TARRANT APPAREL GROUP - 10-Q Quarterly Report

As filed with the Securities and Exchange Commission on August 14, 2002

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x		Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. For the quarterly period ended June 30, 2002 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: 0-26430

TARRANT APPAREL GROUP

(Exact name of registrant as specified in its charter)

California

(State or other jurisdiction of

incorporation or organization)

95-4181026

(I.R.S. Employer

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 ¨

Number of shares of Common Stock of the registrant outstanding as of August 1, 2002: 15,846,315

TARRANT APPAREL GROUP

FORM 10-Q

INDEX

PART I. FINANCIAL INFORMATION

		Page

Item 1.	Financial Statements (Unaudited)

	Consolidated Balance Sheets at June 30, 2002 (Unaudited) and December 31, 2001 (Audited)	4

	Consolidated Statements of Operations for the Three Months and Six Months Ended June 30, 2002 and June 30, 2001	5

	Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2002 and June 30, 2001	6

	Notes to Consolidated Financial Statements	7

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	12

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	20

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	21

Item 2.	Changes in Securities and Use of Proceeds	21

Item 3.	Defaults Upon Senior Securities	21

Item 4.	Submission of Matters to a Vote of Security Holders	21

Item 5.	Other Information	22

Item 6.	Exhibits and Reports on Form 8-K	22

SIGNATURES		24

Cautionary Legend Regarding Forward-looking Statements

Some of the information in this 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 limitations, 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. The Annual Report of Form 10-K for the year ended December 31, 2001 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.

PART I—FINANCIAL INFORMATION

Item 1. Financial Statements.

TARRANT APPAREL GROUP

CONSOLIDATED BALANCE SHEETS

	June 30, 2002			December 31, 2001
	(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	1,920,707		$	1,524,447
Restricted cash		4,000,000			—
Accounts receivable, net		85,037,144			58,576,654
Due from affiliates		291,539			2,064,923
Due from officers		639,731			87,456
Inventory		55,715,030			50,600,584
Temporary quota		1,904,123			369,849
Current portion of note receivable-related party		3,468,490			3,468,490
Prepaid expenses and other receivables		6,047,890			6,274,330
Deferred tax assets		2,447,564			—
Income taxes receivable		102,565			692,868

Total current assets		161,574,783			123,659,601
Property and equipment, net		79,115,208			90,173,451
Permanent quota, net		36,989			73,978
Note receivable-related party, less current portion		41,430,564			41,430,564
Other assets		3,068,644			3,932,146
Excess of cost over fair value of net assets acquired, net		27,445,439			29,196,886

Total assets	$	312,671,627		$	288,466,626

LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Short-term bank borrowings	$	26,887,931		$	22,085,349
Accounts payable		51,053,567			31,560,131
Accrued expenses		14,492,134			9,648,389
Income taxes		7,543,465			7,177,324
Deferred tax liabilities		—			514,913
Due to shareholders		1,128,735			2,307,687
Current portion of long-term obligations		24,880,262			25,256,628

Total current liabilities		125,986,094			98,550,421
Long-term obligations		66,315,748			63,993,808
Minority interest		1,898,326			757,927
Deferred tax liabilities		1,351,478			—

Total liabilities		195,551,646			163,302,156
Commitments and contingencies

Shareholders’ equity:
Preferred stock, 2,000,000 shares authorized; none issued and outstanding		—			—
Common stock, no par value, 35,000,000 shares authorized; 15,842,815 shares (2002) and 15,840,815 shares (2001) issued and outstanding		69,350,887			69,341,090
Contributed capital		1,434,259			1,434,259
Retained earnings		58,936,328			62,958,375
Notes receivable from shareholders		(7,989,178	)		(12,118,773	)
Accumulated other comprehensive income		(4,612,315	)		3,549,519

Total shareholders’ equity		117,119,981			125,164,470

Total liabilities and shareholders’ equity	$	312,671,627		$	288,466,626

See accompanying notes

TARRANT APPAREL GROUP

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

	Three Months Ended June 30					Six Months ended June 30
	2002			2001		2002			2001
Net sales	$	95,306,909		96,125,651		$	160,471,093		180,455,799
Cost of sales		80,882,668		80,311,913			137,627,881		150,223,251

Gross profit		14,424,241		15,813,738			22,843,212		30,232,548
Selling and distribution expenses		2,424,999		3,888,416			5,062,012		7,811,426
General and administrative expenses		7,219,285		7,896,833			13,832,170		16,772,949
Amortization of excess of cost over fair value of net assets acquired		—		728,790			—		1,457,580

Income (loss) from operations		4,779,957		3,299,699			3,949,030		4,190,593
Interest expense		(1,676,709	)	(2,108,305	)		(2,576,675	)	(4,238,912	)
Interest income		77,953		1,016,063			135,631		2,042,392
Other income		72,670		500,403			93,400		1,076,517
Minority interest		(1,439,552	)	—			(1,877,339	)	345,905

Income (loss) before provision for income taxes and cumulative effect of accounting change		1,814,319		2,707,860			(275,953	)	3,416,495
Provision for income taxes		511,983		1,001,908			147,962		1,264,102

Income (loss) before cumulative effect of accounting change	$	1,302,336		1,705,952		$	(423,915	)	2,152,393
Cumulative effect of accounting change, net of tax benefit		—		—			(3,598,132	)	—

Net income (loss)	$	1,302,336		1,705,952		$	(4,022,047	)	2,152,393

Net income (loss) per share—Basic:
Before cumulative effect of accounting change	$	0.08		0.11		$	(0.03	)	0.14
Cumulative effect of accounting change		—		—			(0.22	)	—
After cumulative effect of accounting change	$	0.08		0.11		$	(0.25	)	0.14

Net income (loss) per share—Diluted:
Before cumulative effect of accounting change	$	0.08		0.11		$	(0.03	)	0.14
Cumulative effect of accounting change		—		—			(0.22	)	—
After cumulative effect of accounting change	$	0.08		0.11		$	(0.25	)	0.14

Weighted average common and common equivalent shares:
Basic		15,832,474		15,832,315			15,832,061		15,832,315

Diluted		16,098,557		15,904,570			15,832,061		15,869,608

See accompanying notes

TARRANT APPAREL GROUP

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

	Six Months Ended June 30,
	2002			2001
Operating activities:
Net income (loss)	$	(4,022,047	)	$	2,152,393
Adjustments to reconcile net income (loss) to net cash used in operating activities:
Deferred taxes		(337,887	)		(119,104	)
Depreciation and amortization		5,227,535			7,105,847
Cumulative effect of accounting change		3,598,132			—
Unrealized gain on foreign currency		383,435			(598,537	)
Effect of changes in foreign currency		(604,006	)		1,121,291
Provision for returns and discounts		(1,658,657	)		1,033,639
Minority interest		1,140,399			—
Changes in operating assets and liabilities:
Restricted cash		(4,000,000	)		—
Accounts receivable		(24,801,832	)		(20,828,815	)
Due from affiliates and officers		420,027			(3,775,131	)
Inventory		(5,114,446	)		(7,800,087	)
Temporary quota		(1,534,274	)		(1,630,754	)
Prepaid expenses and other receivables		816,743			(666,831	)
Accounts payable		19,493,436			14,209,155
Accrued expenses and income tax payable		2,413,105			1,215,110

Net cash used in operating activities		(8,580,337	)		(8,581,824	)

Investing activities:
Purchase of fixed assets		(646,394	)		(1,936,896	)
Proceeds from notes receivable		—			1,135,551
Acquisitions		—			(5,507,391	)
(Increase) decrease in other assets		295,557			(961,081	)

Net cash used in investing activities		(350,837	)		(7,269,817	)

Financing activities:
Short-term bank borrowings, net		4,802,582			(16,137,022	)
Proceeds from long-term obligations		25,263,169			37,982,535
Payment of long-term obligations and bank borrowings		(23,701,030	)		(1,959,152	)
Repayments and advances to shareholders/officers		(2,287,398	)		(8,163,837	)
Borrowings from shareholders/officers		5,240,315			1,835,332
Exercise of stock options		9,796			—

Net cash provided by financing activities		9,327,434			13,557,856

Increase (decrease) in cash and cash equivalents		396,260			(2,293,785	)
Cash and cash equivalents at beginning of period		1,524,447			2,649,297

Cash and cash equivalents at end of period	$	1,920,707		$	355,512

See accompanying notes.

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 (formerly “Fashion Resource, Inc.”) (the “Parent Company” or the “Company”), and its wholly owned subsidiaries located primarily in the U.S., Mexico, and Asia. The Company owns 51% of Jane Doe International, LLC (“JDI”), and 50.1% of United Apparel Ventures, LLC (“UAV”). The Company consolidates both of these entities and reflects the minority interests in earnings (losses) of the ventures in the accompanying financial statements. All inter-company amounts are eliminated in consolidation.

The Company serves specialty retail, mass merchandise, department store chains and major international brands by designing, merchandising, contracting for the manufacture of, manufacturing directly and selling casual, moderately priced apparel for women, men and children under private label. Commencing in 1999, the Company expanded its operations from sourcing apparel to sourcing and operating its own vertically integrated manufacturing facilities.

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 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 accounting principles generally accepted in the United States 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, 2001 is derived from audited financial statements which are included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2001, 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 preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Assets and liabilities of the Mexico and Hong Kong subsidiaries are translated at the rate of exchange in effect on the balance sheet date; income and expenses are translated at the average rates of exchange prevailing during the year. The functional currency in which the Company transacts business in Hong Kong is the Hong Kong dollar and in Mexico is the peso.

Total comprehensive income (loss) was $(8,969,000) and $(12,184,000) for the three months and six months ended June 30, 2002 and $6,423,000 and $8,154,000 for the three months and six months ended June 30, 2001. The components of comprehensive income (loss) are net income (loss) and foreign currency translation adjustments.

3. Accounts Receivable

Accounts receivable consists of the following:

	June 30, 2002			December 31, 2001
United States trade accounts receivable	$	60,091,403		$	41,266,134
Foreign trade accounts receivable		20,711,993			17,846,606
Due from factor		3,672,274			1,507,089
Other receivables		5,069,065			4,123,073
Allowance for returns, discounts and bad debts		(4,507,591	)		(6,166,248	)

	$	85,037,144		$	58,576,654

4. Inventory

Inventory consists of the following:

	June 30, 2002		December 31, 2001
Raw materials
Fabric and trim accessories	$	14,848,727	$	16,708,651
Raw cotton		1,041,397		2,096,792
Work-in-process		20,303,111		7,735,827
Finished goods shipments-in-transit		2,375,690		3,706,735
Finished goods		17,146,105		20,352,579

	$	55,715,030	$	50,600,584

5. Debt

Short-term bank borrowings consist of the following:

	June 30, 2002		December 31, 2001
Import trade bills payable	$	6,715,882	$	4,521,675
Bank direct acceptances		12,533,709		13,838,270
Other foreign credit facilities		7,638,340		2,048,420
United States credit facilities		—		1,676,984

	$	26,887,931	$	22,085,349

Long term obligations consist of the following:

	June 30, 2002			December 31, 2001
Vendor financing	$	9,596,960		$	11,043,449
Equipment financing		11,741,048			13,931,997
Debt facility		69,387,002			62,863,990
Other debt		471,000			1,411,000

		91,196,010			89,250,436
Less current portion		(24,880,262	)		(25,256,628	)

	$	66,315,748		$	63,993,808

as adjusted, of the Company will exceed $105 million at the end of 2002, and that the Company will maintain certain debt to equity, fixed charge and interest coverage ratios. As of June 30, 2002, the Company pledged an additional $4 million to UPS as temporary collateral which is reflected as restricted cash in the June 30, 2002 balance sheet, and there were $28.4 million of outstanding borrowings under this facility. Included in the outstanding was a standby letter of credit for $14 million opened in favor of HKSB to cover the transition to move current borrowings outstanding from the bank.

On January 21, 2000, the Company entered into a revolving credit, factoring and security agreement (the “Debt Facility”) with a syndicate of lending institutions in the US. The Debt Facility initially provided a revolving facility of $105.0 million, including a letter of credit facility not to exceed $20.0 million, and matures on January 31, 2005. The Debt Facility provides for interest at LIBOR plus the LIBOR rate margin determined by the Total Leverage Ratio (as defined). The Debt Facility is collateralized by receivables, intangibles, inventory and various other specified non-equipment assets of the Company. In addition, the facility is subject to various financial covenants, including requirements for tangible net worth, fixed charge coverage ratios, and interest coverage ratios, among others, and prohibits the payment of dividends. In March 2002 , the Company entered into an amendment of its Debt Facility with GMAC, who solely assumed the facility in 2000. This amendment reduces the $105.0 million facility to $90.0 million. It also requires the Company to reduce a $25 million over-advance limit under this facility by $500,000 per month beginning February 28, 2001. In 2001, the Company obtained a temporary over-advance credit facility with GMAC up to a total of $10 million expiring on February 5, 2002. The Company has entered into an agreement to repay this temporary facility by $1 million each month starting April 15, 2002 and to accelerate the monthly installment of the $25 million over-advance to $687,500 from August 2002 onwards. Accompanying the waiver given for the first quarter results of 2002, the bank also revised the covenants with regard to the financial ratios of the whole year of 2002. As of June 30, 2002, $69.9 million including letter of credit was outstanding under the credit facility.

As of June 30, 2002, Grupo Famian had a short-term advance from Banco Bilbao Vizcaya amounting to $704,000. This subsidiary also has a new credit facility with Banco Nacional de Comercio Exterior SNC guaranteed by the Company. This facility provides for a $10 million credit line based on purchase orders and is restricted by certain covenants. As of June 30, 2002, the outstanding amount was $4.5 million.

The Company has two equipment loans for $16.25 million and $5.2 million from GE Capital Leasing and Bank of America Leasing, respectively. The leases are secured by equipment located in Puebla and Tlaxcala, Mexico. The amounts outstanding as of June 30, 2002 were $8.4 million due to GE Capital and $2.8 million due to Bank of America. Interest accrues at a rate of 2 1/2% over LIBOR. The loan from GE Capital will mature in the year 2005 and the loan from Bank of America in the year 2004. These facilities are subject to certain restrictive covenants.

During 2000, the Company financed equipment purchases for a manufacturing facility with certain vendors of the related equipment. A total of $16.9 million was financed with five-year promissory notes, which bear interest ranging from 7.0% to 7.5%, and are payable in semiannual payments commencing in February 2000. Of this amount, $9.6 million was outstanding as of June 30, 2002. Of the $9.6 million, $5.2 million is denominated in the Euro. The remainder is payable in U.S. dollars. The Company has covered the risk of any foreign currency fluctuation with forward exchange contracts.

6. Other

On June 28, 2000, the Company signed an exclusive production agreement with Manufactures Cheja (“Cheja”) through February 2002. The Company has agreed on a new contract to extend the agreement for an additional quantity of 6,400,000 units beginning April 1, 2002, which will cover an eighteen-month period. The Company has provided Cheja approximately $3.4 million in advances related to the production agreement to be recouped out of future production. As of June 30, 2002, the advances have come down to $3.1 million.

7. Goodwill—Adoption of Statement No. 142

In July 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 142 “Goodwill and Other Intangible Assets,” which establishes financial accounting and reporting for acquired goodwill and other intangible assets and supersedes APB Opinion No. 17, Intangible Assets. The Company adopted SFAS No. 142 beginning with the first quarter of 2002. SFAS No. 142 requires that goodwill and intangible assets that have indefinite useful lives not be amortized but, instead, tested at least annually for impairment while intangible assets that have finite useful lives continue to be amortized over their respective useful lives. Accordingly, the Company ceased amortization of all goodwill.

SFAS No. 142 requires that goodwill and other intangibles be tested for impairment using a two-step process. The first step is to determine the fair value of the reporting unit, which may be calculated using a discounted cash flow methodology, and compare this value to its carrying value. If the fair value exceeds the carrying value, no further work is required and no impairment loss would be recognized. The second step is an allocation of the fair value of the reporting unit to all of the reporting unit’s assets and liabilities under a hypothetical purchase price allocation. Based on the evaluation performed to adopt SFAS No. 142 along with continuing difficulties being experienced in the industry, the Company recorded a non-cash charge of $3.6 million, net of tax benefit of $1.3 million, to reduce the carrying value of goodwill to the estimated fair value. This charge is non-operational in nature and is reported as a cumulative effect of an accounting change in the accompanying consolidated statement of operations. The Company utilized

the discounted cash flow methodology to estimate fair value. The following table presents the quarterly results of the Company on a comparable basis:

	Three Months Ended June 30,				Six Months Ended June 30,
	2002		2001		2002			2001
Reported net income (loss)	$	1,302,336	$	1,705,952	$	(423,915	)	$	2,152,393
Goodwill amortization, net of tax		—		459,138		—			918,276

Adjusted net income (loss) before cumulative effect of accounting change	$	1,302,336	$	2,165,090	$	(423,915	)	$	3,070,669
Cumulative effect of accounting change		—		—		(3,598,132	)		—

Adjusted net income (loss)	$	1,302,336	$	2,165,090	$	(4,022,047	)	$	3,070,669
Diluted earnings per common share:
Reported income (loss) before cumulative effect of accounting change	$	0.08	$	0.11	$	(0.03	)	$	0.14
Goodwill amortization, net of taxes		—		0.03		—			0.06

Adjusted income (loss) before cumulative effect of accounting change	$	0.08	$	0.14	$	(0.03	)	$	0.20
Cumulative effect of accounting change		—		—		(0.22	)		—
Adjusted net income	$	0.08	$	0.14	$	(0.25	)	$	0.20

The following table displays the change in the gross carrying amount of goodwill by business units for the quarter ended June 30, 2002:

	Total		Jane Doe		Tarrant Mexico-Ajalpan		Tarrant Mexico-Famian		Tag Mex Inc. -Rocky Division	Tag Mex Inc. -Chazzz & MGI Division
Balance as of December 31, 2001	29,196,886		1,904,529		4,427,843		7,260,134		7,521,536	8,082,844
Additional purchase price	2,167,000		—		—		1,667,000		—	500,000
Additional liabilities assumed	1,428,588		1,428,588		—		—		—	—
Impairment losses	(4,871,244	)	(3,182,779	)	(1,688,465	)	—		—	—
Foreign currency translation	(475,791	)	—		—		(475,791	)	—	—

Balance as of June 30, 2002	27,445,439		150,338		2,739,378		8,451,343		7,521,536	8,582,844

8. Recently Issued Accounting Pronouncements

In October 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment of Disposal of Long-Lived Assets”. This statement addresses the financial accounting and reporting for the impairment and disposal of long-lived assets. It supercedes and addresses significant issues relating to the implementation of SFAS No. 121, “Accounting for the Impairment of Disposal of Long-Lived Assets and For Long-Lived Assets to Be Disposed Of”. SFAS No. 144 retains many of the fundamental provisions of SFAS No. 121 and establishes a single accounting model, based on the framework established in SFAS No. 121, for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired. The Company adopted this standard as of the beginning of fiscal 2002. The application of SFAS No. 144 did not have a material impact on the Company’s results of operations and financial position.

9. Earnings Per Share

A reconciliation of the numerator and denominator of basic earnings per share and diluted earnings per share is as follows:

	Three Months Ended June 30,				Six Months Ended June 30,
	2002		2001		2002			2001
Basic EPS Computation:
Numerator	$	1,302,336	$	1,705,952	$	(4,022,047	)	$	2,152,393
Denominator:
Weighted average common shares outstanding		15,832,474		15,832,315		15,832,061			15,832,315

Total shares		15,832,474		15,832,315		15,832,061			15,832,315

Basic EPS	$	0.08	$	0.11	$	(0.25	)	$	0.14

Diluted EPS Computation:
Numerator	$	1,302,336	$	1,705,952	$	(4,022,047	)	$	2,152,393
Denominator:
Weighted average common shares outstanding		15,832,474		15,832,315		15,832,061			15,832,315
Incremental shares from assumed exercise of options		266,083		72,255		—			37,293

Total shares		16,098,557		15,904,570		15,832,061			15,869,608

Diluted EPS	$	0.08		0.11	$	(0.25	)	$	0.14

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

General

The Company serves specialty retail, mass merchandise and department store chains and major internationally recognized brands by designing, merchandising, contracting for the manufacture of, manufacturing directly and selling casual, moderately-priced apparel for women, men and children under private label. The Company’s major customers include specialty retailers, such as Lerner New York, Limited Stores and Express, all of which are divisions of The Limited, as well as Lane Bryant, Abercrombie & Fitch, J.C. Penney, K-Mart, Kohl’s, Mervyns, Sears and Walmart. The Company’s 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.

From inception, the Company relied primarily on independent contract manufactures located primarily in the Far East. Commencing in the third quarter of 1997 and taking advantage of the North American Free Trade Agreement (“NAFTA”), the Company substantially expanded its use of independent cutting, sewing and finishing contractors in Mexico, primarily for basic garments. Since 1999, the Company has engaged in an ambitious program to develop a vertically integrated manufacturing operation in Mexico. The gross sale of products sourced in Mexico was approximately $49 million in the second quarter of 2002 (or 52% of net sales) compared to approximately $40 million in the second quarter of 2001 (or 42% of net sales). In addition, the Company has maintained its sourcing operation from the Far East. The vertical integration of its manufacturing operations through the development and acquisition of fabric and production capacity in Mexico will be concluded in 2002 if the Company elects to exercise its option to acquire the twill mill in Tlaxcala. In addition, the Company is focused on coordinating and improving the efficiencies of its operations in Mexico. The Company believes that the dual strategy of maintaining independent contract manufacturers in the Far East and a Company controlled manufacturing network in Mexico can best serve the different needs of its customers and enable it to take the best advantage of both markets. In addition, the Company believes it has diversified its business risks associated with doing business abroad (including transportation delays, economic or political instability, currency fluctuations, restrictions on the transfer of funds and the imposition of tariffs, export duties, quota, and other trade restrictions).

On March 29, 2001, the Company completed the acquisition of a sewing facility located in Ajalpan, Mexico from Confecciones Jamil, S.A. de C.V. which was majority owned by Kamel Nacif, a principal shareholder of the Company. This facility, which was newly constructed during 1999 and commenced operations in 2000, has been used by the Company for production since 2000. The facility contains 98,702 square feet and eight sewing lines containing up to 840 sewing machines, which can generate a maximum capacity of six million units per year.

The Company paid $11 million for this operating facility. This entire amount had been paid through advances and other trade receivables. The assets acquired include land, buildings and all equipment, in addition to a trained labor force in place of about 2,000 employees. This acquisition completes the Company’s garment production core, which consists of Group Famian and Ajalpan owned by the Company; Tlaxcala, which is currently leased; the UAV joint venture; and a production agreement with Manufactures Cheja.

On June 28, 2000, the Company signed a production agreement with Manufactures Cheja through February 2002. The Company has agreed on a new contract to extend the contract for an additional quantity of 6,400,000 units after April 1, 2002.

On April 12, 2000, the Company formed a new company, Jane Doe International, LLC (“JDI”). This company was formed for the purpose of purchasing the assets of Needletex, Inc., owner of the Jane Doe brand. JDI is owned 51% by Fashion Resource (TCL), Inc., a subsidiary of the Company, and 49% by Needletex, Inc. In March 2001, the Company converted JDI from an operating company to a licensing company.

On December 2, 1998, the Company contracted to acquire a fully operational twill mill being constructed near Puebla, Mexico by an affiliate of Kamel Nacif, a principal shareholder of the Company. Construction of the facility was completed in 2000. The Company began operating a garment processing and distribution facility in the forth quarter of 1999. On October 16, 2000, the Company extended its option to purchase the facility until September 30, 2002. The Company has also entered into a production agreement with the operator of the twill mill granting the Company the first right to purchase all production capacity of the twill mill. The Company is reviewing strategies and available financing related to exercising the option to purchase this facility prior to the expiration of the option in September 2002.

The Company believes there is a major competitive advantage in being a fully integrated supplier with the capability of controlling and managing the process of manufacturing from raw materials to finished garments. In order to execute the garment production operations, facilities have been acquired and developed to support anticipated capacity requirements. Computer systems have been developed and installed, which allow the Company to better track its production and inventory. New operational policies have been implemented to insure operations function efficiently and effectively.

The Company believes that to a large extent, the cost, problems and inefficiencies initially encountered in its vertical integration strategy have been corrected and the benefits of lower cost production should improve margins. From the end of 2000 through the present, the U.S. economy has experienced an economic downturn, which was exacerbated by the events of September 11. In Mexico, the Company faced the challenge of an industry wide slowdown coupled with the fixed costs associated with its manufacturing facilities. The Company responded by implementing programs to cut operating costs, including reducing its workforce by approximately 20% in Mexico and Hong Kong and 50% in the U.S. The Company believes the consolidation of its worldwide operations has helped overcome the economic challenges in the past year. The Company also believes that overhead reductions and the current operating efficiency will result in a stronger operating position.

Factors That May Affect Future Results

This Report on Form 10-Q contains forward-looking statements, which are subject to a variety of risks and uncertainties. The Company’s actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth below.

Vertical Integration. In 1997, the Company commenced the vertical integration of its business. Key elements of this strategy include (i) establishing cutting, sewing, washing, finishing, packing, shipping and distribution activities in company-owned facilities or through the acquisition of established contractors and (ii) establishing fabric production capability through the acquisition of established textile mills or the construction of new mills. Prior to April 1999, the Company had no previous history of operating textile mills or cutting, sewing, washing, finishing, packing or shipping operations upon which an evaluation of the prospects of the Company’s vertical integration strategy can be based. In addition, such operations are subject to the customary risks associated with owning a manufacturing business, including, but not limited to, the maintenance and management of manufacturing facilities, equipment, employees and inventories. The Company is also 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 (including changes in the allocation of quotas) and cultural issues.

Reliance on Key Customers. Affiliated stores owned by The Limited (including Lerner New York, Limited Stores and Express) accounted for approximately 17.2% and 16.8% of the Company’s net sales in the first six months of 2002 and 2001, respectively. Lane Bryant, owned by Charming Shoppes in 2002 and The Limited in 2001, accounted for 23.2% and 24.6% of net sales in the first six months of 2002 and 2001. The loss of such customers could have a material adverse effect on the Company’s results of operations. From time to time, certain of the Company’s major customers have experienced financial difficulties. The Company does not have long-term contracts with any of its customers and, accordingly, there can be no assurance that any customer will continue to place orders with the Company to the same extent it has in the past, or at all. In addition, the Company’s results of operations will depend to a significant extent upon the commercial success of its major customers.

Foreign Risks. Approximately 95% of the Company products were imported in the second quarter of 2002 and most of the Company’s fixed assets are in Mexico. The Company is subject to the risks associated with doing business and owning fixed assets 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 (including changes in the allocation of quotas) and cultural issues. Any changes in those countries’ labor laws and government regulations may have a negative effect on the Company’s profitability.

Management of Complexity. Since the beginning of its vertical integration strategy, the Company has experienced increased complexities. No assurance can be given that the Company will meet the demands on management, management information systems, inventory management, production controls, distribution systems, and financial controls given these complexities. Any disruption in the Company’s order process, production or distribution may have a material effect on the Company’s results of operations.

Manufacturer’s Risks. The Company, as a manufacturer in Mexico, is subject to the customary risks associated with owning a manufacturing business, including, but not limited to, the maintenance and management of manufacturing facilities, equipment, employees, trade unions and inventories. The risk of being a fully integrated manufacturer is amplified in an industry-wide slowdown because of the fixed costs associated with manufacturing facilities

Variability of Quarterly Results. The Company has experienced, and expects to continue to experience, a substantial variation in its net sales and operating results from quarter to quarter. The Company believes that the factors which influence this variability of quarterly results include the timing of the Company’s 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 the Company participates, the timing of trade shows, the product mix of customer orders, the timing of the placement or cancellation of customer orders, the weather, transportation delays, quotas, the occurrence of chargebacks in excess of reserves and the timing of expenditures in anticipation of increased sales and actions of competitors. Accordingly, a comparison of the Company’s results of operations from period to period is not necessarily meaningful, and the Company’s results of operations for any period are not necessarily indicative of future performance.

Economic Conditions. The apparel industry historically has been subject to substantial cyclical variation, and a recession in the general economy or uncertainties regarding future economic prospects that affect consumer spending habits have in the past had, and may in the future have, a materially adverse effect on the Company results of operations. This has been underscored by the events of September 11, 2001. In addition, certain retailers, including some of the Company’s customers, have experienced in the past, and may experience in the future, financial difficulties, which increase the risk of extending credit to such retailers and the risk that financial failure will eliminate a customer entirely. These retailers have attempted to improve their own operating efficiencies by concentrating their purchasing power among a narrowing group of vendors. There can be no assurance that the Company will remain a preferred vendor for its existing customers. A decrease in business from or loss of a major customer could have a material adverse effect on the Company’s results of operations. There can be no assurance that the Company’s factor will approve the extension of credit to certain retail customers in the future. If a customer’s credit is not approved by the factor, the Company could

either assume the collection risk on sales to the customer itself, require that the customer provide a letter of credit or choose not to make sales to the customer.

Key Personnel. The Company depends on the continued services of its senior management. The loss of the services of any key employee could hurt the business. Also, the future success of the Company depends on its ability to identify, attract, hire, train and motivate other highly skilled personnel. Failure to do so may impair future results.

China’s Entry into the WTO. As of 2005, quota on Chinese origin apparel will be phased out. This may pose serious challenges to Mexican apparel products sold to the US market. Products from China now receive the same preferential tariff treatment accorded goods from countries granted Normal Trade Relations status. With China becoming a member of the WTO in December 2001, this status is now permanent. The Company’s Mexican products may be adversely affected by the increased competition from Chinese products.

Dependence on Contract Manufacturers. The Company has reduced its reliance on outside third party contractors through its Mexico vertical integration strategy. However, all international and a portion of its domestic sourcing are manufactured by independent cutting, sewing and finishing contractors. The use of contract manufacturers and the resulting lack of direct control over the production of its products could result in the Company’s failure to receive timely delivery of products of acceptable quality. Although the Company believes that alternative sources of cutting, sewing and finishing services are readily available, the loss of one or more contract manufacturers could have a materially adverse effect on the Company’s results of operations until an alternative source is located and has commenced producing the Company’s products.

Although the Company monitors the compliance of its independent contractors with applicable labor laws, the Company does not control its contractors or their labor practices. The violation of federal, state or foreign labor laws by one of the Company’s contractors can result in the Company being subject to fines and the Company’s goods, that are manufactured in violation of such laws being seized or their sale in interstate commerce being prohibited. From time to time, the Company has been notified by federal, state or foreign authorities that certain of its contractors are the subject of investigations or have been found to have violated applicable labor laws. To date, the Company has not been subject to any sanctions that, individually or in the aggregate, could have a material adverse effect upon the Company, and the Company is not aware of any facts on which any such sanctions could be based. There can be no assurance, however, that in the future the Company will not be subject to sanctions as a result of violations of applicable labor laws by its contractors, or that such sanctions will not have a material adverse effect on the Company. In addition, certain of the Company’s customers, including The Limited, require strict compliance by their apparel manufacturers, including the Company, with applicable labor laws and visit the Company’s facilities often. There can be no assurance that the violation of applicable labor laws by one of the Company’s contractors will not have a material adverse effect on the Company’s relationship with its customers.

Price and Availability of Raw Materials. Raw cotton and cotton fabric are the principal raw materials used in the Company’s apparel. Although the Company believes that its suppliers will continue to be able to procure a sufficient supply of raw cotton and cotton fabric for its production needs, the price and availability of cotton may fluctuate significantly depending on supply, world demand and currency fluctuations, each of which may also affect the price and availability of cotton fabric. There can be no assurance that fluctuations in the price and availability of raw cotton, cotton fabric or other raw materials used by the Company will not have a material adverse effect on the Company’s results of operations.

Management of Growth. Since its inception, the Company has experienced periods of rapid growth. No assurance can be given that the Company will be successful in maintaining or increasing its sales in the future. Any future growth in sales will require additional working capital and may place a significant strain on the Company’s management, management information systems, inventory management, production capability, distribution facilities and receivables management. Any disruption in the Company’s 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 the Company’s distribution facilities.

Overhead Reductions. Since the beginning of 2000, the Company has been reducing overhead by the elimination of functions duplicated in Los Angeles, New York and Mexico. In 2001, the Company became more aggressive as sales declined, reducing headcount by 50% in the U.S. and approximately 20% in both Mexico and Hong Kong. The Company may be adversely affected by the increased workloads.

Computer and Communication Systems. Being a multi-national corporation, the Company relies on its 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 effect on the Company’s operations. Recently, hackers and computer viruses have disrupted the operations of several major companies. The Company may be vulnerable to similar acts of sabotage.

Future Acquisitions. In the future, the Company may continue its growth through acquisition. The Company may not be successful in overcoming the risks associated with acquiring new businesses and this may have a negative effect on future results.

Future Capital Requirements. The Company may not be able to fund its future growth or react to competitive pressures if it lacks sufficient funds. Currently, the Company feels it has sufficient cash available through its bank credit facilities, issuance of long-term debt, proceeds from loans from affiliates, and proceeds from the exercise of stock options to fund existing operations for the foreseeable future. The Company cannot be certain that additional financing will be available in the future if necessary.

Stock Price. The market price of the Company’s Common Stock is likely to be volatile and could be subject to significant fluctuations in response to the factors such as 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 the Company or its 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. Also, general political and economic conditions such as a recession, or interest rate or currency rate fluctuations may adversely affect the market price of the Company’s Common Stock.

Closely Controlled Stock. At June 30, 2002, certain senior executives beneficially owned approximately 57% of the Company’s outstanding Common Stock. These senior executives effectively have the ability to control the outcome on all matters requiring shareholder approval, including, but not limited to, the election and removal of directors, and any merger, consolidation or sale of all or substantially all of the Company’s assets, and to control the Company’s management and affairs.

Results of Operations

The following table sets forth, for the periods indicated, certain items in the Company’s consolidated statements of income as a percentage of net sales:

	Three Months Ended June 30,				Six Months Ended June 30,
	2002		2001		2002		2001
Net sales	100.0	%	100.0	%	100.0	%	100.0	%
Cost of sales	84.9		83.5		85.8		83.2

Gross profit	15.1		16.5		14.2		16.8
Selling and distribution expenses	2.5		4.0		3.1		4.3
General and administration expenses*	7.6		9.1		8.6		10.2

Income (loss) from operations	5.0		3.4		2.5		2.3
Interest expense	(1.8	)	(2.2	)	(1.6	)	(2.3	)
Other income	0.2		1.6		0.1		1.7
Minority interest	(1.5	)	0.0		(1.2	)	0.2

Income (loss) before taxes and cumulative effect of accounting change	1.9		2.8		(0.2	)	1.9
Income taxes	0.5		1.0		0.1		0.7

Net income (loss) before cumulative effect of accounting change	1.4	%	1.8	%	(0.3	)%	1.2	%

Cumulative effect of accounting change net of tax benefit	—		—		(2.2	)	—
Net income (loss)	1.4	%	1.8	%	(2.5	)%	1.2	%

Includes amortization of excess of cost over fair value of net assets acquired, 0.8% of net sales for the second quarter and six months of 2001.

Second Quarter 2002 Compared to Second Quarter 2001

Net sales decreased by $819,000, or 0.9%, from $96.1 million in the second quarter of 2001 to $95.3 million in the second quarter of 2002. The decrease in net sales included an increase in sales of $1.3 million to mass merchandisers, an increase of $1.7 million to divisions of The Limited, Inc. (excluding Lane Bryant which was sold to Charming Shoppes in 2001), offset by a decrease of $2.1 million to Lane Bryant, and a decrease of $2.3 million as a result of the conversion of Jane Doe from a sales company to a licensing company. Sales to divisions of The Limited, Inc. in the second quarter of 2002 amounted to 20.4% of net sales, as compared to 18.5% in the comparable quarter in the prior year.

Gross profit (which consists of net sales less product costs, duties and direct costs attributable to production) for the second quarter of 2002 was $14.4 million, or 15.1% of net sales, compared to $15.8 million, or 16.5%, of net sales in the comparable prior period. The decrease in gross profit occurred primarily because of low-margin orders taken between September 11^th of 2001 and the beginning of the year to fill up production capacity in Mexico.

Selling and distribution expenses decreased from $3.9 million in the second quarter of 2001 to $2.4 million in the second quarter of 2002. As a percentage of net sales, these expenses decreased from 4.0% in the first quarter of 2001 to 2.5% in the second quarter of 2002. General and administrative expenses, excluding amortization of excess of cost over fair value of net assets acquired of $729,000 in the second quarter of 2001, decreased from $7.9 million in the second quarter of 2001 to $7.2 million in the second quarter of 2002. As a percentage of net sales, these expenses decreased from 8.3% in the second quarter of 2001 to 7.6% in the second quarter of 2002. The decrease in such expenses is due to the Company’s continuing cost cutting efforts. Included in this decrease was a decrease of $327,000 of such expenses as a result of the conversion of Jane Doe from a sales company to a licensing company. The increase in the allowance for returns and discounts in the second quarter of 2001 was $366,000 compared to an increase in such allowance of $464,000 in the second quarter of 2002.

Operating income in the second quarter of 2002 was $4.8 million, or 5.0% of net sales, compared to operating income of $3.3 million, or 3.4% of net sales, in the comparable period of 2001 as a result of the factors discussed above.

Interest expense decreased from $2.1 million in the second quarter of 2001 to $1.7 million in the second quarter of 2002. As a percentage of net sales, these expenses decreased from 2.2% in the second quarter of 2001 to 1.8% in the second quarter of 2002. This decrease was a result of reduced borrowings due to the pay down of certain debt facilities during 2001 and interest rate reductions positively impacting the variable rate debt. Interest income was $78,000 in the second quarter of 2002, compared to $1.0 million in the second quarter of 2001. Included in interest income was $1.0 million in the second quarter of 2001 from the note receivable related to the sale of certain equipment pertaining to the turnkey twill mill and garment processing facility in Tlaxcala, Mexico (“Tlaxcala”), compared to $0 income in the second quarter of 2002. Other income decreased from $500,000 in the second quarter of 2001 to $73,000 in the second quarter of 2002 due to the disappearance of exchange gains relating to Deutsch Mark and Euro denominated debts which occurred last year and due to royalty expenses of $281,000 versus royalty income of $53,000 in the same period last year.

Minority interest expense for the second quarter of 2002 was $1.4 million from the UAV joint venture as compared to no such expense for the second quarter of 2001.

First Six Months of 2002 Compared to First Six Months of 2001

Net sales decreased by $20 million, or 11.1%, from $180.5 million for the first six months of 2001 to $160.5 million for the first six months of 2002. The decrease in net sales included a decrease in sales of $4.2 million to mass merchandisers, a decrease of $2.8 million to divisions of The Limited, Inc. (excluding Lane Bryant which was sold to Charming Shoppes in 2001), a decrease of $7.1 million to Lane Bryant, and a decrease of $2.3 million as a result of the conversion of Jane Doe from a sales company to a licensing company. Sales to divisions of The Limited, Inc. for the first six months of 2002 amounted to 17.2% of net sales, as compared to 16.8% in the comparable quarter in the prior year. The decrease in net sales was primarily attributable to the overall economic conditions in the first quarter of 2002, which in turn affected the retail industry. The weakened economy and announced layoffs seriously affected consumer spending habits and caused retailers to reduce their orders from suppliers, such as the Company, in an effort to control their inventory levels.

Gross profit (which consists of net sales less product costs, duties and direct costs attributable to production) for the first six months of 2002 was $22.8 million, or 14.2% of net sales, compared to $30.2 million, or 16.8% of net sales in the comparable prior period. The decrease in gross profit occurred primarily because of low-margin orders taken after September 11^th of 2001 and at the beginning of this year to fill production capacity.

Selling and distribution expenses decreased from $7.8 million for the first six months of 2001 to $5.1 million for the first six months of 2002. As a percentage of net sales, these expenses decreased from 4.3% for the first six months of 2001 to 3.1% for the first six months of 2002. General and administrative expenses, excluding amortization of excess of cost over fair value of net assets acquired of $1.5 million for the first six months of 2001, decreased from $16.8 million for the first six months of 2001 to $13.8 million for the first six months of 2002. As a percentage of net sales, these expenses decreased from 9.4% for the first six months of 2001 to 8.6% for the first six months of 2002. The decrease in such expenses is due to the Company’s continuing cost cutting

efforts. Included in this decrease was a reduction of $1.7 million in expenses as a result of the conversion of Jane Doe from a sales company to a licensing company. The increase in the allowance for returns and discounts for the first six months of 2001 was $1.2 million compared to an increase in such allowance of $575,000 for the first six months of 2002.

Operating income for the first six months of 2002 was $3.9 million, or 2.5% of net sales, compared to operating income of $4.2 million, or 2.3% of net sales, in the comparable prior period of 2001 as a result of the factors discussed above.

Interest expense decreased from $4.2 million for the first six months of 2001 to $2.6 million for the first six months of 2002. As a percentage of net sales, these expenses decreased from 2.3% in the first six months of 2001 to 1.6% for the same period in 2002. This decrease was as a result of reduced borrowings due to the pay down of certain debt facilities during 2001 and interest rate reductions positively impacting the variable rate debt. Interest income was $136,000 in the first six months of 2002, compared to $2.0 million in the second quarter of 2001. Included in interest income from the first six months of 2001 was interest on a $2.0 million note receivable related to the sale of certain equipment pertaining to the turnkey twill mill and garment processing facility in Tlaxcala, Mexico (“Tlaxcala”), compared to $0 income in the second quarter of 2002. Other income decreased from $1.1 million for the first six months of 2001 to $93,000 for the first six months of 2002 due to reduction of exchange gain in the amount of $599,000 from Deutsch Mark and Euro denominated debts in 2001 compared to $66,000 for the same period in 2002, and $331,000 in royalty expenses in 2002 compared to $53,000 royalty income for the same period in 2001.

Minority interest expense for the first six months of 2002 was $1.9 million from the UAV joint venture as compared to income of $346,000 for the first six months of 2001 from JDI.

Liquidity and Capital Resources

The Company’s liquidity requirements arise from the funding of its working capital needs, principally inventory, finished goods shipments-in-transit, work-in-process and accounts receivable, including receivables from the Company’s contract manufacturers that relate primarily to fabric purchased by the Company for use by those manufacturers. The Company’s primary sources for working capital and capital expenditures are cash flow from operations, borrowings under the Company’s bank and other credit facilities, borrowings from principal shareholders, issuance of long-term debt, borrowing from affiliates and the proceeds from the exercise of stock options.

The Company’s liquidity is dependent, in part, on customers paying according to the Company’s terms. Any abnormal chargebacks or returns may affect the Company’s source of short-term funding. The Company is also subject to market price changes. Any changes in credit terms given to major customers would have an impact on the Company’s cash flow. Suppliers’ credit is another major source of short-term financing and any adverse changes in their terms will have negative impact on the Company’s cash flow.

Following is a summary of our contractual obligations and commercial commitments available to us as of June 30, 2002 (in millions):

	Payments Due by Period
Contractual Obligations	Total		Less than 1 year		Between 2-3 years		Between 4-5 years		After 5 years
Long-term debt	$	91.2	$	24.9	$	18.0	$	48.3	$	—
Operating leases	$	5.3	$	1.8	$	1.7	$	0.7	$	1.1
Total contractual cash obligations	$	96.5	$	26.7	$	19.7	$	49.0	$	1.1

Guarantees have been issued in favor of YKK, Universal Fasteners and RVL, Inc. for $750,000, $500,000 and unspecified amount respectively to cover trim purchased by Tag-it Pacific Inc. on behalf of the Company.

	Total Amounts Committed to the Company		Amount of Commitment Expiration per Period
Other Commercial Commitments Available to the Company as of June 30, 2002	Total Amounts Committed to the Company		Less than 1 year		Between 2-3 years		Between 4-5 years		After 5 years
Lines of credit	$	136.9	$	74.2	$	62.3	$	0.4	—
Letters of credit (within lines of credit)	$	45.0		45.0		—		—	—
Total commercial commitments	$	136.9	$	74.2	$	62.3	$	0.4	—

During the first six months of 2002, net cash used in operating activities was $8.6 million, as compared to net cash used in operations of $8.6 million in for the same period in 2001. Net cash outflow used in operating activities in 2002 was caused by the operating loss of $4.0 million offset by depreciation and amortization of $5.2 million. In addition, increases of $4.0 million in

restricted cash, $24.8 million in accounts receivable, $5.1 million in inventory and $1.5 million in temporary quota were offset by an increase of $19.5 million in accounts payable.

During the first six months of 2002, net cash used in investing activities was $351,000, as compared to $7.3 million in for the same period in 2001. Cash used in investing activities in 2002 included approximately $646,000 primarily for acquisition of replacement equipment.

During the first six months of 2002, net cash inflow from financing activities was $9.3 million, as compared to $13.6 million for the same period in 2001. Cash provided by financing activities in 2002 included $4.8 million of net borrowings from lending facilities and advances (net of repayment) from shareholders of $3.0 million.

On June 13, 2002, the Company entered into a letter of credit facility of $25 million with UPS Capital Global Trade Finance Corporation (“UPS”) to replace the credit facility of Hong Kong and Shanghai Banking Corporation Limited (“HKSB”) in Hong Kong. Under this facility, the Company may arrange for the issuance of letters of credit and acceptances. The facility is a one-year facility subject to renewal on its anniversary and is collateralized by the shares and debentures of all its subsidiaries in Hong Kong. In addition, all its permanent quota holdings in Hong Kong are charged to UPS. Besides the guarantees provided by Tarrant Apparel Group and Fashion Resources (TCL) Inc., Mr. Gerard Guez also signed a guarantee of $5 million in favor of UPS to secure this facility. The guarantee of Mr. Guez will be reduced to $3 million at the end of 2002 if the Company delivers an earnings per share of $0.40 for the year. This facility is also subject to certain restrictive covenants, including provisions that the aggregate net worth, as adjusted, of the Company will exceed $105 million at the end of 2002, and that the Company will maintain certain debt to equity ratio, fixed charge ratio and interest coverage. As of June 30, 2002, the Company pledged an additional $4 million to UPS as temporary collateral and there were $28.4 million of outstanding borrowings under this facility. Included in the outstanding was a standby letter of credit for $14 million opened in favor of HKSB to cover the transition to move current outstanding from the bank.

On January 21, 2000, the Company entered into a revolving credit, factoring and security agreement (the “Debt Facility”) with a syndicate of lending institutions in the US. The Debt Facility initially provided a revolving facility of $105.0 million, including a letter of credit facility not to exceed $20.0 million, and matures on January 31, 2005. The Debt Facility provides for interest at LIBOR plus the LIBOR rate margin determined by the Total Leverage Ratio (as defined). The Debt Facility is collateralized by receivables, intangibles, inventory and various other specified non-equipment assets of the Company. In addition, the facility is subject to various financial covenants, including requirements for tangible net worth, fixed charge coverage ratios, and interest coverage ratios, among others, and prohibits the payment of dividends. In March 2002 , the Company entered into an amendment of its Debt Facility with GMAC, who solely assumed the facility in 2000. This amendment reduces the $105.0 million facility to $90.0 million. It also requires the Company to reduce the $25 million over-advance limit under this facility by $500,000 per month beginning February 28, 2001. In 2001, the Company obtained a temporary over-advance credit facility with GMAC up to a total of $10 million. The Company has entered into an agreement to repay this temporary facility by $1 million each month starting April 15, 2002 and to accelerate the monthly repayment of the $25 million over-advance to $687,500 from August 2002 onwards. Accompanying the waiver given for the first quarter results of 2002, the bank also revised the covenants with regard to the financial ratios of the whole year of 2002. As of June 30, 2002, $69.9 million including letters of credit was outstanding under the credit facility.

During 2000, the Company financed equipment purchases for a manufacturing facility with certain vendors of the related equipment. A total of $16.9 million was financed with five-year promissory notes, which bear interest ranging from 7.0% to 7.5%, and are payable in semiannual payments commencing in February 2000. Of this amount, $9.6 million was outstanding as of June 30, 2002. Of the $9.6 million, $5.2 million is denominated in the Euro. The remainder is payable in U.S. dollars. The Company bears the risk of any foreign currency fluctuation with regards to this debt.

The Company has financed its operations from its cash flow from operations, borrowings under its bank and other credit facilities, borrowings from principal shareholders, issuance of long-term debt (including debt to or arranged by vendors of equipment purchased for the Mexican twill and production facility), borrowings from affiliates and the proceeds from the exercise of stock options and from time to time shareholder advances. The Company’s short-term funding relies very heavily on its major customers, bankers, suppliers and major shareholders. From time to time, the Company has temporary over-advances from its bankers and short-term funding from its major shareholders. Any withdrawal of support from these parties would have serious consequences on the Company’s liquidity.

From time to time, the Company has borrowed funds from, and advanced funds to, certain officers and principal shareholders, including Messrs. Guez, Kay and Nacif. The maximum amount of such borrowings from Mr. Kay in the second quarter of 2002 was $1,220,000. The maximum amount of such advances to Messrs. Guez and Nacif during the second quarter of 2002 was approximately $4,893,000 and $8,198,000, respectively. As of June 30, 2002, the Company was indebted to Mr. Kay in the amount of $1,129,000. Messrs. Guez and Nacif had an outstanding advance from the Company of $4,893,000 and $3,096,000 respectively as of June 30, 2002. All advances to, and borrowings from, Messrs. Guez and Kay in 2002 bore interest at the rate of 7.75%. All existing loans to officers and directors before July 30, 2002 are grandfathered under the Sarbanes-Oxley Act of 2002, and no further advances or loans will be made to officers and directors in compliance to the Act.

The Company may seek to finance future capital investment programs through various methods, including, but not limited to, borrowings under the Company’s bank credit facilities, issuance of long-term debt, 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 with the exception of exercising the option to acquire the twill mill in Mexico.

The Company does 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.

Management’s Discussion of Critical Accounting Policies

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. On an ongoing basis, the Company evaluates estimates, including those related to returns, discounts, bad debts, inventories, intangible assets, income taxes, and contingencies and litigation. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

The Company believes 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 to our audited consolidated financial statements included in our Form 10-K.

Accounts Receivable—Allowance for Returns, Discounts and Bad Debts

The Company evaluates the collectibility of accounts receivable and chargebacks (disputes from the customer) based upon a combination of factors. In circumstances where the Company is aware of a specific customer’s inability to meet its financial obligation (e.g., bankruptcy filings, 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, the Company recognizes reserves for bad debts and chargebacks based on the Company’s historical collection experience. If collection experience deteriorates (i.e., an unexpected material adverse change in a major customer’s ability to meet its financial obligations to the Company), the estimates of the recoverability of amounts due us could be reduced by a material amount.

As of June 30, 2002, the balance in the allowance for returns, discounts and bad debts reserves was $4.5 million, compared to $5.4 million at June 30, 2001.

Inventory

The Company’s inventories are valued at the lower of cost or market. Under certain market conditions, estimates and judgments regarding the valuation of inventory are employed by the Company to properly value inventory.

Income Taxes

As part of the process of preparing the Company’s consolidated financial statements, management is required to estimate income taxes in each of the jurisdictions in which it operates. 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 the Company’s consolidated balance sheet. Management records a

valuation allowance to reduce its 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 income. Reserves are also estimated for ongoing audits regarding Federal, state and international issues that are currently unresolved. The Company routinely monitors the potential impact of these situations and believes that it is properly reserved.

Debt Covenants

The Company’s debt agreements require the maintenance of certain financial ratios and a minimum level of net worth as discussed in Note 5 to our financial statements. If the Company’s results of operations are eroded and the Company is not able to obtain waivers from the lenders, the debt would be in default and callable by our lender. In addition, due to cross-default provisions in a majority of the debt agreements, approximately 86% of the Company’s long-term debt would become due in full if any of the debt is in default. However, the Company’s expectations of future operating results and continued compliance with other debt covenants cannot be assured and our lenders’ actions are not controllable by Company. If projections of future operating results are not achieved and the debt is placed in default, the Company would experience a material adverse impact on the reported financial position and results of operations.

Valuation of Long-lived and Intangible Assets and Goodwill

We evaluate our long-lived assets for impairment based on accounting pronouncements that require management to assess fair value of these assets by estimating the future cash flows that will be generated by the assets and then selecting an appropriate discount rate to determine the present value of these future cash flows. An evaluation for impairment must be conducted when circumstances indicate that an impairment may exist; but not less frequently than on an annual basis. The determination of impairment is subjective and based on facts and circumstances specific to our company and the relevant long-lived asset. Factors indicating an impairment condition exists may include permanent declines in cash flows, continued decreases in utilization of a long-lived asset or a change in business strategy. We adopted Financial Accounting Standards (SFAS) No. 142 “Goodwill and Other Intangible Assets,” beginning with the first quarter of 2002. SFAS No. 142 requires that goodwill and intangible assets that have indefinite useful lives not be amortized but, instead, tested at least annually for impairment while intangible assets that have finite useful lives continue to be amortized over their respective useful lives. Accordingly, we ceased amortization of approximately $29.2 million of goodwill, which was our only intangible asset with an indefinite useful life, on January 1, 2002. The Company had recorded approximately $3.3 million of goodwill amortization during 2001. SFAS No. 142 requires that goodwill be tested for impairment using a two-step process. The first step is to determine the fair value of the reporting unit, which may be calculated using a discounted cash flow methodology, and compare this value to its carrying value. If the fair value exceeds the carrying value, no further work is required and no impairment loss would be recognized. The second step is an allocation of the fair value of the reporting unit to all of the reporting unit’s assets and liabilities under a hypothetical purchase price allocation.

Based on the evaluation performed to adopt SFAS 142 and the current impact of the economy on the licensing business in general, we recorded a non-cash charge of $1.9 million, net of tax benefit of $1.3 million to reduce the carrying value of Jane Doe International LLC to its estimated fair value. Furthermore, we also took a similar charge of $1.7 million, net of tax benefit of $0 to reduce the carrying value of Tarrant Mexico, S. de R.L. de C.V.—Ajalpan division because we believe the current economic conditions will have certain adverse impact on the income potential of a purely sewing factory without other services.

We utilized the discounted cash flow methodology to estimate fair value. At June 30, 2002, we have a goodwill balance of $25.3 million and a net property and equipment balance of $79.1 million.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

Foreign Currency Risk. The Company’s 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 Mexico as well as certain debt denominated in the Euro. As a result, the Company bears the risk of exchange rate gains and losses that may result in the future as a result of this financing. At times the Company uses 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 and fixed asset purchase obligations. The Company does not utilize derivative financial instruments for trading or other speculative purposes. The Company actively evaluates the creditworthiness of the financial institutions that are counter parties to derivative financial instruments, and it does not expect any counter parties to fail to meet their obligations.

Interest Rate Risk. Because the Company’s obligations under its various credit agreements bear interest at floating rates (primarily LIBOR rates), the Company is sensitive to changes in prevailing interest rates. A 10% increase or decrease in market

interest rates that affect the Company’s financial instruments would have a material impact on earning or cash flows during the next fiscal year.

The Company’s 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 the Company’s debt. A majority of the Company’s credit facilities are at variable rates.

PART II—OTHER INFORMATION

Item 1. Legal Proceedings.

The Company’s former Chief Information Officer filed a complaint against the Company and its Chairman, Gerard Guez, on September 12, 2001 in Los Angeles County Superior Court, which sought punitive and unspecified monetary damages. The complaint alleged (1) wrongful termination for retaliation; (2) breach of written employment contract; (3) fraud (concerning alleged misrepresentations to convince the former CIO to become an employee); and (4) quantum meruit (claiming he should receive monies for the value of his services). The Defendants’ demurrer to dismiss the fraud and quantum meruit claims was sustained in Defendants’ favor without leave to amend. As a consequence, all claims against Mr. Guez were dismissed. The Company thereafter settled the remaining claims and the case has been fully dismissed.

On December 4, 2001, the former President of Jane Doe International, LLC (“JDI”), filed a demand for arbitration with the American Arbitration Association asserting a claim against the Company, its subsidiary and JDI for breach of employment contract arising out of his termination from JDI. The demand seeks alleged damages of $585,000 in unpaid salary, $725,815 plus the “present value” of $3,074,000 in unpaid bonuses; $24,000 in unreimbursed expenses; $2,000,000 in punitive damages; unspecified attorney’s fees; and unspecified consequential and other damages. The Company believes that the defendants have valid defenses to the arbitration claims and intends to vigorously defend against them. It is management’s opinion that the final resolution of these matters will not have a material adverse effect on the Company’s financial position or results of operation.

The Company purchased a very large piece of equipment from Brugman Machinefabriek, N.V. (“Brugman”) for installation at its subsidiary in Mexico. The total purchase price was $3,100,000. The equipment did not work as represented or warranted and there were significant discussions with the seller about modifications and improvements. Before these modifications and improvements could be completed, Brugman filed for bankruptcy in The Netherlands at the end of November 2001. The payment obligations were evidenced by a series of ten drafts drawn upon, and accepted by, the Company. Half of the drafts were paid by the Company. The draft due on November 15, 2001 in the amount of $300,390 was not paid because of the pending dispute with Brugman. Demands for payment have been made on the Company by Fortis Bank, N.V. in The Netherlands. On or about June 19, 2002, Fortis Bank and NCM (the defendants) filed a challenge to the jurisdiction of the Court claiming that they do not have the required contacts or relations with the State of California to support the case being heard in a California court or, in the alternative, that it would be in the best interests of the parties to have the matter heard in The Netherlands. On July 9, 2002, the Court continued the challenge until September 17, 2002 to give the Company an opportunity to conduct discovery to demonstrate that the defendants’ activities in California meet the minimum requirements to permit the matter to be heard there. The Company intends to vigorously oppose the challenge to the Court’s jurisdiction and to vigorously prosecute the action.

In addition, on or about June 11, 2002, Fortis Bank and NCM brought an action against the Company in the District Court of Rotterdam, The Netherlands, to obtain an order directing that the Company must pay all unpaid drafts previously delivered by the Company in connection with the purchase of the equipment in question, whether or not due by their terms and without regard to the bankruptcy of Brugman. On August 5, 2002, the Company was served officially with this complaint. The Writ of Summons filed with the Dutch District Court requires a response or court appearance by the Company on October 3, 2002. The Company intends to vigorously oppose any attempt by the Court in The Netherlands to assert jurisdiction over it and will vigorously oppose any claim made by Fortis Bank and NCM in this action.

From time to time, the Company is involved in various routine legal proceedings incidental to the conduct of its business. Management does not believe that any of these legal proceedings will have a material adverse impact on the business, financial condition or results of operations of the Company, either due to the nature of the claims, or because management believes that such claims should not exceed the limits of the Company’s insurance coverage.

Item 2. Changes in Securities.

None.

Item 3. Defaults Upon Senior Securities.

None.

Item 4. Submission of Matters to a Vote of Security Holders.

The Company held its 2002 annual meeting of shareholders (the “Meeting”) on May 15, 2002. At the Meeting, the Company’s shareholders considered and voted upon the following maters:

1. Election of Directors. The re-election of the following five persons on the Board of Directors of the Company, to serve until the 2004 annual meeting of shareholders and until their successors have been elected and qualified:

NAME:	FOR:	AGAINST:	ABSTAIN:
Patrick Chow	13,062,991		1,135,456
Gerard Guez	13,062,991		1,135,456
Todd Kay	13,062,991		1,135,456
Joseph Mizrachi	13,912,682		285,756
Eddy Yuen	13,062,941		1,135,506

2. Amendment of Articles. To approve an amendment of the Company’s Restated Articles of Incorporation to increase the authorized shares of Common Stock from 20,000,000 to 35,000,000.

FOR:		AGAINST		ABSTAIN		NON-VOTES
10,095,379		58,828		5,616		4,038,624

3. Amendment of Employee Incentive Plan. To approve an amendment of the Employee Incentive Plan increasing from 3,600,000 to 5,100,000 the number of shares of the Company’s Common Stock which may be subject to awards granted pursuant thereto.

FOR:		AGAINST		ABSTAIN		NON-VOTES
9,801,260		356,947		1,616		4,038,624

4. Ratification of 2002 Employee Incentive Awards. To ratify the grant of 2002 awards to certain executive officers pursuant to the Employee Incentive Plan, payable only if the Company reports a specific amount of pretax income.

FOR:		AGAINST		ABSTAIN		NON-VOTES
10,109,309		48,798		1,716		4,038,624

5. Ratification of Stock Option Grants. To ratify the grant of options to purchase an aggregate of 3,000,000 shares of Common Stock of the Company to certain executive officers/employee.

FOR:		AGAINST		ABSTAIN		NON-VOTES
8,947,282		1,206,125		6,416		4,038,624

6. Ratification of Appointment of Independent Auditors. To ratify the appointment of Ernst & Young LLP as the Company’s Independent Auditors for the fiscal year ending December 31, 2002.

FOR:		AGAINST		ABSTAIN		NON-VOTES
14,185,638		9,593		3,216

Item 5. Other Information.

None.

Item 6. Exhibits and Reports on Form 8-K.

(a) Exhibits: Reference is made to the Index to Exhibits on page 17 for a description of the exhibits filed as part of this Report on Form 10-Q.

Exhibit 3.1.1—Certificate of Amendment of Restated Articles of Incorporation

Exhibit 3.1.2—Certificate of Amendment of Restated Articles of Incorporation

Exhibit 10.77.2—Modification Agreement entered into as of June 7, 2002, by and between General Electric Capital Corporation and Tarrant Apparel Group.

Exhibit 10.101.3—Third Amendment to Operating Agreement dated as of July 5, 2002, by and between Azteca Production International, Inc, and TAG Mex, Inc.

Exhibit 10.105—Guaranty Agreement dated as of May 30, 2002 by and between UPS Capital Global Trade Finance Corporation and Tarrant Apparel Group and Fashion Resource (TCL), Inc.

Exhibit 10.106—Guaranty Agreement dated as of May 30, 2002 by and between UPS Capital Global Trade Finance Corporation and Gerard Guez.

Exhibit 10.107—Syndicated Letter of Credit Facility dated June 13, 2002 by and between Tarrant Company Limited, Marble Limited and Trade Link Holdings Limited as Borrowers and UPS Capital Global Trade Finance Corporation as Agent and Issuer and Certain Banks and Financial Institutions as Banks.

Exhibit 10.107.1—Charge Over Shares dated June 13, 2002 by Fashion Resource (TCL), Inc. in favor of UPS Capital Global Trade Finance Corporation.

Exhibit 10.107.2—Syndicated Composite Guarantee and Debenture dated June 13, 2002 between Tarrant Company Limited, Marble Limited and Trade link Holdings Limited and UPS Capital Global Trade Finance Corporation.

Exhibit 10.108—Assignment of Promissory Note by Tarrant Apparel Group to Tarrant Company Limited and to Trade Link Holdings Company dated December 26, 2001.

Exhibit 10.109—Assignment of Promissory Note by Tarrant Mexico, S. de R.L. de C.V. in favor of Tarrant Apparel Group to TAG dated December 26, 2001.

Exhibit 10.110—Assignment of Promissory Note for full settlement of indebtedness issued by Tex Transas, S.A. de C.V. due to Tarrant Company Limited, Trade Link Holdings Limited dated December 26, 2001.

Exhibit 10.111—Promissory Note dated July 1, 2002 by Tarrant Apparel Group in favor of Todd Kay.

(b) Reports on Form 8-K:

A report on Form 8-K was filed on August 14, 2002 containing certifications under Section 906 of Sarbanes-Oxley Act of 2002.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	TARRANT APPAREL GROUP

Date: August 14, 2002	By:	/s/ PATRICK CHOW
		Patrick Chow Chief Financial Officer


Date: August 14, 2002	By:	/s/ EDDY YUEN
		Eddy Yuen Chief Financial Officer

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