================================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934.
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2003
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934.
FOR THE TRANSITION PERIOD FROM TO
----------------- -----------------
COMMISSION FILE NUMBER: 0-26430
----------
TARRANT APPAREL GROUP
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
CALIFORNIA 95-4181026
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification Number)
3151 EAST WASHINGTON BOULEVARD
LOS ANGELES, CALIFORNIA 90023
(Address of Principal Executive Offices) (Zip Code)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (323) 780-8250
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes |X| No |_|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes |_| No |X|
Number of shares of Common Stock of the registrant outstanding as of August 12,
2003: 18,765,425.
TARRANT APPAREL GROUP
FORM 10-Q
INDEX
PART I. FINANCIAL INFORMATION
PAGE
Item 1. Financial Statements (Unaudited)
Consolidated Balance Sheets at June 30, 2003
(Unaudited) and December 31, 2002 (Audited) ................. 4
Consolidated Statements of Operations for the Three
and Six Months Ended June 30, 2003 and June 30, 2002 ........ 5
Consolidated Statements of Cash Flows for the Six
Months Ended June 30, 2003 and June 30, 2002 ................ 6
Notes to Consolidated Financial Statements .................. 7
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations ......................... 15
Item 3. Quantitative and Qualitative Disclosures About
Market Risk ................................................. 30
Item 4. Controls and Procedures ..................................... 30
PART II. OTHER INFORMATION
Item 1. Legal Proceedings ........................................... 32
Item 2. Changes in Securities and Use of Proceeds ................... 33
Item 3. Defaults Upon Senior Securities ............................. 33
Item 4. Submission of Matters to a Vote of Security Holders ......... 33
Item 5. Other Information ........................................... 34
Item 6. Exhibits and Reports on Form 8-K ............................ 34
SIGNATURES .................................................. 36
2
CAUTIONARY LEGEND REGARDING FORWARD-LOOKING STATEMENTS
Some of the information in this Quarterly Report on Form 10-Q may
constitute forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934,
both as amended. These forward-looking statements are subject to various risks
and uncertainties. The forward-looking statements include, without limitation,
statements regarding our future business plans and strategies and our future
financial position or results of operations, as well as other statements that
are not historical. You can find many of these statements by looking for words
like "will", "may", "believes", "expects", "anticipates", "plans" and
"estimates" and for similar expressions. Because forward-looking statements
involve risks and uncertainties, there are many factors that could cause the
actual results to differ materially from those expressed or implied. These
include, but are not limited to, economic conditions. This Quarterly Report on
Form 10-Q contains important cautionary statements and a discussion of many of
the factors that could materially affect the accuracy of Tarrant's
forward-looking statements and such statements and discussions are incorporated
herein by reference. Any subsequent written or oral forward-looking statements
made by us or any person acting on our behalf are qualified in their entirety by
the cautionary statements and factors contained or referred to in this section.
We do not intend or undertake any obligation to update any forward-looking
statements to reflect events or circumstances after the date of this document or
the date on which any subsequent forward-looking statement is made or to reflect
the occurrence of unanticipated events.
3
PART I-- FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
---------------------
TARRANT APPAREL GROUP
CONSOLIDATED BALANCE SHEETS
JUNE 30, DECEMBER 31,
2003 2002
------------- -------------
(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents ................. $ 1,201,434 $ 1,388,482
Restricted Cash ........................... 2,000,000 --
Accounts receivable, net .................. 69,174,325 65,287,902
Due from affiliates ....................... 8,869,982 8,510,993
Due from officers ......................... 456,501 456,500
Inventory ................................. 53,241,391 44,782,154
Temporary quota ........................... 4,802,516 --
Prepaid expenses and other receivables .... 1,476,383 5,135,672
Income taxes receivable ................... 208,916 280,200
------------- -------------
Total current assets ........................ 141,431,448 125,841,903
Property and equipment, net ............... 154,381,408 159,998,629
Other assets .............................. 3,106,092 2,539,040
Excess of cost over fair value of net
assets acquired, net ................... 8,582,844 28,064,019
------------- -------------
Total assets ................................ $ 307,501,792 $ 316,443,591
============= =============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Short-term bank borrowings ................ $ 39,972,321 $ 29,326,924
Accounts payable .......................... 50,973,854 32,119,854
Accrued expenses .......................... 17,424,000 12,566,475
Income taxes .............................. 13,991,580 12,640,388
Due to affiliates ......................... 5,802,092 5,264,238
Due to shareholders ....................... 383,877 486,875
Current portion of long-term
obligations ............................ 18,321,705 21,706,502
------------- -------------
Total current liabilities ................... 146,869,429 114,111,256
Long-term obligations ........................ 52,494,243 55,903,976
Deferred tax liabilities ..................... 422,156 407,751
Minority interest in UAV ..................... 4,388,980 3,205,167
Minority interest in Tarrant Mexico .......... 15,994,610 21,654,538
Commitments and contingencies
Shareholders' equity:
Preferred stock, 2,000,000 shares
authorized; Preferred stock Series
A, 100,000 shares authorized; 0
share (2003) and 100,000 shares
(2002), issued and outstanding .......... -- 8,820,573
Common stock, no par value, 35,000,000
shares authorized; 18,765,425 shares
(2003) and 15,846,315 shares (2002)
issued and outstanding .................. 77,877,385 69,368,239
Contributed capital ....................... 1,434,259 1,434,259
Retained earnings ......................... 20,422,972 56,873,094
Notes receivable from shareholders ........ (4,855,652) (5,601,804)
Accumulated other comprehensive income .... (7,546,590) (9,733,458)
------------- -------------
Total shareholders' equity .................. 87,332,374 121,160,903
------------- -------------
Total liabilities and shareholders'
equity ................................... $ 307,501,792 $ 316,443,591
============= =============
The accompanying notes are an integral part of these consolidated
financial statements
4
TARRANT APPAREL GROUP
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
2003 2002 2003 2002
------------- ------------- ------------- -------------
Net sales .................................. $ 78,194,081 $ 95,306,909 $ 156,930,285 $ 160,471,093
Cost of sales .............................. 78,626,988 80,882,668 148,560,713 137,627,881
------------- ------------- ------------- -------------
Gross profit (loss) ........................ (432,907) 14,424,241 8,369,572 22,843,212
Selling and distribution expenses .......... 3,114,848 2,424,999 5,844,360 5,062,012
General and administrative expenses ........ 8,542,839 7,219,285 15,925,861 13,832,170
Impairment of assets ....................... 22,276,510 -- 22,276,510 --
------------- ------------- ------------- -------------
Income (loss) from operations .............. (34,367,104) 4,779,957 (35,677,159) 3,949,030
Interest expense ........................... (1,426,047) (1,676,709) (2,919,060) (2,576,675)
Interest income ............................ 88,062 77,953 175,326 135,631
Other income ............................... 156,205 685,953 472,519 910,414
Other expense .............................. (193,762) (613,283) (519,505) (817,014)
Minority interest .......................... 3,729,688 (1,439,552) 3,493,291 (1,877,339)
------------- ------------- ------------- -------------
Income (loss) before provision for income
taxes and cumulative effect of accounting
change ................................... (32,012,958) 1,814,319 (34,974,588) (275,953)
Provision for income taxes ................. 558,236 511,983 1,475,534 147,962
------------- ------------- ------------- -------------
Income (loss) before cumulative effect of
accounting change ....................... (32,571,194) 1,302,336 (36,450,122) (423,915)
Cumulative effect of accounting change ..... -- -- -- (4,871,244)
------------- ------------- ------------- -------------
Net income (loss) .......................... $ (32,571,194) $ 1,302,336 $ (36,450,122) $ (5,295,159)
============= ============= ============= =============
Net income (loss) per share - Basic:
Before cumulative effect of accounting
change ................................ $ (1.94) $ 0.08 $ (2.23) $ (0.03)
Cumulative effect of accounting change .. -- -- -- (0.31)
After cumulative effect of accounting
change ................................ $ (1.94) $ 0.08 $ (2.23) $ (0.34)
============= ============= ============= =============
Net income (loss) per share - Diluted:
Before cumulative effect of accounting
change ................................ $ (1.94) $ 0.08 $ (2.23) $ (0.03)
Cumulative effect of accounting change .. -- -- -- (0.31)
After cumulative effect of accounting
change ................................ $ (1.94) $ 0.08 $ (2.23) $ (0.34)
============= ============= ============= =============
Weighted average common and common
equivalent shares:
Basic ................................... 16,832,092 15,832,474 16,334,204 15,832,061
============= ============= ============= =============
Diluted ................................. 16,832,092 16,098,557 16,334,204 15,832,061
============= ============= ============= =============
The accompanying notes are an integral part of these consolidated
financial statements
5
TARRANT APPAREL GROUP
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
SIX MONTHS ENDED JUNE 30,
2003 2002
------------- -------------
Operating activities:
Net loss ..................................... $ (36,450,122) $ (5,295,159)
Adjustments to reconcile net loss to net
cash used in operating activities:
Deferred taxes ............................ 14,405 (337,887)
Depreciation and amortization ............. 8,140,849 5,227,535
Cumulative effect of accounting change .... -- 4,871,244
Asset impairment .......................... 22,276,510 --
Inventory write-down ...................... 10,986,153 --
Unrealized loss on foreign currency ....... 401,369 383,435
Provision for returns and discounts ....... 1,477,361 (1,658,657)
Minority interest ......................... (3,493,291) 1,140,399
Changes in operating assets and
liabilities:
Restricted Cash ......................... (2,000,000) (4,000,000)
Accounts receivable ..................... (6,454,784) (24,801,832)
Due from affiliates ..................... 407,446 420,027
Inventory ............................... (19,445,390) (5,114,446)
Temporary quota ......................... (4,802,516) (1,534,274)
Prepaid expenses and other
receivables .......................... 958,583 816,743
Accounts payable ........................ 18,854,000 19,493,436
Accrued expenses and income tax
payable .............................. 6,208,716 2,413,105
------------- -------------
Net cash used in operating activities ... (2,920,711) (7,976,331)
Investing activities:
Purchase of fixed assets .................. (378,459) (646,394)
(Increase) decrease in other assets ....... (1,366,820) 295,557
Repayments of advances from
shareholders/officers .................. 746,151 --
------------- -------------
Net cash used in investing activities ... (999,128) (350,837)
Financing activities:
Short-term bank borrowings, net ........... 10,645,397 4,802,582
Proceeds from long-term obligations ....... 124,784,919 25,263,169
Payment of long-term obligations and
bank borrowings ........................ (131,980,818) (23,701,030)
Repayments to shareholders/officers ....... (102,998) (2,287,398)
Borrowings from shareholders/officers ..... -- 5,240,315
Exercise of stock options ................. -- 9,796
Repurchase of stock ....................... (393,178) --
------------- -------------
Net cash provided by financing
activities ........................... 2,953,322 9,327,434
Effect of changes in foreign currency ........ 779,469 (604,006)
------------- -------------
Increase (decrease) in cash and cash
equivalents ............................... (187,048) 396,260
Cash and cash equivalents at beginning
of period ................................. 1,388,482 1,524,447
------------- -------------
Cash and cash equivalents at end of
period .................................... $ 1,201,434 $ 1,920,707
============= =============
The accompanying notes are an integral part of these consolidated
financial statements
6
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. ORGANIZATION AND BASIS OF CONSOLIDATION
The accompanying financial statements consist of the consolidation of
Tarrant Apparel Group, a California corporation (formerly "Fashion Resource,
Inc.") (the "Parent Company" or the "Company"), and its wholly owned
subsidiaries located primarily in the U.S. and Asia. The Company owns 75% of its
subsidiaries in Mexico, 51% of Jane Doe International, LLC ("JDI"), and 50.1% of
United Apparel Ventures, LLC ("UAV"). The Company consolidates these entities
and reflects the minority interests in earnings (losses) of the ventures in the
accompanying financial statements. All inter-company amounts are eliminated in
consolidation.
The Company serves specialty retail, mass merchandise and department
store chains and major international brands by designing, merchandising,
contracting for the manufacture of, manufacturing directly and selling casual,
moderately priced apparel for women, men and children under private label.
Commencing in 1999, the Company expanded its operations from sourcing apparel to
sourcing and operating its own vertically integrated manufacturing facilities.
Historically, the Company's operating results have been subject to
seasonal trends when measured on a quarterly basis. This trend is dependent on
numerous factors, including the markets in which the Company operates, holiday
seasons, consumer demand, climate, economic conditions and numerous other
factors beyond the Company's control. Generally, the second and third quarters
are stronger than the first and fourth quarters. There can be no assurance that
the historic operating patterns will continue in future periods.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accompanying unaudited financial statements have been prepared in
accordance with accounting principles generally accepted in the United States
for interim financial information and with the instructions to Form 10-Q and
Article 10 of Regulation S-X. Accordingly, they do not include all of the
information and footnotes required by accounting principles generally accepted
in the United States for complete financial statements. In the opinion of
management, all adjustments (consisting of normal recurring accruals) considered
necessary for a fair presentation of the results of operations for the periods
presented have been included.
The consolidated financial data at December 31, 2002 is derived from
audited financial statements which are included in the Company's Annual Report
on Form 10-K for the year ended December 31, 2002, and should be read in
conjunction with the audited financial statements and notes thereto. Interim
results are not necessarily indicative of results for the full year.
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ from those
estimates.
Assets and liabilities of the Mexico and Hong Kong subsidiaries are
translated at the rate of exchange in effect on the balance sheet date; income
and expenses are translated at the average rates of exchange prevailing during
the year. The functional currency in which the Company transacts business in
Hong Kong is the Hong Kong dollar and in Mexico is the peso.
Certain 2002 amounts have been reclassified to conform to the 2003
presentation.
3. STOCK BASED COMPENSATION
The Company has adopted the disclosure provisions of Statement of
Financial Accounting Standards ("SFAS") No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure," an amendment of FASB Statement No.
123. This pronouncement requires prominent disclosures in both annual and
interim financial statements regarding the method of accounting for stock-based
employee compensation and the effect of the method used on reported results. The
Company accounts for stock compensation awards under the intrinsic value method
of Accounting Principles Board ("APB") Opinion No. 25, which requires
compensation cost to be recognized based on the excess, if any, between the
quoted market price of the stock at the date of grant and the amount an employee
must pay to acquire the stock. All options awarded under all of the Company's
plans are granted with an exercise price equal to the fair market value on the
date of the grant. The following table presents the effect on the Company's net
income (loss) and income (loss) per share had the Company adopted the fair value
method of accounting for stock-based compensation under SFAS No. 123,
"Accounting for Stock-Based Compensation":
7
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
------------------------------------------------------------
2003 2002 2003 2002
------------------------------------------------------------
Pro forma net income (loss) ... $(33,863,810) $ 498,580 $(38,715,280) $ (6,661,145)
Pro forma compensation expense,
net of tax ................. $ (1,292,616) $ (803,756) $ (2,265,158) $ (1,365,986)
Net income (loss) as reported . $(32,571,194) $ 1,302,336 $(36,450,122) $ (5,295,159)
Pro forma income (loss) per
share - Basic and Diluted .. $ (2.01) $ 0.03 $ (2.37) $ (0.42)
Net income (loss) per share -
Basic and Diluted .......... $ (1.94) $ 0.08 $ (2.23) $ (0.34)
The fair value of each option grant is estimated on the date of grant
using the Black-Scholes option-pricing model with the following weighted average
assumptions used for grants in 2002 and 2003; expected volatility of 0.65,
risk-free interest rates of 4%, dividend yield of 0% and expected lives of 4
years. These pro forma results may not be indicative of the future results for
the full fiscal year due to potential grants vesting and other factors.
4. ACCOUNTS RECEIVABLE
Accounts receivable consists of the following:
JUNE 30, DECEMBER 31,
2003 2002
------------ ------------
United States trade accounts
receivable ............................ $ 44,487,153 $ 42,979,762
Foreign trade accounts receivable ........ 21,998,142 16,445,868
Due from factor .......................... 1,992,605 4,176,598
Other receivables ........................ 6,478,967 6,002,295
Allowance for returns, discounts
and bad debts ......................... (5,782,542) (4,316,621)
------------ ------------
$ 69,174,325 $ 65,287,902
============ ============
5. INVENTORY
Inventory consists of the following:
JUNE 30, DECEMBER 31,
2003 2002
----------- -----------
Raw materials
Fabric and trim accessories ............... $ 8,026,660 $12,451,447
Raw cotton ................................ 2,230,246 1,017,963
Work-in-process .............................. 18,084,885 9,948,700
Finished goods shipments-in-transit .......... 9,715,417 4,877,002
Finished goods ............................... 15,184,183 16,487,042
----------- -----------
$53,241,391 $44,782,154
=========== ===========
8
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
6. DEBT
Short-term bank borrowings consist of the following:
JUNE 30, DECEMBER 31,
2003 2002
----------- -----------
Import trade bills payable ................. $ 6,915,276 $ 5,686,327
Bank direct acceptances .................... 10,640,054 11,272,375
Other Hong Kong credit facilities .......... 16,143,448 6,206,103
Other Mexican credit facilities ............ 3,650,913 4,968,309
Uncleared checks ........................... 2,622,630 1,193,810
----------- -----------
$39,972,321 $29,326,924
=========== ===========
Long-term obligations consist of the following:
JUNE 30, DECEMBER 31,
2003 2002
------------ ------------
Vendor financing ................... $ 5,899,412 $ 7,257,683
Equipment financing ................ 7,583,299 9,682,290
Debt facility ...................... 54,856,237 58,193,505
Other debt ......................... 2,477,000 2,477,000
------------ ------------
70,815,948 77,610,478
Less current portion ............... (18,321,705) (21,706,502)
------------ ------------
$ 52,494,243 $ 55,903,976
============ ============
IMPORT TRADE BILLS PAYABLE AND BANK DIRECT ACCEPTANCES
On June 13, 2002, the Company entered into a letter of credit facility
of $25 million with UPS Capital Global Trade Finance Corporation ("UPS") to
replace the credit facility of The Hong Kong and Shanghai Banking Corporation
Limited in Hong Kong. Under this facility, the Company may arrange for the
issuance of letters of credit and acceptances. The facility is a one-year
facility subject to renewal on its anniversary and is collateralized by the
shares and debentures of all of the Company's subsidiaries in Hong Kong, as well
as the Company's permanent quota holdings in Hong Kong. In addition to the
guarantees provided by Tarrant Apparel Group, Fashion Resource (TCL) Inc., and
Tarrant Luxembourg Sarl (previously known as Machrima Luxembourg Sarl), a new
holding company the Company formed during 2002, Mr. Gerard Guez (the Company's
Chairman) also signed a guarantee of $5 million in favor of UPS to secure this
facility. This facility is also subject to certain restrictive covenants,
including aggregate net worth, fixed charge ratio, and leverage ratio. All the
covenants for 2003 have been re-set in line with those of our Debt Facility (see
Debt facility below). In June 2003, a temporary additional line of credit
consisting of $3 million of cash advances and $12 million of letters of credit
was made available to the Company against a restricted deposit $2 million in
cash and the deposit of $15 million in value of export letters of credit. This
temporary facility will expire on September 1, 2003 while the expiry date of the
main credit line of $25 million has been extended to December 1, 2003. The
Company was in violation of all covenants as of June 30, 2003, and a waiver has
been obtained subject to the payment of a fee of $25,000. As of June 30, 2003,
$38.3 million was outstanding under this facility of which $7.9 million was
letters of credit.
Since March 2003, Dao Heng Bank in Hong Kong has made available a
letter of credit facility of up to HKD 20 million (equivalent to US $2.6
million) to the Company's subsidiaries in Hong Kong. This is a demand facility
and is secured by the pledge of the Company's office property owned by Gerard
Guez and Todd Kay and the Company's guarantee. As of June 30, 2003, $2.2 million
was outstanding under this facility.
OTHER MEXICAN CREDIT FACILITIES
As of June 30, 2003, Tarrant Mexico, Famian division had a short-term
advance from Banco Bilbao Vizcaya amounting to $50,000. This subsidiary also had
a credit facility of $10 million with Banco Nacional de Comercio Exterior SNC,
based on purchase orders and restricted by certain covenants. After the merger
of Grupo Famian into Tarrant Mexico, Banco Nacional de Comercio Exterior SNC has
agreed that Tarrant Mexico will repay the outstanding amount by making payments
of $523,000 per month commencing on March 26, 2003. As of June 30, 2003, $3.6
million was outstanding under this facility.
9
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
VENDOR FINANCING
During 2000, the Company financed equipment purchases for a new
manufacturing facility with certain vendors. A total of $16.9 million was
financed with five-year promissory notes, which bear interest ranging from 7.0%
to 7.5%, and are payable in semiannual payments, which commenced in February
2000. Of this amount, $5.9 million was outstanding as of June 30, 2003. Of the
$5.9 million, $3.9 million is denominated in Euros and the remainder is payable
in U.S. dollars. The Company is subject to foreign exchange risk resulting from
the fluctuation of the Euro. An unrealized loss of $401,000 and $383,000 was
recorded for the six months ended June 30, 2003 and 2002, respectively, related
to this fluctuation and is recorded in other income in the accompanying
financial statements.
From time to time, the Company opens letters of credit under an
uncommitted credit arrangement with Aurora Capital Associates which issues these
credits through Israeli Discount Bank. As of June 30, 2003, $2.5 million was
open in letters of credit under this arrangement.
EQUIPMENT FINANCING
The Company has two equipment loans with the initial borrowings of
$16.25 million and $5.2 million from GE Capital Leasing ("GE Capital") and Bank
of America Leasing ("BOA"), respectively. The loans are secured by equipment
located in Puebla and Tlaxcala, Mexico. The amounts outstanding as of June 30,
2003 were $5.6 million due to GE Capital and $1.8 million due to BOA. Interest
accrues at a rate of 2.5% over LIBOR. The loan from GE Capital will mature in
2005, and the loan from BOA will mature in 2004. The GE Capital facilities are
subject to covenants on Tangible Net Worth ($30 million), leverage ratio of not
more than two times at the end of each financial year, and no losses for two
consecutive quarters. The Company was in violation of the covenant on
consecutive quarterly losses as of June 30, 2003 and obtained a waiver from GE
Capital subject to the following: A fee of $50,000, a principal prepayment of
$500,000 to the loan and a second lien on the Company's headquarters owned by
Gerard Guez and Todd Kay. The Company intends on making the required payments
and providing the second lien on the Company's headquarters and has therefore
classified the GE debt as long-term. The second lien on the Company's
headquarters will be released upon the Company returning to profitability in the
next two quarters. The BOA facility is subject to a financial benchmark on debt
service coverage (0.8:1 before March 31, 2003 and 1.25:1 thereafter) and a
leverage ratio of not more than two times. The Company was in violation of the
two benchmarks and is negotiating for a waiver of the breach. Under the
agreement, BOA has the option to accelerate repayment of all outstanding
principal amount to become payable in six equal monthly installments of $302,000
each. For this reason, the BOA debt has been classified as a current liability.
The Debt Facility with GMAC Commercial Credit, LLC ("GMAC") (described
below) and the credit facilities with GE Capital, UPS and BOA all carry
cross-default clauses. A breach of a financial covenant set by GMAC, UPS or GE
Capital constitutes an event of default, entitling these banks to demand payment
in full of all outstanding amounts under their respective debt and credit
facilities.
DEBT FACILITY
On January 21, 2000, the Company entered into a new revolving credit,
factoring and security agreement (the "Debt Facility") with a syndicate of
lending institutions. The Debt Facility initially provided a revolving facility
of $105.0 million, including a letter of credit facility not to exceed $20.0
million, and matures on January 31, 2005. The Debt Facility provides for
interest at LIBOR plus the LIBOR rate margin determined by the Total Leverage
Ratio (as defined). The Debt Facility is collateralized by receivables,
intangibles, inventory and various other specified non-equipment assets of the
Company. In addition, the facility is subject to various financial covenants on
tangible net worth, interest coverage, fixed charge ratio and leverage ratio and
prohibits the payment of dividends. On March 2, 2001, the Company entered into
an amendment of our Debt Facility with GMAC, who solely assumed the facility in
2000. This amendment reduced the $105.0 million facility to $90.0 million. The
over-advance line of $25 million was converted to a term facility to be repaid
by monthly installments of $500,000 before August 2001 and $687,500 thereafter.
In March 2003, the Company and GMAC established new financial covenants for the
remainder of fiscal 2003 based on the Company's projections. As of June 30,
2003, the Company was in breach of all the financial covenants and has obtained
a waiver subject to the payment of a fee of $100,000. Furthermore, Gerard Guez
has also agreed to increase his personal guarantee to $10 million. GMAC and the
Company have also agreed to re-set all financial covenants for the year before
October 1, 2003 based on the Company's
10
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
projections; provided, however that, in the event that the financial covenants
are not amended and restated on terms acceptable to GMAC in its sole discretion
on or prior to October 1, 2003, such failure shall be deemed to be an Event of
Default under the Credit Agreement and the other documents. A total of $54.9
million was outstanding under the Debt Facility at June 30, 2003.
GUARANTEES
Guarantees have been issued in favor of YKK, Universal Fasteners and
RVL Inc. for $750,000, $500,000 and unspecified amount, respectively, to cover
trim purchased by Tag-It Pacific Inc. on behalf of the Company.
7. OTHER ASSETS
In April 2003, the Company acquired an equity interest in the owner of
the trademark "American Rag CIE," for $1.4 million and the Company's subsidiary,
Private Brands, Inc., acquired a license to certain exclusive rights to this
trademark. Private Brands also entered into a multi-year exclusive distribution
agreement with Federated Merchandising Group ("FMG"), the sourcing arm of
Federated Department Stores, to supply FMG with American Rag CIE, a new casual
sportswear collection for juniors and young men. Private Brands will design and
manufacture a full collection of American Rag apparel, which will be distributed
by FMG exclusively to Federated stores across the country. Beginning in August
2003, the American Rag collection will be available in approximately 100 select
Macy's, the Bon Marche, Burdines, Goldsmith's, Lazarus and Rich's-Macy's
locations.
8. GOODWILL - STATEMENT NO. 142
SFAS No. 142, "Goodwill and Other Intangible Assets," requires that
goodwill and other intangibles be tested for impairment using a two-step
process. The first step is to determine the fair value of the reporting unit,
which may be calculated using a discounted cash flow methodology, and compare
this value to its carrying value. If the fair value exceeds the carrying value,
no further work is required and no impairment loss would be recognized. The
second step is an allocation of the fair value of the reporting unit to all of
the reporting unit's assets and liabilities under a hypothetical purchase price
allocation. Based on the evaluation performed to adopt SFAS No. 142 along with
continuing difficulties being experienced in the industry, the Company recorded
a non-cash charge of $4.9 million in the first quarter of 2002 to reduce the
carrying value of goodwill to the estimated fair value.
The Company has determined to cease directly operating a substantial
majority of its equipment and fixed assets in Mexico, and is negotiating to
lease a large portion of its manufacturing facilities and operations in Mexico
to a related third party, or contract with the related third party for their
operation, which the Company expects to consummate in the second half of fiscal
2003. The Company has made an interim review of all of its goodwill and
intangible assets and has decided to write off all goodwill and intangible
assets affected by the Company's strategic changes in Mexico. These include $9.1
million and $2.7 million directly relating to Tarrant Mexico - Famian and
Ajalpan divisions, respectively, and another $7.5 million relating to the
acquisition of Rocky Apparel LLC ("Rocky"). It is very unlikely that Tommy
Hilfiger, whose business the Company acquired in the Rocky acquisition, will
continue to purchase merchandise from UAV following implementation of the
restructuring in Mexico. The Company also has written off goodwill relating to
the acquisition of JDI due to current litigation with the minority shareholder
(see Part II-Legal Proceedings).
11
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The following table displays the change in the gross carrying amount of
goodwill by business units for the six months ended June 30, 2003:
Tag Mex
Tarrant Tarrant Inc. - Tag Mex Inc.
Mexico - Mexico - Rocky - Chazzz &
Total Jane Doe Ajalpan Famian Division MGI Division
----------- -------- ---------- ---------- ---------- ------------
Balance as of
December 31, 2002.... $28,064,019 $150,338 $2,739,378 $9,069,923 $7,521,536 $8,582,844
Impairment
Losses............... 19,504,521 150,338 2,739,378 9,093,269 7,521,536 0
Effect of changes in
foreign currency..... 23,346 0 0 23,346 0 0
----------- -------- ---------- ---------- ---------- ------------
Balance as of
June 30, 2003........ $8,582,844 $0 $0 $0 $0 $8,582,844
=========== ======== ========== ========== ========== ============
9. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In November 2002, the Financial Accounting Standards Board (FASB)
issued FASB Interpretation No. (FIN) 45, "Guarantor's Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of
Others." FIN 45 requires that guarantees issued after December 31, 2002 are
recorded as liabilities at fair value, with the offsetting entry recorded based
on the circumstances in which the guarantee was issued. Adoption of FIN 45 did
not have a material impact on the Company's financial statements.
In December 2002, the FASB issued SFAS 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure - an amendment of SFAS 123." This
statement provides alternate methods of transition for a voluntary change to the
fair value method of accounting for stock-based compensation. This statement
also amends the disclosure requirements of SFAS 123 and APB Opinion 28, "Interim
Financial Reporting" to require prominent disclosure in both annual and interim
financial statements about the method of accounting for stock-based compensation
and the effect of the method used on reported results. The Company has adopted
the disclosure provisions of SFAS 148.
In January 2003, the Financial Accounting Standards Board ("FASB")
issued Interpretation No. 46, "Consolidation of Variable Interest Entities,"
which addresses consolidation by business enterprises of variable interest
entities. Consolidation by a primary beneficiary of the assets, liabilities and
results of activities of variable interest entities will provide more complete
information about the resources, obligations, risks and opportunities of the
consolidated company. The Interpretation also requires disclosures about
variable interest entities that the Company is not required to consolidate but
in which it has a significant variable interest. The consolidation requirements
of Interpretation No. 46 apply immediately to variable interest entities created
after January 31, 2003 and apply to older entities in the first fiscal year or
interim period beginning after June 15, 2003. Certain of the disclosure
requirements apply in all financial statements issued after January 31, 2003,
regardless of when the variable interest entity was established. The Company
adopted Interpretation No. 46 as of January 1, 2003. The Company does not expect
FIN 46 to have a material impact on its financial statements.
In May 2003, the FASB issued Statement No. 150 ("SFAS 150"),
"Accounting for Certain Financial Instruments with Characteristics of both
Liabilities and Equity." This statement establishes standards for how an issuer
classifies and measures in its statement of financial position certain financial
instruments with characteristics of both liabilities and equity. In accordance
with the standard, financial instruments that embody obligations for the issuer
are required to be classified as liabilities. SFAS 150 is effective for all
financial instruments created or modified after May 31, 2003, and otherwise
shall be effective at the beginning of the first interim period beginning after
June 15, 2003. The adoption of
12
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
SFAS 150 is not expected to have a material effect on the Company's consolidated
financial condition or results of operations.
In November 2002, the EITF reached a consensus on Issue No. 00-21,
"Revenue Arrangements with Multiple Deliverables." EITF Issue No. 00-21 provides
guidance on how to account for arrangements that involve the delivery or
performance of multiple products, services and/or rights to use assets. The
provisions of EITF Issue No. 00-21 will apply to revenue arrangements entered
into in fiscal periods beginning after June 15, 2003. The Company is currently
evaluating the effect of the adoption of EITF Issue No. 00-21, but the Company
does not expect its adoption to have a material impact on its consolidated
financial position or results of operations.
10. INCOME TAXES
The Company's effective tax rate differs from the statutory rate
principally due to the following reasons: (1) A full valuation allowance has
been provided for deferred tax assets as a result of the operating losses in the
United States and Mexico, since recoverability of those assets has not been
assessed as more likely than not; (2) Although the Company has taxable losses in
Mexico, it is subject to a minimum tax; and (3) The earnings of the Company's
Hong Kong subsidiary are taxed at a rate of 16% versus the 35% U.S. federal
rate.
The Internal Revenue Service (IRS) currently is examining the Company's
federal income tax returns for the years ended December 31, 1996 through 2001.
The IRS has proposed significant adjustments to increase taxable income for the
six years under examination. The Company believes it has meritorious defenses to
these proposed adjustments and is vigorously defending these adjustments. The
Company does not believe that the adjustments, if any, arising from the IRS
examination will result in an additional income tax liability beyond what is
recorded in the accompanying balance sheet.
11. EARNINGS PER SHARE AND EQUITY
A reconciliation of the numerator and denominator of basic earnings per
share and diluted earnings per share is as follows:
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
2003 2002 2003 2002
------------ ------------ ------------ ------------
Basic EPS Computation:
Numerator .............. $(32,571,194) $ 1,302,336 $(36,450,122) $ (5,295,159)
Denominator:
Weighted average common
shares outstanding ..... 16,832,092 15,832,474 16,334,204 15,832,061
------------ ------------ ------------ ------------
Total shares ........... 16,832,092 15,832,474 16,334,204 15,832,061
------------ ------------ ------------ ------------
Basic EPS .............. $ (1.94) $ 0.08 $ (2.23) $ (0.34)
============ ============ ============ ============
Diluted EPS Computation:
Numerator .............. $(32,571,194) $ 1,302,336 $(36,450,122) $ (5,295,159)
Denominator:
Weighted average common
shares outstanding ..... 16,832,092 15,832,474 16,334,204 15,832,061
Incremental shares from
assumed exercise of
options ................ -- 266,083 -- --
------------ ------------ ------------ ------------
Total shares ........... 16,832,092 16,098,557 16,334,204 15,832,061
------------ ------------ ------------ ------------
Diluted EPS ............ $ (1.94) $ 0.08 $ (2.23) $ (0.34)
============ ============ ============ ============
13
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Net loss per share has been computed in accordance with SFAS No. 128,
"Earnings Per Share." All options have been excluded from the computation in the
period presented in the above table as the impact would be anti-dilutive.
Pursuant to a put option agreement, in March 2003, the Company
completed the purchase of an aggregate of 80,890 shares of the Company's common
stock from Gabe Zeitouni, a former employee of the Company, and Rocky Apparel,
Inc. and Gabriel Manufacturing Company, entities controlled by Mr. Zeitouni.
Pursuant to the terms of the put option, the per share purchase price for these
shares was $18.54 for an aggregate purchase price of $1,499,701. Of this amount,
$1,106,523 was previously advanced by the Company to Mr. Zeitouni in accordance
with the terms of a separation agreement between the Company and Mr. Zeitouni,
and $393,178 was paid to Mr. Zeitouni upon receipt of the purchased shares. The
purchased shares have been returned to the status of authorized but un-issued
shares.
Pursuant to an Agreement for the Purchase of Assets and Stock, dated as
of December 31, 2002, the Company's non-voting Series A Preferred Stock was
converted by the holder into 3,000,000 shares of Common Stock following approval
of the conversion by our shareholders at the annual shareholders' meeting held
on May 28, 2003.
12. COMPREHENSIVE INCOME (LOSS)
The components of comprehensive income (loss) were as follows:
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
------------------------------- --------------------------------
2003 2002 2003 2002
------------ ------------ ------------ -------------
Net income (loss) .......... $(32,571,194) $ 1,302,336 $(36,450,122) $ (5,295,159)
Foreign currency translation
adjustment .............. $ 6,544,418 $(10,271,046) $ 2,186,868 $ (8,161,834)
Total comprehensive loss ... $(26,026,776) $ (8,968,710) $(34,263,254) $(13,456,993)
13. SUBSEQUENT EVENTS
The Company is negotiating to lease a large portion of its
manufacturing facilities and operations in Mexico to a related third party, or
contract with the related third party for their operation, which the Company
expects to consummate in the second half of fiscal 2003. Because of its
decision, in the quarter ended June 30, 2003 the Company wrote off $19.5 million
of goodwill and $2.8 million of a prepaid sub-contracting contract with a
Mexican vendor, and wrote down $11 million of inventory in Mexico in
anticipation of its liquidation. The Company allocated $3.0 million and $1.4
million of the write-down of goodwill and inventory, respectively, to the
minority shareholder of Tarrant Mexico.
14
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
BUSINESS OVERVIEW AND RECENT DEVELOPMENTS
We are a leading provider of private label casual apparel, serving
specialty retail, mass merchandise and department store chains and major
international brands located primarily in the United States by designing,
merchandising, contracting for the manufacture of, manufacturing directly and
selling casual, moderately-priced apparel for women, men and children. Our major
customers include specialty retailers, such as Limited Stores and Express, both
of which are divisions of The Limited, as well as Lane Bryant, Lerner New York,
Abercrombie & Fitch, J.C. Penney, K-Mart, Kohl's, Mervyns, Sears and Wal-Mart.
Our products are manufactured in a variety of woven and knit fabrications and
include jeans wear, casual pants, t-shirts, shorts, blouses, shirts and other
tops, dresses and jackets.
From inception, we relied primarily on independent contract
manufacturers located primarily in the Far East. Commencing in the third quarter
of 1997, and taking advantage of the North American Free Trade Agreement, or
NAFTA, we substantially expanded our use of independent cutting, sewing and
finishing contractors in Mexico, primarily for basic garments. Commencing in
1999, and concluding in December 2002 with the purchase of a denim and twill
manufacturing plant in Tlaxacala, Mexico, we engaged in an ambitious program to
develop a vertically integrated manufacturing operation in Mexico while
maintaining our sourcing operation in the Far East. We believed that the dual
strategy of maintaining independent contract manufacturers in the Far East and
operating manufacturing facilities in Mexico controlled by us could best serve
the different needs of our customers and enable us to capitalize on advantages
offered by both markets. We believed this diversified approach would help to
mitigate the risks of doing business outside of North America, such as
transportation delays, economic and political instability, currency
fluctuations, restrictions on the transfer of funds and the imposition of
tariffs, export duties, quota, and other trade restrictions.
In August 2003, we determined to abandon our strategy of being both a
trading and manufacturing company, and will cease directly operating a
substantial majority of our equipment and fixed assets in Mexico commencing in
the third quarter of 2003. We made our determination based on many factors,
including the following:
o Our vertical integration strategy in Mexico requires
significant working capital, which has required us to
significantly increase debt to finance our Mexico operations.
This financing is difficult to obtain in Mexico.
o We have been facing the challenges of rising overhead costs
and the need to take low and sometimes negative margin orders
in slow seasons to fill capacity at our facilities, which has
reduced our overall average gross margin.
o The elimination of quotas on World Trade Organization member
countries by 2005, and the other effects of trade agreements
among WTO countries, will result in increased competition from
developing countries, which historically have lower labor
costs, including China and Taiwan, both of which recently
became members of the WTO.
Our withdrawal from company-owned and operated facilities in Mexico
will, among other things, reduce our working capital requirements, eliminate the
need to accept low or negative margin orders to fill production capacity, and
permit us to source production in the best location world-wide. We also believe
that our strong design, merchandising and sourcing capabilities are competitive
advantages that will enable us to overcome the desire by some retailers to
purchase merchandise directly from the manufacturer. We are in discussions to
lease our manufacturing facilities and operations in Mexico to a related third
party, or contract with the related third party for their operation, which we
expect to consummate in the second half of fiscal 2003. Due to our change of
strategy in Mexico, at June 30, 2003 we wrote off approximately $19.5 million in
goodwill associated with certain assets we acquired in Mexico, and wrote down
$11 million of inventory in Mexico in anticipation of its liquidation.
In April 2003, we acquired an equity interest in the owner of the
trademark "American Rag CIE," and our subsidiary, Private Brands, Inc., acquired
a license to certain exclusive rights to this trademark. Private Brands also
entered into multi-year exclusive distribution agreement with Federated
Merchandising Group ("FMG"), the sourcing arm of Federated Department Stores, to
supply FMG with American Rag CIE, a new casual sportswear collection for juniors
and young men. Private Brands will design and manufacture a full collection of
American Rag apparel, which will be
15
distributed by FMG exclusively to Federated stores across the country. Beginning
in August 2003, the American Rag collection will be available in approximately
100 select Macy's, the Bon Marche, Burdines, Goldsmith's, Lazarus and
Rich's-Macy's locations.
On June 28, 2000, we signed a production agreement with Manufactures
Cheja, the original term of which extended through February 2002. We extended
the contract for an additional quantity of 6.4 million units commencing on April
1, 2002, which was amended on November 8, 2002, for the manufacture of 5.7
million units through September 30, 2004. We have unrecouped advances to Cheja
of approximately $2.8 million related to the production agreement to be recouped
out of future production. In June 2003, we have written off all the advances to
Cheja.
On April 12, 2000, we formed a new company, Jane Doe International,
LLC, or JDI. This company was formed for the purpose of purchasing the assets of
Needletex, Inc., owner of the Jane Doe brand. JDI is owned 51% by Fashion
Resource (TCL), Inc., a subsidiary of ours, and 49% by Needletex, Inc. In March
2001, we converted JDI from an operating company to a licensing company, and
entered into two licenses with regards to the use of the Jane Doe trademark.
Pending the outcome of our litigation with Patrick Bensimon, owner of Needletex
Inc., this licensing company has been largely dormant during 2002 and 2003. As a
consequence, at June 30, 2003, we wrote off approximately $150,000 in goodwill
associated with the assets we acquired from Needletex, Inc. For a description of
the terms of this acquisition and details of the litigation, see "Part II, Item
1. Legal Proceedings."
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Management's discussion and analysis of our financial condition and
results of operations are based upon our consolidated financial statements,
which have been prepared in accordance with accounting principles generally
accepted in the United States of America for interim financial statements. The
preparation of these financial statements requires us to make estimates and
judgments that affect the reported amounts of assets, liabilities, revenues and
expenses, and related disclosures of contingent assets and liabilities. On an
ongoing basis, we evaluate estimates, including those related to returns,
discounts, bad debts, inventories, intangible assets, income taxes, and
contingencies and litigation. We base our estimates on historical experience and
on various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results may differ from these estimates under different
assumptions or conditions.
We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our consolidated
financial statements. For a further discussion on the application of these and
other accounting policies, see Note 1 to our audited consolidated financial
statements included in our Annual Report on Form 10-K for the year ended
December 31, 2002.
ACCOUNTS RECEIVABLE--ALLOWANCE FOR RETURNS, DISCOUNTS AND BAD DEBTS
We evaluate the collectibility of accounts receivable and charge backs
(disputes from the customer) based upon a combination of factors. In
circumstances where we are aware of a specific customer's inability to meet its
financial obligations (such as in the case of bankruptcy filings or substantial
downgrading of credit sources), a specific reserve for bad debts is taken
against amounts due to reduce the net recognized receivable to the amount
reasonably expected to be collected. For all other customers, we recognize
reserves for bad debts and charge backs based on our historical collection
experience. If collection experience deteriorates (for example, due to an
unexpected material adverse change in a major customer's ability to meet its
financial obligations to us), the estimates of the recoverability of amounts due
us could be reduced by a material amount.
As of June 30, 2003, the balance in the allowance for returns,
discounts and bad debts reserves was $5.8 million, compared to $4.5 million at
June 30, 2002.
INVENTORY
Our inventories are valued at the lower of cost or market. Under
certain market conditions, estimates and judgments regarding the valuation of
inventory are employed by us to properly value inventory. Reserve adjustments
are
16
made for the difference between the cost of the inventory and the estimated
market value and charged to operations in the period in which the facts that
give rise to the adjustments become known.
VALUATION OF LONG-LIVED AND INTANGIBLE ASSETS AND GOODWILL
We assess the impairment of identifiable intangibles, long-lived assets
and goodwill whenever events or changes in circumstances indicate that the
carrying value may not be recoverable. Factors considered important that could
trigger an impairment review include, but are not limited to, the following:
o a significant underperformance relative to expected historical
or projected future operating results;
o a significant change in the manner of the use of the acquired
asset or the strategy for the overall business; or
o a significant negative industry or economic trend.
Effective January 1, 2002, we adopted Statement of Financial Accounting
Standards No. 142, "Goodwill and Other Intangible Assets." According to this
statement, goodwill and other intangible assets with indefinite lives are no
longer subject to amortization, but rather an annual assessment of impairment
applied on a fair-value-based test. We adopted SFAS No. 142 in fiscal 2002 and
performed our first annual assessment of impairment, which resulted in an
impairment loss of $4.9 million.
We utilized the discounted cash flow methodology to estimate fair
value. At June 30, 2003, we have a goodwill balance of $8.6 million, and a net
property and equipment balance of $154.4 million, as compared to a goodwill
balance of $28.1 million and a net property and equipment balance of $160.0
million at December 31, 2002. Our goodwill balance reflects the write-down of
$19.5 million of goodwill as discussed in Note 7 to our consolidated financial
statements.
INCOME TAXES
As part of the process of preparing our consolidated financial
statements, management is required to estimate income taxes in each of the
jurisdictions in which we operate. The process involves estimating actual
current tax expense along with assessing temporary differences resulting from
differing treatment of items for book and tax purposes. These timing differences
result in deferred tax assets and liabilities, which are included in our
consolidated balance sheet. Management records a valuation allowance to reduce
its deferred tax assets to the amount that is more likely than not to be
realized. Management has considered future taxable income and ongoing tax
planning strategies in assessing the need for the valuation allowance. Increases
in the valuation allowance result in additional expense to be reflected within
the tax provision in the consolidated statement of operations. Accruals are also
estimated for ongoing audits regarding Federal tax issues that are currently
unresolved. We routinely monitor the potential impact of these situations and
believe that amounts are properly accrued for.
DEBT COVENANTS
Our debt agreements require the maintenance of certain financial ratios
and a minimum level of net worth as discussed in Note 6 to our consolidated
financial statements. If our results of operations erode and we are not able to
obtain waivers from the lenders, the debt would be in default and callable by
our lenders. In addition, due to cross-default provisions in a majority of the
debt agreements, approximately 88% of our long-term debt would become due in
full if any of the debt is in default. In anticipation of us not being able to
meet the required covenants due to various reasons, we either negotiate for
changes in the relative covenants or an advance waiver or reclassify the
relevant debt as current. We believe that results of operations will improve for
the year ending December 31, 2003 and thereafter and the likelihood of our
defaulting on debt covenants is decreasing absent any material negative event
affecting the U.S. economy as a whole. We also believe that our lenders would
provide waivers if necessary. However, our expectations of future operating
results and continued compliance with other debt covenants cannot be assured and
our lenders' actions are not controllable by us. If projections of future
operating results are not achieved and the debt is placed in default, we would
be required to reduce our expenses, including by curtailing operations, and to
raise capital through the sale of assets, issuance of equity or otherwise, any
of which could have a material adverse effect on our financial condition and
results of operations.
17
RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, certain
items in our consolidated statements of income as a percentage of net sales:
THREE MONTHS SIX MONTHS
ENDED JUNE 30, ENDED JUNE 30,
2003 2002 2003 2002
----- ----- ----- -----
Net sales ............................ 100.0% 100.0% 100.0% 100.0%
Cost of sales ........................ 100.6 84.9 94.7 85.8
----- ----- ----- -----
Gross profit ......................... (0.6) 15.1 5.3 14.2
Selling and distribution expenses .... 4.0 2.5 3.7 3.1
General and administration
expenses .......................... 10.9 7.6 10.1 8.6
Impairment of assets ................. 28.5 -- 14.2 --
----- ----- ----- -----
Income (loss) from operations ........ (44.0) 5.0 (22.7) 2.5
Interest expense ..................... (1.8) (1.8) (1.9) (1.6)
Interest Income ...................... 0.1 0.1 0.1 0.1
Other income ......................... 0.2 0.7 0.3 0.5
Other expense ........................ (0.2) (0.6) (0.3) (0.5)
Minority interest .................... 4.7 (1.5) 2.2 (1.2)
----- ----- ----- -----
Income (loss) before taxes and
cumulative effect of accounting
change ............................... (41.0) 1.9 (22.3) (0.2)
Income taxes ......................... 0.7 0.5 0.9 0.1
----- ----- ----- -----
Net income (loss) before
cumulative effect of accounting
change ............................... (41.7)% 1.4% (23.2)% (0.3)%
===== ===== ===== =====
Cumulative effect of accounting ...... -- -- -- (3.0)
change net of tax benefit
Net income (loss) .................... (41.7)% 1.4% (23.2)% (3.3)%
===== ===== ===== =====
SECOND QUARTER 2003 COMPARED TO SECOND QUARTER 2002
Net sales decreased by $17.1 million, or 18.0%, to $78.2 million in the
second quarter of 2003 from $95.3 million in the second quarter of 2002. The
decrease in net sales included a decrease in sales of $3.4 million to mass
merchandisers, a decrease of $2.7 million to Lerner's, a decrease of $9.8
million to Lane Bryant / Charming Shoppe and a decrease of $7.7 million to Tommy
Hilfiger, partially offset by an increase in sales of $2.3 million to divisions
of The Limited, Inc. The drop was caused partly by the
18
adverse economic conditions in the U.S. and partly by delays in clearing goods
through Customs, which caused sales of the goods to be recognized after the
second quarter.
Gross profit consists of net sales less product costs, direct labor,
manufacturing overhead, duty, quota, freight in, brokerage, and warehousing.
Gross profit decreased by $14.9 million, or 103%, to $(433,000), or (0.6)% of
net sales in the second quarter of 2003 from $14.4 million, or 15.1% of net
sales in the second quarter of 2002. The decrease in gross profit as a
percentage of net sales occurred primarily because of an inventory write-down of
$11 million. The write-down was taken for inventory located in Mexico in
anticipation of steep discounts and allowances normally associated with
wholesale liquidation of finished goods and fabric, and anticipated defects in
work-in-process that frequently occur following announcement of workforce
reductions. Excluding the effect of this write-down, the gross profit decreased
by $3.9 million, or 26.8%, to $10.6 million, or 13.5% of net sales in the second
quarter of 2003. The decrease was a result of an increase in fixed manufacturing
overhead and depreciation after our acquisition in December 2002 of additional
manufacturing facilities in Mexico.
Selling and distribution expenses increased by $690,000, or 28.4%, to
$3.1 million in the second quarter of 2003 from $2.4 million in the second
quarter of 2002. As a percentage of net sales, these expenses increased to 4.0%
in the second quarter of 2003 from 2.5% in the second quarter of 2002. The
increase in such expense is primarily due to an increase of freight expense to
$829,000 in the second quarter of 2003 compared to freight expense of $429,000
in the second quarter of 2002 primarily the result of a reclassification in the
second quarter of 2003 of freight expense of UAV from cost of goods sold to
selling and distribution expense.
General and administrative expenses increased by $1.3 million, or
18.3%, to $8.5 million in the second quarter of 2003 from $7.2 million in the
second quarter of 2002. As a percentage of net sales, these expenses increased
to 10.9% in the second quarter of 2003 from 7.6% in the second quarter of 2002.
The increase in such expenses is primarily due to an increase of reserves for
accounts receivables to $1.0 million in the second quarter of 2003 compared to
$464,000 in the second quarter of 2002, and the addition of $542,000 of
additional payroll, pre-production, legal and accounting expenses related to the
launch of our private brand strategy in the second quarter of 2003.
Impairment of assets expense was $22.3 million in the second quarter of
2003, compared to zero expense in the second quarter of 2002. This expense is a
consequence of our decision to lease substantially all of our manufacturing
operations in Mexico commencing in the third quarter of 2003. See Note 7 to our
consolidated financial statements.
Operating loss in the second quarter of 2003 was $34.4 million, or
(44.0)% of net sales, compared to operating income of $4.8 million, or 5.0% of
net sales, in the comparable period of 2002, because of the factors discussed
above.
Interest expense decreased by $251,000, or 14.9%, to $1.4 million in
the second quarter of 2003 from $1.7 million in the second quarter of 2002. As a
percentage of net sales, these expenses remained the same at 1.8% both in the
second quarter of 2003 and in the second quarter of 2002. Other income was
$156,000 in the second quarter of 2003, compared to $686,000 in the second
quarter of 2002, due to a realized exchange gain relating to Euro denominated
debts of $450,000 in the second quarter of 2002 and $0 in the second quarter of
2003. Other expense decreased to $194,000 in the second quarter of 2003 from
$613,000 in the second quarter of 2002, due to the unrealized exchange loss
relating to Euro denominated debts of $138,000 in the second quarter of 2003
compared to $271,000 in the second quarter of 2002, and a decrease in royalty
expense to $16,000 in the second quarter of 2003 compared to $281,000 in the
second quarter of 2002.
Net income from minority interest in the second quarter of 2003 was
$3.7 million representing $871,000 profit shared by the 49.9% minority partner
in the UAV joint venture, offset by $240,000 attributed to the minority
shareholder in Tarrant Mexico for his 25% share in operating losses and $4.4
million for his share in the special write-down on goodwill and inventory owned
by Tarrant Mexico. In the second quarter of 2002, minority interest expense was
$1.4 million made up of profit shared by the minority partner in the UAV joint
venture.
FIRST SIX MONTHS OF 2003 COMPARED TO FIRST SIX MONTHS OF 2002
Net sales decreased by $3.5 million, or 2.2%, to $156.9 million in the
first six months of 2003 from $160.5 million in the first six months of 2002.
The decrease in net sales included a decrease in sales of $1.9 million to mass
merchandisers, a decrease of $5.0 million to Lerner's, a decrease of $17.0
million to Lane Bryant / Charming Shoppes, and a decrease of $4.8 million to
Tommy
19
Hilfiger, partially offset by an increase of $6.4 million to divisions of
The Limited, Inc. The decrease was mainly a result of the adverse conditions in
the retail market.
Gross profit decreased by $14.5 million, or 63.4%, to $8.4 million, or
5.3% of net sales in the first six months of 2003 from $22.8 million, or 14.2%
of net sales in the first six months of 2002. The decrease in gross profit was
due primarily to a special inventory write-down of $11 million. Before this
inventory write-down, gross profit decreased by $3.5 million, or 15.3%, to $19.4
million, or 12.3% of net sales for the first six months of 2003. This decrease
was due to an increase in fixed manufacturing overhead and depreciation after
our acquisition in December 2002 of additional manufacturing facilities in
Mexico.
Selling and distribution expenses increased by $782,000, or 15.5%, to
$5.8 million in the first six months of 2003 from $5.1 million in the first six
months of 2002. As a percentage of net sales, these expenses increased from 3.1%
for the first six months of 2002 to 3.7% for the first six months of 2003. The
increase in such expense is primarily due to an increase of freight expense to
$1.2 million in the first six months of 2003 compared to $773,000 in the first
six months of 2002, primarily the result of a reclassification in the second
quarter of 2003 of freight expense of UAV from cost of goods sold to selling and
distribution expense.
General and administrative expenses increased by $2.1 million, or
15.1%, to $15.9 million in the first six months of 2003 from $13.8 million in
the first six months of 2002. As a percentage of net sales, these expenses
increased to 10.1% in the first six months of 2003 from 8.6% in the second
quarter of 2002. The increase in such expenses is primarily due to an increase
of reserves for accounts receivables to $1.7 million in the first six months of
2003 compared to $575,000 in the first six months of 2002, and the addition of
$676,000 of additional payroll, pre-production, legal and accounting expenses
related to the launch of our private brand strategy in the first six months of
2003.
Impairment of assets expense was $22.3 million in the first six months
of 2003, compared to no expense in the first six months of 2002. This expense is
primarily due to our decision to cease directly operating a substantial majority
of our equipment and fixed assets in Mexico commencing in the third quarter of
2003. See Note 7 to our consolidated financial statements.
Operating loss for the first six months of 2003 was $35.7 million, or
(22.7)% of net sales, compared to operating income of $3.9 million, or 2.5% of
net sales, in the comparable prior period of 2002 as a result of the factors
discussed above.
Interest expense increased by $342,000, or 13.3%, to $2.9 million in
the first six months of 2003 from $2.6 million in the first six months of 2002.
The increase was due to increased interest margin paid to certain of our
lenders. As a percentage of net sales, these expenses increased from 1.6% in the
first six months of 2002 to 1.9% for the same period in 2003. Interest income
was $175,000 in the first six months of 2003, compared to $136,000 in the first
six months of 2002. Other income was $473,000 in the first six months of 2003,
compared to $910,000 in the first six months of 2002, due to a realized exchange
gain relating to Euro denominated debts of $450,000 in the first six months of
2002 compared to $124,000 in the first six months of 2003. Other expense was
$520,000 in the first six months of 2003, compared to $817,000 in the first six
months of 2002, due to a decrease in royalty expense to $69,000 in the first six
months of 2003 compared to $331,000 in the first six months of 2002.
Net income from minority interest in the first six months of 2003 was
$3.5 million representing $2.1 million of profit shared by the 49.9% minority
partner in the UAV joint venture, offset by $1.3 million attributed to the
minority shareholder in Tarrant Mexico for his 25% share in the loss and $4.4
million for his share in the special write-down on goodwill and inventory owned
by Tarrant Mexico. In the first six months of 2002, minority interest expense
was $1.9 million made up of profit shared by the minority partner in the UAV
joint venture.
LIQUIDITY AND CAPITAL RESOURCES
Our liquidity requirements arise from the funding of our working
capital needs, principally inventory, finished goods shipments-in-transit,
work-in-process and accounts receivable, including receivables from our contract
manufacturers that relate primarily to fabric we purchase for use by those
manufacturers. Our primary sources for working capital and capital expenditures
are cash flow from operations, borrowings under our bank and other credit
facilities, borrowings from principal shareholders, issuance of long-term debt,
borrowing from affiliates and the proceeds from the exercise of stock options.
Our liquidity is dependent, in part, on customers paying on time. Any
abnormal charge backs or returns may affect our source of short-term funding. We
are also subject to market price changes. Any changes in credit terms given to
20
major customers may have an impact on our cash flow. Suppliers' credit is
another major source of short-term financing and any adverse changes in their
terms will have negative impact on our cash flow.
Following is a summary of our contractual obligations and commercial
commitments available to us as of June 30, 2003 (in millions):
CONTRACTUAL OBLIGATIONS PAYMENTS DUE BY PERIOD
- ----------------------- ------------------------------------------------------
LESS THAN BETWEEN BETWEEN AFTER
TOTAL 1 YEAR 2-3 YEARS 4-5 YEARS 5 YEARS
------- -------- --------- --------- -------
Long-term debt......... $ 70.8 $ 18.3 $ 52.5 $ 0 $ 0
Operating leases....... $ 11.2 $ 2.7 $ 2.7 $ 2.6 $ 3.2
Total contractual cash
obligations......... $ 82.0 $ 21.0 $ 55.2 $ 2.6 $ 3.2
Guarantees have been issued in favor of YKK, Universal Fasteners and
RVL Inc. for $750,000, $500,000 and unspecified amount, respectively, to cover
trim purchased by Tag-It Pacific Inc. on behalf of the Company.
AMOUNT OF COMMITMENT EXPIRATION PER PERIOD
--------------------------------------------
TOTAL
COMMERCIAL COMMITMENTS AMOUNTS
AVAILABLE TO US AS OF COMMITTED LESS THAN BETWEEN BETWEEN AFTER
JUNE 30, 2003 TO US 1 YEAR 2-3 YEARS 4-5 YEARS 5 YEARS
- ----------------------- ------- -------- --------- --------- -------
Lines of credit........ $ 143.7 $ 59.4 $ 84.3 $ -- $ --
Letters of credit
(within lines of
credit)............. $ 39.6 $ 39.6 $ -- $ -- $ --
Total commercial
commitments......... $ 143.7 $ 59.4 $ 84.3 $ -- $ --
During the first six months of 2003, net cash used by operating
activities was $2.9 million, as compared to $8.0 million for the same period in
2002. Net cash outflow from operating activities in 2003 was caused by the
operating loss of $36.5 million offset by depreciation and amortization of $8.1
million, asset impairment of $22.3 million and inventory write-down of $11.0
million. In addition, increases of $6.5 million in accounts receivable, $19.4
million in inventory and $4.8 million in temporary quota were offset by
increases of $18.9 million in accounts payable and $6.2 million in accrued
expenses and income tax payable.
During the first six months of 2003, net cash used by investing
activities was $999,000, as compared to $351,000 for the same period in 2002.
Cash used in investing activities in 2003 included approximately $1.4 million of
increase in other assets and $746,000 of repayments of advances from
shareholders/officers.
During the first six months of 2003, net cash provided by financing
activities was $3.0 million, as compared to $9.3 million for the same period in
2002. Cash provided by financing activities in 2003 included $10.6 million of
short-term bank borrowings and $124.8 million of proceeds from long-term
obligations, offset by $132.0 million of payments of long-term obligations and
bank borrowings.
As of June 30, 2003, Tarrant Mexico, Famian division had a short-term
advance from Banco Bilbao Vizcaya amounting to $50,000. This subsidiary also had
a credit facility of $10 million with Banco Nacional de Comercio Exterior SNC,
based on purchase orders and restricted by certain covenants. After the merger
of Grupo Famian into Tarrant Mexico, Banco Nacional de Comercio Exterior SNC has
agreed that Tarrant Mexico will repay the outstanding amount by making payments
of $523,000 per month commencing on March 26, 2003. As of June 30, 2003, $3.6
million was outstanding under this facility.
We have two equipment loans with the initial borrowings of $16.25
million and $5.2 million from GE Capital Leasing ("GE Capital") and Bank of
America Leasing ("BOA"), respectively. The loans are secured by equipment
located in Puebla and Tlaxcala, Mexico. The amounts outstanding as of June 30,
2003 were $5.6 million due to GE Capital and $1.8 million due to BOA. Interest
accrues at a rate of 2.5% over LIBOR. The loan from GE Capital will mature in
2005, and the loan from BOA will mature in 2004. The GE Capital facilities are
subject to covenants on Tangible Net Worth ($30 million), leverage ratio of not
more than two times at the end of each financial year, and no losses for two
consecutive quarters. We were in violation of the covenant on consecutive
quarterly losses and obtained a waiver from GE Capital subject to the following:
A fee of $50,000, a principal
21
prepayment of $500,000 to the loan and a second lien on our headquarters owned
by Gerard Guez and Todd Kay. We intend to make the required payments and provide
the second lien on our headquarters and therefore classified the GE debt as
long-term. The second lien on our headquarters will be released upon our
returning to profitability in the coming two quarters. The BOA facility is
subject to a financial benchmark on debt service coverage (0.8:1 before March
31, 2003 and 1.25:1 thereafter) and a leverage ratio of not more than 2 times.
We were in violation of both benchmarks and are negotiating for a waiver of the
breach. Under the agreement, BOA has the option to accelerate repayment of all
outstanding principal amount to become payable in six equal monthly installments
of $302,000 each. For this reason, the BOA debt has been classified as a current
liability.
On January 21, 2000, we entered into a new revolving credit, factoring
and security agreement (the "Debt Facility") with a syndicate of lending
institutions. The Debt Facility initially provided a revolving facility of
$105.0 million, including a letter of credit facility not to exceed $20.0
million, and matures on January 31, 2005. The Debt Facility provides for
interest at LIBOR plus the LIBOR rate margin determined by the Total Leverage
Ratio (as defined). The Debt Facility is collateralized by receivables,
intangibles, inventory and various other specified non-equipment assets. In
addition, the facility is subject to various financial covenants on tangible net
worth, interest coverage, fixed charge ratio and leverage ratio and prohibits
the payment of dividends. On March 2, 2001, we entered into an amendment of our
Debt Facility with GMAC Commercial Credit, LLC, who solely assumed the facility
in 2000. This amendment reduced the $105.0 million facility to $90.0 million.
The over-advance line of $25 million was converted to a term facility to be
repaid by monthly installments of $500,000 before August 2001 and $687,500
thereafter. In March 2003, we and GMAC established new financial covenants for
the remainder of fiscal 2003 based on our projections. As of June 30 2003, we
were in breach of all the financial covenants and have obtained a waiver subject
to the payment of a fee of $100,000. Gerard Guez has also agreed to increase his
personal guarantee to $10 million. GMAC and we have also agreed to re-set all
financial covenants for the year before October 1, 2003 based on our
projections; provided, however that, in the event that the financial covenants
are not amended and restated on terms acceptable to GMAC in its sole discretion
on or prior to October 1, 2003, such failure shall be deemed to be an Event of
Default under the Credit Agreement and the other documents. A total of $54.9
million was outstanding under the Debt Facility at June 30, 2003.
On June 13, 2002, we entered into a letter of credit facility of $25
million with UPS Capital Global Trade Finance Corporation ("UPS") to replace the
credit facility of The Hong Kong and Shanghai Banking Corporation Limited in
Hong Kong. Under this facility, we may arrange for the issuance of letters of
credit and acceptances. The facility is a one-year facility subject to renewal
on its anniversary and is collateralized by the shares and debentures of all of
our subsidiaries in Hong Kong, as well as our permanent quota holdings in Hong
Kong. In addition to the guarantees provided by Tarrant Apparel Group, Fashion
Resource (TCL) Inc., and Tarrant Luxembourg Sarl (previously known as Machrima
Luxembourg Sarl), a new holding company we formed during 2002, Mr. Gerard Guez
(our Chairman) also signed a guarantee of $5 million in favor of UPS to secure
this facility. This facility is also subject to certain restrictive covenants,
including aggregate net worth, fixed charge ratio, and leverage ratio. All the
covenants for 2003 have been re-set in line with those of our Debt Facility (see
Debt facility below). In June 2003, a temporary additional line of credit
consisting of $3 million cash advances and $12 million letters of credit was
made available to us against a restricted deposit $2 million and the deposit of
$15 million worth of export letters of credit. This temporary facility will
expire on September 1, 2003 while the expiry date of the main credit line of $25
million has been extended to December 1, 2003. We were in violation of all the
covenants as of June 30, 2003, and a waiver has been obtained subject to the
payment of a fee of $25,000. As of June 30, 2003, $38.3 million was outstanding
under this facility of which $7.9 million was letters of credit.
Since March 2003, Dao Heng Bank in Hong Kong has made available a
letter of credit facility of up to HKD 20 million (equivalent to US $2.6
million) to our subsidiaries in Hong Kong. This is a demand facility and is
secured by the pledge of our office property owned by Gerard Guez and Todd Kay
and the Company's guarantee. As of June 30, 2003, $2.2 million was outstanding
under this facility.
The Debt Facility with GMAC and the credit facilities with UPS, GE
Capital and BOA all carry cross-default clauses. A breach of a financial
covenant set by GMAC, UPS or GE Capital constitutes an event of default,
entitling these banks to demand payment in full of all outstanding amounts under
their respective debt and credit facilities.
During 2000, we financed equipment purchases for the new manufacturing
facility with certain vendors. A total of $16.9 million was financed with
five-year promissory notes, which bear interest ranging from 7.0% to 7.5%, and
are payable in semiannual payments commencing in February 2000. Of this amount,
$5.9 million was outstanding as of June 30, 2003. Of the $5.9 million, $3.9
million is denominated in the Euro. The remainder is payable in U.S. dollars. We
are subject to foreign exchange risk on this Euro exposure.
22
From time to time, we open letters of credit under an uncommitted line
of credit from Aurora Capital Associates who issues these letters of credits out
of Israeli Discount Bank. As of June 30, 2003, $2.5 million in letters of credit
were open under this arrangement.
We have financed our operations from our cash flow from operations,
borrowings under our bank and other credit facilities, issuance of long-term
debt (including debt to or arranged by vendors of equipment purchased for our
Mexican twill and production facility), the proceeds from the exercise of stock
options and from time to time shareholder advances. Our short-term funding
relies very heavily on our major customers, banks, suppliers and major
shareholders. From time to time, we have had temporary over-advances from our
banks. Any withdrawal of support from these parties will have serious
consequences on our liquidity.
From time to time in the past, we borrowed funds from, and advanced
funds to, certain officers and principal shareholders, including Gerard Guez,
Todd Kay and Kamel Nacif. The greatest outstanding balance of such borrowings
from Mr. Kay in the second quarter of 2003 was $487,000. The greatest
outstanding balance of such advances to Mr. Guez during the second quarter of
2003 was approximately $4,867,000. As of June 30, 2003, we were indebted to Mr.
Kay and Mr. Nacif in the amount of $384,000 and $1.6 million, respectively. Mr.
Guez had an outstanding advance from us in the amount of $4,856,000 as of June
30, 2003. All advances to, and borrowings from, Messrs. Guez and Kay bore
interest at the rate of 7.75% during the period. Since the enactment of the
Sarbanes-Oxley Act in 2002, no further personal loans (or amendments to existing
loans) have been or will be made to officers or directors of Tarrant.
The Internal Revenue Service (IRS) currently is examining our federal
income tax returns for the years ended December 31, 1996 through 2001. The IRS
has proposed significant adjustments to increase taxable income for the six
years under examination. We believe that we have meritorious defenses to these
proposed adjustments and are vigorously defending these adjustments. We do not
believe that the adjustments, if any, arising from the IRS examination will
result in an additional income tax liability beyond what is recorded in the
accompanying balance sheet.
We may seek to finance future capital investment programs through
various methods, including, but not limited to, borrowings under our bank credit
facilities, issuance of long-term debt, leases and long-term financing provided
by the sellers of facilities or the suppliers of certain equipment used in such
facilities. To date, there is no plan for any major capital expenditure.
We do not believe that the moderate levels of inflation in the United
States in the last three years have had a significant effect on net sales or
profitability.
RELATED PARTY TRANSACTIONS
We lease our principal offices and warehouse located in Los Angeles,
California and office space in Hong Kong from corporations owned by Gerard Guez,
our Chairman and Chief Executive Officer, and Todd Kay, our President and a
member of our Board of Directors. We believe, at the time the leases were
entered into, the rents on these properties were comparable to then prevailing
market rents. We paid $664,000 in the six month period ended June 30, 2003, for
rent for office and warehouse facilities.
From time to time in the past, we borrowed funds from, and advanced
funds to, certain officers and principal shareholders, including Gerard Guez,
Todd Kay and Kamel Nacif. The greatest outstanding balance of such borrowings
from Mr. Kay in the second quarter of 2003 was $487,000. The greatest
outstanding balance of such advances to Mr. Guez during the second quarter of
2003 was approximately $4,867,000. As of June 30, 2003, we were indebted to Mr.
Kay and Mr. Nacif in the amount of $384,000 and $1.6 million, respectively. Mr.
Guez had an outstanding advance from us in the amount of $4,856,000 as of June
30, 2003. All advances to, and borrowings from, Messrs. Guez and Kay bore
interest at the rate of 7.75% during the period. Since the enactment of the
Sarbanes-Oxley Act in 2002, no further personal loans (or amendments to existing
loans) have been or will be made to officers or directors of Tarrant.
On December 31, 2002, our wholly owned subsidiaries, Tarrant Mexico and
Tarrant Luxembourg Sarl (previously known as Machrima Luxembourg Sarl), acquired
a denim and twill manufacturing plant in Tlaxcala, Mexico, including all
machinery and equipment used in the plant, the buildings, and the real estate on
which the plant is located. Pursuant to an Agreement for the Purchase of Assets
and Stock, dated as of December 31, 2002, Tarrant Mexico purchased from Trans
Textil International, S.A. de C.V. ("Trans Textil") all of the machinery and
equipment used in and located at the plant, and the Purchasers acquired from
Jorge Miguel Echevarria Vazquez and Rosa Lisette Nacif Benavides (the
"Inmobiliaria Shareholders") all the issued and outstanding capital stock of
Inmobiliaria Cuadros, S.A. de C.V. ("Inmobiliaria"), which owns the buildings
and real estate. The purchase price for the machinery and equipment was paid by
cancellation of $42 million in indebtedness owed by Trans Textil to Tarrant
Mexico. The purchase price for the Inmobiliaria shares consisted of a nominal
cash payment to the Inmobiliaria Shareholders of $500, and subsequent repayment
by us and our affiliates of approximately $34.7 million in indebtedness of
Inmobiliaria to Kamel Nacif Borge, his daughter Rosa Lisette Nacif
23
Benavides, and certain of their affiliates, which payment was made by: (i)
delivery to Rosa Lisette Nacif Benavides of one hundred thousand shares of our
newly created, non-voting Series A Preferred Stock, which shares will become
convertible into three million shares of common stock if our common stockholders
approve the conversion at the Annual Meeting; (ii) delivery to Rosa Lisette
Nacif Benavides of an ownership interest representing twenty-five percent of the
voting power of and profit participation in Tarrant Mexico; and (iii)
cancellation of approximately $14.9 million of indebtedness of Mr. Nacif and his
affiliates.
The Series A Preferred Stock was converted into 3,000,000 shares of
Common Stock following approval of the conversion by our shareholders at the
annual shareholders' meeting held on May 28, 2003.
Kamel Nacif Borge is an employee of Tarrant Mexico and the beneficial
owner of more than 5% of our outstanding common stock. Jamil Textil, S.A. de
C.V., an entity we believe is controlled by Mr. Nacif, owns 1,724,000 shares of
our common stock, representing approximately 9.2% of our outstanding common
stock as of June 30, 2003. Furthermore, his daughter, Rosa Lisette Nacif
Benavides owns 3,000,000 shares of our common stock, representing approximately
16.0% of our outstanding common stock as of June 30, 2003. Trans Textil, an
entity controlled by Mr. Nacif and his family members, was initially
commissioned by us to construct and develop the plant in December 1998.
Subsequent to completion, Trans Textil purchased and/or leased the plant's
manufacturing equipment from us and entered into a production agreement that
gave us the first right to all production capacity of the plant. This production
agreement included the option for us to purchase the facility and discontinue
the production agreement with Trans Textil through September 30, 2002. We
exercised the option and acquired the plant as described above.
From time to time, we have advanced funds to Mr. Nacif and his
affiliates, and Mr. Nacif and such affiliates have advanced funds to us.
Immediately prior to the mill acquisition, Mr. Nacif and his affiliates owed us
approximately $7.5 million, which indebtedness was cancelled as part of the
repayment by Inmobiliaria of indebtedness due Mr. Nacif and his affiliates.
On July 1, 2001, we formed an entity to jointly market, share certain
risks and achieve economies of scale with Azteca Production International, Inc.,
called United Apparel Ventures, LLC. This entity was created to coordinate the
production of apparel for a single customer of our branded business. UAV is
owned 50.1% by Tag Mex, Inc., a wholly owned subsidiary of ours, and 49.9% by
Azteca. Results of the operation of UAV have been consolidated into our results
since July 2001 with the minority partner's share of all gains and loses
eliminated through the minority interest line in our financial statements. Since
October 2002 and March 31, 2003, UAV has begun to service both parties' business
with Express and Levi Strauss & Co., respectively. UAV makes purchases from two
related parties in Mexico, Azteca and Tag-It Pacific, Inc.
In 1998, a California limited liability company owned by Messrs. Guez
and Kay purchased 2,390,000 shares of the Common Stock of Tag-It Pacific, Inc.
(or approximately 37% of such Common Stock then outstanding). Tag-It is a
provider of brand identity programs to manufacturers and retailers of apparel
and accessories. Tag-It assumed the responsibility for managing and sourcing all
trim and packaging used in connection with products manufactured by or on our
behalf in Mexico. This arrangement is terminable by either Tag-It or us at any
time. We believe that the terms of this arrangement, which is subject to the
acceptance of our customers, are no less favorable to us than could be obtained
from unaffiliated third parties. We purchased $10.0 million of trim inventory
from Tag-It during the six months ended June 30, 2003. From time to time, we
have guaranteed the indebtedness of Tag-It for the purchase of trim on our
behalf.
We have adopted a policy that any transactions between us and any of
our affiliates or related parties, including our executive officers, directors,
the family members of those individuals and any of their affiliates, must (i) be
approved by a majority of the members of the Board of Directors and by a
majority of the disinterested members of the Board of Directors and (ii) be on
terms no less favorable to us than could be obtained from unaffiliated third
parties.
FACTORS THAT MAY AFFECT FUTURE RESULTS
This Quarterly Report on Form 10-Q contains forward-looking statements,
which are subject to a variety of risks and uncertainties. Our actual results
could differ materially from those anticipated in these forward-looking
statements as a result of various factors, including those set forth below.
24
RISKS RELATED TO OUR BUSINESS
WE DEPEND ON A GROUP OF KEY CUSTOMERS FOR A SIGNIFICANT PORTION OF OUR SALES. A
SIGNIFICANT ADVERSE CHANGE IN A CUSTOMER RELATIONSHIP OR IN A CUSTOMER'S
FINANCIAL POSITION COULD HARM OUR BUSINESS AND FINANCIAL CONDITION.
Affiliated stores owned by The Limited (including Limited Stores and
Express) accounted for approximately 12.2% and 7.9% of our net sales for the
first six months of 2003 and 2002, respectively. Lane Bryant accounted for 13.0%
and 23.2% of our net sales for the first six months of 2003 and 2002,
respectively. Lerner New York accounted for 6.3% and 9.2% of our net sales for
the first six months of 2003 and 2002, respectively. We believe that
consolidation in the retail industry has centralized purchasing decisions and
given customers greater leverage over suppliers like us, and we expect this
trend to continue. If this consolidation continues, our net sales and results of
operations may be increasingly sensitive to deterioration in the financial
condition of, or other adverse developments with, one or more of our customers.
While we have long-standing customer relationships, we do not have
long-term contracts with any of them, including The Limited. As a result,
purchases generally occur on an order-by-order basis, and the relationship, as
well as particular orders, can generally be terminated by either party at any
time. A decision by a major customer, whether motivated by competitive
considerations, financial difficulties, and economic conditions or otherwise, to
decrease its purchases from us or to change its manner of doing business with
us, could adversely affect our business and financial condition. In addition,
during recent years, various retailers, including some of our customers, have
experienced significant changes and difficulties, including consolidation of
ownership, increased centralization of purchasing decisions, restructurings,
bankruptcies and liquidations.
These and other financial problems of some of our retailers, as well as
general weakness in the retail environment, increase the risk of extending
credit to these retailers. A significant adverse change in a customer
relationship or in a customer's financial position could cause us to limit or
discontinue business with that customer, require us to assume more credit risk
relating to that customer's receivables, limit our ability to collect amounts
related to previous purchases by that customer, or result in required prepayment
of our receivables securitization arrangements, all of which could harm our
business and financial condition.
FAILURE TO MANAGE OUR GROWTH AND EXPANSION COULD IMPAIR OUR BUSINESS.
Since our inception, we have experienced periods of rapid growth. No
assurance can be given that we will be successful in maintaining or increasing
our sales in the future. Any future growth in sales will require additional
working capital and may place a significant strain on our management, management
information systems, inventory management, production capability, distribution
facilities and receivables management. Any disruption in our order processing,
sourcing or distribution systems could cause orders to be shipped late, and
under industry practices, retailers generally can cancel orders or refuse to
accept goods due to late shipment. Such cancellations and returns would result
in a reduction in revenue, increased administrative and shipping costs and a
further burden on our distribution facilities.
FAILURE TO MANAGE OUR RESTRUCTURING IN MEXICO COULD IMPAIR OUR BUSINESS.
We have determined to cease directly operating a substantial majority
of our equipment and fixed assets in Mexico, and to lease a large portion of our
facilities and operations in Mexico to a third party, which we expect to
consummate in the second half of fiscal 2003. As a consequence, we will return
to being primarily a trading company, relying on third party manufacturers to
produce the merchandise we sell to our customers. We face many challenges
related to our decision to cease directly operating a substantial majority of
our equipment and fixed assets in Mexico. Any failure on our part to
successfully manage these challenges may result in loss of customers and sales,
reduced gross margins, and other adverse impact on operations. The challenges we
face include:
o We may lose customers who desire to produce merchandise
directly from the manufacturer;
o We may experience unanticipated expenses in winding down
manufacturing operations in Mexico, including labor costs and
additional write down of inventory, which may adversely affect
our results of operations in the short term;
25
o The party to whom we lease our manufacturing operations in
Mexico may default in its obligations to us, in which case we
may not be able to lease the facilities to another party, or
recommence use of the facilities to manufacture goods without
significant cost; and
o We may not be able to expand our trading division in time to
handle the increase in orders we expect as we shift business
from our manufacturing division, due, for instance, to
difficulty in finding third party manufacturers and capital
constraints.
OUR OPERATING RESULTS MAY FLUCTUATE SIGNIFICANTLY.
We have experienced, and expect to continue to experience, substantial
variations in our net sales and operating results from quarter to quarter. We
believe that the factors which influence this variability of quarterly results
include the timing of our introduction of new product lines, the level of
consumer acceptance of each new product line, general economic and industry
conditions that affect consumer spending and retailer purchasing, the
availability of manufacturing capacity, the seasonality of the markets in which
we participate, the timing of trade shows, the product mix of customer orders,
the timing of the placement or cancellation of customer orders, the weather,
transportation delays, quotas, the occurrence of charge backs in excess of
reserves and the timing of expenditures in anticipation of increased sales and
actions of competitors. Due to fluctuations in our revenue and operating
expenses, we believe that period-to-period comparisons of our results of
operations are not a good indication of our future performance. It is possible
that in some future quarter or quarters, our operating results will be below the
expectations of securities analysts or investors. In that case, our stock price
could fluctuate significantly or decline.
INCREASES IN THE PRICE OF RAW MATERIALS OR THEIR REDUCED AVAILABILITY COULD
INCREASE OUR COST OF SALES AND DECREASE OUR PROFITABILITY.
The principal raw material used in our apparel is cotton. The price and
availability of cotton may fluctuate significantly, depending on a variety of
factors, including crop yields, weather, supply conditions, government
regulation, economic climate and other unpredictable factors. Any raw material
price increases could increase our cost of sales and decrease our profitability
unless we are able to pass higher prices on to our customers. Moreover, any
decrease in the availability of cotton could impair our ability to meet our
production requirements in a timely manner.
THE SUCCESS OF OUR BUSINESS DEPENDS UPON OUR ABILITY TO OFFER INNOVATIVE AND
UPGRADED PRODUCTS.
The apparel industry is characterized by constant product innovation
due to changing consumer preferences and by the rapid replication of new
products by competitors. As a result, our success depends in large part on our
ability to continuously develop, market and deliver innovative products at a
pace and intensity competitive with other manufacturers in our segments. In
addition, we must create products that appeal to multiple consumer segments at a
range of price points. Any failure on our part to regularly develop innovative
products and update core products could:
o limit our ability to differentiate, segment and price our
products;
o adversely affect retail and consumer acceptance of our
products; and
o limit sales growth.
The increasing importance of product innovation in apparel requires us
to strengthen our internal research and commercialization capabilities, to rely
on successful commercial relationships with third parties such as fiber, fabric
and finishing providers and to compete and negotiate effectively for new
technologies and product components.
THE FINANCIAL CONDITION OF OUR CUSTOMERS COULD AFFECT OUR RESULTS OF OPERATIONS.
Certain retailers, including some of our customers, have experienced in
the past, and may experience in the future, financial difficulties, which
increase the risk of extending credit to such retailers and the risk that
financial failure will eliminate a customer entirely. These retailers have
attempted to improve their own operating efficiencies by concentrating their
purchasing power among a narrowing group of vendors. There can be no assurance
that we will remain a preferred
26
vendor for our existing customers. A decrease in business from or loss of a
major customer could have a material adverse effect on our results of
operations. There can be no assurance that our factor will approve the extension
of credit to certain retail customers in the future. If a customer's credit is
not approved by the factor, we could assume the collection risk on sales to the
customer itself, require that the customer provide a letter of credit, or choose
not to make sales to the customer.
THE SUCCESS OF OUR BUSINESS DEPENDS ON OUR ABILITY TO ATTRACT AND RETAIN
QUALIFIED EMPLOYEES.
We need talented and experienced personnel in a number of areas
including our core business activities. Our success is dependent upon
strengthening our management depth across our business at a rapid pace. An
inability to retain and attract qualified personnel or the loss of any of our
current key executives could harm our business. Our ability to attract and
retain qualified employees is adversely affected by the Los Angeles location of
our corporate headquarters due to the high cost of living in the Los Angeles
area.
WE DEPEND ON OUR COMPUTER AND COMMUNICATIONS SYSTEMS.
As a multi-national corporation, we rely on our computer and
communication network to operate efficiently. Any interruption of this service
from power loss, telecommunications failure, weather, natural disasters or any
similar event could have a material adverse affect on our business and
operations. Additionally, hackers and computer viruses have disrupted operations
at many major companies. We may be vulnerable to similar acts of sabotage, which
could have a material adverse effect on our business and operations.
WE MAY REQUIRE ADDITIONAL CAPITAL IN THE FUTURE.
We may not be able to fund our future growth or react to competitive
pressures if we lack sufficient funds. Currently, we believe we have sufficient
cash available through our bank credit facilities, issuance of long-term debt,
proceeds from loans from affiliates, and proceeds from the exercise of stock
options to fund existing operations for the foreseeable future. However, in the
future we may need to raise additional funds through equity or debt financings
or collaborative relationships. This additional funding may not be available or,
if available, it may not be available on economically reasonable terms. In
addition, any additional funding may result in significant dilution to existing
stockholders. If adequate funds are not available, we may be required to curtail
our operations or obtain funds through collaborative partners that may require
us to release material rights to our products.
OUR BUSINESS IS SUBJECT TO RISKS ASSOCIATED WITH IMPORTING PRODUCTS.
Substantially all of our import operations are subject to tariffs
imposed on imported products and quotas imposed by trade agreements. In
addition, the countries in which our products are manufactured or imported may
from time to time impose additional new quotas, duties, tariffs or other
restrictions on our imports or adversely modify existing restrictions. Adverse
changes in these import costs and restrictions, or our suppliers' failure to
comply with customs or similar laws, could harm our business. We cannot assure
that future trade agreements will not provide our competitors with an advantage
over us, or increase our costs, either of which could have an adverse effect on
our business and financial condition.
Our operations are also subject to the effects of international trade
agreements and regulations such as the North American Free Trade Agreement, and
the activities and regulations of the World Trade Organization. Generally, these
trade agreements benefit our business by reducing or eliminating the duties
and/or quotas assessed on products manufactured in a particular country.
However, trade agreements can also impose requirements that adversely affect our
business, such as limiting the countries from which we can purchase raw
materials and setting quotas on products that may be imported into the United
States from a particular country. In addition, the World Trade Organization may
commence a new round of trade negotiations that liberalize textile trade by
further eliminating quotas or reducing tariffs. The elimination of quotas on
World Trade Organization member countries by 2005 and other effects of these
trade agreements could result in increased competition from developing
countries, which historically have lower labor costs, including China and
Taiwan, both of which recently became members of the World Trade Organization.
This potential increase in competition from developing countries is one of the
several reasons why we have determined to lease our manufacturing operations in
Mexico to a third party.
27
Our ability to import products in a timely and cost-effective manner
may also be affected by problems at ports or issues that otherwise affect
transportation and warehousing providers, such as labor disputes. These problems
could require us to locate alternative ports or warehousing providers to avoid
disruption to our customers. These alternatives may not be available on short
notice or could result in higher transit costs, which could have an adverse
impact on our business and financial condition.
OUR DEPENDENCE ON INDEPENDENT MANUFACTURERS REDUCES OUR ABILITY TO CONTROL THE
MANUFACTURING PROCESS, WHICH COULD HARM OUR SALES, REPUTATION AND OVERALL
PROFITABILITY.
We depend on independent contract manufacturers to secure a sufficient
supply of raw materials and maintain sufficient manufacturing and shipping
capacity in an environment characterized by declining prices, continuing cost
pressure and increased demands for product innovation and speed-to-market. This
dependence could subject us to difficulty in obtaining timely delivery of
products of acceptable quality. In addition, a contractor's failure to ship
products to us in a timely manner or to meet the required quality standards
could cause us to miss the delivery date requirements of our customers. The
failure to make timely deliveries may cause our customers to cancel orders,
refuse to accept deliveries, impose non-compliance charges through invoice
deductions or other charge-backs, demand reduced prices or reduce future orders,
any of which could harm our sales, reputation and overall profitability. We do
not have material long-term contracts with any of our independent contractors
and any of these contractors may unilaterally terminate their relationship with
us at any time. To the extent we are not able to secure or maintain
relationships with independent contractors that are able to fulfill our
requirements, our business would be harmed.
Although we monitor the compliance of our independent contractors with
applicable labor laws, we do not control our contractors or their labor
practices. The violation of federal, state or foreign labor laws by one of the
our contractors could result in our being subject to fines and our goods that
are manufactured in violation of such laws being seized or their sale in
interstate commerce being prohibited. From time to time, we have been notified
by federal, state or foreign authorities that certain of our contractors are the
subject of investigations or have been found to have violated applicable labor
laws. To date, we have not been subject to any sanctions that, individually or
in the aggregate, have had a material adverse effect on our business, and we are
not aware of any facts on which any such sanctions could be based. There can be
no assurance, however, that in the future we will not be subject to sanctions as
a result of violations of applicable labor laws by our contractors, or that such
sanctions will not have a material adverse effect on our business and results of
operations. In addition, certain of our customers, including The Limited,
require strict compliance by their apparel manufacturers, including us, with
applicable labor laws and visit our facilities often. There can be no assurance
that the violation of applicable labor laws by one of our contractors will not
have a material adverse effect on our relationship with our customers.
OUR BUSINESS IS SUBJECT TO RISKS OF OPERATING IN A FOREIGN COUNTRY AND TRADE
RESTRICTIONS.
Approximately 92% of our products were imported from outside the U.S.
in the second quarter of 2003, and most of our fixed assets are located in
Mexico. We are subject to the risks associated with doing business and owning
fixed assets in foreign countries, including, but not limited to, transportation
delays and interruptions, political instability, expropriation, currency
fluctuations and the imposition of tariffs, import and export controls, other
non-tariff barriers (including changes in the allocation of quotas) and cultural
issues. Any changes in those countries' labor laws and government regulations
may have a negative effect on our profitability.
WE CANNOT GUARANTEE THAT OUR FUTURE ACQUISITIONS WILL BE SUCCESSFUL.
In the future, we may seek to continue our growth through acquisition.
We compete for acquisition and expansion opportunities with companies which have
significantly greater financial and management resources than us. There can be
no assurance that suitable acquisition or investment opportunities will be
identified, that any of these transactions can be consummated, or that, if
acquired, these new businesses can be integrated successfully and profitably
into our operations. These acquisitions and investments may also require a
significant allocation of resources, which will reduce our ability to focus on
the other portions of our business, including many of the factors listed in the
prior risk factor.
28
RISK ASSOCIATED WITH OUR INDUSTRY
OUR SALES ARE HEAVILY INFLUENCED BY GENERAL ECONOMIC CYCLES.
Apparel is a cyclical industry that is heavily dependent upon the
overall level of consumer spending. Purchases of apparel and related goods tend
to be highly correlated with cycles in the disposable income of our consumers.
Our customers anticipate and respond to adverse changes in economic conditions
and uncertainty by reducing inventories and canceling orders. As a result, any
substantial deterioration in general economic conditions, increases in interest
rates, acts of war, terrorist or political events that diminish consumer
spending and confidence in any of the regions in which we compete, could reduce
our sales and adversely affect our business and financial condition. This has
been underscored by the events of September 11, 2001 and the war in the Middle
East.
OUR BUSINESS IS HIGHLY COMPETITIVE AND DEPENDS ON CONSUMER SPENDING PATTERNS.
The apparel industry is highly competitive. We face a variety of
competitive challenges including:
o anticipating and quickly responding to changing consumer
demands;
o developing innovative, high-quality products in sizes, colors
and styles that appeal to consumers of varying age groups and
tastes;
o competitively pricing our products and achieving customer
perception of value; and
o providing strong and effective marketing support.
WE MUST SUCCESSFULLY GAUGE FASHION TRENDS AND CHANGING CONSUMER PREFERENCES TO
SUCCEED.
Our success is largely dependent upon our ability to gauge the fashion
tastes of our customers and to provide merchandise that satisfies retail and
customer demand in a timely manner. The apparel business fluctuates according to
changes in consumer preferences dictated in part by fashion and season. To the
extent, we misjudge the market for our merchandise, our sales may be adversely
affected. Our ability to anticipate and effectively respond to changing fashion
trends depends in part on our ability to attract and retain key personnel in our
design, merchandising and marketing staff. Competition for these personnel is
intense, and we cannot be sure that we will be able to attract and retain a
sufficient number of qualified personnel in future periods.
OUR BUSINESS IS SUBJECT TO SEASONAL TRENDS.
Historically, our operating results have been subject to seasonal
trends when measured on a quarterly basis. This trend is dependent on numerous
factors, including the markets in which we operate, holiday seasons, consumer
demand, climate, economic conditions and numerous other factors beyond our
control. There can be no assurance that our historic operating patterns will
continue in future periods as we cannot influence or forecast many of these
factors.
RISKS RELATED TO OUR COMMON STOCK
OUR MANAGEMENT OWNS A SIGNIFICANT PERCENTAGE OF OUR COMMON STOCK AND WILL BE
ABLE TO EXERCISE SIGNIFICANT INFLUENCE OVER OUR AFFAIRS.
Our executive officers and directors beneficially own 50.3% of our
outstanding common stock, based upon the beneficial ownership of our common
stock as of June 30, 2003. Accordingly, these stockholders effectively have the
ability to control the outcome on all matters requiring stockholder approval,
including the election and removal of directors and any change in control. This
concentration of ownership of our common stock could have the effect of delaying
or preventing a change of control of us or otherwise discouraging or preventing
a potential acquirer from attempting to obtain control of us. This, in turn,
could have a negative effect on the market price of our common stock. It could
also prevent our stockholders from realizing a premium over the market prices
for their shares of common stock.
29
OUR STOCK PRICE HAS BEEN VOLATILE.
Our common stock is quoted on the Nasdaq National Market System, and
there can be substantial volatility in the market price of our common stock. The
market price of our common stock has been, and is likely to continue to be,
subject to significant fluctuations due to a variety of factors, including
quarterly variations in operating results, operating results which vary from the
expectations of securities analysts and investors, changes in financial
estimates, changes in market valuations of competitors, announcements by us or
our competitors of a material nature, loss of one or more customers, additions
or departures of key personnel, future sales of common stock and stock market
price and volume fluctuations. In addition, general political and economic
conditions such as a recession, or interest rate or currency rate fluctuations
may adversely affect the market price of our common stock.
In addition, the stock market in general has experienced extreme price
and volume fluctuations that have affected the market price of our common stock.
Often, price fluctuations are unrelated to operating performance of the specific
companies whose stock is affected. In the past, following periods of volatility
in the market price of a company's stock, securities class action litigation has
occurred against the issuing company. If we were subject to this type of
litigation in the future, we could incur substantial costs and a diversion of
our management's attention and resources, each of which could have a material
adverse effect on our revenue and earnings. Any adverse determination in this
type of litigation could also subject us to significant liabilities.
ABSENCE OF DIVIDENDS COULD REDUCE OUR ATTRACTIVENESS TO YOU.
Some investors favor companies that pay dividends, particularly in
general downturns in the stock market. We have not declared or paid any cash
dividends on our common stock. We currently intend to retain any future earnings
for funding growth, and we do not currently anticipate paying cash dividends on
our common stock in the foreseeable future. Because we may not pay dividends,
your return on this investment likely depends on your selling our stock at a
profit.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
FOREIGN CURRENCY RISK. Our earnings are affected by fluctuations in the
value of the U.S. dollar as compared to foreign currencies as a result of doing
business in Mexico as well as certain debt denominated in the Euro. As a result,
we bear the risk of exchange rate gains and losses that may result in the future
as a result of this financing. At times we use forward exchange contracts to
reduce the effect of fluctuations of foreign currencies on purchases and
commitments. These short-term assets and commitments are principally related to
trade payables positions and fixed asset purchase obligations. We do not utilize
derivative financial instruments for trading or other speculative purposes. We
actively evaluate the creditworthiness of the financial institutions that are
counter parties to derivative financial instruments, and we do not expect any
counter parties to fail to meet their obligations.
INTEREST RATE RISK. Because our obligations under our various credit
agreements bear interest at floating rates (primarily LIBOR rates), we are
sensitive to changes in prevailing interest rates. Any major increase or
decrease in market interest rates that affect our financial instruments would
have a material impact on earning or cash flows during the next fiscal year.
Our interest expense is sensitive to changes in the general level of
U.S. interest rates. In this regard, changes in U.S. interest rates affect
interest paid on our debt. A majority of our credit facilities is at variable
rates.
ITEM 4. CONTROLS AND PROCEDURES.
As of June 30, 2003, the end of the period covered by this report, our
Chief Executive Officer and our Chief Financial Officer, with the participation
of our management, carried out an evaluation of the effectiveness of our
disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based
upon that evaluation, the Chief Executive Officer and the Chief Financial
Officer believe that, as of the date of the evaluation, our disclosure controls
and procedures are effective in making known to them material information
relating to us (including our consolidated subsidiaries) required to be included
in this report.
30
Disclosure controls and procedures, no matter how well designed and
implemented, can provide only reasonable assurance of achieving an entity's
disclosure objectives. The likelihood of achieving such objectives is affected
by limitations inherent in disclosure controls and procedures. These include the
fact that human judgment in decision-making can be faulty and that breakdowns in
internal control can occur because of human failures such as simple errors or
mistakes or intentional circumvention of the established process.
There were no significant changes in our internal controls or in other
factors that could significantly affect internal controls, known to the Chief
Executive Officer or the Chief Financial Officer, subsequent to the date of the
evaluation.
During 2003, our prior independent public accountants, Ernst & Young,
LLP, advised us and discussed with the Audit Committee of our Board of Directors
that, due in part to certain acquisitions by our subsidiaries in Mexico and
modifications to our inventory costing methodology, certain improvements in the
internal controls of those subsidiaries were necessary to ensure reporting from
the subsidiaries would be sufficient for us to develop reliable financial
statements. We will address the deficiencies identified by Ernst & Young, LLP in
consultation with Grant Thornton, LLP, our new independent public accountants.
31
PART II -- OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
PATRICK BENSIMON
Patrick Bensimon caused his company Needletex, Inc., to transfer its
assets to a newly formed limited liability company now known as Jane Doe
International, LLC pursuant to the terms of an Asset Purchase Agreement dated
April 12, 2000. The new company is beneficially owned 51% by us and 49% by
Bensimon. At the same time, Bensimon entered into an employment agreement with
the new company, which provided for the payment of a salary to Bensimon and a
bonus tied to the new company's sales performance. The existing lenders to
Needletex, Inc. agreed to the asset transfer in return for, among other things,
the confirmation of Bensimon's continuing guaranty of the loan obligations, the
assumption of the loan obligations by the new company and a guaranty of those
obligations by us. We received an express indemnity by Needletex, Inc. and
Bensimon to reimburse it for all amounts we paid to those lenders for the
account of Needletex and Bensimon.
Thereafter a dispute arose as to whether Bensimon had performed in
accordance with his terms of employment set forth in the Employment Agreement.
When an amicable resolution of this dispute could not be achieved, Bensimon
commenced an arbitration proceeding against his employer (Jane Doe
International, LLC), Fashion Resource (TCL), Inc., the managing member of Jane
Doe International, and us. We and the other respondents contested and vigorously
opposed the matter.
On January 21, 2003, after the hearing, the arbitration panel issued an
interim award in favor of Bensimon awarding him $1,425,655.00 for salary and
bonus plus interest accrued thereon and legal fees and costs to be determined.
All other claims by Bensimon were denied. The affirmative defenses and
counterclaims asserted by the respondents also were denied. On April 7, 2003,
the panel issued a final award in favor of Bensimon confirming the prior interim
award and awarding Bensimon costs and attorneys fees in the amount of
$489,639.83. On April 28, 2003, Bensimon sought a court order confirming the
final award. The hearing on this request of Bensimon is scheduled for August 12,
2003. We have asked the court to vacate or modify the final award and a hearing
presently is scheduled for September 15, 2003. In the meantime, we intend to ask
the court to hold the hearing on this request to vacate or modify at the same
time as Bensimon's request for Court confirmation of the award.
On March 10, 2003, we commenced an action against Bensimon in the Los
Angeles County Superior Court seeking damages arising out of the express
indemnity. The amount of the claim held by us is $2,159,387.17, which is
approximately the same amount of the total award made by the arbitration panel
in favor of Bensimon. We sought the appointment of a referee by the Court in
accordance with the terms of the Asset Purchase Agreement. The Court denied this
motion but reserved judgment as to whether the prior arbitration proceedings
previously adjudicated the issue of Bensimon's liability under his express
indemnity. Bensimon filed a request with the Court for a ruling that any such
indemnity claims were heard and determined previously by the arbitration panel.
A hearing on this request is scheduled for August 22, 2003. We intend to
continue to vigorously oppose any attempt by Bensimon to have this suit
dismissed.
At the outset of the dispute, we tendered the claim by Bensimon to our
insurance carrier, which accepted the tender with a reservation of rights as to
whether coverage existed for the claim. The carrier observed the arbitration
process and hearing. After the interim award was made, the insurance carrier
denied coverage. After the final award by the arbitration panel, we made demand
on the insurance carrier, which was denied. We then commenced suit against the
insurance carrier in the Los Angeles County Superior Court for breach of
contract and related claims arising out of its denial of coverage for the costs
and fees awarded to Bensimon in the arbitration. The carrier has asked the Court
to dismiss this claim and a hearing on this request is scheduled for August 21,
2003. In the meantime, we have filed a request with the Court for summary
judgment on our claims, which will be heard on October 7, 2003. We intend to
vigorously pursue these claims against the insurance carrier.
OTHER MATTERS
From time to time, we are involved in various routine legal proceedings
incidental to the conduct of our business. Our management does not believe that
any of these legal proceedings will have a material adverse impact on our
business, financial condition or results of operations, either due to the nature
of the claims, or because our management believes that such claims should not
exceed the limits of the our insurance coverage.
32
ITEM 2. CHANGES IN SECURITIES.
On December 31, 2002, we issued 100,000 shares of Series A Preferred
Stock (the "Series A Shares") to Rosa Lissette Nacif Benevides. The Series A
Shares were issued in connection with the acquisition by our wholly-owned
subsidiaries, Tarrant Mexico, S. de R.L. de C.V. and Tarrant Luxembourg Sarl
(previously known as Machrima Luxembourg Sarl), of a denim and twill
manufacturing plant in Tlaxcala, Mexico, including all machinery and equipment
used in the plant, the buildings, and the real estate on which the plant is
located (the "Acquisition"). The Acquisition was made pursuant to an Agreement
for the Purchase of Assets and Stock, dated as of December 31, 2002, by and
among us, Trans Textil International, S.A. de C.V., Inmobiliaria Cuadros, S.A.
de C.V., Rosa Lisette Nacif Benavides, Gazi Nacif Borge, Jorge Miguel Echevarria
Vazquez, and Kamel Nacif Borge. Pursuant to the purchase agreement, Tarrant
Mexico purchased from Trans Textil all of the machinery and equipment used in
and located at the plant, and the Purchasers acquired from Jorge Miguel
Echevarria Vazquez and Rosa Lisette Nacif Benavides all the issued and
outstanding capital stock of Inmobiliaria, which owns the buildings and real
estate. A portion of the purchase price for the Inmobiliaria shares consisted of
the issuance to Rosa Lisette Nacif Benavides of the Series A Shares, which would
become convertible, at the option of the holder, into 3,000,000 shares of common
stock upon the approval by our shareholders at the 2003 annual meeting. Pursuant
to the Purchase Agreement, we issued the Series A Shares to a subsidiary of
ours, and subsequently caused the transfer of the Series A Shares to Rosa
Lisette Nacif Benavides as partial repayment of indebtedness owed by
Inmobiliaria to Ms. Benavides. Ms. Benevides represented to us that she was an
"accredited investor" within the meaning of Rule 501 of Regulation D under the
Securities Act of 1933, and that she was purchasing the securities for
investment and not in connection with a distribution thereof. The issuance and
sale of these securities was exempt from the registration and prospectus
delivery requirements of the Securities Act pursuant to Section 4(2) of the
Securities Act as a transaction not involving any public offering.
In June 2003, Ms. Benevides converted all of the Series A Shares into
3,000,000 shares of our Common Stock following approval of the conversion by our
shareholder at our annual shareholders' meeting held on May 28, 2003.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES. None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
On May 28, 2003, we held our 2003 Annual Meeting of Shareholders. At
the annual meeting, there were 15,597,443 shares entitled to vote, and
14,695,960 shares (94%) were represented at the meeting in person or by proxy.
Immediately prior to the meeting, the Board of Directors was comprised of Gerard
Guez, Todd Kay, Patrick Chow, Joseph Mizrachi, Barry Aved, Mitchell Simbal and
Milton Koffman. Following the meeting, the Board of Directors was comprised of
Gerard Guez, Todd Kay, Patrick Chow, Joseph Mizrachi, Stephane Farouze, Larry
Russ, Barry Aved, Mitchell Simbal and Milton Koffman
The following summarizes vote results for those matters submitted to
our shareholders for action at the annual meeting:
1. Proposal to elect Barry Aved, Mitchell Simbal and Milton
Koffman to serve as our Class I directors for two years and until their
successors has been elected.
DIRECTOR FOR WITHHELD
-------- --- --------
Barry Aved 14,413,417 282,543
Mitchell Simbal 14,244,772 451,188
Milton Koffman 14,243,922 452,038
33
2. Proposal to approve the issuance of up to 3 million shares of
common stock issuable upon conversion of the outstanding shares of Series A
Preferred Stock.
FOR AGAINST ABSTAIN BROKER NON-VOTES
--- ------- ------- ----------------
8,924,529 289,207 722,716 4,759,508
3. Proposal to ratify the grant of options to purchase an
aggregate of 2 million shares of common stock to certain executive officers.
FOR AGAINST ABSTAIN BROKER NON-VOTES
--- ------- ------- ----------------
13,595,172 1,077,278 23,510 0
4. Proposal to ratify the appointment of Ernst & Young LLP as the
Company's independent public accountants for the year ended December 31, 2003.
FOR AGAINST ABSTAIN BROKER NON-VOTES
--- ------- ------- ----------------
14,514,597 180,497 866 0
ITEM 5. OTHER INFORMATION. None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits:
Exhibit 10.23.3: Second Amendment to Employment Agreement
dated April 1, 2003 between Tarrant Apparel
Group and Gerard Guez.
Exhibit 10.24.3: Second Amendment to Employment Agreement
dated April 1, 2003 between Tarrant Apparel
Group and Todd Kay.
Exhibit 10.102.1: Letter agreement regarding employment dated
April 1, 2003 between Fashion Resource
(TCL), Inc. and Eddy Yuen.
Exhibit 10.103.1: First Amendment to Employment Agreement
dated April 1, 2003 between Tarrant Apparel
Group and Patrick Chow.
Exhibit 10.107.3: Fourth Deed of Variation to Syndicated
Letter of Credit Facility dated June 18,
2003 among Tarrant Company Limited, Marble
Limited and Trade Link Holdings Limited and
UPS Capital Global Trade Finance
Corporation.
Exhibit 10.116: Promissory Note dated May 31, 2003 made by
Gerard Guez in favor of Tarrant Apparel
Group.
Exhibit 10.117: Indemnification Agreement dated April 10,
2003 between Tarrant Apparel Group and Seven
Licensing Company, LLC.
Exhibit 31.1: Certificate of Chief Executive Officer
pursuant to Rule 13a-14(a) under the
Securities and Exchange Act of 1934, as
amended.
Exhibit 31.2: Certificate of Chief Financial Officer
pursuant to Rule 13a-14(a) under the
Securities and Exchange Act of 1934, as
amended.
Exhibit 32.1: Certificate of Chief Executive Officer
pursuant to Rule 13a-14(b) under the
Securities and Exchange Act of 1934, as
amended.
Exhibit 32.2: Certificate of Chief Financial Officer
pursuant to Rule 13a-14(b) under the
Securities and Exchange Act of 1934, as
amended.
34
(b) Reports on Form 8-K.
Current Report on Form 8-K dated March 31, 2003, reporting
Items 7 and 9, as filed on April 4, 2003.
Current Report on Form 8-K dated May 15, 2003, reporting Items
7 and 9, as filed on May 16, 2003.
35
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
TARRANT APPAREL GROUP
Date: August 19, 2003 By: /s/ Patrick Chow
----------------------------
Patrick Chow,
Chief Financial Officer
Date: August 19, 2003 By: /s/ Gerard Guez
----------------------------
Gerard Guez,
Chief Executive Officer
36