the conversion. The intrinsic value of the conversion
option, and the value of the warrant amortized in the first nine months of 2006
was $237,000. Total deferred financing cost amortized in the first nine months
of 2006 was $95,000. Total interest paid to the holders of the Debentures in the
first nine months of 2006 was $198,000. On June 26, 2006, we paid off the
remaining balance of the outstanding Debentures of $6.9 million plus all accrued
and unpaid interest and a prepayment penalty of $171,000. As a result of the
repayment, the Debentures were terminated effective June 26, 2006. Upon paying
off the Debentures, debt discount of $278,000 related to the intrinsic value of
the conversion option of $804,000 was expensed, and of the $620,000 financing
cost paid to the placement agent, $214,000 was expensed. The remaining value of
the warrants to holders of our Debentures of $433,000 and warrants to the
placement agent of $69,000 was also expensed.
15
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
10. EQUITY TRANSACTIONS
In March 2005, in connection with a settlement of a dispute involving a
former employee named Nicolas Nunez, we agreed to compensate Mr. Nunez in the
total amount of $875,000. In April 2005, we issued 195,313 shares of our common
stock (having a value of $375,000) to Mr. Nunez pursuant to the terms of an
agreement and plan of reorganization and paid Mr. Nunez $500,000 in settlement
of all remaining claims by Mr. Nunez against us. In connection with this
settlement, in March 2006, we cancelled 10,000 shares of our common stock
previously issued to him.
11. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
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. This interpretation
is effective for fiscal years beginning after December 15, 2006. We are
currently evaluating the effect that the application of FIN 48 will have on our
results of operations and financial condition.
In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing
of Financial Assets" ("SFAS No. 156"), which provides an approach to simplify
efforts to obtain hedge-like (offset) accounting. This Statement amends FASB
Statement No. 140, "Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities", with respect to the accounting for
separately recognized servicing assets and servicing liabilities. The Statement
(1) requires an entity to recognize a servicing asset or servicing liability
each time it undertakes an obligation to service a financial asset by entering
into a servicing contract in certain situations; (2) requires that a separately
recognized servicing asset or servicing liability be initially measured at fair
value, if practicable; (3) permits an entity to choose either the amortization
method or the fair value method for subsequent measurement for each class of
separately recognized servicing assets or servicing liabilities; (4) permits at
initial adoption a one-time reclassification of available-for-sale securities to
trading securities by an entity with recognized servicing rights, provided the
securities reclassified offset the entity's exposure to changes in the fair
value of the servicing assets or liabilities; and (5) requires separate
presentation of servicing assets and servicing liabilities subsequently measured
at fair value in the balance sheet and additional disclosures for all separately
recognized servicing assets and servicing liabilities. SFAS No. 156 is effective
for all separately recognized servicing assets and liabilities as of the
beginning of an entity's fiscal year that begins after September 15, 2006, with
earlier adoption permitted in certain circumstances. The Statement also
describes the manner in which it should be initially applied. We are currently
evaluating the impact of this Statement.
In September 2006, the FASB issued SFAS No. 157, "Fair Value
Measurements" ("SFAS No. 157"). 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 position or results of operations.
12. INCOME TAXES
Our effective tax rate differs from the statutory rate principally due
to the following reasons: (1) a full valuation allowance has been provided for
deferred tax assets as a result of the operating losses in the United States and
Mexico, since recoverability of those assets has not been assessed as more
likely than not; (2) although we have taxable losses in Mexico, we are subject
to a minimum tax; and (3) the earnings of our Hong Kong subsidiary are taxed at
a rate of 17.5% versus the 35% U.S. federal rate. The impairment charge in
Mexico did not result in a tax benefit due to an increase in the valuation
allowance against the future tax benefit. We believe it is more likely than not
that the tax benefit will not be realized based on our future business plans in
Mexico.
16
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
In January 2004, the Internal Revenue Service ("IRS") completed its
examination of our Federal income tax returns for the years ended December 31,
1996 through 2001. The IRS has proposed adjustments to increase our income tax
payable for the six years under examination. In addition, in July 2004, the IRS
initiated an examination of our Federal income tax return for the year ended
December 31, 2002. In March 2005, the IRS proposed an adjustment to our taxable
income of approximately $6 million related to similar issues identified in their
audit of the 1996 through 2001 federal income tax returns. The proposed
adjustments to our 2002 federal income tax return would not result in additional
tax due for that year due to the tax loss reported in the 2002 federal return.
However, it could reduce the amount of net operating losses available to offset
taxes due from the preceding tax years. This adjustment would also result in
additional state taxes and interest. We believe that we have meritorious
defenses to and intend to vigorously contest the proposed adjustments. If the
proposed adjustments are upheld through the administrative and legal process,
they could have a material impact on our earnings and cash flow. We believe we
have provided adequate reserves for any reasonably foreseeable outcome related
to these matters on the consolidated balance sheets included in the consolidated
financial statements under the caption "Income Taxes". The maximum amount of
loss in excess of the amount accrued in the financial statements is $7.7
million. We do not believe that the adjustments, if any, arising from the IRS
examination, will result in an additional income tax liability beyond what is
recorded in the accompanying consolidated balance sheets.
13. NET INCOME (LOSS) PER SHARE
A reconciliation of the numerator and denominator of basic earnings
(loss) per share and diluted earnings (loss) per share is as follows:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------------- ----------------------------
2006 2005 2006 2005
------------ ------------ ------------ ------------
Basic EPS Computation:
Numerator ..................... $(25,352,414) $ 1,702,417 $(23,904,758) $ 2,467,436
Denominator:
Weighted average common shares
outstanding ................... 30,543,763 30,365,502 30,546,217 29,451,054
------------ ------------ ------------ ------------
Basic EPS ..................... $ (0.83) $ 0.06 $ (0.78) $ 0.08
============ ============ ============ ============
Diluted EPS Computation:
Numerator ..................... $(25,352,414) $ 1,702,417 $(23,904,758) $ 2,467,436
Denominator:
Weighted average common shares
outstanding ................... 30,543,763 30,365,502 30,546,217 29,451,054
Incremental shares from assumed
exercise of warrants .......... -- 403,266 -- 59,040
options ....................... -- 17,029 -- 7,157
------------ ------------ ------------ ------------
Total shares .................. 30,543,763 30,785,797 30,546,217 29,517,251
------------ ------------ ------------ ------------
Diluted EPS ................... $ (0.83) $ 0.06 $ (0.78) $ 0.08
============ ============ ============ ============
Basic and diluted earnings (loss) per share has been computed in
accordance with SFAS No. 128, "Earnings Per Share".
Only 7,157 shares of outstanding options were included in the
computation of net income per share in the nine months ended September 30, 2005,
as the exercise prices of the remaining shares were greater than the average
market price for the nine months ended September 30, 2005. All outstanding
options of 2006 were excluded from the computation of net loss per share in the
nine months ended September 30, 2006 as the impact would be anti-dilutive. All
warrants were excluded from the computation of net income (loss) per share in
the nine months ended September 30, 2006 and 2005, as the impact would be
anti-dilutive. The effect of applying "IF Converted Method" to the convertible
17
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
debenture was anti-dilutive; therefore, it was excluded from the computation of
income per share in the nine months ended September 30, 2006 and 2005. The
following table presents outstanding options, warrants and convertible
debentures.
AS OF SEPTEMBER 30,
-----------------------
2006 2005
---------- ----------
Options .............. 7,946,859 6,745,175
Warrants ............. 5,931,732 2,361,732
Convertible debentures -- 3,456,313
---------- ----------
Total ................ 13,878,591 12,563,220
========== ==========
14. RELATED PARTY TRANSACTIONS
As of September 30, 2006, related party affiliates were indebted to us
in the amounts of $8.3 million. These include amounts due from Gerard Guez, our
Chairman and Interim Chief Executive Officer. From time to time in the past, we
borrowed funds from, and advanced funds to, Mr. Guez. The greatest outstanding
balance of such advances to Mr. Guez in the third quarter of 2006 was
approximately $2,234,000. At September 30, 2006, the entire balance due from Mr.
Guez totaling $2.2 million is payable on demand and has been shown as reductions
to shareholders' equity in the accompanying financial statements. All advances
to Mr. Guez bore interest at the rate of 7.75% during the period. Total interest
paid by Mr. Guez was $129,000 and $165,000 for the nine months ended September
30, 2006 and 2005, respectively. Mr. Guez paid expenses on our behalf of
approximately $226,000 and $321,000 for the nine months ended September 30, 2006
and 2005, respectively, which amounts were applied to reduce accrued interest
and principal on Mr. Guez's loan. These amounts included fuel and related
expenses incurred by 477 Aviation, LLC, a company owned by Mr. Guez, when our
executives used this company's aircraft for business purposes. Since the
enactment of the Sarbanes-Oxley Act in 2002, no further personal loans (or
amendments to existing loans) have been or will be made to our executive
officers or directors.
On July 1, 2001, we formed an entity to jointly market, share certain
risks and achieve economics of scale with Azteca Production International, Inc.
("Azteca"), a corporation owned by the brothers of Gerard Guez, our Chairman and
Interim Chief Executive Officer, called United Apparel Ventures, LLC. This
entity was created to coordinate the production of apparel for a single customer
of our branded business. UAV is owned 50.1% by Tag Mex, Inc., our wholly owned
subsidiary, and 49.9% by Azteca. Results of the operation of UAV have been
consolidated into our results since July 2001 with the minority partner's share
of gain and losses eliminated through the minority interest line in our
financial statements. Due to the restructuring of our Mexico operations, we
discontinued manufacturing for UAV customers in the second quarter of 2004. UAV
made purchases from two related parties in Mexico, an affiliate of Azteca and
Tag-It Pacific, Inc.
At September 30, 2006, Messrs. Guez and Kay beneficially owned 590,000
and 1,003,500 shares, respectively, of common stock of Tag-It Pacific, Inc.,
collectively representing approximately 8.7% of Tag-It Pacific's common stock.
Tag-It Pacific is a provider of brand identity programs to manufacturers and
retailers of apparel and accessories. Starting from 1998, Tag-It Pacific assumed
the responsibility for managing and sourcing all trim and packaging used in
connection with products manufactured by or on behalf of us in Mexico. Due to
the restructuring of our Mexico operations, Tag-It Pacific no longer manages our
trim and packaging requirements. We purchased $205,000 and $55,000 of trim
inventory from Tag-It Pacific in the nine months ended September 30, 2006 and
2005, respectively. Our sales of garment accessories to Tag-It Pacific were
$39,000 and $0 in the nine months ended September 30, 2006 and 2005,
respectively. We purchased $0 and $135,000 of finished goods and services from
Azteca and its affiliates in the nine months ended September 30, 2006 and 2005,
respectively. Our sales of fabric and services to Azteca in the nine months
ended September 30, 2006 and 2005 was $9,000 and $63,000, 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 be its buying agent to source and purchase apparel merchandise.
Seven Licensing is beneficially owned by Gerard Guez. Net amount due from these
related parties as of September 30, 2006 was $5.5 million.
18
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
In August 2004, we entered into an Agreement for Purchase of Assets
with affiliates of Mr. Kamel Nacif, a shareholder at the time of the
transaction, which agreement was amended in October 2004. Pursuant to the
agreement, as amended, on November 30, 2004, we sold to the purchasers
substantially all of our assets and real property in Mexico, including the
equipment and facilities we previously leased to Mr. Nacif's affiliates in
October 2003, for an aggregate purchase price consisting of: a) $105,400 in cash
and $3,910,000 by delivery of unsecured promissory notes bearing interest at
5.5% per annum; and b) $40,204,000, by delivery of secured promissory notes
bearing interest at 4.5% per annum, maturing on December 31, 2005 and every year
thereafter until December 31, 2014. The secured promissory notes are payable in
partial or total amounts anytime prior to the maturity of each note. Included in
the $41.0 million notes receivable - related party on the accompanying balance
sheet as of September 30, 2006 was $1.3 million of Mexico value added taxes on
the real property component of this transaction. Historically, we have 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 have satisfied our payment obligations for the fabric by
offsetting the amounts payable against the amounts due to us under the notes.
However, the purchasers have recently 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 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 will continue to pursue payments under the notes
receivable and believe the remaining $14 million balance at September 30, 2006
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 purchased $0 and $4.1 million of fabric from Acabados y
Terminados in the nine months ended September 30, 2006 and 2005, respectively.
In addition to the above notes receivable, net amount due from these parties as
of September 30, 2006 was $412,000, related to reimbursement expenses.
We lease our executive offices in Los Angeles, California from GET, a
corporation which is owned by Gerard Guez (our Chairman and Interim Chief
Executive Officer) and Todd Kay (our Vice Chairman). Additionally, we lease our
warehouse and office space in Hong Kong from Lynx International Limited, a Hong
Kong corporation that is owned by Messrs. Guez and Kay. We paid $807,000 and
$764,000 in rent in the nine months ended September 30, 2006 and 2005,
respectively, for office and warehouse facilities. During the first seven months
of 2006, our Los Angeles offices and warehouse was leased on a month to month
basis. 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 January 1, 2006, we renewed
our lease agreement with Lynx International Limited for our office space in Hong
Kong for one year.
On May 1, 2006, we sublet our executive office in Los Angeles,
California and our sales office in New York to Seven Licensing Company, LLC
("Seven Licensing") for a monthly payment of $25,000 on a month to month basis.
Seven Licensing is beneficially owned by Gerard Guez, our Chairman and Interim
Chief Executive Officer. We received $125,000 in rental income from this
sublease in the nine months ended September 30, 2006.
At September 30, 2006, we had various employee receivables totaling
$258,000 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
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
19
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
and marketing expenses in 2005. In March 2006, we agreed to terminate our
agreement to design, market and sell House of Dereon by Tina Knowles branded
apparel and we agreed to sell all remaining inventory to the licensor or its
designee. As a result, we will no longer be involved in the sales of this
private brand. Prior to December 31, 2005, we had written off the capitalized
balance of $1.2 million related to the first year term of the agreement and
recognized a corresponding loss in 2005.
On October 17, 2004, Private Brands, Inc. entered into an agreement
with J. S. Brand Management to design, manufacture and distribute Jessica
Simpson branded jeans and casual apparel. This agreement has an initial
three-year term, and provided we are in compliance with the terms of the
agreement, is renewable for one additional two-year term. Minimum net sales are
$20 million in year 1, $25 million in year 2 and $30 million in year 3. The
agreement provides for payment of a sales royalty and advertising commitment at
the rate of 8% and 3%, respectively, of net sales, for a total minimum payment
obligation of $8.3 million over the initial term of the agreement. In December
2004, we advanced $2.2 million as payment for the first year's minimum
royalties. We applied $1.1 million from the above advance against the royalty
and marketing expenses in 2005 and $884,000 in the first three months of 2006.
In March 2006, we had written off the capitalized balance of $192,000 and
recognized a corresponding loss. The loss was classified as royalty expense on
our consolidated statements of operations. In March 2006, we became involved in
a dispute with the licensor of the Jessica Simpson brands over our continued
rights to these brands. We are presently in litigation with the licensor. See
Note 17 of the "Notes to Consolidated Financial Statements"
In the second quarter of 2003, we acquired a 45% equity interest in the
owner of the trademark "American Rag CIE" and the operator of American Rag
retail stores for $1.4 million, and our subsidiary, Private Brands, Inc.,
acquired a license to certain exclusive rights to this trademark. We have
guaranteed the payment to the licensor of minimum royalties of $10.4 million
over the initial 10-year term of the agreement. The guaranteed annual minimum
royalty is payable in equal monthly installments during the term of the
agreement. The royalty owed to the licensor in excess of the guaranteed minimum,
if any, 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. At September 30, 2006, the total commitment on royalties remaining
on the term was $8.6 million.
In August 2004, we entered into an Agreement for Purchase of Assets
with affiliates of Mr. Kamel Nacif; a shareholder at the time of the
transaction, with agreement was amended in October 2004. Pursuant to the
agreement, as amended, on November 30, 2004, we sold to the purchasers
substantially all of our assets and real property in Mexico, including the
equipment and facilities we previously leased to Mr. Nacif's affiliates. Upon
consummation of the sale, we entered into a purchase commitment agreement with
the purchasers, pursuant to which we have agreed to purchase annually over the
ten-year term of the agreement, $5 million of fabric manufactured at our former
facilities acquired by the purchasers at negotiated market prices. We purchased
$0 and $3.2 million of fabric under this agreement in the nine months ended
September 30, 2006 and 2005, respectively.
In July 2006, we terminated our License Agreements and the parent
guaranty with Cynthia Rowley. In consideration of termination of the License
Agreements, $400,000 was paid to Cynthia Rowley in July 2006.
On September 1, 2006, our subsidiary in Hong Kong, Tarrant Company
Limited, entered into an agreement with Seven Licensing Company, LLC ("Seven
Licensing") to be its buying agent to source and purchase apparel merchandise.
Seven Licensing is beneficially owned by Gerard Guez. Net amount due from these
related parties as of September 30, 2006 was $5.5 million.
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 January 1, 2006, we renewed
our lease agreement with Lynx International Limited for our office space in Hong
Kong for one year.
20
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 four geographic
regions: the United States, Asia, Mexico and Luxembourg. We evaluate performance
of each region based on profit or loss from operations before income taxes not
including the cumulative effect of change in accounting principles. Information
about our operations in the United States, Asia, Mexico and Luxembourg is
presented below. Inter-company revenues and assets have been eliminated to
arrive at the consolidated amounts.
ADJUSTMENTS
AND
UNITED STATES ASIA MEXICO LUXEMBOURG ELIMINATIONS TOTAL
------------ ------------ ------------ ------------ ------------ ------------
THREE MONTHS ENDED
SEPTEMBER 30, 2006
Sales .................... $ 53,092,000 $ 1,545,000 $ 8,000 $ -- $ -- $ 54,645,000
Inter-company sales ...... -- 28,221,000 -- -- (28,221,000) --
------------ ------------ ------------ ------------ ------------ ------------
Total revenue ............ $ 53,092,000 $ 29,766,000 $ 8,000 $ -- $(28,221,000) $ 54,645,000
============ ============ ============ ============ ============ ============
Income (loss) from
operations ............ $ 1,510,000 $ 1,057,000 $ (144,000) $(27,142,000) $ -- $(24,719,000)
============ ============ ============ ============ ============ ============
Interest income .......... $ 137,000 $ 796,000 $ -- $ 28,000 $ (796,000) $ 165,000
============ ============ ============ ============ ============ ============
Interest expense ......... $ 1,530,000 $ 32,000 $ 1,000 $ 795,000 $ (796,000) $ 1,562,000
============ ============ ============ ============ ============ ============
Provision for depreciation
and amortization ...... $ 574,000 $ 28,000 $ -- $ -- $ -- $ 602,000
============ ============ ============ ============ ============ ============
Capital expenditures ..... $ 31,000 $ 36,000 $ -- $ -- $ -- $ 67,000
============ ============ ============ ============ ============ ============
THREE MONTHS ENDED
SEPTEMBER 30, 2005
Sales .................... $ 69,023,000 $ 536,000 $ 7,000 $ -- $ -- $ 69,566,000
Inter-company sales ...... -- 43,576,000 -- -- (43,576,000) --
------------ ------------ ------------ ------------ ------------ ------------
Total revenue ............ $ 69,023,000 $ 44,112,000 $ 7,000 $ -- $(43,576,000) $ 69,566,000
============ ============ ============ ============ ============ ============
Income (loss) from
operations ............ $ 309,000 $ 2,568,000 $ 168,000 $ (34,000) $ -- $ 3,011,000
============ ============ ============ ============ ============ ============
Interest income .......... $ 46,000 $ 525,000 $ -- $ 459,000 $ (524,000) $ 506,000
============ ============ ============ ============ ============ ============
Interest expense ......... $ 1,206,000 $ 95,000 $ -- $ 524,000 $ (524,000) $ 1,301,000
============ ============ ============ ============ ============ ============
Provision for depreciation
and amortization ...... $ 462,000 $ 26,000 $ -- $ -- $ -- $ 488,000
============ ============ ============ ============ ============ ============
Capital expenditures ..... $ 186,000 $ 75,000 $ 112,000 $ -- $ -- $ 373,000
============ ============ ============ ============ ============ ============
21
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
ADJUSTMENTS
AND
UNITED STATES ASIA MEXICO LUXEMBOURG ELIMINATIONS TOTAL
------------- ------------- ------------- ------------- ------------- -------------
NINE MONTHS ENDED
SEPTEMBER 30, 2006
Sales .................... $ 172,538,000 $ 2,526,000 $ (75,000) $ -- $ -- $ 174,989,000
Inter-company sales ...... -- 89,145,000 -- -- (89,145,000) --
------------- ------------- ------------- ------------- ------------- -------------
Total revenue ............ $ 172,538,000 $ 91,671,000 $ (75,000) $ -- $ (89,145,000) $ 174,989,000
============= ============= ============= ============= ============= =============
Income (loss) from
operations ............ $ 3,859,000 $ 3,367,000 $ (547,000) $ (27,144,000) $ -- $ (20,465,000)
============= ============= ============= ============= ============= =============
Interest income .......... $ 229,000 $ 2,190,000 $ -- $ 901,000 $ (2,188,000) $ 1,132,000
============= ============= ============= ============= ============= =============
Interest expense ......... $ 4,525,000 $ 159,000 $ 12,000 $ 2,188,000 $ (2,188,000) $ 4,696,000
============= ============= ============= ============= ============= =============
Provision for depreciation
and amortization ...... $ 2,302,000 $ 82,000 $ -- $ -- $ -- $ 2,384,000
============= ============= ============= ============= ============= =============
Capital expenditures ..... $ 63,000 $ 67,000 $ -- $ -- $ -- $ 130,000
============= ============= ============= ============= ============= =============
Total assets ............. $ 114,484,000 $ 117,481,000 $ 14,528,000 $ 183,588,000 $(325,588,000) $ 104,493,000
============= ============= ============= ============= ============= =============
NINE MONTHS ENDED
SEPTEMBER 30, 2005
Sales .................... $ 163,828,000 $ 1,006,000 $ 100,000 $ -- $ -- $ 164,934,000
Inter-company sales ...... -- 105,576,000 -- -- (105,576,000) --
------------- ------------- ------------- ------------- ------------- -------------
Total revenue ............ $ 163,828,000 $ 106,582,000 $ 100,000 $ -- $(105,576,000) $ 164,934,000
============= ============= ============= ============= ============= =============
Income (loss) from
operations ............ $ (537,000) $ 5,444,000 $ (192,000) $ (34,000) $ -- $ 4,681,000
============= ============= ============= ============= ============= =============
Interest income .......... $ 169,000 $ 1,345,000 $ -- $ 1,406,000 $ (1,344,000) $ 1,576,000
============= ============= ============= ============= ============= =============
Interest expense ......... $ 3,090,000 $ 309,000 $ 1,000 $ 1,344,000 $ (1,344,000) $ 3,400,000
============= ============= ============= ============= ============= =============
Provision for depreciation
and amortization ........ $ 1,664,000 $ 75,000 $ -- $ -- $ -- $ 1,739,000
============= ============= ============= ============= ============= =============
Capital expenditures ..... $ 278,000 $ 175,000 $ -- $ -- $ -- $ 453,000
============= ============= ============= ============= ============= =============
Total assets ............. $ 141,941,000 $ 128,811,000 $ 32,006,000 $ 212,387,000 $(354,447,000) $ 160,698,000
============= ============= ============= ============= ============= =============
22
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
17. LITIGATION
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. Our
complaint includes eight causes of action, including two seeking a declaration
that the sublicense agreement is exclusive and remains in full force and effect,
as well as claims for breach of contract by Camuto Consulting, breach of the
duty of good faith and fair dealing and fraudulent inducement against Camuto
Consulting, and a claim against With You, Inc. and Ms. Simpson that we are an
intended third party beneficiary of the licenses between those defendants and
Camuto Consulting. On or about April 26, 2006, Camuto Consulting served its
answer to our complaint and included a counterclaim against us for breach of the
sublicense agreement and alleging damages of no less than $100 million. Camuto
Consulting has also served a motion to dismiss our cause of action for
fraudulent inducement. On or about May 22, 2006, we served our reply to Camuto
Consulting's counterclaim. On or about April 27, 2006, Ms. Simpson served a
motion seeking dismissal of the cause of action asserted against her. On or
about May 10, 2006, we served our opposition to Ms. Simpson motion to dismiss.
On or about June 14, 2006, we served a cross-motion seeking leave to amend our
complaint to add Vincent Camuto as a defendant. On October 18, 2006, the Court:
(i) granted our cross-motion seeking leave to file a supplemental summons and
amended complaint adding Vincent Camuto as a defendant and supplementing the
allegations of fraud against Camuto Consulting; (ii) denied Camuto Consulting's
motion to dismiss the cause of action for fraudulent inducement; and (iii)
denied Ms. Simpson's motion to dismiss the cause of action asserted against her.
On or about October 30, 2006, Camuto Consulting and Vincent Camuto served their
answer to the amended complaint, with a counterclaim that is virtually identical
to the original counterclaim. We intend to continue to vigorously defend
Camuto's counterclaim and vigorously oppose Ms. Simpson's motion. Discovery in
the matter has been underway since May 2006. A status conference is scheduled
before the Court on November 21, 2006.
Shortly before May 2004, Bazak International Corp. commenced an action
against us in the New York County Supreme Court claiming that we breached an
oral contract to sell a quantity of close-out goods, as a consequence of which
Bazak was damaged to the extent of $1.3 million. Bazak International Corp.
claimed that our liability exists under a theory of breach of contract or unjust
enrichment. This case is currently pending in the United States District Court
for the Southern District of New York and is scheduled for trial on November 27,
2006. We will continue to vigorously defend against the breach of contract and
unjust enrichment claim.
From time to time, we are involved in various routine legal proceedings
incidental to the conduct of our business. Our management does not believe that
any of these legal proceedings will have a material adverse impact on our
business, financial condition or results of operations, either due to the nature
of the claims, or because our management believes that such claims should not
exceed the limits of the our insurance coverage.
23
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
BUSINESS OVERVIEW AND RECENT DEVELOPMENTS
We are a design and sourcing company for private label and private
brand casual apparel serving mass merchandisers, department stores, branded
wholesalers and specialty chains located primarily in the United States. Our
major customers include leading retailers, such as Kohl's, Chico's, Macy's
Merchandising Group, Mervyn's, Mothers Work, Sears, Wal-Mart, Dillard's, Lane
Bryant, Lerner New York, and the Avenue. Our products are manufactured in a
variety of woven and knit fabrications and include jeans wear, casual pants,
t-shirts, shorts, blouses, shirts and other tops, dresses and jackets. Our
private brands include American Rag Cie 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 net sales in the
first nine months of 2006 were $135.8 million compared to $119.5 million in the
first nine months of 2005.
The exposure of developing private brands collections has created new
opportunities within the private label business to add value in the development
and marketing of new initiatives for Sears, Mothers Work, Avenue, Chico's, and
other retailers. These initiatives were launched during 2005, and are on track
to be significant growth areas for 2006.
PRIVATE BRANDS
We launched our private brands initiative in 2003, pursuant to which we
acquire ownership of or license rights to a brand name and sell apparel products
under this brand, generally to a single retail company within a geographic
region. Private brands net sales in the first nine months of 2006 were $39.2
million compared to $45.4 million in the first nine months of 2005. During the
nine months ended September 30, 2006, we owned or licensed rights to the
following private brands:
o AMERICAN RAG CIE: During the first quarter of 2005, we
extended our agreement with Macy's Merchandising Group for
nine years, pursuant to which we exclusively distribute our
American Rag Cie brand through Macy's Merchandising Group's
national Department Store organization of more than 600
stores. Net sales of American Rag Cie branded apparel totaled
$23.1 million in the first nine months of 2006.
o ALAIN WEIZ: We continue to sell Alan Weiz apparel exclusively
to Dillard's Department Stores. Net sales of Alain Weiz
branded apparel totaled $4.6 million in the first nine months
of 2006.
o SOUVENIR BY CYNTHIA ROWLEY: In July 2006, we terminated our
License Agreements and the parent guaranty with Cynthia
Rowley. In consideration of termination of the License
Agreements, $400,000 was paid to Cynthia Rowley in July 2006.
o GEAR 7: During the fourth quarter of 2005, K-Mart discontinued
sales of Gear 7 products, which resulted in a decline in sales
for this brand in the fourth quarter of 2005. We do not
anticipate sales of Gear 7 branded apparel in 2006.
o JESSICA SIMPSON brands: The JS by Jessica Simpson brand was
originally launched as a denim line with Charming Shoppes. Net
sales of JS by Jessica Simpson and Princy by Jessica Simpson,
which is the department store and better specialty store
brand, totaled $9.3 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.
24
o HOUSE OF DEREON BY TINA KNOWLES: We began shipping products
for the House of Dereon by Tina Knowles brand in the fourth
quarter of 2005, resulting in net sales of $309,000 in 2005.
In March 2006, we terminated our license agreement for this
brand, and sold our remaining inventory to the licensor or its
designee. Prior to December 31, 2005, we had written off the
capitalized balance of $1.2 million related to the agreement
and recognized a corresponding loss in 2005. Net sales of
House of Dereon by Tina Knowles branded apparel totaled $2.2
million in the first quarter of 2006 which included $1.5
million of sales of inventory to a designee of the licensor.
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 issued us unsecured promissory notes
of $3,910,000 that mature on November 30, 2007 and secured promissory notes of
$40,204,000 that mature on December 31, 2014 and 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 were $41.1 million prior to the reserve. Historically, we
have 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 have satisfied our payment obligations for the fabric by
offsetting the amounts payable against the amounts due to us under the notes.
However, the purchasers have recently 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 a 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 will continue to pursue payment of all amounts
under the notes receivable and believe the remaining $14 million balance at
September 30, 2006 is realizable. The entire reserve was recorded in the
Luxembourg geographic reporting segment.
CREDIT FACILITY REFINANCING
In June 2006, we entered into a new $65 million credit facility with
Guggenheim Corporate Funding, LLC (as agent for certain lenders) and expanded
our existing facilities with GMAC Commercial Finance Credit, LLC and DBS Bank
(Hong Kong) Limited. The credit facility with Guggenheim consists of an initial
term loan of $25 million, of which $15.5 million was advanced at the initial
closing. The initial term loan was or will be used to repay certain existing
indebtedness and fund general operating and working capital needs. A second term
loan of up to $40 million will be available to finance acquisitions acceptable
to Guggenheim as agent. In addition, in June 2006, our credit facility with GMAC
Commercial Finance Credit, LLC and other lenders was increased from $45 million
to $55 million, and our credit facility with DBS Bank (Hong Kong) Limited was
increased from $4.5 million to $25 million. These financings significant expand
our borrowing base, which provides enhanced financial flexibility to us.
INTERNAL REVENUE SERVICE AUDIT
In January 2004, the Internal Revenue Service completed its examination
of our Federal income tax returns for the years ended December 31, 1996 through
2001. The IRS has proposed adjustments to increase our income tax payable for
the six years under examination. This adjustment would also result in additional
state taxes and interest. In addition, in July 2004, the IRS initiated an
examination of our Federal income tax return for the year ended December 31,
2002. In March 2005, the IRS proposed an adjustment to our taxable income of
approximately $6 million related to similar issues identified in their audit of
the 1996 through 2001 federal income tax returns. The proposed adjustments to
our 2002 federal income tax return would not result in additional tax due for
that year due to the tax loss reported in the 2002 federal return. However, it
could reduce the amount of net operating losses available to offset taxes due
from the preceding tax years. We believe that we have meritorious defenses to
and intend to vigorously contest the proposed adjustments made to our federal
income tax returns for the years ended 1996 through 2002. If the proposed
adjustments are upheld through the administrative and legal process, they could
have a material impact on our earnings and cash flow. We believe we have
provided adequate reserves for any reasonably foreseeable outcome related to
these matters on the consolidated balance sheets included in the consolidated
financial statements under the caption "Income Taxes". The maximum amount of
loss in excess of the amount accrued in the financial statements is $7.7
million. We do not believe that the adjustments, if any, arising
25
from the IRS examination, will result in an additional income tax liability
beyond what is recorded in the accompanying consolidated balance sheets.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Management's discussion and analysis of our financial condition and
results of operations are based upon our consolidated financial statements,
which have been prepared in accordance with accounting principles generally
accepted in the United States of America. The preparation of these financial
statements requires us to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenues and expenses, and related disclosures
of contingent assets and liabilities. We are required to make assumptions about
matters, which are highly uncertain at the time of the estimate. Different
estimates we could reasonably have used or changes in the estimates that are
reasonably likely to occur could have a material effect on our financial
condition or result of operations. Estimates and assumptions about future events
and their effects cannot be determined with certainty. On an ongoing basis, we
evaluate estimates, including those related to returns, discounts, bad debts,
inventories, notes receivable - related parties reserve, intangible assets,
income taxes, stock options valuation, and contingencies and litigation. We base
our estimates on historical experience and on various assumptions believed to be
applicable and reasonable under the circumstances. These estimates may change as
new events occur, as additional information is obtained and as our operating
environment changes. In addition, management is periodically faced with
uncertainties, the outcomes of which are not within its control and will not be
known for prolonged period of time.
We believe our financial statements are fairly stated in accordance
with accounting principles generally accepted in the United States of America
and provide a meaningful presentation of our financial condition and results of
operations.
We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our consolidated
financial statements. For a further discussion on the application of these and
other accounting policies, see Note 1 of the "Notes to Consolidated Financial
Statements" included in our Annual Report on Form 10-K for the year ended
December 31, 2005.
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
to us could be reduced by a material amount.
As of September 30, 2006, the balance in the allowance for returns,
discounts and bad debts reserves was $3.3 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:
26
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 September 30, 2006, 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, management is required to estimate income taxes in each of the
jurisdictions in which we operate. The process involves estimating actual
current tax expense along with assessing temporary differences resulting from
differing treatment of items for book and tax purposes. These timing differences
result in deferred tax assets and liabilities, which are included in our
consolidated balance sheet. Management records a valuation allowance to reduce
our net deferred tax assets to the amount that is more likely than not to be
realized. Management has considered future taxable income and ongoing tax
planning strategies in assessing the need for the valuation allowance. Increases
in the valuation allowance result in additional expense to be reflected within
the tax provision in the consolidated statement of operations.
In addition, accruals are also estimated for ongoing audits regarding
U.S. Federal tax issues that are currently unresolved, based on our estimate of
whether, and the extent to which, additional taxes will be due. We routinely
monitor the potential impact of these situations and believe that amounts are
properly accrued for. If we ultimately determine that payment of these amounts
is unnecessary, we will reverse the liability and recognize a tax benefit during
the period in which we determine that the liability is no longer necessary. We
will record an additional charge in our provision for taxes in any period we
determine that the original estimate of a tax liability is less than we expect
the ultimate assessment to be. See Note 12 of the "Notes to Consolidated
Financial Statements" for a discussion of current tax matters.
DEBT COVENANTS
Our debt agreements require certain covenants including a minimum level
of EBITDA and tangible net worth as discussed in Note 8 of the "Notes to
Consolidated Financial Statements." As of September 30, 2006, we were in
violation with the EBITDA covenants and waivers were obtained during the
default. 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.
VALUATION OF DERIVATIVE INSTRUMENTS
Statements 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 (the
27
"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.
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."
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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------- -------------------------
2006 2005 2006 2005
---------- ---------- ---------- ----------
Net sales ......................... 100.0% 100.0% 100.0% 100.0%
Cost of sales ..................... 78.4 79.1 78.9 78.8
---------- ---------- ---------- ----------
Gross profit ...................... 21.6 20.9 21.1 21.2
Selling and distribution expenses . 4.7 4.1 4.7 4.7
General and administration expenses 12.0 10.6 11.4 12.3
Royalty expenses .................. 0.5 1.9 1.2 1.3
Loss on notes receivable - related
parties ........................ 49.7 -- 15.5 --
---------- ---------- ---------- ----------
Income (loss) from operations ..... (45.3) 4.3 (11.7) 2.9
Interest expense .................. (2.8) (1.9) (2.7) (2.1)
Interest Income ................... 0.3 0.7 0.7 1.0
Interest in income (loss) of equity
method investee ................ 0.0 0.2 0.1 0.3
Other income ...................... 0.2 0.1 0.1 0.1
Adjustment to fair value of
derivative ..................... 1.3 (0.0) 0.3 (0.0)
Other expense ..................... 0.0 (0.0) (0.2) (0.0)
Minority interest in consolidated
subsidiary ..................... 0.0 (0.2) 0.0 (0.1)
---------- ---------- ---------- ----------
Income (loss) before taxes ........ (46.3) 3.2 (13.4) 2.1
Income taxes ...................... 0.1 0.7 0.2 0.6
---------- ---------- ---------- ----------
Net income (loss) ................. (46.4)% 2.5% (13.6)% 1.5%
========== ========== ========== ==========
THIRD QUARTER 2006 COMPARED TO THIRD QUARTER 2005
Net sales decreased by $14.9 million, or 21.4%, to $54.6 million in the
third quarter of 2006 from $69.6 million in the third quarter of 2005. Sales of
private label in the third quarter of 2006 were $46.1 million compared to $47.0
million in the same period of 2005, with the decrease resulting primarily from
decreased sales to Wal-Mart, offset by increased sales to Charlotte Russe,
Mothers Work and Mervyn's. Sales of private brands in the third quarter of 2006
were $8.5 million compared to $22.6 million in the same period of 2005 with the
decrease resulting primarily from no sales of Gear7 and Jessica Simpson brands
in the third quarter of 2006.
Gross profit consists of net sales less product costs, direct labor,
manufacturing overhead, duty, quota, freight in, brokerage, and warehousing.
Gross profit decreased by $2.7 million to $11.8 million in the third quarter of
2006 from $14.5 million in the third quarter of 2005. 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 third quarter of 2005 to 21.6%
in the third quarter of 2006. The increase in gross margin is primarily
attributable to changes in customer mix in private label and improved sourcing
in private brand business in the third quarter of 2006 as compared to the same
period of 2005.
Selling and distribution expenses decreased by $278,000, or 9.8%, to
$2.6 million in the third quarter of 2006 from $2.8 million in the third quarter
of 2005. As a percentage of net sales, these expenses increased to 4.7% in the
third quarter of 2006 from 4.1% in the third quarter of 2005 due to decreased
sales during the third quarter of 2006.
28
General and administrative expenses decreased by $847,000, or 11.5%, to
$6.6 million in the third quarter of 2006 from $7.4 million in the third quarter
of 2005. The decrease was primarily due to reduced overhead associated with our
private brands business. As a percentage of net sales, these expenses increased
to 12.0% in the third quarter of 2006 from 10.6% in the third quarter of 2005
due to decreased sales during the third quarter of 2006.
Royalty and marketing allowance expenses decreased by $1.0 million, or
79.5%, to $264,000 in the third quarter of 2006 from $1.3 million in the third
quarter of 2005. As a percentage of net sales, these expenses decreased to 0.5%
in the third quarter of 2006 from 1.9% in the third quarter of 2005.
Loss on notes receivable - related parties was $27.1 million, or 49.7%
of net sales, in the third quarter of 2006, compared to $0 in the third quarter
of 2005. The purchasers of the Mexico assets have recently ceased providing
fabric and are not currently making payments under the notes. We evaluated the
recoverability of the notes receivable and recorded a loss on the notes
receivable in an amount equal to the outstanding balance less the value of the
underlying assets securing the notes. See Note 7 of the "Notes to Consolidated
Financial Statements".
Operating loss in the third quarter of 2006 was $24.7 million, or
(45.3)% of net sales, compared to operating income of $3.0 million, or 4.3% of
net sales, in the comparable period of 2005, primarily due to loss on notes
receivable - related parties in the amount of $27.1 million and the other
factors discussed above.
Interest expense increased by $261,000, or 20.1%, to $1.6 million in
the third quarter of 2006 from $1.3 million in the third quarter of 2005. As a
percentage of net sales, this expense increased to 2.8% in the third quarter of
2006 from 1.9% in the third quarter of 2005. Interest income decreased by
$341,000, or 67.3%, to $165,000 in the third quarter of 2006 from $506,000 in
the third quarter of 2005. Other income was $109,000 in the third quarter of
2006, compared to $39,000 in the third quarter of 2005. Adjustment to fair value
of derivative was $729,000 in the third quarter of 2006, compared to $0 in the
third quarter of 2005. Other expense was $0 in the third quarter of 2006 and
2005.
Losses allocated to minority interests in the third quarter of 2006
were $14,000, representing the minority partner's share of losses in PBG7.
Income allocated to minority interests in the third quarter of 2005 were
$164,000, representing the minority partner's share of profit in PBG7.
FIRST NINE MONTHS OF 2006 COMPARED TO FIRST NINE MONTHS OF 2005
Net sales increased by $10.1 million, or 6.1%, to $175.0 million in the
first nine months of 2006 from $164.9 million in the first nine months of 2005.
Sales of private label in the first nine months of 2006 were $135.8 million
compared to $119.5 million in the same period of 2005, with the increase
resulting primarily from increased sales to Kohl's, Charlotte Russe, Chico's,
Mervyn's and Mothers Work and offset by decreased sales to Wal-Mart and Lerner.
Sales of private brands in the nine months of 2006 were $39.2 million compared
to $45.4 million in the same period of 2005.
Gross profit increased by $2.0 million to $37.0 million in the first
nine months of 2006 from $34.9 million in the first nine months of 2005. The
increase in gross profit occurred primarily because of an increase in sales. As
a percentage of net sales, gross profit decreased slightly from 21.2% in the
first nine months of 2005 to 21.1% in the first nine months of 2006.
Selling and distribution expenses increased by $483,000, or 6.2%, to
$8.3 million in the first nine months of 2006 from $7.8 million in the first
nine months of 2005, due primarily to increased sales. As a percentage of net
sales, these expenses remained unchanged at 4.7% for the first nine months of
2005 and 2006.
General and administrative expenses decreased by $356,000, or 1.8%, to
$19.9 million in the first nine months of 2006 from $20.3 million in the first
nine months of 2005. As a percentage of net sales, these expenses decreased to
11.4% in the first nine months of 2006 from 12.3% in the first nine months of
2005 due to increased sales during the first nine months 2006. Included in the
general and administrative expenses in the first nine months of 2006 was
$284,000 of expensing the financing cost paid to the placement agent and the
remaining value of the
29
warrants to placement agent and $171,000 of prepayment penalty paid to the
debenture holders as a result of the repayment of the Debentures.
Royalty and marketing allowance expenses decreased by $82,000, or 3.8%,
to $2.1 million in the first nine months of 2006 from $2.2 million in the first
nine months of 2005. As a percentage of net sales, these expenses decreased to
1.2% in the first nine months of 2006 from 1.3% in the first nine months of
2005.
Loss on notes receivable - related parties was $27.1 million, or 15.5%
of net sales, in the first nine months of 2006, compared to $0 in the first nine
months of 2005. The purchasers of the Mexico assets have recently ceased
providing fabric and are not currently making payments under the notes. We
evaluated the recoverability of the notes receivable and recorded a loss on the
notes receivable in an amount equal to the outstanding balance less the value of
the underlying assets securing the notes. See Note 7 of the "Notes to
Consolidated Financial Statements".
Operating loss for the first nine months of 2006 was $20.5 million, or
(11.7)% of net sales, compared to operating income of $4.7 million, or 2.9% of
net sales, in the comparable prior period of 2005 as a result of the loss on
notes receivable - related parties in the amount of $27.1 million and the other
factors discussed above.
Interest expense increased by $1.3 million or 38.1%, to $4.7 million in
the first nine months of 2006 from $3.4 million in the first nine months of
2005. As a percentage of net sales, this expense increased to 2.7% in the first
nine months of 2006 from 2.1% in the first nine months of 2005. The increase was
primarily due to expensing $711,000 in the first nine months of 2006 of debt
discount related to the intrinsic value of the conversion option of Debentures
and the remaining value of the warrants to holders of Debentures as a result of
the repayment of the Debentures in June 2006. Interest income decreased by
$444,000 or 28.2%, to $1.1 million in the first nine months of 2006 from $1.6
million in the first nine months of 2005. Other income was $233,000 in the first
nine months of 2006, compared to $278,000 in the first nine months of 2005.
Adjustment to fair value of derivative was $511,000 in the first nine months of
2006, compared to $0 in the first nine months of 2005. Other expense was
$400,000 in the first nine months of 2006, compared to $0 in the first nine
months of 2005.
Losses allocated to minority interests in the first nine months of 2006
were $18,000, representing the minority partner's share of losses in PBG7.
Income allocated to minority interests in the first nine months of 2005 were
$164,000, representing the minority partner's share of profit in PBG7.
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
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.
30
Principal factors that could affect our ability to obtain cash from
external sources include:
o financial covenants contained in our current or future bank
and debt facilities; and
o volatility in the market price of our common stock or in the
stock markets in general.
Cash flows for the nine months ended September 30, 2006 and 2005 were
as follows (dollars in thousands):
CASH FLOWS: 2006 2005
-------- --------
Net cash provided by (used in)
operating activities ....................... $ 10,297 $(22,802)
Net cash provided by investing
activities ................................. $ 1,125 $ 3,316
Net cash (used in) provided by
financing activities ....................... $(12,087) $ 19,908
During the first nine months of 2006, net cash provided by operating
activities was $10.3 million, as compared to net cash used in operating
activities of $22.8 million for the same period in 2005. Net cash provided by
operating activities in the first nine months of 2006 resulted primarily from a
net loss of $23.9 million and the decrease of $15.1 million in accounts payable,
offset by $27.1 million of loss on notes receivable - related parties, $2.4
million of depreciation and amortization expense, a decrease of $7.3 million in
accounts receivable, and a decrease in inventory of $11.2 million. The decrease
in inventory was primarily due to the increase in sales in the first nine months
of 2006, and the decrease in accounts payable resulted from the pay down of
payables.
During the first nine months of 2006, net cash provided by investing
activities was $1.1 million, as compared to net cash provided by investing
activities of $3.3 million for the same period in 2005. Net cash provided by
investing activities in the first nine months of 2006 resulted primarily from
the collection on notes receivable.
During the first nine months of 2006, net cash used in financing
activities was $12.1 million, as compared to net cash provided by financing
activities of $19.9 million for the same period in 2005. Net cash used in
financing activities in the first nine months of 2006 resulted primarily from
$1.3 million net repayments of our short-term bank borrowings, net repayments of
our long-term obligations of $16.5 million, and repayments of borrowings from
convertible debentures of $6.9 million, offset by financing of $15.5 million
under our credit facility with Guggenheim.
CONTRACTUAL OBLIGATIONS AND COMMITMENTS
Following is a summary of our contractual obligations and commercial
commitments available to us as of September 30, 2006 (in millions):
PAYMENTS DUE BY PERIOD
----------------------------------------------------
Less Between Between
than 2-3 4-5 After
CONTRACTUAL OBLIGATIONS Total 1 year years years 5 years
-------- -------- -------- -------- --------
Long-term debt (1) .................... $ 45.1 $ 23.4 $ 3.9 $ 17.8 $ --
Operating leases ...................... 9.2 1.5 2.5 2.5 2.7
Minimum royalties ..................... 14.6 5.1 3.5 2.4 3.6
Purchase commitment ................... 45.4 9.2 10.0 10.0 16.2
-------- -------- -------- -------- --------
Total Contractual Cash Obligations .... $ 114.3 $ 39.2 $ 19.9 $ 32.7 $ 22.5
(1) Includes interest on long-term debt obligations. Based on outstanding
borrowings as of September 30, 2006, and assuming all such indebtedness
remained outstanding and the interest rates remained unchanged, we
estimate that our interest cost on long-term debt would be
approximately $9.8 million.
31
AMOUNT OF COMMITMENT EXPIRATION PER PERIOD
-------------------------------------------------
TOTAL
AMOUNTS LESS BETWEEN BETWEEN
COMMERCIAL COMMITMENTS COMMITTED THAN 2 -3 4 -5 AFTER
AVAILABLE TO US TO US 1 YEAR YEARS 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 $ -- $ -- $ --
On June 13, 2002, we entered into a letter of credit facility of $25
million with UPS Capital Global Trade Finance Corporation ("UPS"). Under this
facility, we could arrange for the issuance of letters of credit and
acceptances. The facility was collateralized by the shares and debentures of all
of our subsidiaries in Hong Kong. In addition to the guarantees provided by us
and our subsidiaries, Fashion Resource (TCL) Inc. and Tarrant Luxembourg Sarl,
Gerard Guez, our Chairman and Interim Chief Executive Officer, also signed a
guarantee of $5 million in favor of UPS to secure this facility. Under this
facility, we were subject to certain restrictive covenants, including that we
maintain a specified tangible net worth, fixed charge ratio, and leverage ratio.
Additionally, Gerard Guez, our Chairman and Interim Chief Executive Officer,
pledged to UPS 4.6 million shares of our common stock held by Mr. Guez to secure
the obligations under the credit facility. On June 9, 2006, we completed the
pay-off of all remaining amounts due under the letter of credit facility with
UPS. As a result of the payment of these obligations, the letter of credit
facility was terminated and all collateral released. There was no prepayment
penalty under this arrangement. As of September 30, 2006, $0 was outstanding
under this facility with UPS.
On December 31, 2004, our Hong Kong subsidiaries entered into a loan
agreement with UPS pursuant to which UPS made a $5 million term loan, the
proceeds of which were used to repay $5 million of indebtedness owed to UPS
under the letter of credit of facility. The principal amount of this loan was
due and payable in 24 equal monthly installments of approximately $208,333 each,
plus interest equivalent to the "prime rate" plus 2% commencing on February 1,
2005. Under the amended loan agreement, we were subject to restrictive financial
covenants of maintaining tangible net worth of $25 million at December 31, 2005
and the last day of each fiscal quarter thereafter. There was also a provision
capping maximum capital expenditure per quarter at $800,000. The obligations
under the loan agreement were collateralized by the same security interests and
guarantees provided under our letter of credit facility with UPS. Additionally,
the term loan was secured by two promissory notes payable to Tarrant Luxembourg
Sarl in the amounts of $2,550,000 and $1,360,000 and a pledge by Gerard Guez,
our Chairman and Interim Chief Executive Officer, of 4.6 million shares of our
common stock. On June 9, 2006, we completed the pay-off of all remaining amounts
due under the term loan agreement with UPS. As a result of the payment of these
obligations, the term loan agreement was terminated and all collateral released.
There was no prepayment penalty under this arrangement.
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) 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 October 2005, a
tax loan for HKD 6.233 million (equivalent to US $804,000) 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 9.25% per annum at September 30, 2006. As of September 30, 2006,
$70,000 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 8.75% per annum at
September 30, 2006, or the Standard Bills Rate quoted by DBS plus 0.5% if paid
in any other currency, which the interest rate was 8.6% per annum at September
30, 2006. 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, our
Chairman and Interim Chief Executive Officer, and Todd Kay, our Vice Chairman
and by our guarantee. The DBS facility includes customary default provisions. In
addition, we are subject
32
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. As of
September 30, 2006, $12.3 million was outstanding under this facility. In
addition, $4.7 million of open letters of credit was outstanding and $8.0
million was available for future borrowings as of September 30, 2006.
As of September 30, 2006, the total balance outstanding under the DBS
credit facilities was $12.4 million (classified above as follows: $4.5 million
in import trade bills payable, $3.8 million in bank direct acceptances and $4.1
million in other Hong Kong credit facilities).
On October 1, 2004, we amended and restated our previously existing
credit facility with GMAC Commercial Finance Credit, LLC ("GMAC CF") by entering
into a new factoring agreement with GMAC CF. The amended and restated agreement
(the factoring agreement) extended the expiration date of the facility to
September 30, 2007 and added as parties our subsidiaries Private Brands, Inc and
No! Jeans, Inc. In addition, in connection with the factoring agreement, our
indirect majority-owned subsidiary PBG7, LLC entered into a separate factoring
agreement with GMAC CF. Pursuant to the terms of the factoring agreement, we and
our subsidiaries agree to assign and sell to GMAC CF, as factor, all accounts
which arise from our sale of merchandise or rendition of service created on a
going forward basis. At our request, GMAC CF, in its discretion, may make
advances to us up to the lesser of (a) up to 90% of our accounts on which GMAC
CF has the risk of loss and (b) $40 million, minus in each case, any amount owed
by us to GMAC CF. In May 2005, we amended our factoring agreement with GMAC CF
to permit our subsidiaries party thereto and us, to borrow up to the lesser of
$3 million or 50% of the value of eligible inventory. In connection with this
amendment, we granted GMAC CF a lien on certain of our inventory located in the
United States. On January 23, 2006, we further amended our factoring agreement
with GMAC CF to increase the amount we may borrow against inventory to the
lesser of $5 million or 50% of the value of eligible inventory. The $5 million
limit 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 amounts 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 September 30, 2006. As of
September 30, 2006, we were in violation with the EBITDA covenant and a waiver
was obtained during the default. A total of $19.7 million was outstanding with
respect to receivables factored under the GMAC CF facility at September 30,
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 amount we can borrow under the 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.
33
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 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 $4.9 million using the Black-Scholes option valuation 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. As of September 30, 2006, $352,000 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 Capital 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 Capital 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 option valuation 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 Capital 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. As of September 30, 2006, $23,000 was amortized.
The Guggenheim facility bore interest at 12.33% per annum at September
30, 2006. As of September 30, 2006, we were in violation with the EBITDA
covenant and a waiver was obtained during the default. A total of $10.9 million,
net of $4.6 million of debt discount, was outstanding under this facility at
September 30, 2006.
As of June 30, 2006, the warrants were being accounted for as a
liability pursuant to the provisions of 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" ("EITF 00-19").
This is because we granted the warrant holders certain registration rights that
are outside our control. In accordance with SFAS No. 133, the warrants are being
valued at each reporting period. Changes in fair value are 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 133, re-evaluated
the warrants on June 30, 2006 at
34
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 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 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 on our
consolidated statements of operations.
On December 14, 2004, we completed a $10 million financing through the
issuance of (i) 6% Secured Convertible Debentures and (ii) warrants to purchase
up to 1,250,000 shares of our common stock. Prior to maturity, the investors may
convert the convertible debentures into shares of our common stock at a price of
$2.00 per share. The warrants have a term of five years and an exercise price of
$2.50 per share. The warrants were valued at $866,000 using the Black-Scholes
option valuation model with the following assumptions: risk-free interest rate
of 4%; dividend yields of 0%; volatility factors of the expected market price of
our common stock of 0.55; and an expected life of four years. The convertible
debentures bear interest at a rate of 6% per annum and have a term of three
years. We may elect to pay interest on the convertible debentures in shares of
our common stock if certain conditions are met, including a minimum market price
and trading volume for our common stock. The convertible debentures contain
customary events of default and permit the holder thereof to accelerate the
maturity if the full principal amount together with interest and other amounts
owing upon the occurrence of such events of default. The convertible debentures
are secured by a subordinated lien on certain of our accounts receivable and
related assets. The closing market price of our common stock on the closing date
of the financing was $1.96. The convertible debentures were thus valued at
$8,996,000, resulting in an effective conversion price of $1.799 per share. The
intrinsic value of the conversion option of $804,000 was being amortized over
the life of the loan. The value of the warrants of $866,000 and the intrinsic
value of the conversion option of $804,000 were netted from the $10 million
presented as the convertible debentures, net on our accompanying balance sheets
at December 31, 2004.
The placement agent in the financing, received compensation for its
services in the amount of $620,000 in cash and issuance of five year warrants to
purchase up to 200,000 shares of our common stock at an exercise price of $2.50
per share. The warrants to purchase 200,000 shares of our common stock were
valued at $138,000 using the Black-Scholes option valuation model with the
following assumptions: risk-free interest rate of 4%; dividend yields of 0%;
volatility factors of the expected market price of our common stock of 0.55; and
an expected life of four years. The financing cost paid to the placement agent
of $620,000, and the value of the warrants to purchase 200,000 shares of our
common stock of $138,000 were included in the deferred financing cost, net on
our accompanying balance sheets and was amortized over the life of the loan.
In June 2005, holders of our convertible debentures converted an
aggregate of $2.3 million of convertible debentures into 1,133,687 shares of our
common stock. In August 2005, holders of our convertible debentures converted an
aggregate of $820,000 of convertible debentures into 410,000 shares of our
common stock. These convertible debentures were converted at the option of the
holders at a price of $2.00 per share. Debt discount of $248,000 related to the
intrinsic value of the conversion option of $804,000 was expensed upon the
conversion. Of the $620,000 financing cost paid to the placement agent, $191,000
was expensed upon the conversion. The intrinsic value of the conversion option,
and the value of the warrant amortized in the first nine months of 2006 was
$237,000. Total deferred financing cost amortized in the first nine months of
2006 was $95,000. Total interest paid to the holders of the convertible
debentures in the first nine months of 2006 was $198,000. On June 26, 2006, we
paid off the remaining balance of the outstanding convertible debentures of $6.9
million plus all accrued and unpaid interest and a prepayment penalty of
$171,000. As a result of the repayment, the convertible debentures were
terminated effective June 26, 2006. Upon paying off the convertible debentures,
debt discount of $278,000 related to the intrinsic value of the conversion
option of $804,000 was expensed, and of the $620,000 financing cost paid to the
placement agent, $214,000 was expensed. The remaining value of the warrants to
holders of the convertible debentures of $433,000 and warrants to the placement
agent of $69,000 was also expensed.
35
On January 19, 2006, we borrowed $4.0 million from Max Azria pursuant
to the terms of a promissory note, which amount bore interest at the rate of
5.5% per annum and was payable in weekly installments of $200,000 beginning on
March 1, 2006. This was an unsecured loan. We paid off the remaining balance of
this loan in July 2006.
We had three equipment loans outstanding at December 31, 2005. One of
these equipment loans bore interest at 6% payable in installments through 2009,
which we paid off in January 2006. The second loan bears interest at 15.8%
payable in installment through 2007 and the third loan bears interest at 6.15%
payable in installment through 2007. In August 2006, we entered into a new auto
loan that bears interest at 4.75% payable in installment through 2008. As of
September 30, 2006, $46,000 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 September 30, 2006, $164,000 was outstanding
under this facility (classified above under import trade bills payable) and $1.0
million of letters of credit were open under this arrangement. We pay a
commission fee of 2.25% on all letters of credits issued under this arrangement.
We have financed our operations from our cash flow from operations,
borrowings under our bank and other credit facilities, issuance of long-term
debt, and sales of equity and debt security. Our short-term funding relies very
heavily on our major customers, banks, and suppliers. From time to time, we have
had temporary over-advances from our banks. Any withdrawal of support from these
parties will have serious consequences on our liquidity.
From time to time in the past, we borrowed funds from, and advanced
funds to, certain officers and principal shareholders, including Gerard Guez and
Todd Kay. See disclosure under "-Related Party Transactions" below.
The Internal Revenue Service has proposed adjustments to our Federal
income tax returns to increase our income tax payable for the years ended
December 31, 1996 through 2001. This adjustment would also result in additional
state taxes and interest. In addition, in July 2004, the IRS initiated an
examination of our Federal income tax return for the year ended December 31,
2002. In March 2005, the IRS proposed an adjustment to our taxable income of
approximately $6 million related to similar issues identified in their audit of
the 1996 through 2001 federal income tax returns. We believe that we have
meritorious defenses to and intend to vigorously contest the proposed
adjustments made to our federal income tax returns for the years ended 1996
through 2002. If the proposed adjustments are upheld through the administrative
and legal process, they could have a material impact on our earnings and, in
particular, cash flow. We may not have an adequate cash reserve to pay the final
adjustments resulting from the IRS examination. As a result, we may be required
to arrange for payments over time, to borrow additional funds under our bank
facilities or raise additional capital in order to meet these obligations. We
believe we have provided adequate reserves for any reasonably foreseeable
outcome related to these matters on the consolidated balance sheets included in
the consolidated financial statements under the caption "Income Taxes." The
maximum amount of loss in excess of the amount accrued in the financial
statements is $7.7 million. We do not believe that the adjustments, if any,
arising from the IRS examination, will result in an additional income tax
liability beyond what is recorded in the accompanying consolidated balance
sheets.
We may seek to finance future capital investment programs through
various methods, including, but not limited to, borrowings under our bank credit
facilities, issuance of long-term debt, sales of equity securities, leases and
long-term financing provided by the sellers of facilities or the suppliers of
certain equipment used in such facilities. To date, there is no plan for any
major capital expenditure.
We do not believe that the moderate levels of inflation in the United
States in the last three years have had a significant effect on net sales or
profitability.
RELATED PARTY TRANSACTIONS
We lease our executive offices in Los Angeles, California from GET, a
corporation which is owned by Gerard Guez (our Chairman and Interim Chief
Executive Officer) and Todd Kay (our Vice Chairman), both of which are
significant shareholders. Additionally, we lease our warehouse and office space
in Hong Kong from Lynx
36
International Limited, a Hong Kong corporation that is owned by Messrs. Guez and
Kay. We paid $807,000 and $764,000 in rent in the nine months ended September
30, 2006 and 2005, respectively, for office and warehouse facilities. During the
first seven months of 2006, our Los Angeles offices and warehouse was leased on
a month to month basis. 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 January
1, 2006, we renewed our lease agreement with Lynx International Limited for our
office space in Hong Kong for one year.
On May 1, 2006, we sublet our executive office in Los Angeles,
California and our sales office in New York to Seven Licensing Company, LLC
("Seven Licensing") for a monthly payment of $25,000 on a month to month basis.
Seven Licensing is beneficially owned by Gerard Guez, our Chairman and Interim
Chief Executive Officer. We received $125,000 in rental income from this
sublease in the nine months ended September 30, 2006.
On September 1, 2006, our subsidiary in Hong Kong, Tarrant Company
Limited, entered into an agreement with Seven Licensing to be its buying agent
to source and purchase apparel merchandises.
In August 2004, we entered into an Agreement for Purchase of Assets
with affiliates of Mr. Kamel Nacif, a shareholder at the time of the
transaction, which agreement was amended in October 2004. Pursuant to the
agreement, as amended, on November 30, 2004, we sold to the purchasers
substantially all of our assets and real property in Mexico, including the
equipment and facilities we previously leased to Mr. Nacif's affiliates in
October 2003, for an aggregate purchase price consisting of: a) $105,400 in cash
and $3,910,000 by delivery of unsecured promissory notes bearing interest at
5.5% per annum; and b) $40,204,000, by delivery of secured promissory notes
bearing interest at 4.5% per annum, maturing on December 31, 2005 and every year
thereafter until December 31, 2014. The secured promissory notes are payable in
partial or total amounts anytime prior to the maturity of each note. Included in
the $41.0 million notes receivable - related party on the accompanying balance
sheet as of September 30, 2006 was $1.3 million of Mexico value added taxes on
the real property component of this transaction. Historically, we have 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 have satisfied our payment obligations for the fabric by
offsetting the amounts payable against the amounts due to us under the notes.
However, the purchasers have recently 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 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 will continue to pursue payments on the notes
receivable and believe the remaining $14 million balance at September 30, 2006
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 purchased $0 and $4.1 million of fabric from Acabados y
Terminados in the nine months ended September 30, 2006 and 2005, respectively.
In addition to the notes receivable, net amount due from these parties as of
September 30, 2006 was $412,000, related to reimbursement expenses.
From time to time in the past, we borrowed funds from, and advanced
funds to, Mr. Guez. The greatest outstanding balance of such advances to Mr.
Guez in the third quarter of 2006 was approximately $2,234,000. At September 30,
2006, the entire balance due from Mr. Guez totaling $2.2 million is payable on
demand and has been shown as reductions to shareholders' equity in the
accompanying financial statements. All advances to Mr. Guez bore interest at the
rate of 7.75% during the period. Total interest paid by Mr. Guez was $129,000
and $165,000 for the nine months ended September 30, 2006 and 2005,
respectively. Mr. Guez paid expenses on our behalf of approximately $226,000 and
$321,000 for the nine months ended September 30, 2006 and 2005, respectively,
which amounts were applied to reduce accrued interest and principal on Mr.
Guez's loan. These amounts included fuel and related expenses incurred by 477
Aviation, LLC, a company owned by Mr. Guez, when our executives used this
company's aircraft for business purposes. Since the enactment of the
Sarbanes-Oxley Act in 2002, no further personal loans (or amendments to existing
loans) have been or will be made to our executive officers or directors.
At September 30, 2006, we had various employee receivables totaling
$258,000 included in due from related parties.
37
On July 1, 2001, we formed an entity to jointly market, share certain
risks and achieve economies of scale with Azteca Production International, Inc.
("Azteca"), a corporation owned by the brothers of Gerard Guez, our Chairman and
Interim Chief Executive Officer, called United Apparel Ventures, LLC. This
entity was created to coordinate the production of apparel for a single customer
of our branded business. UAV is owned 50.1% by Tag Mex, Inc., our wholly owned
subsidiary, and 49.9% by Azteca. Results of the operation of UAV have been
consolidated into our results since July 2001 with the minority partner's share
of gain and losses eliminated through the minority interest line in our
financial statements. Due to the restructuring of our Mexico operations, we
discontinued manufacturing for UAV customers in the second quarter of 2004. UAV
made purchases from two related parties in Mexico, an affiliate of Azteca and
Tag-It Pacific, Inc.
At September 30, 2006, Messrs. Guez and Kay beneficially owned 590,000
and 1,003,500 shares, respectively, of common stock of Tag-It Pacific, Inc.,
collectively representing approximately 8.7% of Tag-It Pacific's common stock.
Tag-It Pacific is a provider of brand identity programs to manufacturers and
retailers of apparel and accessories. Starting from 1998, Tag-It Pacific assumed
the responsibility for managing and sourcing all trim and packaging used in
connection with products manufactured by or on behalf of us in Mexico. Due to
the restructuring of our Mexico operations, Tag-It Pacific no longer manages our
trim and packaging requirements. We purchased $205,000 and $55,000 of trim
inventory from Tag-It Pacific in the nine months ended September 30, 2006 and
2005, respectively. Our sales of garment accessories to Tag-It Pacific were
$39,000 and $0 in the nine months ended September 30, 2006 and 2005,
respectively. We purchased $0 and $135,000 of finished goods and services from
Azteca and its affiliates in the nine months ended September 30, 2006 and 2005,
respectively. Our sales of fabric and services to Azteca in the nine months
ended September 30, 2006 and 2005 was $9,000 and $63,000, respectively. Net
amount due from these related parties as of September 30, 2006 was $5.5 million.
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. 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.
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 September 30, 2006, the end of the period covered by
this report. Members of the our management, including our Chief Executive
Officer and Chief Financial Officer, also conducted an evaluation of our
internal control over financial reporting to determine whether any changes
occurred during the further quarter of 2006 that have materially affected, or
are reasonably likely to materially affect, our internal control over financial
reporting. Based upon that evaluation, the Chief Executive Officer and Chief
Financial Officer concluded that our disclosure controls and procedures are
effective.
CHANGES IN CONTROLS AND PROCEDURES
There were no significant changes in our internal controls or in other
factors that could significantly affect internal controls, known to the Chief
Executive Officer or the Chief Financial Officer during the third quarter of
2006.
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. Our
complaint includes eight causes of action, including two seeking a declaration
that the sublicense agreement is exclusive and remains in full force and effect,
as well as claims for breach of contract by Camuto Consulting, breach of the
duty of good faith and fair dealing and fraudulent inducement against Camuto
Consulting, and a claim against With You, Inc. and Ms. Simpson that we are an
intended third party beneficiary of the licenses between those defendants and
Camuto Consulting. On or about April 26, 2006, Camuto Consulting served its
answer to our complaint and included a counterclaim against us for breach of the
sublicense agreement and alleging damages of no less than $100 million. Camuto
Consulting has also served a motion to dismiss our cause of action for
fraudulent inducement. On or about May 22, 2006, we served our reply to Camuto
Consulting's counterclaim. On or about April 27, 2006, Ms. Simpson served a
motion seeking dismissal of the cause of action asserted against her. On or
about May 10, 2006, we served our opposition to Ms. Simpson motion to dismiss.
On or about June 14, 2006, we served a cross-motion seeking leave to amend our
complaint to add Vincent Camuto as a defendant. On October 18, 2006, the Court:
(i) granted our cross-motion seeking leave to file a supplemental summons and
amended complaint adding Vincent Camuto as a defendant and supplementing the
allegations of fraud against Camuto Consulting; (ii) denied Camuto Consulting's
motion to dismiss the cause of action for fraudulent inducement; and (iii)
denied Ms. Simpson's motion to dismiss the cause of action asserted against her.
On or about October 30, 2006, Camuto Consulting and Vincent Camuto served their
answer to the amended complaint, with a counterclaim that is virtually identical
to the original counterclaim. We intend to continue to vigorously defend
Camuto's counterclaim and vigorously oppose Ms. Simpson's motion. Discovery in
the matter has been underway since May 2006. A status conference is scheduled
before the Court on November 21, 2006.
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.
Five customers accounted for approximately 64% and 48% of our net sales
in first nine months of 2006 and 2005, respectively. We believe that
consolidation in the retail industry has centralized purchasing decisions and
given customers greater leverage over suppliers, like us, and we expect this
trend to continue. If this consolidation continues, our net sales and results of
operations may be increasingly sensitive to deterioration in the financial
condition of, or other adverse developments with, one or more of our customers.
While we have long-standing customer relationships, we generally do not
have long-term contracts with them. Purchases generally occur on an
order-by-order basis, and relationships exist as long as there is a perceived
benefit to both parties. A decision by a major customer, whether motivated by
competitive considerations, financial difficulties, and economic conditions or
otherwise, to decrease its purchases from us or to change its manner of doing
business with us, could adversely affect our business and financial condition.
In addition, during recent years, various retailers, including some of our
customers, have experienced significant changes and difficulties, including
40
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 contest the lawsuit
vigorously, no assurances can be given that the results of these matters will be
favorable to us. An adverse resolution of any of these lawsuits could have a
material adverse affect on our financial position and results of operations.
Additionally, we have incurred significant legal fees in this litigation, and
unless the case is settled, we will continue to incur additional legal fees in
increasing amounts as the case accelerates to trial.
FAILURE TO MANAGE OUR GROWTH AND EXPANSION COULD IMPAIR OUR BUSINESS.
Since our inception, we have experienced periods of rapid growth. No
assurance can be given that we will be successful in maintaining or increasing
our sales in the future. Any future growth in sales will require additional
working capital and may place a significant strain on our management, management
information systems, inventory management, sourcing capability, distribution
facilities and receivables management. Any disruption in our order processing,
sourcing or distribution systems could cause orders to be shipped late, and
under industry practices, retailers generally can cancel orders or refuse to
accept goods due to late shipment. Such cancellations and returns would result
in a reduction in revenue, increased administrative and shipping costs and a
further burden on our distribution facilities.
OUR OPERATING RESULTS MAY FLUCTUATE SIGNIFICANTLY.
We have experienced, and expect to continue to experience, substantial
variations in our net sales and operating results from quarter to quarter. We
believe that the factors which influence this variability of quarterly results
include the timing of our introduction of new product lines, the level of
consumer acceptance of each new product line, general economic and industry
conditions that affect consumer spending and retailer purchasing, the
availability of manufacturing capacity, the seasonality of the markets in which
we participate, the timing of trade
41
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. Such disruption
may continue to affect us to some extent in the future.
OUR DEPENDENCE ON INDEPENDENT MANUFACTURERS REDUCES OUR ABILITY TO CONTROL THE
MANUFACTURING PROCESS, WHICH COULD HARM OUR SALES, REPUTATION AND OVERALL
PROFITABILITY.
We depend on independent contract manufacturers to secure a sufficient
supply of raw materials and maintain sufficient manufacturing and shipping
capacity in an environment characterized by declining prices, labor shortage,
continuing cost pressure and increased demands for product innovation and
speed-to-market. This dependence could subject us to difficulty in obtaining
timely delivery of products of acceptable quality. In addition, a contractor's
failure to ship
42
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 initiated a factory compliance agreement with our suppliers,
and monitor our independent contractors' compliance with applicable labor laws,
but we do not control our contractors or their labor practices. The violation of
federal, state or foreign labor laws by one of the our contractors could result
in our being subject to fines and our goods that are manufactured in violation
of such laws being seized or their sale in interstate commerce being prohibited.
From time to time, we have been notified by federal, state or foreign
authorities that certain of our contractors are the subject of investigations or
have been found to have violated applicable labor laws. To date, we have not
been subject to any sanctions that, individually or in the aggregate, have had a
material adverse effect on our business, and we are not aware of any facts on
which any such sanctions could be based. There can be no assurance, however,
that in the future we will not be subject to sanctions as a result of violations
of applicable labor laws by our contractors, or that such sanctions will not
have a material adverse effect on our business and results of operations. In
addition, certain of our customers, require strict compliance by their apparel
manufacturers, including us, with applicable labor laws and visit our facilities
often. There can be no assurance that the violation of applicable labor laws by
one of our contractors will not have a material adverse effect on our
relationship with our customers.
OUR DEPENDENCE ON THIRD PARTIES FOR BRANDED APPAREL PRODUCTS REDUCES OUR ABILITY
TO CONTROL THE MARKETING PROCESS, WHICH COULD HARM OUR SALES, REPUTATION AND
OVERALL PROFITABILITY.
For certain branded apparel lines, in particular celebrity brands, we
depend on the cooperation and efforts of the celebrity personality and/or master
licensor to support our design and marketing efforts for apparel products. A
celebrity's failure to adequately support our marketing efforts could adversely
affect the sales for new products and lines. In addition, we are subject to the
terms of our agreements with the master licensor for licensed brands, and our
rights to exploit certain brands may therefore be limited. Further, we may, from
time to time, become involved in disputes with the master licensor with respect
to our contractual relationship. To the extent we are not able to receive
adequate support from the master licensor and/or celebrity or maintain good
working relationships with master licensors, our business would be harmed.
OUR BUSINESS IS SUBJECT TO RISKS OF OPERATING IN A FOREIGN COUNTRY AND TRADE
RESTRICTIONS.
Approximately 81% of our products were imported from outside the U.S.
in fiscal 2005. We are subject to the risks associated with doing business in
foreign countries, including, but not limited to, transportation delays and
interruptions, political instability, expropriation, currency fluctuations and
the imposition of tariffs, import and export controls, other non-tariff barriers
and cultural issues. Any changes in those countries' labor laws and government
regulations may have a negative effect on our profitability.
RISK ASSOCIATED WITH OUR INDUSTRY
OUR SALES ARE HEAVILY INFLUENCED BY GENERAL ECONOMIC CYCLES.
Apparel is a cyclical industry that is heavily dependent upon the
overall level of consumer spending. Purchases of apparel and related goods tend
to be highly correlated with cycles in the disposable income of our consumers.
Our customers anticipate and respond to adverse changes in economic conditions
and uncertainty by reducing inventories and canceling orders. As a result, any
substantial deterioration in general economic conditions, increases in interest
rates, acts of war, terrorist or political events that diminish consumer
spending and confidence in any of the regions in which we compete, could reduce
our sales and adversely affect our business and financial condition.
43
OUR BUSINESS IS HIGHLY COMPETITIVE AND DEPENDS ON CONSUMER SPENDING PATTERNS.
The apparel industry is highly competitive. We face a variety of
competitive challenges including:
o anticipating and quickly responding to changing consumer
demands;
o developing innovative, high-quality products in sizes, colors
and styles that appeal to consumers of varying age groups and
tastes;
o competitively pricing our products and achieving customer
perception of value; and
o the need to provide strong and effective marketing support.
WE MUST SUCCESSFULLY GAUGE FASHION TRENDS AND CHANGING CONSUMER PREFERENCES TO
SUCCEED.
Our success is largely dependent upon our ability to gauge the fashion
tastes of our customers and to provide merchandise that satisfies retail and
customer demand in a timely manner. The apparel business fluctuates according to
changes in consumer preferences dictated in part by fashion and season. To the
extent we misjudge the market for our merchandise; our sales may be adversely
affected. Our ability to anticipate and effectively respond to changing fashion
trends depends in part on our ability to attract and retain key personnel in our
design, merchandising and marketing staff. Competition for these personnel is
intense, and we cannot be sure that we will be able to attract and retain a
sufficient number of qualified personnel in future periods.
OUR BUSINESS IS SUBJECT TO SEASONAL TRENDS.
Historically, our operating results have been subject to seasonal
trends when measured on a quarterly basis. This trend is dependent on numerous
factors, including the markets in which we operate, holiday seasons, consumer
demand, climate, economic conditions and numerous other factors beyond our
control. There can be no assurance that our historic operating patterns will
continue in future periods as we cannot influence or forecast many of these
factors.
OTHER RISKS RELATED TO AN INVESTMENT IN OUR COMMON STOCK
THE ULTIMATE RESOLUTION OF THE INTERNAL REVENUE SERVICE'S EXAMINATION OF OUR TAX
RETURNS MAY REQUIRE US TO INCUR AN EXPENSE BEYOND WHAT HAS BEEN RESERVED FOR ON
OUR BALANCE SHEET OR MAKE CASH PAYMENTS BEYOND WHAT WE ARE THEN ABLE TO PAY.
In January 2004, the Internal Revenue Service proposed adjustments to
increase our federal income tax payable for the years ended December 31, 1996
through 2001. This adjustment would also result in additional state taxes,
penalties and interest. In addition, in July 2004, the IRS initiated an
examination of our Federal income tax return for the year ended December 31,
2002. In March 2005, the IRS proposed an adjustment to our taxable income of
approximately $6 million related to similar issues identified in their audit of
the 1996 through 2001 federal income tax returns. We believe that we have
meritorious defenses to and intend to vigorously contest the proposed
adjustments made to our federal income tax returns for the years ended 1996
through 2002. If the proposed adjustments are upheld through the administrative
and legal process, they could have a material impact on our earnings and cash
flow. We believe we have provided adequate reserves for any reasonably
foreseeable outcome related to these matters on the consolidated balance sheets
included in the Consolidated Financial Statements. The maximum amount of loss in
excess of the amount accrued in the financial statements is $7.7 million. If the
amount of any actual liability, however, exceeds our reserves, we would
experience an immediate adverse earnings impact in the amount of such additional
liability, which could be material. Additionally, we anticipate that the
ultimate resolution of these matters will require that we make significant cash
payments to the taxing authorities. Presently we do not have sufficient cash or
borrowing ability to make any future payments that may be required. No assurance
can be given that we will have sufficient surplus cash from operations to make
the required payments. Additionally, any cash used for these purposes will not
be available for other corporate purposes, which could have a material adverse
effect on our financial condition and results of operations.
44
INSIDERS OWN A SIGNIFICANT PORTION OF OUR COMMON STOCK, WHICH COULD LIMIT OUR
SHAREHOLDERS' ABILITY TO INFLUENCE THE OUTCOME OF KEY TRANSACTIONS.
As of September 30, 2006, our executive officers and directors and
their affiliates owned approximately 43% of the outstanding shares of our common
stock. Gerard Guez, our Chairman and Interim Chief Executive Officer, and Todd
Kay, our Vice Chairman, alone own approximately 33.1% and 8.4%, respectively, of
the outstanding shares of our common stock at September 30, 2006. Accordingly,
our executive officers and directors have the ability to affect the outcome of,
or exert considerable influence over, all matters requiring shareholder
approval, including the election and removal of directors and any change in
control. This concentration of ownership of our common stock could have the
effect of delaying or preventing a change of control of us or otherwise
discouraging or preventing a potential acquirer from attempting to obtain
control of us. This, in turn, could have a negative effect on the market 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.
ABSENCE OF DIVIDENDS COULD REDUCE OUR ATTRACTIVENESS TO YOU.
Some investors favor companies that pay dividends, particularly in
general downturns in the stock market. We have not declared or paid any cash
dividends on our common stock. We currently intend to retain any future earnings
for funding growth, and we do not currently anticipate paying cash dividends on
our common stock in the foreseeable future. Additionally, we cannot pay
dividends on our common stock unless the terms of our bank credit facilities and
outstanding preferred stock, if any, permit the payment of dividends on our
common stock. Because we may not pay dividends, your return on this investment
likely depends on your selling our stock at a profit.
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ITEM 6. EXHIBITS.
Exhibit
Number Description
------- -----------------------------------------------------------------------
10.39.1 Amendment No. 1 to Credit Agreement, dated July 5, 2006, by and among
Tarrant Apparel Group, Fashion Resource (TCL), Inc., Tag Mex, Inc.,
United Apparel Ventures, LLC, Private Brands, Inc. and NO! Jeans, Inc.,
the Guarantor a party thereto, the Lenders a party thereto and
Guggenheim Corporate Funding, LLC.
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: November 14, 2006 By: /s/ Corazon Reyes
---------------------------------
Corazon Reyes,
Chief Financial Officer
Date: November 14, 2006 By: /s/ Gerard Guez
---------------------------------
Gerard Guez,
Interim Chief Executive Officer
47