UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended May 29, 2004
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: 0-18926
INNOVO GROUP INC.
(Exact name of registrant as specified in its charter)
Delaware 11-2928178
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
5804 East Slauson Avenue, Commerce, California 90040
(Address of principal executive offices) (Zip Code)
(323) 725-5516
(Registrant's telephone number, including area code)
NO CHANGE
(Former name, former address and former fiscal year, if changed since last
report)
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. |X| Yes |_| No
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). |_| Yes |X| No
As of July 13, 2004, there were 29,090,390 shares of the issuer's only
class of common stock outstanding.
INNOVO GROUP INC.
QUARTERLY REPORT ON FORM 10-Q
Part I. FINANCIAL INFORMATION Page
----
Item 1. Financial Statements 1
Consolidated Condensed Balance Sheets 1
Consolidated Condensed Statement of Operations 2
Consolidated Condensed Statement of Cash Flows 3
Notes to Consolidated Condensed Financial Statements 4
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations 16
Item 3. Quantitative and Qualitative Disclosures about Market Risk 56
Item 4. Controls and Procedures 57
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 60
Item 2. Changes in Securities and Use of Proceeds 60
Item 3. Defaults Upon Senior Securities 61
Item 4. Submission of Matters to a Vote of Security Holders 61
Item 5. Other Information 62
Item 6. Exhibits and Reports on Form 8-K 62
Signatures 64
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements.
INNOVO GROUP INC. AND SUBSIDIARIES
CONSOLIDATED CONDENSED BALANCE SHEETS
(in thousands, except per share data)
05/29/04 11/29/03
----------- -----------
(unaudited)
ASSETS
CURRENT ASSETS
Cash and cash equivalents $ 7 $ 7,248
Accounts receivable and due from factor, net of allowance for
customer credits and allowances of $2,026 (2004) and $2,158 (2003) 1,394 1,683
Inventories 11,596 7,524
Prepaid expenses and other current assets 332 2,115
----------- -----------
TOTAL CURRENT ASSETS 13,329 18,570
----------- -----------
PROPERTY, PLANT and EQUIPMENT, net 1,121 2,067
GOODWILL 12,592 12,592
INTANGIBLE ASSETS, NET 12,374 13,058
OTHER ASSETS 58 78
----------- -----------
TOTAL ASSETS $ 39,474 $ 46,365
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Accounts payable and accrued expenses $ 11,160 $ 6,128
Due to factor 263 332
Due to related parties 141 579
Note payable to officer 500 500
Current maturities of long-term debt (including related parties) 93 168
----------- -----------
TOTAL CURRENT LIABILITIES 12,157 7,707
LONG-TERM DEBT, less current maturities (including related parties) 9,632 22,176
Commitments and Contingencies
8% Redeemable preferred stock, $0.10 par value: Authorized shares-5,000,
194 shares (2004) and (2003) -- --
STOCKHOLDERS' EQUITY
Common stock, $0.10 par - shares, Authorized 40,000
Issued and outstanding 29,166 (2004), and 25,785 (2003) 2,917 2,579
Additional paid-in capital 71,582 59,077
Accumulated deficit (53,523) (41,824)
Promissory note-officer (703) (703)
Treasury stock, 76 shares (2004) and (2003) (2,588) (2,588)
Accumulated other comprehensive loss -- (59)
----------- -----------
TOTAL STOCKHOLDERS' EQUITY 17,685 16,482
----------- -----------
TOTAL LIABILITIES and STOCKHOLDERS' EQUITY $ 39,474 $ 46,365
=========== ===========
See accompanying notes
1
INNOVO GROUP INC. AND SUBSIDIARIES
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
Three Months Ended Six Months Ended
-------------------------- --------------------------
05/29/04 05/31/03 05/29/04 05/31/03
----------- ----------- ----------- -----------
(unaudited) (unaudited) (unaudited) (unaudited)
NET SALES $ 30,023 $ 12,013 $ 46,627 $ 23,928
COST OF GOODS SOLD 26,593 8,655 40,327 17,311
----------- ----------- ----------- -----------
Gross profit 3,430 3,358 6,300 6,617
OPERATING EXPENSES
Selling, general and administrative 8,935 3,596 15,817 6,383
Depreciation and amortization 414 85 869 164
----------- ----------- ----------- -----------
9,349 3,681 16,686 6,547
INCOME (LOSS) FROM OPERATIONS (5,919) (323) (10,386) 70
INTEREST EXPENSE (279) (215) (698) (365)
OTHER INCOME 65 109 85 234
OTHER EXPENSE (630) (74) (692) (97)
----------- ----------- ----------- -----------
INCOME (LOSS) BEFORE INCOME TAXES (6,763) (503) (11,691) (158)
INCOME TAXES (35) (10) 6 53
----------- ----------- ----------- -----------
NET INCOME (LOSS) $ (6,728) $ (493) $ (11,697) $ (211)
=========== =========== =========== ===========
NET INCOME (LOSS) PER SHARE:
Basic $ (0.23) $ (0.03) $ (0.43) $ (0.01)
Diluted $ (0.23) $ (0.03) $ (0.43) $ (0.01)
WEIGHTED AVERAGE SHARES OUTSTANDING
Basic 28,928 15,020 27,358 14,931
Diluted 28,928 15,020 27,358 14,931
See accompanying notes
2
INNOVO GROUP INC. AND SUBSIDIARIES
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
(in thousands)
Six Months Ended
--------------------------
05/29/04 05/31/03
----------- -----------
(unaudited) (unaudited)
CASH USED IN OPERATING ACTIVITIES $ (7,349) $ (1,296)
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from investment in real estate 98 853
Redemption of preferred shares -- (368)
Purchases of fixed assets (116) (103)
----------- -----------
Cash (used in) provided by investing activities $ (18) $ 382
CASH FLOWS FROM FINANCING ACTIVITIES
Purchase of treasury stock $ -- $ (16)
Payments on notes payables and long term debt (119) (370)
Repayments of factor borrowings (69) 847
Proceeds from note payable to officer -- 500
Proceeds from issuance of stock and
exercise of stock options, net of expense 314 593
----------- -----------
Cash provided by financing activities $ 126 $ 1,554
Effect of exchange rate on cash -- 20
NET CHANGE IN CASH AND CASH EQUIVALENTS $ (7,241) $ 660
CASH AND CASH EQUIVALENTS, at beginning of period 7,248 222
----------- -----------
CASH AND CASH EQUIVALENTS, at end of period $ 7 $ 882
=========== ===========
See accompanying notes
3
INNOVO GROUP INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
NOTE 1 - BASIS OF PRESENTATION
In the opinion of management, the accompanying unaudited condensed
consolidated financial statements contain all adjustments (consisting of only
normal recurring and consolidating adjustments) considered necessary to present
fairly the balance sheets, the results of operations and cash flows for the
period reported. The accompanying unaudited condensed consolidated financial
statements include the financial results of Innovo Group Inc. (Innovo Group) and
all its wholly-owned subsidiaries (collectively, in these Notes to Consolidated
Financial Statements as Innovo Group). All inter-company balances have been
eliminated. As used in these accompanying notes to unaudited condensed
consolidated financial statements, Innovo Group's subsidiaries include the
following entities: Innovo, Inc., (Innovo), Joe's Jeans, Inc. (Joe's), Innovo
Azteca Apparel, Inc. (IAA), Leaseall Management, Inc., (Leaseall) and Innovo
Realty, Inc. (IRI).
These accompanying unaudited condensed consolidated 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. The balance
sheet at November 29, 2003 has been derived from the audited financial
statements at that date, but does not include all of the information and
footnotes required by accounting principles generally accepted in the United
States for complete financial statements.
While management believes that the disclosures presented are adequate to
make the information not misleading, it is recommended that the condensed
consolidated financial statements and footnotes be read in conjunction with the
consolidated financial statements included in our Annual Report on Form 10-K for
the year ended November 29, 2003. Operating results for the three and six month
period ended May 29, 2004, or second quarter of fiscal 2004, are not necessarily
indicative of the results that may be expected for the year ended November 27,
2004.
NOTE 2 - INVENTORY
Inventories are stated at the lower of cost, which is determined by the
first-in-first-out method or market. Inventories consisted of the following (in
thousands):
05/29/04 11/29/03
--------------------------
Finished goods $ 8,323 $ 10,189
Work in progress 4,880 199
Raw materials 1,918 1,329
--------------------------
15,121 11,717
Less allowance for obsolescence and
slow moving items (3,525) (4,193)
--------------------------
$ 11,596 $ 7,524
==========================
4
NOTE 3 - LONG-TERM DEBT
A summary of our long-term debt follows (in thousands):
05/29/04 11/29/03
--------------------------
First mortgage loan on Springfield property $ 425 $ 476
Promissory note to Azteca (Blue Concepts) 9,300 21,800
Promissory note to Azteca (Knit Div.) -- 68
--------------------------
Total long-term debt 9,725 22,344
Less current maturities 93 168
--------------------------
Total long-term debt $ 9,632 $ 22,176
==========================
As used herein, Azteca means Azteca Production International, Inc., an
entity which two of our substantial stockholders, Hubert Guez and Paul Guez,
have a controlling interest.
NOTE 4 - DUE FROM FACTOR AND SHORT TERM DEBT
CIT Commercial Services
On June 1, 2001, Innovo Group's subsidiaries, Innovo and Joe's, entered
into accounts receivable factoring agreements with CIT Commercial Services, a
unit of CIT Group, Inc. (CIT), which may be terminated with 60 days notice by
CIT, on the anniversary date by Innovo or Joe's or earlier as may be permitted
by the agreements. Under the terms of the agreements, Innovo or Joe's has the
option to factor receivables with CIT on a non-recourse basis, provided the CIT
approves the receivable in advance. Innovo or Joe's may, at their option, also
factor non-approved receivables on a recourse basis. Innovo or Joe's continues
to be obligated in the event of product defects and other disputes, unrelated to
the credit worthiness of the customer. Innovo or Joe's has the ability to obtain
advances against factored receivables up to 85% of the face amount of the
factored receivables. The agreement calls for a 0.8% factoring fee on invoices
factored with CIT and a per annum rate equal to the greater of the Chase prime
rate plus 0.25% or 6.5% on funds borrowed against the factored receivables. On
September 10, 2001, IAA entered into a similar factoring agreement with CIT upon
the same terms.
On or about August 20, 2002, each of Innovo and Joe's entered into certain
amendments to their respective factoring agreements, which included inventory
security agreements, to permit the subsidiaries to obtain advances of up to 50%
of the eligible inventory up to $400,000 each. According to the terms of the
agreements, amounts loaned against inventory are to bear an interest rate equal
to the greater of the bank's prime rate plus 0.75% or 6.5% per annum.
On or about June 10, 2003, the existing financial facilities with CIT for
each of Innovo and Joe's were amended, to be effective as of April 11, 2003,
primarily to remove the fixed aggregate cap of $800,000 on their inventory
security agreement to allow for Innovo and Joe's to borrow up to 50% of the
value of certain eligible inventory calculated on the basis of the lower of cost
or market, with cost calculated on the first-in-first-out basis. In connection
with these amendments, IAA, entered into an inventory security agreement with
CIT based on the same terms as Joe's and Innovo also with no fixed aggregate
cap. IAA did not previously have an inventory security agreement with CIT. Under
the factoring arrangements, Innovo Group though its subsidiaries may borrow up
to 85% of the value of eligible factored receivables outstanding. The factoring
rate that Innovo Group pays to CIT to factor accounts, on which CTI bears some
of all of the credit risk, was lowered to 0.4% and the interest rate associated
with borrowings under the inventory lines and factoring facility were reduced to
the bank's
5
prime rate. Innovo Group has also established a letter of credit
facility with CIT whereby Innovo Group can open letters of credit, for 0.125% of
the face value, with international and domestic suppliers provided Innovo Group
has availability on its inventory line of credit. In addition, Innovo Group also
may elect to factor with CIT its receivables by utilizing an adjustment of the
interest rate as set on a case-by-case basis, whereby certain allocation of risk
would be borne by Innovo Group, depending upon the interest rate adjustment.
Innovo Group records its accounts receivable on the balance sheet net of
receivable factored with CIT, since the factoring of receivable is non-recourse
to Innovo Group. Further, in the event Innovo Group's loan balance with CIT
exceeds the face value of the receivables factored with CIT, Innovo Group
records the difference between the face value of the factored receivables and
the outstanding loan balance as a liability on Innovo Group's balance sheet as
"Due to Factor." At May 29, 2004, Innovo Group's loan balance with CIT was
$9,316,000 and an aggregate amount of $327,000 of open letters of credit were
outstanding. On June 10, 2003, cross guarantees were executed by and among
Innovo, Joe's, and IAA and Innovo Group entered into a guarantee for its
subsidiaries' obligations in connection with the amendments to the existing
credit facilities. In connection with the agreements with CIT, all of our
inventory, merchandise, and/or goods, including raw materials through finished
goods and receivables are pledged to CIT.
NOTE 5 - EARNINGS PER SHARE
A reconciliation of the numerator and denominator of basic earnings
(loss) per share and diluted earnings (loss) per share is as follows:
Three Months Ended Six Months Ended
(in thousands, except (in thousands, except
per share data) per share data)
-------------------------- --------------------------
05/29/04 05/31/03 05/29/04 05/31/03
----------- ----------- ----------- -----------
Basic EPS Computation:
Numerator $ (6,728) $ (493) $ (11,697) $ (211)
Denominator:
Weighted average common shares outstanding 28,928 15,020 27,358 14,931
----------- ----------- ----------- -----------
Total shares 28,928 15,020 27,358 14,931
----------- ----------- ----------- -----------
Basic EPS $ (0.23) $ (0.03) $ (0.43) $ (0.01)
=========== =========== =========== ===========
Diluted EPS Calculation:
Numerator $ (6,728) $ (493) $ (11,697) $ (211)
Denominator:
Weighted average common shares
outstanding 28,928 15,020 27,358 14,931
Incremental shares outstanding
from assumed exercise of options
and warrants -- -- -- --
----------- ----------- ----------- -----------
Total shares 28,928 15,020 27,358 14,931
----------- ----------- ----------- -----------
Diluted EPS $ (0.23) $ (0.03) $ (0.43) $ (0.01)
=========== =========== =========== ===========
6
A total of 3,471,661 options and warrants were excluded from calculation of
diluted EPS at May 29, 2004 because these options and warrants either had an
exercise price in excess of the average market price of Innovo Group's common
stock during the quarter or their effect would have been anti-dilutive.
A total of 8,214,604 options and warrants were excluded from calculation of
diluted EPS at May 31, 2003 because these options and warrants either had an
exercise price in excess of the average market price of Innovo Group's common
stock during the quarter or their effect would have been anti-dilutive.
NOTE 6 - OTHER INCOME AND EXPENSE
Other Income and Expense consists of the following:
Three Months Ended Six Months Ended
(in thousands) (in thousands)
-----------------------------------------------------
05/29/04 05/31/03 05/29/04 05/31/03
----------- ----------- ----------- -----------
Rental, real estate, and management fee income $ 13 $ 82 $ 27 $ 176
Realized/unrealized gain on foreign currency 5 -- 5 27
Other items 47 27 53 31
----------- ----------- ----------- -----------
Total other income $ 65 $ 109 $ 85 $ 234
=========== =========== =========== ===========
Rental expense $ 6 $ 20 $ 13 $ 43
Realized/unrealized loss on foreign currency 47 54 102 54
Loss on fixed asset disposal 3 -- 3 --
Asset impairment charge on rental property 574 -- 574 --
----------- ----------- ----------- -----------
Total other expense $ 630 $ 74 $ 692 $ 97
=========== =========== =========== ===========
Subsequent to the quarter ended May 29, 2004, management made a
determination to offer for sale our former headquarters located in Springfield,
Tennessee, which we have partially rented since relocating our headquarters.
Management decided that maintaining the property was no longer a beneficial use
of our working capital. As a result of the change in intended use and other
impairment factors, Innovo Group recorded an impairment loss on the property of
$574,000 reducing the carrying value from $1,174,000 to $600,000. The remaining
mortgage balance on the property is approximately $425,000. The property will be
reclassified as held for sale in the third quarter financial statements.
In connection with the termination of Joe's Jeans Japan's operations,
during the six months ended May 29, 2004, the accumulated other comprehensive
loss resulting from the translation of the subsidiary's financial statements
from yen to dollars was reclassified to the statement of operations, resulting
in a $55,000 loss during the period.
NOTE 7 -INCOME TAXES
Innovo Group income tax expense for the six months ended May 29, 2004 and
May 31, 2003, respectively, represents estimated state and foreign income and
franchise tax expense. For the 2004 period, Innovo Group recorded $6,000 of
income tax, which represents estimated state taxes net of a tax benefit from the
recovery of taxes previously paid in Japan. For the 2004 and 2003 periods, the
effective tax rate differs from the statutory rate primarily as a result of the
accrual for state and foreign taxes and the recording of a valuation allowance
which fully offset the benefit of the losses for the period.
7
NOTE 8 - STOCK COMPENSATION
Statement of Financial Accounting Standards No. 123, "Accounting for Stock
Based Compensation" (SFAS No. 123), encourages, but does not require, companies
to record compensation cost for stock-based employee compensation plans at fair
value. Innovo Group has chosen to continue to account for employee stock-based
compensation using the method prescribed in Accounting Principles Board Opinion
No. 25, "Accounting for Stock Issued to Employees," and related interpretations.
Innovo Group has adopted the disclosure-only provisions of SFAS No. 123.
Accordingly, no compensation expense has been recorded in conjunction with the
fair value of the options at the grant date and amortized over the option's
vesting period, consistent with the method prescribed by SFAS No. 123, Innovo
Group's net income (loss) would have been increased to the pro forma amounts
indicated below for the six months ended May 29, 2004 and May 31, 2003:
Three Months Ended Six Months Ended
(in thousands, except (in thousands, except
per share data) per share data)
-------------------------- --------------------------
05/29/04 05/31/03 05/29/04 05/31/03
-------------------------- --------------------------
Net loss as reported $ (6,728) $ (493) $ (11,697) $ (211)
Add:
Stock based employee compensation
expense included in reported net loss, net of
related tax effects -- 25 -- 50
Deduct:
Total stock based employee compensation
expense determined under fair market value
based method for all awards, net of related
tax effects 92 142 184 295
-------------------------- --------------------------
Pro forma net loss $ (6,820) $ (610) $ (11,881) $ (456)
========================== ==========================
Net loss per share
As reported - basic $ (0.23) $ (0.03) $ (0.43) $ (0.01)
As reported - diluted $ (0.23) $ (0.03) $ (0.43) $ (0.01)
Pro forma - basic $ (0.24) $ (0.04) $ (0.43) $ (0.03)
Pro forma - diluted $ (0.24) $ (0.04) $ (0.43) $ (0.03)
The fair value of each option granted is estimated on the date of grant
using the Black-Scholes option pricing model with the following assumptions used
for grants in 2003:
2003
----
Estimated dividend yield................... 0.0%
Expected stock price volatility............ 48%
Risk-free interest rate.................... 5.0%
Expected life of options................... 4 yrs.
The Black-Scholes model was developed for use in estimating the fair value
of traded options, which have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly
subjective assumptions, including, the expected stock price volatility. Because
Innovo Group's employee stock options have characteristics significantly
different from those of traded options and because changes in the subjective
input assumptions can materially affect the fair value estimates, in
management's opinion, the existing models do not necessarily provide a reliable
single measure of the fair value of its employee stock options.
8
NOTE 9 - BLUE CONCEPT ACQUISITION
On July 17, 2003, our IAA subsidiary entered into an asset purchase
agreement (APA) with Azteca, Hubert Guez and Paul Guez, whereby IAA acquired the
Blue Concept Division of Azteca. The Blue Concept Division sells primarily denim
jeans to American Eagle Outfitters, Inc. (AEO), a national retailer. Hubert Guez
and Paul Guez, two of our substantial stockholders and parties to the APA,
together have a controlling interest in Azteca.
Pursuant to the terms of the APA, IAA paid $21.8 million for the Blue
Concept Division, subject to adjustment as noted below. Pursuant to the APA, IAA
employed all 30 of the existing employees of the Blue Concept Division, but did
not assume any of the Blue Concept Division's or Azteca's existing liabilities.
The purchase price was paid through the issuance of a seven-year, partially
convertible promissory note (the Blue Concept Note). The Blue Concept Note bears
interest at a rate of 6% and requires payment of interest only during the first
24 months and then is fully amortized over the remaining five-year period. The
terms of the transaction further allowed Innovo Group, upon stockholder
approval, to convert a portion of the Blue Concept Note into 3,125,000 shares of
common stock valued at the greater of $4.00 per share or the market value of
Innovo Group's common stock at the date stockholder approval is obtained. On
March 5, 2004 in accordance with the APA and Nasdaq rules, Innovo Group
conducted a special meeting of its stockholders to convert up to $12.5 million
of the debt into up to 4,166,667 shares of common stock. The conversion was
approved by stockholders and as a result, Azteca has initially been issued
3,125,000 shares of common stock at a conversion price of $4.00 per share with
the possible issuance of up to 1,041,667 additional shares of common stock upon
the occurrence of certain contingencies described in the Blue Concept APA. As a
result of this conversion, the Blue Concept Note was reduced from $21.8 million
to $9.3 million and the shares issued pursuant to the conversion are subject to
certain lock-up periods. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations - Debt Conversions" for a further discussion
of the conversion of the Blue Concept Note.
In the event that sales of the Blue Concept Division fall below $70
million during the first 17 month period (Period I) following the closing of the
acquisition, or $65 million during the 12 month period (Period II) following
Period I, certain terms of the APA allow for a reduction in the purchase price
through a decrease in the principal balance of the Blue Concept Note and/or the
return of certain locked-up shares of Innovo Group's common stock. In the event
the Blue Concept Note is reduced during Period I and the sales of the Blue
Concept Division in Period II are greater than $65 million, the Blue Concept
Note shall be increased by half of the amount greater than the decrease in
Period I.
In the event that principal amount of the Blue Concept Note needs to be
reduced beyond the outstanding principal balance of such Blue Concept Note, then
an amount of the locked-up shares equal to the balance of the required reduction
shall be returned to Innovo Group. For these purposes, the locked-up shares
shall be valued at $4.00 per share. Additionally, if during the 12-month period
following the closing, AEO is no longer a customer of IAA, the locked-up shares
will be returned to Innovo Group, and any amount remaining on the balance of the
Blue Concept Note will be forgiven.
In the event the revenues of the Blue Concept Division decrease to $35
million or less during Period I or Period II, IAA shall have the right to sell
the purchased assets back to Azteca, and Azteca shall have the right to buy back
the purchased assets for the remaining balance of the Blue Concept Note and any
and all Locked Up Shares shall be returned to Innovo Group. In addition, IAA
will pay to Sweet Sportswear, LLC, an entity owned by Hubert Guez and Paul Guez
who were parties to the Blue Concept asset purchase agreement, an amount equal
to 2.5% of IAA's revenues generated as a result of sales to AEO.
9
As part of the transaction, IAA and AZT International SA de CV, a Mexico
corporation and wholly-owned subsidiary of Azteca (AZT), entered into a
two-year, renewable, non-exclusive supply agreement (Supply Agreement) for
products to be sold by Blue Concept Division. Under the terms of the Supply
Agreement, Innovo Group has agreed to market and sell the products to be
purchased from AZT Innovo Group's customers, more particularly the customers of
the Blue Concept Division. In addition to the customary obligations, the Supply
Agreement requires that: (i) Innovo Group shall submit written purchase orders
to AZT on a monthly basis specifying (x) the products to be supplied and (y) a
specified shipping date for products to be shipped; (ii) Innovo Group shall give
AZT reasonable time allowances upon placing its purchase orders with AZT prior
to delivery of the products by AZT; (iii) AZT shall receive payment immediately
upon receipt by Innovo Group of invoices for its purchase orders; (iv) Innovo
Group shall have a guaranteed profit margin of 15% on a "per unit" basis; and
(v) the products to be supplied shall be subject to quality control measures by
Innovo Group and by the customer of the Blue Concept Division.
The results of operations of the Blue Concept Division have been included
in Innovo Group's statement of operations from July 17, 2003.
The following table shows Innovo Group's unaudited pro forma consolidated
results of operations for the six months ended May 29, 2004 and May 31, 2003
assuming the Blue Concept Division acquisition had occurred at the beginning of
the respective fiscal years:
Three Months Ended Six Months Ended
(in thousands, except (in thousands, except
per share data) per share data)
-------------------------- --------------------------
05/29/04 05/31/03 05/29/04 05/31/03
----------- ----------- ----------- -----------
Net sales $ 30,023 $ 33,700 $ 46,627 $ 64,826
Net income (loss) (6,728) 348 (11,697) 1,731
Earnings (loss) per share:
Basic $ (0.23) $ 0.02 $ (0.43) $ 0.10
Diluted $ (0.23) $ 0.02 $ (0.43) $ 0.10
Management and the board of directors entered into the Blue Concept
acquisition for the following reasons: (i) Innovo Group was able to enter into
an acquisition with a seller with which Innovo Group has a long-standing
relationship; (ii) Innovo Group was able to acquire a profitable business that
has (x) a financial history of producing conservative profit margins with
significant revenues; (iii) Blue Concept had a strong customer relationship with
AEO, (iv) the manufacturing relationships with Azteca to produce effectively and
efficiently; and (v) was able to acquire the personnel and talent of a
profitable business. Further, although there can be no assurance, the Blue
Concept Division is expected to increase Innovo Group's revenue growth and is
expected to maintain positive cash flows. In the second quarter of fiscal 2004,
the Blue Concept Division accounted for $15,761,000 or 52% of our net revenue.
Furthermore, the APA protects Innovo Group if revenue expectations are not
realized by providing "downside" protections, such as guaranteed sales minimums,
and a buy-sell provision that allows for the sale of the business if revenues do
not reach $35 million.
The acquisition of the Blue Concept Division was accounted for under the
purchase method of accounting. Of the $21.8 million purchase price, $13.2
million was recorded as an intangible asset representing the value of the
customer relationship, $361,000 was recorded as an intangible asset representing
the fair value of the existing purchase orders at the closing of the
acquisitions and the balance of the purchase price of $8.32 million was recorded
as goodwill. The purchase price allocation was based upon a third party
valuation.
10
NOTE 10 - REPORTABLE SEGMENTS
Current Operating Segments
During the six-months ended May 29, 2004, Innovo Group continued to
operate in two segments, accessories and apparel. The accessories segment
represents Innovo Group's historical line of business as conducted by Innovo.
The apparel segment is comprised of the operations of Joe's and IAA, both of
which began in fiscal 2001, as a result of acquisitions. Innovo Group's real
estate operations and real estate transactions of its Leaseall and IRI
subsidiaries do not require substantial management oversight and have therefore
been treated as "other" for purposes of segment reporting. The operating
segments have been classified based upon the nature of their respective
operations, customer base and the nature of the products sold.
Innovo Group evaluates performance and allocates resources based on gross
profits, and profit or loss from operations before interest and income taxes.
The accounting policies of the reportable segments are the same as those
described in the summary of significant accounting policies.
Information for each reportable segment during each of the periods ending
May 29, 2004 and May 31, 2003 is as follows:
11
Three Months Ended 5/29/04 Accessories Apparel Other Total
--------------------------------------------------------
(in thousands)
Net Sales to External Customers $ 4,477 $ 25,546 $ -- $ 30,023
Gross Profit 970 2,460 -- 3,430
Depreciation & Amortization (19) (365) (30) (414)
Operating Loss (37) (4,558) (1,324) (5,919)
Total Assets 4,208 30,387 4,879 39,474
Three Months Ended 5/31/03 Accessories Apparel Other Total
--------------------------------------------------------
(in thousands)
Net Sales to External Customers(1) $ 3,185 $ 8,828 $ -- $ 12,013
Gross Profit 765 2,593 -- 3,358
Depreciation & Amortization (10) (52) (23) (85)
Operating Income (Loss) 68 333 (724) (323)
Total Assets 3,737 12,195 1,920 17,852
1. Excludes intercompany sales of $532,000 in the second quarter of fiscal 2003.
Six Months Ended 5/29/04 Accessories Apparel Other Total
--------------------------------------------------------
(in thousands)
Net Sales to External Customers $ 8,092 $ 38,535 $ -- $ 46,627
Gross Profit 1,843 4,457 -- 6,300
Depreciation & Amortization (38) (775) (56) (869)
Operating Loss (71) (7,788) (2,527) (10,386)
Total Assets 4,208 30,387 4,879 39,474
Six Months Ended 5/31/03 Accessories Apparel Other Total
--------------------------------------------------------
(in thousands)
Net Sales to External Customers(2) $ 5,928 $ 18,000 $ -- $ 23,928
Gross Profit 1,530 5,087 -- 6,617
Depreciation & Amortization (17) (104) (43) (164)
Operating Income (Loss) 125 1,155 (1,210) 70
Total Assets 3,737 12,195 1,920 17,852
2. Excludes intercompany sales of $906,000 in the six months ended May 31, 2003.
12
NOTE 11 - SUBSEQUENT EVENTS
Sale of Convertible Notes and Warrants
Subsequent to the end of our second quarter of fiscal 2004, on June 15,
2004, June 18, 2004 and June 22, 2004, Innovo Group executed agreements for the
sale of convertible promissory notes and common stock purchase warrants which
resulted in aggregate gross proceeds of $2.5 million and will result in an
additional $451,875 in aggregate gross proceeds upon exercise of the warrants.
The convertible promissory notes in the aggregate principal amount of $2.5
million, together with common stock purchase warrants to purchase an aggregate
of 312,500 shares of Innovo Group's common stock were sold to three "accredited
investors," as defined in Regulation D promulgated under the Securities Act of
1933, as amended, or the Securities Act. The transaction documents executed with
each purchaser were substantially similar.
The convertible promissory note issued to each purchaser bears interest at
a rate of 7.5% per annum and has a maturity date twelve months from the date of
issuance. The convertible note is convertible at any time from the date of
issuance into shares of common stock at a price per share equal to 110% of the
average of the closing price of Innovo Group's common stock for the five trading
days immediately prior to the date of issuance, which, for each purchaser,
resulted in a conversion price of $1.53, $1.41 and $1.35, respectively. Innovo
Group will pay interest only payments until the maturity date of the convertible
note, unless it is converted or prepaid. Innovo Group has an option to make one
prepayment of the note, in whole or in part, without penalty at any time after
three months. However, in the event that Innovo Group elects to prepay all or a
portion of the convertible note, a purchaser may elect within 3 days to convert
all or a portion of the note into common stock and thus prevent Innovo Group's
prepayment of the convertible note.
Each purchaser was also issued warrants to purchase shares of common
stock. The number of shares that the purchaser will be eligible to purchase is
equal to 12.5% of the aggregate amount of the convertible promissory note and
the exercise price of the warrants on a per share basis is equal to 110% of the
average of the closing price of Innovo Group's common stock for the five trading
days immediately prior to the date of issuance of the warrant, which, for each
purchaser, resulted in an exercise price of $1.53, $1.41 and $1.35,
respectively. The warrants expire five years from the date of issuance and are
exercisable immediately. In connection with both the convertible notes and the
warrants, Innovo Group entered into a registration rights agreement with each of
the purchasers, whereby Innovo Group agreed to register for resale the shares
underlying the convertible notes and warrants.
NOTE 12 - TERMINATION OF LICENSE AGREEMENTS
As disclosed in Innovo Group's Quarterly Report on Form 10-Q for the three
months ended February 28, 2004, filed with the Securities and Exchange
Commission on April 13, 2004, Innovo Group has been re-evaluating the license
agreements associated with its branded label apparel operating segments. As a
result of this re-evaluation process, two of its branded label apparel licenses
were terminated in the second quarter of fiscal 2004, as discussed in detail
below.
Fetish(TM)
On May 13, 2004, IAA mutually agreed to terminate the license agreement
for the manufacture and sale of apparel and accessories bearing the Fetish(TM)
mark with Blondie Rockwell, Inc., the licensor of entertainment personality
Eve's Fetish(TM) mark.
13
On May 25, 2004, the parties executed a definitive Settlement Agreement
and Release. Under the terms of the settlement, the license agreement was
immediately terminated; however, IAA continued to have the ability to market,
distribute and sell the 2004 summer Fetish(TM) line, other excess apparel
inventory and unsold and returned merchandise to certain approved customers
until December 31, 2004. Furthermore, IAA agreed to pay to Blondie Rockwell a
termination fee, which included unpaid and future accelerated royalties, in
three installments over a three month period. As of July 13, 2004, Innovo Group
has made two installment payments totaling $587,171 and has one installment
payment in the amount of $250,000 remaining, which is payable on July 15, 2004.
In exchange for the termination fee and accelerated royalties, IAA has no
further obligation to pay any additional royalties on sales from the 2004
Fetish(TM) summer line, excess apparel inventory or unsold or returned
merchandise. In addition, IAA continues to have the right to finish the
production, marketing, distribution and sale of Fetish(TM) accessories
identified in the Settlement Agreement through March 31, 2005, and will pay a
royalty in the amount of 8% on all such accessory sales. As part of the
Settlement Agreement and Release, Innovo Group executed a Guaranty Agreement to
and in favor of Blondie Rockwell, Inc. guaranteeing payment in full and
performance of all of IAA's obligations and liabilities in the Settlement
Agreement and Release.
In connection with the termination of the Fetish(TM) license agreement,
IAA recorded a charge in the amount of $750,000 to reflect the termination
payment as well as $1,355,000 representing the write-off of fixed assets related
to the licensed brand and prepaid advertising license expenses. IAA also
recorded a charge of $1,707,000 related to the write-down to estimated net
realizable value of the Fetish(TM) inventory during the quarter ended May 29,
2004.
Hot Wheels(R)
In July of 2002, IAA entered into a license agreement with Mattel, Inc.
for Hot Wheels(R) branded adult apparel and accessories. Since that time, due to
lack of interest in the consumer marketplace, IAA did not have any sales under
this license agreement. Due to these and other factors, IAA terminated the
license agreement for Hot Wheels(R) branded apparel and accessory products. In
connection with the termination, IAA paid $70,000, representing the final
payment of royalty obligations to Mattel. Due to the termination, IAA reversed
an accrual of approximately $224,000 during the second quarter of fiscal 2004
which represented the maximum contractual future royalty obligations originally
due under the license agreement.
NOTE 13 - EXERCISE OF WARRANTS
During the second quarter of fiscal 2004, Innovo Group issued 247,500
shares of its common stock in connection with the exercise of certain previously
issued warrants. These warrants ranged in exercise price from $0.90 to $2.50.
All but two of the warrants exercised expired on March 31, 2004. Two of the
warrants exercised expired on December 19, 2005. On May 20, 2004, an aggregate
of 168,500 warrants ranging in exercise price from $2.50 to $3.00 expired
unexercised. These shares issued upon exercise of the warrants have been
registered for resale by Innovo Group.
NOTE 14 - ASSET IMPAIRMENT
Subsequent to the quarter ended May 29, 2004, management made a
determination to offer for sale our former headquarters located in Springfield,
Tennessee, which we have partially rented since relocating our headquarters.
Management decided that maintaining the property was no longer a beneficial use
of our working capital. As a result of the change in intended use and other
impairment factors, Innovo Group recorded an impairment loss on the property of
$574,000 reducing the carrying
14
value from $1,174,000 to $600,000. The remaining mortgage balance on the
property is approximately $425,000. The property will be reclassified as held
for sale in the third quarter financial statements.
15
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operation.
Forward-Looking Statements
When used in this Quarterly Report on Form 10-Q, the words "may," "will,"
"expect," "anticipate," "intend," "estimate," "continue," "believe" and similar
expressions are intended to identify forward-looking statements. Similarly,
statements that describe our future expectations, objectives and goals or
contain projections of our future results of operations or financial condition
are also forward-looking statements. Statements looking forward in time are
included in this Quarterly Report on Form 10-Q pursuant to the "safe harbor"
provision of the Private Securities Litigation Reform Act of 1995. Such
statements are subject to certain risks and uncertainties, which could cause
actual results to differ materially, including, without limitation, continued
acceptance of our product, product demand, competition, capital adequacy and the
potential inability to raise additional capital if required, and the risk
factors contained in our reports filed with the Securities and Exchange
Commission pursuant to the Securities Exchange Act of 1934, as amended,
including our Annual Report on Form 10-K and Amendment No. 1 to our Annual
Report of Form 10-K for the year ended November 29, 2003. Readers are cautioned
not to place undue reliance on these forward-looking statements, which speak
only as of the date hereof. Our future results, performance or achievements
could differ materially from those expressed or implied in these forward-looking
statements. We do not undertake and specifically decline any obligation to
publicly revise these forward-looking statements to reflect events or
circumstances occurring after the date hereof or to reflect the occurrence of
unanticipated events.
The following discussion provides information and analysis of our results
of operations for the six month period ended May 29, 2004 and May 31, 2003, and
our liquidity and capital resources. The following discussion and analysis
should be read in conjunction with our Notes to Consolidated Condensed Financial
Statements included elsewhere herein.
We completed our acquisition of the Blue Concept Division from Azteca
Production International, Inc., on July 17, 2003. The results of operations of
the Blue Concept Division are included in our operating results from the date of
acquisition. Accordingly, the financial position and results of operations
presented and discussed herein are not directly comparable between years. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Recent Acquisitions and Licenses" for a further discussion of the
Blue Concept Division Acquisition.
Introduction
This discussion and analysis summarizes the significant factors affecting
our results of operations and financial conditions during the six month periods
ended May 29, 2004 and May 31, 2003. This discussion should be read in
conjunction with our Consolidated Condensed Financial Statements, Notes to
Consolidated Condensed Financial Statements and supplemental information in Item
1 of this Quarterly Report on Form 10-Q for the period ended May 29, 2004. The
discussion and analysis contains statements that may be considered
forward-looking. These statements contain a number of risks and uncertainties as
discussed here, under the heading "Forward-Looking Statements" of this Quarterly
Report on Form 10-Q for the period ended May 29, 2004 that could cause actual
results to differ materially.
16
Executive Overview
Our principal business activity involves the design, development and
worldwide marketing of high quality consumer products for the apparel and
accessory markets. We do not manufacture any apparel or accessory products, but
may, from time to time at our cost, produce sample apparel and accessory
products for new or existing customers or internal use. We sell our products to
many retail, distributors and private label customers around the world. Retail
customers and distributors purchase finished goods directly from us. Retail
customers then sell the products through their retail stores and distributors
sell our products to retailers in the international market place. Private label
customers outsource the production and sourcing of their private label products
to us and then sell through their own distribution channels. Private label
customers are generally retail chains who desire to sell apparel and accessory
products under their own brand name. We work with our private label customers to
create their own brand image by custom designing products. In creating a unique
brand, our private label customers may provide samples to us or may select
styles already available in our showrooms. We believe we have established a
reputation among these private label buyers for the ability to arrange for the
manufacture of apparel and accessory products on a reliable, expeditious and
cost-effective basis.
Our branded label products, which include accessories and apparel, are
designed, developed and marketed by us internally pursuant to the license
agreement under which we have licensed the brand and/or mark or as a
company-owned brand, such as indie(TM) for apparel and Friendship(TM) and Clear
Gear(TM) for accessories. We then outsource the manufacturing and distribution
of the branded products. We sell our branded products to retail customers or
distributors. We are then obligated to pay a certain percentage of royalties on
our net sales of the branded products to the licensor, if it is a licensed
product. Since the beginning of the second quarter of fiscal 2004, we have
reduced our non-denim branded apparel operations by the termination of our
license agreement for Fetish(TM) apparel, the termination of our license
agreement for Hot Wheels(R) apparel and accessories, and the cessation of
production for Shago(R) apparel and accessories. Without these non-denim branded
apparel licenses, as well as their respective royalty obligations, we have been
able to reduce our headcount and direct our resources to focus primarily on
denim wear and accessories. While there can be no assurance that this direction
will result in profitability, we believe that these changes represent steps for
growth and profitability in areas of proven ability. We continue to retain our
branded accessory licenses for Fetish(TM) on a limited basis and Bongo(R), as
well as our licenses for our branded denim and denim related apparel, such as
Joe's Jeans(R), Betsey Johnson(R) and our new line, indie(TM).
Reportable Segments
For the periods ended May 29, 2004 and May 31, 2003, we operated in two
segments: apparel and accessories. The apparel segment is conducted by our Joe's
Jeans, Inc., or Joe's, and Innovo Azteca Apparel, Inc., or IAA, subsidiaries,
both of which are involved in the design, development and marketing of apparel
products. The accessory segment, which represents our historical business, is
conducted by our Innovo, Inc., or Innovo, subsidiary. The apparel and accessory
operating segments have been classified based upon the nature of their
respective operations, customer base and the nature of the products sold.
Our real estate transactions and our other corporate activities are
categorized under "other" and are represented by the operations of Innovo Group
Inc., or IGI, the parent company, and our two-wholly owned subsidiaries,
Leaseall Management Inc., or Leaseall, and Innovo Realty Inc., or IRI, which
conduct our real estate operations. Our real estate operations do not currently
require a substantial allocation of our resources and are not a significant part
of management's daily operational functions.
17
Our Principal Sources of Revenue
Joe's
Since its introduction in 2001, Joe's has gained national and
international recognition, primarily in the women's denim market. However, since
this introduction and beginning in fiscal 2003, Joe's has expanded its offerings
to include women's sportswear and men's apparel items. Further, Joe's has
announced that it is developing a new line of branded denim apparel under the
direction of Joe's Jeans design team under the brand name indie(TM). indie(TM)
will initially include women's denim jeans and skirts, tops and jackets, with
the collection targeted for the fall/holiday season in 2004 on a limited basis
and a full launch to better department and specialty stores for Spring of 2005.
IAA
Under our IAA subsidiary, we design and market private and branded apparel
products under various license agreements and other arrangements, such as
purchase orders. The private label business represents our largest source of
sales, both under IAA and in the aggregate of all our subsidiaries, primarily
because of our knowledge, resources and experience particularly within the denim
business. Through private label arrangements, we sell denim products primarily
to American Eagle Outfitters, Inc., or AEO, and Target Corporation. We
anticipate growth in private label sales throughout fiscal 2004 compared to
previous reporting periods, primarily because we will have conducted a full
fiscal year of sales to AEO as a result of the acquisition of the Blue Concept
Division from Azteca.
Since the beginning of fiscal 2004, we have been re-evaluating the license
agreements in our branded label apparel operating segments. On May 25, 2004, we
entered into a settlement agreement, or Settlement Agreement, whereby we
terminated our license agreement for Fetish(TM) branded apparel with Blondie
Rockwell, Inc., the licensor of entertainment personality Eve's Fetish(TM) mark.
Under the terms of the Settlement Agreement, we continue to have the ability to
market, distribute and sell the 2004 summer Fetish(TM) line, other excess
apparel inventory and unsold and returned merchandise to certain approved
customers until December 31, 2004 with no obligation to pay additional royalties
on sales, in exchange for a termination fee, which included past and accelerated
royalty payments. IAA agreed to pay to Blondie Rockwell the termination fee and
accelerated royalty payments in three installments over a three month period. As
of July 13, 2004, we have made two installment payments totaling $587,171 and
have one installment payment in the amount of $250,000 remaining, which is
payable on July 15, 2004. In addition, we continue to have the right to finish
the production of, market, distribute and sell Fetish(TM) accessories already
identified by the parties through March 31, 2005, and will pay royalties in the
amount of 8% on net sales, as originally defined in the license agreement, on
all such accessory sales.
In June of 2004, we also terminated our license agreement with Mattel,
Inc., or Mattel, for Hot Wheels(R) branded apparel and accessory products.
Because we did not have any sales in fiscal 2003 or through the second quarter
of fiscal 2004 under this license agreement due to lack of interest in the
consumer marketplace, we were able to terminate the license agreement. In
connection with the termination, we paid $70,000, representing the final payment
of royalty obligations to Mattel. Due to the termination, we reversed an accrual
of approximately $224,000 during the second quarter of fiscal 2004, which
represents the maximum contractual future royalty obligations due under the
original license agreement.
With respect to the license agreement for Shago(R) branded apparel and
accessories, we have also been in discussion with Bravado International Group,
Inc., the licensor of the entertainment personality Bow Wow's Shago(R) mark,
regarding the future of the Shago(R) branded apparel. As of July 13, 2004, we
have had discussions with representatives with the Shago(R) brand regarding its
future, but have not yet formally terminated the license agreement. We believe
that we will be able to terminate this license
18
agreement amicably and on terms favorable to us, however, there can be no
assurance that such a termination will take place. In the interim, we have
ceased production on Shago(R) branded apparel and accessories.
On February 6, 2004, we entered into an assignment with Blue Concept LLC,
which is controlled by Paul Guez, one of our significant stockholders, for all
the rights, benefits and obligations of a license agreement between Blue Concept
LLC and B.J. Vines, Inc., the licensor of the Betsey Johnson(R) apparel brand.
The license agreement provides for the exclusive right to design, market and
distribute women's jeans and coordinating denim related apparel, such as
t-shirts and tops, under the Betsey Johnson(R) brand name in the United States,
its territories and possessions, and Canada. As of July 13, 2004, we have
received a limited number of orders for our Betsey Johnson(R) branded apparel
products. We believe this license agreement, because it is limited to denim and
denim-related apparel, will allow us to utilize our strength in the denim and
denim-related apparel market.
Innovo
Our accessory business is conducted through our Innovo subsidiary. We
produce craft accessories to sell to large retailers such as Wal-Mart and
Michaels Stores, Inc, as well as private label and branded label accessories
through license agreements under which we have licensed brands, such as Bongo(R)
and Fetish(TM) or as company-owned brands, such as Friendship(TM) and Clear Gear
(TM). In addition, even though our IAA subsidiary has terminated certain of its
branded apparel licenses, we have been granted permission to continue to finish
the production and sale of accessories identified by the parties in the
Settlement Agreement under the Fetish(TM) brand through March 31, 2005.
Strategic relationship with two of our significant stockholders, Hubert Guez and
Paul Guez, and affiliated companies
Beginning in the summer of 2000, we entered into a series of transactions
with two of our significant stockholders, Hubert Guez and Paul Guez, and their
affiliated companies, such as Azteca Production International, Inc., or Azteca,
and/or Commerce Investment Group LLC, or Commerce. The Guez brothers and their
affiliated companies have in the aggregate more that fifty years of experience
in the apparel industry with a specialty in denim apparel and related products.
As discussed in greater detail below, our strategic relationship with the Guez
brothers and their affiliated companies has had many tangible benefits for us.
Our relationship with the Guez brothers began in the summer of 2000 when
the Guez brothers through their affiliated company, Commerce, which the Guez
brothers control, invested in our company. Pursuant to a stock and warrant
purchase agreement, Commerce acquired 2,863,637 shares of our common stock and
3,300,000 common stock purchase warrants. An investor rights agreement also
provides Commerce with a contractual right to nominate three individuals to our
board of directors. Commerce has not exercised this right at this time. Based
upon the Schedule 13D/A filed on May 18, 2004 and a Form 4 filed on May 20,
2004, the Guez brothers and/or their affiliates beneficially own in the
aggregate approximately 24.98% of our common stock outstanding as of July 13,
2004.
As part of Commerce's equity investment in our company, we entered into
several other arrangements with Commerce in order to reduce our manufacturing
and distribution costs and to increase the effectiveness and capacity of our
distribution network. Pursuant to a supply agreement and distribution agreement
with Commerce, we agreed to purchase all of our accessory products, which at the
time primarily consisted of denim tote bags and aprons, from Commerce and to
have Commerce distribute these products out of its Los Angeles distribution
facility. Commerce manufactures our accessory products out of its facilities in
Mexico. These agreements were renewed in August 2002 for an
19
additional two-year term and are automatically renewed for additional two-year
terms unless terminated by either party with 90 days notice.
Our strategic relationship with Commerce allowed us to close our domestic
manufacturing and distribution facilities and to move forward with diversifying
our product mix and offerings to include apparel products in addition to
accessory products. In an effort to enter the apparel market quickly and
efficiently we, through IAA, acquired Azteca's knit apparel division in August
2001 in exchange for 700,000 shares of our common stock and promissory notes in
the amount of $3.6 million. To further solidify our presence in the apparel
market and enhance and complement our existing private label business, in July
2003, we acquired the Blue Concept Division from Azteca in exchange for a
convertible promissory note in the original amount of $21.8 million dollars, or
the Blue Concept Note. In connection with the acquisition of the Blue Concept
Division, we obtained the rights relating to the design, manufacture and
wholesaling of denim jeans to AEO. On March 5, 2004, our stockholders approved
the conversion of $12.5 million of principal amount of the Blue Concept Note
into 3,125,000 shares of our common stock initially, with the potential issuance
of up to 1,041,667 additional shares of our common stock upon the occurrence of
certain contingencies described in the purchase agreement. As a result of this
conversion, the Blue Concept Note has been reduced to $9.3 million.
During fiscal 2003, we moved our headquarters and principal executive
offices from 5900 S. Eastern Avenue, Suite 120, Commerce, California 90040 to
5804 East Slauson Avenue, Commerce, California 90040. The 5804 East Slauson
Avenue space is utilized under a verbal agreement with Azteca, pursuant to which
we pay to Azteca a fee for allocated expenses associated with our use of office
and warehouse space and expenses incurred in connection with maintaining such
office and warehouse space. These allocated expenses include, but are not
limited to: rent, security, office supplies, machine leases and utilities. In
addition, we have verbal agreements with Azteca and/or its affiliates regarding
the supply and distribution of other apparel products we sell.
Results of Operations
We completed our acquisition of the Blue Concept Division from Azteca on
July 17, 2003. The results of operations of the Blue Concept Division are
included in our operating results from the date of acquisition.
Accordingly, the financial position and results of operations presented
and discussed herein are not directly comparable between years. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Recent Acquisitions and Licenses" for a further discussion of the
Blue Concept acquisition.
The following table sets forth certain statements of operations data for
the three and six-month periods as indicated:
20
Three Months Ended
(in thousands)
--------------------------------------------------------
05/29/04 05/31/03 $ Change % Change
----------- ----------- ----------- -----------
Net Sales $ 30,023 $ 12,013 $ 18,010 150%
Cost of Goods Sold 26,593 8,655 17,938 207
----------- ----------- ----------- -----------
Gross Profit 3,430 3,358 72 2
Selling, General & Administrative 8,935 3,596 5,339 148
Depreciation & Amortization 414 85 329 387
----------- ----------- ----------- -----------
Loss from Operations (5,919) (323) (5,596) 1,733
Interest Expense (279) (215) (64) 30
Other Income 65 109 (44) (40)
Other Expense (630) (74) (556) (A)
----------- ----------- ----------- -----------
Loss before Income Taxes (6,763) (503) (6,260) (A)
Income Taxes (35) (10) (25) 250
----------- ----------- ----------- -----------
Net Loss $ (6,728) $ (493) $ (6,235) (A)
=========== =========== ===========
(A) Not Meaningful
Six Months Ended
(in thousands)
--------------------------------------------------------
05/29/04 05/31/03 $ Change % Change
----------- ----------- ----------- -----------
Net Sales $ 46,627 $ 23,928 $ 22,699 95%
Cost of Goods Sold 40,327 17,311 23,016 133
----------- ----------- ----------- -----------
Gross Profit 6,300 6,617 (317) (5)
Selling, General & Administrative 15,817 6,383 9,434 148
Depreciation & Amortization 869 164 705 430
----------- ----------- ----------- -----------
Income (Loss) from Operations (10,386) 70 (10,456) (A)
Interest Expense (698) (365) (333) 91
Other Income 85 234 (149) (64)
Other Expense (692) (97) (595) (A)
----------- ----------- ----------- -----------
Loss before Income Taxes (11,691) (158) (11,533) (A)
Income Taxes 6 53 (47) (89)
----------- ----------- ----------- -----------
Net Loss $ (11,697) $ (211) $ (11,486) (A)
=========== =========== ===========
(A) Not Meaningful
21
Comparison of Three Months Ended May 29, 2004 to Three Months Ended May 31, 2003
Three Months Ended May 29, 2004 Overview
For the three months ended May 29, 2004, or the second quarter of fiscal
2004, our net sales increased to $30,023,000 from $12,013,000 for the three
months ended May 31, 2003, or the second quarter fiscal 2003, or a 150%
increase. We generated a net loss of $6,728,000 for the second quarter of fiscal
2004 compared to a net loss of $493,000 for the second quarter fiscal 2003, or a
1,222% increase. As further discussed below, we have identified the issues
associated with our continued losses in the second quarter of fiscal 2004 and we
are taking steps to address these issues.
The primary reasons for our net loss in the second quarter of fiscal 2004
compared to the second quarter of fiscal 2003 were the following:
o Lower gross margins as a result of: (i) sales of slow moving and
out-of-season Fetish(TM) and Shago(R) branded apparel and
accessories, (ii) $1,707,000 of additional charges taken against the
remaining Fetish(TM) inventory, (iii) lower gross margins for Joe's
Jeans as a result of a change in inventory purchasing, and (iv) an
increased percentage of sales coming from private label apparel and
accessories, which historically carry lower gross margins;
o An increase in employee wages and related benefits of $1,266,000
primarily as a result of hiring 31 employees related to the Blue
Concept Division acquisition and the hiring of additional employees
to support or facilitate the establishment of and increase sales for
Fetish(TM), Shago(R) and Joe's(R) branded products;
o An increase in advertising, marketing, tradeshow and related costs
of $280,000 incurred in order to market the Joe's(R), Shago(R)and
Fetish(TM)brands;
o An increase in royalties and commissions associated with our
Fetish(TM) and Shago(R) branded apparel products and the earnout
associated with the Blue Concept Division purchase of $813,000;
o An increase in our legal and accounting fees of $336,000;
o An increase in depreciation and amortization costs of $329,000
primarily associated with the acquisition of the Blue Concept
Division from Azteca in July 2003;
o Costs of $2,105,000 associated with the termination of our
Fetish(TM)license agreement; and
o An asset impairment charge of $574,000 to reflect a change in the
market value of our former manufacturing facility and headquarters
in Springfield, Tennessee. See "Management's Discussion and Analysis
of Financial Condition and Result of Operations - Other Income -
Leasall" for a further discussion of our Springfield facility.
As discussed above, we classify our business in two reportable segments.
The following table sets forth certain statements of operations data by segment
for the periods indicated.
22
Three Months Ended
5/29/04 Accessories Apparel Other (A) Total
--------------------------------------------------------
(in thousands)
Net Sales $ 4,477 $ 25,546 $ -- $ 30,023
Gross Profit 970 2,460 -- 3,430
Depreciation & Amortization (19) (365) (30) (414)
Interest Expense (21) (241) (17) (279)
Three Months Ended
5/31/03 Accessories Apparel Other (A) Total
--------------------------------------------------------
(in thousands)
Net Sales $ 3,185 $ 8,828 $ -- $ 12,013
Gross Profit 765 2,593 -- 3,358
Depreciation & Amortization (10) (52) (23) (85)
Interest Expense (57) (145) (13) (215)
Three Months Ended
5/29/04 to 5/31/04 Accessories Apparel Other (A) Total
$ Change % Change $ Change % Change $ Change % Change $ Change % Change
---------------------------------------------------------------------------------------------
(in thousands)
Net Sales $ 1,292 41% $ 16,718 189% $ -- N/A $ 18,010 150%
Gross Profit 205 27 (133) (5) -- N/A 72 2
Depreciation & Amortization (9) 90 (313) 602 (7) 30 (329) 387
Interest Expense 36 (63) (96) 66 (4) 31 (64) 30
Net Sales
Our net sales increased to $30,023,000 in the second quarter of fiscal
2004 from $12,013,000 in the second quarter of fiscal 2003, or a 150% increase.
The primary reasons for this increase in our net sales were due to: (i)
increased sales to our private label customers in both the apparel and
accessories segments, a large portion of which is attributable to sales
generated as a result of the Blue Concept Division acquisition; (ii) growth in
sales of Joe's Jeans in both the domestic and international markets; and (iii)
sales from our Fetish(TM) branded apparel and accessory products. As previously
discussed, we terminated our license agreement for Fetish(TM) branded apparel
and accessory products on May 25, 2004. Based upon the termination of this and
other branded apparel and accessory license agreements, we expect our net sales
attributed to licensed branded labels to decrease in subsequent quarters.
Accessory
Innovo
Net sales for our accessory segment increased to $4,477,000 in the second
quarter of fiscal 2004 from $3,185,000 in the second quarter of fiscal 2003, or
a 41% increase. The increase is primarily a result of higher sales of Innovo's
private label accessory products and continued sales of our Fetish(TM) branded
accessory products.
23
Net Sales
($ in thousands) % of Total Net Sales
------------------- --------------------
Three Months Ended Three Months Ended
------------------- --------------------
5/29/04 5/31/03 % Chg. 5/29/04 5/31/03
------------------- -------- --------------------
Craft $ 1,327 $ 1,231 8% 30% 39%
Private Label 1,993 1,506 32% 45% 47%
Branded 1,157 448 158% 26% 14%
-------------------
Total Net Sales $ 4,477 $ 3,185 41% 100% 100%
===================
Craft Accessories
Innovo's net sales from its craft accessories business increased to
$1,327,000 in the second quarter of fiscal 2004 from $1,231,000 in the second
quarter of fiscal 2003, or an 8% increase. Craft accessories sales accounted for
30% of Innovo's net sales in the second quarter of fiscal 2004 compared to 39%
in the second quarter of fiscal 2003. Our net sales in the craft market remained
relatively flat. However, our craft sales grew by 8% because certain orders that
were scheduled to ship in February of our first quarter of fiscal 2004 were
delayed and subsequently shipped in March of our second quarter of fiscal 2004.
Private Label Accessories
Innovo's net sales from its private label business increased to $1,993,000
in the second quarter of fiscal 2004 from $1,506,000 in the second quarter of
fiscal 2003, or a 32% increase. Private label accessories sales accounted for
45% of Innovo's net sales in the second quarter of fiscal 2004. This increase
was due to increased sales to a private label customer with which we did minimal
business in the second quarter of fiscal 2003 and increased sales volume with
one of our largest existing customers, AEO. In fiscal 2004, we expect sales to
private label customers to increase as we continue to expand sales with existing
customers and increase our customer base through the introduction of washed bags
in other fabrications such as canvas and corduroy in addition to denim.
Branded Accessories
Innovo's net sales from its branded accessory business increased to
$1,157,000 in the second quarter of fiscal 2004 from $448,000 the second quarter
of fiscal 2003, or a 158% increase. Branded accessories sales accounted for 26%
on Innovo's net sales in the second quarter of fiscal 2004 compared to 14% in
the second quarter of fiscal 2003. Innovo's branded accessories carry the
following brand names: Bongo(R), Fetish(TM), Friendship(TM) and Clear Gear(TM).
Sales of branded accessories increased primarily as a result of the addition of
sales of Fetish(TM) branded accessories products, which we did not have in the
second quarter of fiscal 2003. As discussed previously, while IAA's license for
Fetish(TM) branded apparel was terminated on May 25, 2004, Innovo will continue
to have the right to finish the production of, market, distribution and sale of
Fetish(TM) branded accessory products as identified in the Settlement Agreement
through March 31, 2005. The parties have been in discussions to continue the
license for the Fetish(TM) branded accessory products. However, if Innovo does
not secure a separate license to continue the production, manufacture and sale
of the Fetish(TM) branded accessory products beyond March 2005, Innovo expects
its net sales from its branded accessory business to decrease in the same
quarter for fiscal 2005.
24
Net sales of Bongo(R) accessories, our second largest licensed accessories
brand as measured by net sales, did not increase in the second quarter of fiscal
2004 compared to the second quarter of fiscal 2003. The lack of sales growth is
attributable to a shift in buying by some of our customers, which includes
certain larger better department stores, away from low-end junior bags to
higher-end and urban junior bags. As a result of this shift, we have changed and
expanded our Bongo(R) branded line of bags to include a signature print series.
We expect that this change and expansion in our Bongo(R) branded line of bags
will result in an increase in sales in subsequent quarters, as we expect the
product to be attractive to mid-tier retailers. Throughout the remainder of
fiscal 2004, we anticipate net sales of certain other company-owned branded
accessories, such as Friendship(TM) and Clear Gear(TM), to continue to decrease
in future quarters of fiscal 2004 as we continue to sell off existing inventory.
Apparel
Joe's
Joe's net sales increased to $4,394,000 in the second quarter of fiscal
2004 from $2,638,000 in the second quarter of fiscal 2003, or a 67% increase as
a result of increased sales in both the domestic and international markets. The
increase in net sales is attributable to a higher number of units of Joe's sold.
At the end of the first quarter of fiscal 2004, we incurred a number of
production delays that resulted in a decline in sales. In the second quarter of
fiscal 2004, we completed the consolidation of Joe's production under the
existing production department we use for our other private and branded label
apparel products. As a result, we incurred fewer production delays and were able
to fulfill the vast majority of our backlog. Further, throughout fiscal 2004, to
increase Joe's net sales we have been expanding our collection of products to
include pants in materials other than denim, and tops, such as shirts and
jackets and expanding our denim pants line to include six fits that are tailored
to different body types.
Net Sales % of Total
($ in thousands) Net Sales
------------------- --------------------
Three Months Ended Three Months Ended
------------------- -------- --------------------
5/29/04 5/31/03 % Chg. 5/29/04 5/31/03
------------------- -------- -------- --------
Domestic $ 3,028 $ 1,705 78% 69% 65%
International 1,366 933 46% 31% 35%
-------------------
Total Net Sales $ 4,394 $ 2,638 67% 100% 100%
===================
25
Domestic
Joe's domestic net sales increased to $3,028,000 in the second quarter of
fiscal 2004 from $1,705,000 in the second quarter of fiscal 2003, or a 78%
increase. The increase in domestic net sales is attributable to a higher number
of units Joe's sold in the domestic market. In order to increase Joe's net sales
in the domestic market, we increased advertising spending to include billboards
as well as print ads. We expect Joe's net sales to continue to grow throughout
the remainder of fiscal 2004 based upon orders on-hand and a strong denim market
in the United States.
International
Joe's net sales to international markets increased to $1,366,000 in the
second quarter of fiscal 2004 from $933,000 in the second quarter of fiscal
2003, or a 46% increase. Currently, Joe's products are sold internationally
primarily in Japan, France, England, Canada, Australia, Norway and Korea. The
increase in international sales is attributable to an increase in the number of
international markets into which Joe's is selling product and growth in Joe's
key international markets. In fiscal 2004, we expect sales to international
distributors to increase as a result of partnering with Beyond Blue. Beyond Blue
is responsible for managing the existing relationships with Joe's international
distributors and opening new territories by obtaining additional international
sub-distributors and sales agents. See "Management's Discussion and Analysis of
Financial Condition and Results of Operation - Recent Acquisitions and Licenses"
for a further discussion regarding the international distribution agreement with
Beyond Blue.
IAA
IAA's net sales increased to $21,151,000 in the second quarter of fiscal
2004 from $6,189,000 in the second quarter of fiscal 2003, or a 242% increase.
IAA segregates its operations between two businesses: private label and branded
apparel. IAA's increase in net sales is attributable to an increase in sales
from its private label business, most notably due to sales within the Blue
Concept Division, which we acquired from Azteca, Hubert Guez and Paul Guez in
July 2003. See "Management's Discussion and Analysis of Financial Condition and
Results of Operation - Recent Acquisitions and Licenses" for a further
discussion regarding the acquisition of the Blue Concept Division from Azteca.
Due to limited continuing sales of Fetish(TM) and Shago(R) related apparel sold
pursuant to the under the license agreements entered into during fiscal 2002 and
2003, IAA generated approximately only 12% of its net sales from its branded
business in the second quarter of fiscal 2004. For the second quarter of fiscal
2004, net sales of Shago(R) and Fetish(TM) branded apparel were $228,000 and
$2,392,000, respectively. For a further discussion of the termination of the Hot
Wheels(R), and Fetish(TM) license agreements and the status of the Shago(R)
license agreement, see "Management's Discussion and Analysis of Financial
Condition and Results of Operations - Executive Overview."
Net Sales
($ in thousands) % of Total Net Sales
------------------- --------------------
Three Months Ended Three Months Ended
------------------- --------------------
5/29/04 5/31/03 % Chg. 5/29/04 5/31/03
------------------- -------- --------------------
Branded $ 2,620 $ 68 (A) 12% 1%
Private Label 18,531 6,121 203% 88% 99%
-------------------
Total Net Sales $ 21,151 $ 6,189 242% 100% 100%
===================
(A) Not Meaningful
26
Private Label Apparel
IAA's net sales from its private label business increased to $18,531,000
in the second quarter of fiscal 2004 from $6,121,000 in the second quarter of
fiscal 2003, or a 203% increase. The increase in sales is attributable to sales
generated as a result of acquisition of the Blue Concept Division from Azteca in
July 2003. In fiscal 2004, we expect sales from IAA's private label division to
increase as we anticipate benefiting from a full year's contribution of sales
from the Blue Concept Division compared to only four months in fiscal 2003, as
well as opening new private label accounts.
Branded Apparel
IAA's net sales from its branded apparel business increased to $2,620,000
in the second quarter of fiscal 2004 from $68,000 in the second quarter of
fiscal 2003. Branded apparel sales accounted for 12% of IAA's net sales in the
second quarter of fiscal 2004 compared to just 1% in the second quarter of
fiscal 2003. Due to the termination of the license agreement for Fetish(TM) and
Hot Wheels(R) branded apparel, as well as limited sales and the cessation of
production under the existing Shago(R) license, we expect sales within our
branded apparel business to be limited in the subsequent quarters of fiscal
2004. For a further discussion of the termination of the Hot Wheels(R) and
Fetish(TM) license agreements and the status of the Shago(R) license agreement,
see "Management's Discussion and Analysis of Financial Condition and Results of
Operations - Executive Overview."
In February 2004, we were assigned a license agreement with B.J. Vines,
Inc., licensor of the Betsey Johnson(R) brand for the exclusive right to design,
market and distribute women's jeans and coordinating denim related apparel, such
as t-shirts and tops, under the Betsey Johnson(R) brand name in the United
States, its territories and possessions, and Canada. As a result, we expect to
generate sales under this license agreement in the fourth quarter in fiscal
2004. Production of the apparel under the Betsey Johnson(R) brand name is
currently underway and we anticipate introducing the Betsey Johnson(R) products
in the third quarter of fiscal 2004. See "Management's Discussion and Analysis
of Financial Condition and Results of Operation - Recent Acquisitions and
Licenses" for a further discussion of the Betsey Johnson(R) license.
Gross Margin
Our gross profit increased to $3,430,000 in the second quarter of fiscal
2004 from $3,358,000 in the second quarter of fiscal 2003, or a 2% increase.
Overall, gross margin, as a percentage of net sales, decreased to 11% in the
second quarter of fiscal 2004 from 28% in the second quarter of fiscal 2003. The
decline was attributable to: (i) sales of slow moving and out-of-season
Fetish(TM) and Shago(R) branded apparel and accessories at cost; (ii) a charge
we recorded against our remaining slow moving and out-of-season Fetish(TM)
branded apparel; (iii) an increased percentage of our sales coming from
international distributors and domestic discounters, which carry lower margins;
and (iv) a higher percentage of sales coming from private label apparel, which
also carries lower margins.
Accessory
Innovo
Innovo's gross profit increased to $970,000 in the second quarter of
fiscal 2004 from $710,000 in the second quarter of fiscal 2003, or a 37%
increase. Innovo's gross margin was 22% in the second quarter of fiscal 2004
compared to 22% in the second quarter of fiscal 2003. Innovo's gross margin is a
27
function of its product mix, such as private label, craft and branded accessory
products, for a given period. Our craft and private label accessory products
have traditionally experienced lower gross margins than our branded accessory
products. Despite higher sales of higher margin branded accessories in the
second quarter of fiscal 2004 compared to the second quarter of fiscal 2003,
gross margin remained at the same level primarily as a result of increased air
freight due to late shipments. Increased air freight impacted gross margins by
three percentage points.
Apparel
Joe's
Joe's gross profit increased to $1,417,000 in the second quarter of fiscal
2004 from $1,416,000 in the second quarter of fiscal 2003, or a 0.1% increase.
Joe's gross margin decreased to 32% in the second quarter of fiscal 2004 from
54% in the second quarter of fiscal 2003 for the following two reasons: (i)
increased sales to domestic discounters, and (ii) higher cost of goods sold. We
had a higher level of sales to domestic discounters during the second quarter of
fiscal 2004 than in the second quarter of fiscal 2003 because we chose to sell
slow moving inventory at lower margins. Further, our cost of goods sold
increased as a result of no longer being able to purchase finished goods from
our domestic supplier at prices previously offered, which resulted in the need
to change our inventory purchasing strategy during at the end of the second
quarter of fiscal 2003 from buying finished goods to buying raw materials and
outsourcing the manufacturing of our goods. Joe's cost to buy raw materials and
outsource the manufacturing of its own goods was significantly higher than its
cost to buy finished goods. However, we expect Joe's margins to continue to
improve throughout the remainder of fiscal 2004 as a result of consolidating
Joe's production under the existing production department we use for our other
private and branded label apparel products.
IAA
IAA's gross profit decreased to $1,044,000 in the second quarter of fiscal
2004 from $1,176,000 in the second quarter of fiscal 2003, or an 11% decrease.
IAA's gross margin decreased to 5% in the second quarter of fiscal 2004 from 19%
in the second quarter of fiscal 2003. The decrease in gross margin is primarily
attributable to lower gross margins associated with sales of private label
apparel products, primarily sales associated with the purchase of the Blue
Concept Division and lower gross margins associated with sales of our
out-of-season and slow moving Shago(R) and Fetish(TM) inventory.
Private Label Apparel
IAA's private label gross profit increased to $2,868,000 in the second
quarter of fiscal 2004 from $1,150,000 in the second quarter of fiscal 2003, or
a 149% increase. IAA's private label gross margin decreased to 16% in the second
quarter of fiscal 2004 from 19% in the second quarter of fiscal 2003. The
decrease in gross margin is attributable to lower gross margins associated with
sales as a result of the acquisition of the Blue Concept Division and the
acquisition's related fixed margin supply agreement with Azteca.
Branded Apparel
IAA's branded apparel gross profit decreased to a loss of $1,824,000 in
the second quarter of fiscal 2004 from a profit of $26,000 in the second quarter
of fiscal 2003. IAA's branded apparel gross margins decreased to negative 70% in
the second quarter of fiscal 2004 from positive 38% in the second quarter of
fiscal 2003. The decrease in gross margin is attributable to charges we took
against our Fetish(TM) inventory as a result of termination of the license
agreement. In the second quarter of fiscal
28
2004 we recorded a charge of an additional $444,000 against out-of-season Fall
and Holiday Fetish(TM) inventory, and we recorded a charge of an additional
$1,263,000 against Spring and Summer Fetish(TM) inventory.
Selling, General and Administrative Expense
Selling, general and administrative, or SG&A, expenses increased to
$8,935,000 in the second quarter of fiscal 2004 from $3,694,000 in the second
quarter of fiscal 2003, or a 142% increase.
The SG&A increase in the second quarter of fiscal 2004 compared to the
second quarter of fiscal 2003 is largely a result of the following factors: (i)
an increase in advertising expenditures to establish and market our Fetish(TM),
Shago(R) and Joe's(R) branded products through both advertising and tradeshows;
(ii) the hiring of additional employees to support or facilitate the
establishment of and increase sales for Fetish(TM), Shago(R) and Joe's(R)
branded products and the addition of the personnel hired in connection with
acquisition of the Blue Concept Division from Azteca; (iii) an increase in
royalty and commission expense associated with our existing and new branded
accessory and apparel lines; (iv) an increase in outside legal and accounting
fees as a result of increased business activity; and (v) an earn-out expense and
other SG&A expenses associated with the purchase of Blue Concept Division; and
(vi) a charge directly related to the termination of the Fetish(TM) license.
As discussed in greater detail below, we incurred the following SG&A
expenses in the second quarter of fiscal 2004: (i) $448,000 of expense in the
second quarter of fiscal 2004 from $168,000 of expense in the second quarter of
fiscal 2003, or a 167% increase, to establish and market our branded products
through advertising and tradeshows; (ii) $2,592,000 of expense in the second
quarter of fiscal 2004 from $1,326,000 of expense in the second quarter of
fiscal 2003, or a 95% increase, for hiring additional employees and wage
increase; (iii) $919,000 of expense in the second quarter of fiscal 2004 from
$276,000 of expense in the second quarter of fiscal 2003, or a 233% increase,
for royalties and commissions associated with our existing and new branded
accessory and apparel lines; (iv) $667,000 of expense in the second quarter of
fiscal 2004 from $331,000 of expense in the second quarter of fiscal 2003, or a
102% increase, for increased legal and accounting fees as a result of increased
business activity associated with the Fetish(TM) termination, trademark matters,
registration of unregistered shares sold in fiscal 2003, and the conversion of
the Blue Concept Note; (v) $394,000 of earn-out expense and $187,000 of other
SG&A expense associated with the purchase of Blue Concept Division from Azteca;
and (vi) $2,105,000 of expense directly related to the termination of the
Fetish(TM) license, namely: (a) $300,000 to write off the Fetish(TM) tradeshow
booth; (b) $1,055,000 to write off the outstanding prepaid advertising balance
relating to the Fetish(TM) license; and (c) $750,000 to terminate the Fetish(TM)
license.
Accessory
Innovo
Innovo's SG&A expenses increased to $988,000 in the second quarter of
fiscal 2004 from $689,000 in the second quarter of fiscal 2003, or a 43%
increase. This SG&A expense increase is primarily attributable to wage and
related benefit increases. Innovo's employee wages and related benefits
increased to $454,000 in the second quarter of fiscal 2004 from $313,000 in the
second quarter of fiscal 2003, or a 45% increase. Employee wages and related
benefits increases are a result of hiring of additional salespeople to replace
outsourced sales personnel working on a "commission-only" basis and the hiring
of additional employees in our sourcing office in Hong Kong in fiscal 2004.
Due to the expansion of the branded accessories product line in the second
quarter of fiscal 2004 compared to the second quarter of fiscal 2003, three
other SG&A expense categories increased, namely:
29
(i) royalty expense; (ii) travel expenses; and (iii) rent. First, the addition
of sales of Fetish(TM) branded accessories resulted in an increase in our
royalty expense to $87,000 in the second quarter of fiscal 2004 from $16,000 in
the second quarter of fiscal 2003, or a 444% increase. Second, as a result of
increased travel overseas to expand our Hong Kong sourcing office and the travel
associated with attending additional sales shows, our travel and related
expenses increased to $65,000 in the second quarter of fiscal 2004 from $16,000
in the second quarter of fiscal 2003, or a 306% increase. Third, rent expenses
increased to $63,000 in the second quarter of fiscal 2004 from $28,000 in the
second quarter of fiscal 2003, or a 125% increase. The increase in rent is
primarily attributable to expansion of our New York showroom to include support
for the branded accessory lines. While we will continue to have the right to
continue the production of, the market, sale and distribution of Fetish(TM)
branded accessories until March 2005 and there can be no assurance that we will
be able to secure a license to produce Fetish(TM) branded accessories after this
date, until then, we will continue to incur expenses associated with the
Fetish(TM) branded accessories.
Apparel
Joe's
Joe's SG&A expenses increased to $1,820,000 during the second quarter of
fiscal 2004 from $1,443,000 in the second quarter of fiscal 2003, or a 26%
increase. This increase is primarily attributable to the following factors: (i)
wage and related benefits increase in connection with the hiring additional
employees in order to expand Joe's product lines from denim pants to a full
sportswear collection of pants and tops bearing the Joe's(R) brand for Spring
2004; (ii) an increase in advertising expenditures on marketing and advertising
the Joe's(R) and Joe's Jeans(R) brand through print and billboard; (iii) an
increase in legal, accounting and professional fees associated with the
dissolution of our Joe's Jeans subsidiary in Japan and with the filing and
prosecution for the protection of its trademarks domestically and
internationally; (iv) an increase in royalties and commissions as a result of
increased sales; (v) an increase in sample expense as a result of increased
distribution in the international markets; and (vi) an increase in tradeshow
expenses due to purchasing a booth rather than continuing to rent.
More specifically, Joe's employee wages and related benefits expenses
increased to $608,000 in the second quarter of fiscal 2004 from $469,000 in the
second quarter of fiscal 2003, or a 30% increase. Advertising expenditures
increased to $201,000 in the second quarter of fiscal 2004 from $89,000 in the
second quarter of fiscal 2003, or a 126% increase. Legal, accounting and
professional fees increased to $117,000 in the second quarter of fiscal 2004
from $78,000 in the second quarter of fiscal 2003, or a 50% increase. Royalty
and commission expense increased to $446,000 in the second quarter of fiscal
2004 from $231,000 in the second quarter of fiscal 2003, or a 93% increase as a
result of higher sales. Joe's sample expense increased to $112,000 in the second
quarter of fiscal 2004 from $65,000 in the second quarter of fiscal 2003, or a
72% increase. Tradeshow expense increased to $117,000 in the second quarter of
fiscal 2004 from $37,000 in the second quarter of fiscal 2003, or a 216%
increase.
IAA
IAA's SG&A expenses increased to $4,833,000 in the second quarter of
fiscal 2004 from $764,000 in the second quarter of fiscal 2003, or a 533%
increase. The increase in SG&A expense is primarily attributable to the growth
in IAA's branded apparel business and the acquisition of the Blue Concept
Division from Azteca.
IAA had higher employee costs associated with the expansion of its branded
apparel business and the acquisition of the Blue Concept Division. In addition,
we expanded our Hong Kong sourcing office to include sourcing for apparel
products, as discussed in the Innovo section above. As a result, employee
30
wages and benefits increased to $1,211,000 in the second quarter of fiscal 2004
from $319,000 in the second quarter of fiscal 2003, or a 280% increase.
During the second quarter of fiscal 2004, we incurred $126,000 of royalty
and commission expense versus only $18,000 in the second quarter of fiscal 2003,
or an increase of 600%. The increase in royalty and commission expense is a
result of sales of our Fetish(TM) and Shago(R) branded apparel lines. In the
second quarter of fiscal 2003, we had only $68,000 of Shago(R) sales and the
minimum royalty payment associated with the Hot Wheels(R) license. The $126,000
of royalty and commission expense we incurred in the second quarter of fiscal
2004 includes a reversal of $224,000 of a $294,000 accrual we recorded in fiscal
2003 against our future minimum royalty payments to Hot Wheels(R).
During the second quarter of fiscal 2004, we recognized $2,105,000 of
expense in connection with the termination of the Fetish(TM) license. We
recognized the following three expenses: (i) $300,000 to write-off the
Fetish(TM) tradeshow booth; (ii) $1,055,000 to write-off the outstanding prepaid
advertising royalty balance; and (iii) $750,000 to terminate the Fetish(TM)
license.
During the second quarter of fiscal 2004, we incurred $90,000 of tradeshow
expense to promote and sell our Fetish(TM) and Shago(R) branded apparel lines
compared to $11,000 in the second quarter of fiscal 2003. In addition, sample
expense including freight increased to $140,000 in the second quarter of fiscal
2004 from $86,000 in the second quarter of fiscal 2003, or a 63% increase.
Rental expense increased to $184,000 in the second quarter of fiscal 2004
from $15,000 in the second quarter of fiscal 2003. The primary reason for the
increase was due to our branded apparel showroom in New York. IAA did not have a
New York showroom in the second quarter of fiscal 2003. In addition, our
computer support expenses increased to $26,000 in the second quarter of fiscal
2004 from $4,000 in the second quarter of fiscal 2003, or a 550% increase for
support for our New York showroom and for additional licenses for our apparel
management software. In an effort to decrease rental expenses and due to the
termination of the our branded apparel licenses for Fetish(TM), Shago(R) and Hot
Wheels(R), we are in the process of evaluating our New York showroom sublease
agreement and obtaining permission from all necessary parties to further
sublease all or a portion of the New York showroom space.
Travel, meals and entertainment expense increased to $88,000 in the second
quarter of fiscal 2004 from $52,000 in the second quarter of fiscal 2003, or a
69% increase, as a result of the larger employee and customer base.
As a part of the acquisition of the Blue Concept Division, IAA pays to
Azteca a fee for allocated expenses associated with the use of its office space
and expenses incurred in connection with maintaining office space. These
allocated expenses include, but are not limited to: rent, security, office
supplies, machine leases and utilities. In the second quarter of fiscal 2004,
IAA recorded $181,000 for such expenses compared to no allocation in the second
quarter of fiscal 2003 since the business was not acquired until the third
quarter of fiscal 2003.
During fiscal 2003, we incurred $394,000 of expense to Sweet Sportswear
LLC, or Sweet Sportswear, pursuant to an earn-out agreement. In connection with
the Blue Concept Division acquisition, IAA pays to Sweet Sportswear, an entity
owned by Hubert Guez and Paul Guez who were parties to the Blue Concept asset
purchase agreement, an earn-out on a quarterly basis equal to 2.5% of the gross
sales of the division. This earn-out agreement was additional consideration for
the acquisition of the Blue Concept Division. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations - Recent Acquisitions
and Licenses" for further discussion regarding the
31
acquisition of the Blue Concept Division. We expect earn-out expenses to
increase as we anticipate sales growth from the Blue Concept Division for a full
year of sales in fiscal 2004.
Other
IGI
IGI, which reflects our corporate expenses and operates under the "other"
segment, does not have sales. IGI's expense, excluding interest, depreciation
and amortization, increased to $1,220,000 in the second quarter of fiscal 2004
from $682,000 in the second quarter of fiscal 2004, or a 79% increase. IGI's
management level wages and related benefits increased to $318,000 in the second
quarter of fiscal 2004 from $199,000 in the second quarter of fiscal 2003, or a
60% increase, primarily as a result of hiring five additional management level
employees to provide the infrastructure necessary to manage our growth. In the
second quarter of fiscal 2004, we recorded a charge of $161,000 for liquidated
damages payable to certain purchasers associated with a previous equity offering
because we were not able to have a registration statement declared effective by
the SEC within the time periods prescribed within the related equity financing
documents. Legal, accounting and professional fees increased to $540,000 in the
second quarter of fiscal 2004 compared to $246,000 in the second quarter of
fiscal 2003, or a 120% increase as a result of increased business activity,
registration of unregistered shares sold in fiscal 2003 and the termination of
the Fetish(TM) license.
Leaseall
Leaseall's SG&A expense increased to $73,000 in the second quarter of
fiscal 2004 from $10,000 in the second quarter of fiscal 2003, or a 630%
increase, due to $64,000 of expenses incurred to maintain and operate our former
manufacturing facility and headquarters located in Springfield, Tennessee, which
is now partially leased to third party tenants.
Depreciation and Amortization Expenses
Our depreciation and amortization expenses increased to $414,000 in the
second quarter of fiscal 2004 from $85,000 in the second quarter of fiscal 2003,
or a 387% increase. The increase is primarily attributable the amortization of
$330,000 of the intangible asset related to the value of the customer list
obtained through the purchase of the Blue Concept Division from Azteca. The
remaining depreciation and amortization expense of $84,000 is due to: (i)
depreciation of $24,000 in connection with the Springfield, Tennessee facility
and related leasehold improvements; (ii) amortization of $12,000 in connection
with the licensing rights to the Joe's(R) and Joe's Jeans(R) marks acquired on
February 7, 2001; and (iii) depreciation of $48,000 related to small operational
assets such as furniture, fixtures, machinery and software.
Interest Expense
Our combined interest expense increased to $279,000 in the second quarter
of fiscal 2004 from $215,000 in the second quarter of fiscal 2003, or a 30%
increase. Our interest expense is primarily associated with: (i) $111,000 of
interest expense from our factoring and inventory lines of credit and letter's
of credit from CIT used to help support our working capital increases; (ii)
$150,000 of interest expense incurred as a result of the $21,800,000 convertible
note issued as a part of the purchase of the Blue Concept Division in July of
2003 (which such interest expense has been partially eliminated due to the
$12,500,000 conversion of the convertible note at our March 5, 2004 special
meeting of stockholders); (iii) $10,000 of interest expense from two loans
totaling $500,000 provided by Marc Crossman, our Chief
32
Financial Officer, to Innovo Group on February 7, 2003 and February 13, 2003;
and (iv) $7,000 of interest expense from a mortgage on our former manufacturing
facility and headquarters i