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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934. FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934.
FOR THE TRANSITION PERIOD FROM TO
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COMMISSION FILE NUMBER: 0-26430
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TARRANT APPAREL GROUP
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
CALIFORNIA 95-4181026
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification Number)
3151 EAST WASHINGTON BOULEVARD
LOS ANGELES, CALIFORNIA 90023
(Address of Principal Executive Offices) (Zip Code)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (323) 780-8250
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes |X| No |_|
Indicate by check mark whether the registrant is 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 November
12, 2003: 18,797,443.
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TARRANT APPAREL GROUP
FORM 10-Q
INDEX
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited) PAGE
Consolidated Balance Sheets at September 30, 2003
(Unaudited) and December 31, 2002 (Audited)................... 4
Consolidated Statements of Operations and Comprehensive
Income (Loss) for the Three Months and Nine Months
Ended September 30, 2003 and September 30, 2002............... 5
Consolidated Statements of Cash Flows for the Nine
Months Ended September 30, 2003 and September 30,
2002.......................................................... 6
Notes to Consolidated Financial Statements.................... 7
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations .......................... 16
Item 3. Quantitative and Qualitative Disclosures About
Market Risk .................................................. 31
Item 4. Controls and Procedures....................................... 31
PART II. OTHER INFORMATION
Item 1. Legal Proceedings............................................ 33
Item 2. Changes in Securities and Use of Proceeds..................... 34
Item 3. Defaults Upon Senior Securities .............................. 34
Item 4. Submission of Matters to a Vote of Security Holders........... 34
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
SEPTEMBER 30, DECEMBER 31,
2003 2002
------------- -------------
(unaudited)
ASSETS
Current assets:
Cash and cash equivalents ................. $ 690,752 $ 1,388,482
Restricted cash ........................... 2,000,000 --
Accounts receivable, net .................. 69,357,182 65,287,902
Due from affiliates ....................... 14,360,831 8,510,993
Due from officers ......................... 456,486 456,500
Inventory ................................. 44,910,630 44,782,154
Temporary quota ........................... 1,746,983 --
Prepaid expenses and other receivables .... 1,599,564 5,135,672
Income taxes receivable ................... 218,725 280,200
------------- -------------
Total current assets ........................ 135,341,153 125,841,903
Property and equipment, net ............... 142,078,860 159,998,629
Other assets .............................. 3,174,347 2,539,040
Excess of cost over fair value of net
assets acquired, net ................... 8,582,844 28,064,019
------------- -------------
Total assets ................................ $ 289,177,204 $ 316,443,591
============= =============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Short-term bank borrowings ................ $ 41,082,617 $ 29,326,924
Accounts payable .......................... 49,630,527 32,119,854
Accrued expenses .......................... 13,738,542 12,566,475
Income taxes .............................. 14,468,357 12,640,388
Due to affiliates ......................... 9,215,500 5,264,238
Due to shareholders ....................... 365,547 486,875
Current portion of long-term obligations .. 17,635,661 21,706,502
------------- -------------
Total current liabilities ................... 146,136,751 114,111,256
Long-term obligations ........................ 44,532,979 55,903,976
Deferred tax liabilities ..................... 419,584 407,751
Minority interest in UAV ..................... 4,472,392 3,205,167
Minority interest in Tarrant Mexico .......... 15,282,713 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 .................. 77,877,386 69,368,239
Contributed capital ....................... 1,434,259 1,434,259
Retained earnings ......................... 20,561,818 56,873,094
Notes receivable from shareholders ........ (4,842,575) (5,601,804)
Accumulated other comprehensive income .... (16,698,103) (9,733,458)
------------- -------------
Total shareholders' equity .................. 78,332,785 121,160,903
------------- -------------
Total liabilities and shareholders' equity .. $ 289,177,204 $ 316,443,591
============= =============
The accompanying notes are an integral part of these consolidated financial
statements
4
TARRANT APPAREL GROUP
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
(Unaudited)
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
------------------------------ ------------------------------
2003 2002 2003 2003
------------- ------------- ------------- -------------
Net sales ................................ $ 96,457,780 $ 94,327,981 $ 253,388,065 $ 254,799,074
Cost of sales ............................ 84,943,929 80,098,265 233,504,642 217,726,145
------------- ------------- ------------- -------------
Gross profit ............................. 11,513,851 14,229,716 19,883,423 37,072,929
Selling and distribution expenses ........ 2,878,886 2,911,129 8,723,246 7,973,140
General and administrative expenses ...... 7,186,640 7,692,584 23,112,501 21,524,755
Impairment of assets ..................... -- -- 22,276,510 --
------------- ------------- ------------- -------------
Income (loss) from operations ............ 1,448,325 3,626,003 (34,228,834) 7,575,034
Interest expense ......................... (1,591,130) (1,375,400) (4,510,190) (3,952,075)
Interest income .......................... 88,122 93,901 263,448 229,533
Other income ............................. 1,106,649 1,029,394 1,579,168 1,939,808
Other expense ............................ (706,535) (755,014) (1,226,041) (1,572,029)
Minority interest ........................ 283,227 (740,948) 3,776,518 (2,618,287)
------------- ------------- ------------- -------------
Income (loss) before provision for income
taxes and cumulative effect of
accounting change ..................... 628,658 1,877,936 (34,345,931) 1,601,984
Provision for income taxes ............... 489,811 751,173 1,965,345 899,136
------------- ------------- ------------- -------------
Income (loss) before cumulative effect of
accounting change ..................... 138,847 1,126,763 (36,311,276) 702,848
Cumulative effect of accounting change ... -- -- -- (4,871,244)
------------- ------------- ------------- -------------
Net income (loss) ........................ $ 138,847 $ 1,126,763 $ (36,311,276) $ (4,168,396)
============= ============= ============= =============
Net income (loss) per share - Basic and
Diluted:
Before cumulative effect of accounting
change .............................. $ 0.01 $ 0.07 $ (2.12) $ 0.04
Cumulative effect of accounting change -- -- -- (0.30)
After cumulative effect of accounting
change .............................. $ 0.01 $ 0.07 $ (2.12) $ (0.26)
============= ============= ============= =============
Weighted average common and common
equivalent shares:
Basic ................................. 18,765,425 15,836,049 17,144,611 15,833,390
============= ============= ============= =============
Diluted ............................... 18,767,701 15,930,969 17,144,611 15,833,390
============= ============= ============= =============
Net income (loss) ........................ $ 138,847 $ 1,126,763 $ (36,311,276) $ (4,168,396)
Foreign currency translation adjustment .. (9,151,513) (2,471,914) (6,964,645) (10,633,748)
------------- ------------- ------------- -------------
Total comprehensive loss ................. $ (9,012,666) $ (1,345,151) $ (43,275,921) $ (14,802,144)
============= ============= ============= =============
The accompanying notes are an integral part of these consolidated financial
statements
5
TARRANT APPAREL GROUP
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
NINE MONTHS ENDED SEPTEMBER 30,
2003 2002
------------- -------------
Operating activities:
Net loss ..................................... $ (36,311,276) $ (2,895,284)
Adjustments to reconcile net loss to net
cash provided by operating activities:
Deferred taxes ............................ 11,833 230,511
Depreciation and amortization ............. 11,919,289 7,732,568
Loss on sale of fixed assets .............. 732,365 --
Cumulative effect of accounting change .... -- 3,598,132
Asset impairment .......................... 22,276,510 --
Inventory write-down ...................... 10,986,153 --
Unrealized loss on foreign currency ....... 173,287 839,234
Provision for returns and discounts ....... 1,042,856 (1,691,503)
Minority interest ......................... (3,776,518) 1,482,439
Legal settlement .......................... -- (471,693)
Changes in operating assets and
liabilities:
Restricted cash ......................... (2,000,000) --
Accounts receivable ..................... (6,203,135) (10,226,562)
Due from affiliates ..................... (2,104,209) (2,404,637)
Inventory ............................... (11,114,629) (4,137,139)
Temporary quota ......................... (1,746,983) (1,289,585)
Prepaid expenses and other receivables .. 825,594 1,272,971
Accounts payable ........................ 17,510,673 7,492,262
Accrued expenses and income tax payable . 3,000,035 7,932,427
------------- -------------
Net cash provided by operating
activities ............................ 5,221,845 7,464,141
Investing activities:
Purchase of fixed assets .................. (442,277) (1,190,357)
Proceeds from sale of fixed assets ........ 209,788 --
Purchase consideration for acquisitions ... -- (1,884,000)
(Increase) decrease in other assets ....... (1,800,137) 390,158
Repayments of advances from shareholders/
officers ................................ 759,242 --
------------- -------------
Net cash used in investing activities ... (1,273,384) (2,684,199)
Financing activities:
Short-term bank borrowings, net ........... 11,755,693 4,623,823
Proceeds from long-term obligations ....... 193,782,799 115,532,601
Payment of long-term obligations and
bank borrowings ......................... (209,397,923) (123,521,747)
Repayments to shareholders/officers ....... (121,328) (3,041,512)
Borrowings from shareholders/officers ..... -- 2,109,369
Exercise of stock options ................. -- 29,263
Repurchase of stock ....................... (393,178) --
------------- -------------
Net cash used in financing activities ... (4,373,937) (4,268,203)
Effect of changes in foreign currency ........ (272,254) (1,227,428)
------------- -------------
Decrease in cash and cash equivalents ........ (697,730) (715,689)
Cash and cash equivalents at beginning of
period .................................... 1,388,482 1,524,447
------------- -------------
Cash and cash equivalents at end of period ... $ 690,752 $ 808,758
============= =============
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.
In August 2003, the Company determined to abandon its strategy of being both a
trading and vertically integrated manufacturing company, and effective September
1, 2003, the Company leased and outsourced operation of its manufacturing
facilities in Mexico to affiliates of Mr. Kamel Nacif.
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 accompanying unaudited financial statements represent the financial
position, results of operations and cash flows of the Company and its
majority-owned subsidiaries. The equity method of accounting is used when the
Company has a 20% to 50% interest in other entities, except for variable
interest entities for which the Company is considered the primary beneficiary
under Financial Accounting Standards Board ("FASB") Interpretation No. 46,
"Consolidation of Variable Interest Entities," an interpretation of ARB No. 51.
Under the equity method, original investments are recorded at cost and adjusted
by the Company's share of undistributed earnings or losses of these entities.
All significant intercompany transactions and balances have been eliminated from
the consolidated financial statements.
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 reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Significant estimates used by the Company in
preparation of its consolidated financial statements include: (i) allowance for
returns, discounts and bad debts, (ii) inventory, (iii) valuation of long lived,
intangible assets, and goodwill, (iv) income taxes, and (v) debt covenants.
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 respective periods. 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.
7
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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":
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------------- ----------------------------
2003 2002 2003 2002
------------ ------------ ------------ ------------
Pro forma net income (loss) ............. $ (812,305) $ (52,783) $(39,527,586) $ (6,713,928)
Pro forma compensation expense, net of
tax .................................. $ (951,152) $ (1,179,546) $ (3,216,310) $ (2,545,532)
Net income (loss) as reported ........... $ 138,847 $ 1,126,763 $(36,311,276) $ (4,168,396)
Pro forma income (loss) per share - Basic
and Diluted .......................... $ (0.04) $ (0.00) $ (2.31) $ (0.42)
Net income (loss) per share - Basic and
Diluted .............................. $ 0.01 $ 0.07 $ (2.12) $ (0.26)
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:
SEPTEMBER 30, DECEMBER 31,
2003 2002
------------ ------------
United States trade accounts receivable .... $ 40,445,433 $ 42,979,762
Foreign trade accounts receivable .......... 23,718,598 16,445,868
Due from factor ............................ 5,566,175 4,176,598
Other receivables .......................... 4,831,121 6,002,295
Allowance for returns, discounts and
bad debts ............................... (5,204,145) (4,316,621)
------------ ------------
$ 69,357,182 $ 65,287,902
============ ============
5. INVENTORY
Inventory consists of the following:
SEPTEMBER 30, DECEMBER 31,
2003 2002
----------- -----------
Raw materials
Fabric and trim accessories ............... $10,917,688 $12,451,447
Raw cotton ................................ 991,341 1,017,963
Work-in-process .............................. 12,116,023 9,948,700
Finished goods shipments-in-transit .......... 7,960,313 4,877,002
Finished goods ............................... 12,925,265 16,487,042
----------- -----------
$44,910,630 $44,782,154
=========== ===========
8
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
6. DEBT
Short-term bank borrowings consist of the following:
SEPTEMBER 30, DECEMBER 31,
2003 2002
----------- -----------
Import trade bills payable ................. $ 4,391,683 $ 5,686,327
Bank direct acceptances .................... 4,416,985 11,272,375
Other Hong Kong credit facilities .......... 22,722,636 6,206,103
Other Mexican credit facilities ............ 2,898,752 4,968,309
Uncleared checks ........................... 6,652,561 1,193,810
----------- -----------
$41,082,617 $29,326,924
=========== ===========
Long-term obligations consist of the following:
SEPTEMBER 30, DECEMBER 31,
2003 2002
------------ ------------
Vendor financing ................... $ 4,638,705 $ 7,257,683
Equipment financing ................ 5,839,751 9,682,290
Debt facility ...................... 49,213,184 58,193,505
Other debt ......................... 2,477,000 2,477,000
------------ ------------
62,168,640 77,610,478
Less current portion ............... (17,635,661) (21,706,502)
------------ ------------
$ 44,532,979 $ 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 of $2 million in
cash and the deposit of $15 million in value of export letters of credit. This
temporary facility expired on September 1, 2003 while the expiry date of the
main credit line of $25 million has been extended to December 1, 2003. In
October 2003, the Company and UPS established new financial covenants for the
period ended September 30, 2003 and for the remainder of the fiscal year based
on the Company's projections. Tangible Net Worth, Fixed Charge Ratio and
Leverage Ratio were fixed at $65 million, 0.75 to 1 and 3 to 1 respectively for
the third quarter and $65 million, 0.74 to 1 and 2.55 to 1 respectively for the
fourth quarter of 2003. As of September 30, 2003, $27.8 million was outstanding
under this facility of which $14.9 million was letters of credit. As of
September 30, 2003, the Company was in compliance with these covenants.
Since March 2003, DBS Bank (Hong Kong) Limited (formerly known as Dao
Heng Bank) 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.
The facility was increased to HKD 23 million (equivalent to US $3.0 million) in
August 2003. As of September 30, 2003, $2.0 million was outstanding under this
facility.
9
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
OTHER MEXICAN CREDIT FACILITIES
As of September 30, 2003, Tarrant Mexico, Famian division had paid down
all advances from Banco Bilbao Vizcaya. 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 agreed that
Tarrant Mexico will repay the outstanding amount by making payments of $523,000
per month commencing on March 26, 2003. The repayment schedule was revised to
$250,000 per month in September 2003. As of September 30, 2003, $2.9 million was
outstanding under this facility.
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, $4.6 million was outstanding as of September 30, 2003. Of
the $4.6 million, $3.0 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 $173,000 and
$839,000 was recorded for the nine months ended September 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 September 30, 2003, $6.0
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 September
30, 2003 were $4.3 million due to GE Capital and $1.3 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 of $30 million,
leverage ratio of not more than two times at the end of each financial year, and
no losses for two consecutive quarters. As additional collateral to secure
repayment of amounts outstanding under the GE Capital facilities, Gerard Guez
and Todd Kay agreed to provide GE Capital a second lien on the Company's
headquarters, which is owned by Messrs. Guez and Kay. The second lien on the
Company's headquarters will be released upon the Company returning to
profitability in the third and fourth quarters of 2003. As of September 30,
2003, the Company was in compliance with these covenants. The BOA facility is
subject to certain financial benchmarks on debt service coverage and a leverage
ratio. In October 2003, the Company paid off the BOA facility in its entirety.
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 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 million, including a letter of credit facility not to exceed $20
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 million facility to $90 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
10
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
October 2003, the Company and GMAC established new financial covenants for the
period ended September 30, 2003 and for the remainder of fiscal 2003 based on
the Company's projections. Tangible Net Worth, Fixed Charge Ratio and Leverage
Ratio were fixed at $65 million, 0.75 to 1 and 3 to 1 respectively for the third
quarter and $65 million, 0.74 to 1 and 2.55 to 1 respectively for the fourth
quarter of 2003. A total of $49.2 million was outstanding under the Debt
Facility at September 30, 2003. As of September 30, 2003, the Company was in
compliance with these covenants.
GUARANTEES
Guarantees have been issued since 2001 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 ceased directly operating a substantial majority of its
equipment and fixed assets in Mexico, and started leasing a large portion of its
manufacturing facilities and operations in Mexico to a related third party
effective September 1, 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 nine months ended September 30, 2003:
Tarrant Tarrant Tag Mex Tag Mex Inc.
Mexico - Mexico - Inc.- 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
September 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 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.
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 SFAS 150 as of July 1, 2003 did not have a
material impact on the Company's consolidated financial condition or results of
operations.
12
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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 evaluated the
effect of the adoption of EITF Issue No. 00-21, and determined that it does not
have a material impact on the Company's 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 (LOSS) 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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------------- ----------------------------
2003 2002 2003 2002
------------ ------------ ------------ ------------
Basic EPS Computation:
Numerator ..................... $ 138,847 $ 1,126,763 $(36,311,276) $ (4,168,396)
Denominator:
Weighted average common shares
outstanding ................... 18,765,425 15,836,049 17,144,611 15,833,390
------------ ------------ ------------ ------------
Total shares .................. 18,765,425 15,836,049 17,144,611 15,833,390
------------ ------------ ------------ ------------
Basic EPS ..................... $ 0.01 $ 0.07 $ (2.12) $ (0.26)
============ ============ ============ ============
Diluted EPS Computation:
Numerator ..................... $ 138,847 $ 1,126,763 $(36,311,276) $ (4,168,396)
Denominator:
Weighted average common shares
outstanding ................... 18,765,42 15,836,049 17,144,611 15,833,390
Incremental shares from assumed
exercise of options ........... 2,276 94,920 -- --
------------ ------------ ------------ ------------
Total shares .................. 18,767,701 15,930,969 17,144,611 15,833,390
------------ ------------ ------------ ------------
Diluted EPS ................... $ 0.01 $ 0.07 $ (2.12) $ (0.26)
============ ============ ============ ============
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
nine months ended September 30, 2003 and 2002 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. RELATED PARTY TRANSACTIONS
On October 16, 2003, the Company leased to affiliates of Mr. Kamel
Nacif, a substantial portion of the Company's manufacturing facilities and
operations in Mexico including real estate and equipment. The Company leased its
twill mill in Tlaxcala, Mexico, and its sewing plant in Ajalpan, Mexico, for a
period of 6 years and for an annual rental fee of $11 million. Mr. Nacif is a
significant stockholder of the Company. In connection with this transaction, the
Company also entered into a management services agreement pursuant to which Mr.
Nacif's affiliates will manage the operation of the Company's remaining
facilities in Mexico. The term of the management services agreement is also for
a period of 6 years. The Company has agreed to purchase annually, 6 million
yards of fabric manufactured at the facilities leased and/or operated by Mr.
Nacif's affiliates at negotiated market price (See Note 13).
Since June 2003, United Apparel Venture LLC has been selling to Seven
Licensing Company, LLC ("Seven Licensing"), jeans wear bearing the brand
"Seven7", which is ultimately purchased by Express. Seven Licensing is
beneficially owned by Gerard Guez. In the nine months period ended September 30,
2003, total sales to Seven Licensing was $8.4 million and $2.5 million was open
as trade receivable as of September 30, 2003.
On December 31, 2002, the Company's 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 the Company and its affiliates of approximately $34.7 million in indebtedness
of Inmobiliaria to Kamel Nacif Borge, his daughter Rosa Lisette Nacif Benavides,
and certain of their affiliates, which payment was made by: (i) delivery to Rosa
Lisette Nacif Benavides of one hundred thousand shares of the Company's newly
created, non-voting Series A Preferred Stock, which shares became convertible
into three million shares of common stock following approval by the Company's
common stockholders of the conversion; (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 the Company's shareholders
at the annual shareholders' meeting held on May 28, 2003.
Trans Textil, an entity controlled by Mr. Nacif and his family members,
was initially commissioned by the Company to construct and develop the plant in
December 1998. Subsequent to completion, Trans Textil purchased and/or leased
the plant's manufacturing equipment from the Company and entered into a
production agreement that gave the Company the first right to all
14
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
production capacity of the plant. This production agreement included the option
for the Company to purchase the facility and discontinue the production
agreement with Trans Textil through September 30, 2002. The Company exercised
the option and acquired the plant as described above.
13. SUBSEQUENT EVENTS
On October 16, 2003, the Company leased to affiliates of Mr. Kamel
Nacif a substantial portion of the Company's manufacturing facilities and
operations in Mexico including real estate and equipment. The Company leased its
twill mill in Tlaxcala, Mexico, and its sewing plant in Ajalpan, Mexico, for a
period of 6 years and for an annual rental fee of $11 million. The assets
subject to this lease have a net book value of approximately $96 million as of
September 30, 2003. Mr. Nacif is a significant stockholder of the Company.
In connection with this transaction, the Company also entered into a
management services agreement pursuant to which Mr. Nacif's affiliates will
manage the operation of our remaining facilities in Mexico. The term of the
management services agreement is also for a period of 6 years. The Company has
agreed to purchase annually, 6 million yards of fabric manufactured at the
facilities leased and/or operated by Mr. Nacif's affiliates at negotiated market
price.
In October 2003, the Company sold an aggregate of 881,732 shares of the
Series A Preferred Stock, at $38 per share, to a group of institutional
investors and high net worth individuals and raised an aggregate of
approximately $31.1 million after payment of commissions and expenses. These
preferred shares will be convertible into an aggregate of 8,817,320 shares of
common stock if the conversion is approved by the Company's shareholders at a
special meeting scheduled for December 4, 2003. Messrs. Gerard Guez, Todd Kay
and Kamel Nacif have already signed voting agreements in favor of the
conversion.
15
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 Express, a division of The
Limited, as well as Chicos, Lane Bryant, Lerner New York, Abercrombie & Fitch,
J.C. Penney, K-Mart, Kohl's, Mervyns, Sears and Wal-Mart. We have recently
launched a private brands initiative which is the distribution of one of our
brands exclusively with one retail company such as "No Jeans" with Wet Seal, and
"American Rag, Cie" with Federated. 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 commencing September 1, 2003, we ceased
directly operating a substantial majority of our equipment and fixed assets in
Mexico by leasing and outsourcing the management of a substantial majority of
our Mexican operations to affiliates of Mr. Kamel Nacif. 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. 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.
16
In October 2003, we sold an aggregate of 881,732 shares of the Series A
Preferred Stock, at $38 per share, to a group of institutional investors and
high net worth individuals and raised an aggregate of approximately $31.1
million, after payment of commissions and expenses. Of these proceeds, at
October 31, 2003, we had used approximately $25.5 million to pay current
liabilities, and we presently intend to use the balance for general working
capital purposes. The preferred stock will be convertible into an aggregate of
8,817,320 shares of common stock if the conversion is approved by our
shareholders at a special meeting scheduled for December 4, 2003.
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 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.
17
As of September 30, 2003, the balance in the allowance for returns,
discounts and bad debts reserves was $5.2 million, compared to $4.5 million at
September 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 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 September 30, 2003, we have a goodwill balance of $8.6 million, and a
net property and equipment balance of $142.1 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 off of
$19.5 million of goodwill as discussed in Note 8 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
18
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.
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 ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2003 2002 2003 2002
----- ----- ----- -----
Net sales ........................ 100.0% 100.0% 100.0% 100.0%
Cost of sales .................... 88.1 84.9 92.2 85.5
----- ----- ----- -----
Gross profit ..................... 11.9 15.1 7.8 14.5
Selling and distribution expenses 3.0 3.1 3.4 3.1
General and administration
expenses ...................... 7.4 8.2 9.1 8.4
Impairment of assets ............. -- -- 8.8 --
----- ----- ----- -----
Income (loss) from operations .... 1.5 3.8 (13.5) 3.0
Interest expense ................. (1.6) (1.4) (1.7) (1.6)
Interest income .................. 0.0 0.0 0.1 0.0
Other income ..................... 1.1 1.1 0.6 0.8
Other expense .................... (0.7) (0.7) (0.5) (0.6)
Minority interest ................ 0.3 (0.8) 1.5 (1.0)
----- ----- ----- -----
Income (loss) before taxes and
cumulative effect of accounting
change ........................ 0.6 2.0 (13.5) 0.6
Income taxes ..................... 0.5 0.8 0.8 0.3
----- ----- ----- -----
Net income (loss) before
cumulative effect of accounting
change ........................ 0.1% 1.2% (14.3)% 0.3%
===== ===== ===== =====
Cumulative effect of accounting .. -- -- -- (1.9)
change net of tax benefit
===== ===== ===== =====
Net income (loss) ................ 0.1% 1.2% (14.3)% (1.6)%
===== ===== ===== =====
THIRD QUARTER 2003 COMPARED TO THIRD QUARTER 2002
Net sales increased by $2.1 million, or 2.3%, to $96.4 million in the
third quarter of 2003 from $94.3 million in the third quarter of 2002. The
increase in net sales included new business of $12.6 million from our private
brands business, and an increase of $2.9 million to Abercrombie & Fitch and
Hollister, which increases were offset by decreases in net sales of $13.2
million to Tommy Hilfiger.
Gross profit consists of net sales less product costs, direct labor,
manufacturing overhead, duty, quota, freight in, brokerage, and warehousing.
Gross profit decreased by $2.7 million, or 19.1%, to $11.5 million, or 11.9% of
net sales in the third quarter of 2003 from $14.2 million, or 15.1% of net sales
in the third quarter of 2002. The decrease in average gross profit as a
percentage of net sales occurred after approximately $1.0 million of severance
payments to Mexican employees as part of cost of goods sold and the negative
impact of $9.1 million of closeouts and fabric sales at low or negative margins,
both of which occurred due to the restructuring of our manufacturing operations
in Mexico during the third quarter of 2003.
19
Selling and distribution expenses remained flat at $2.9 million in the
third quarter of 2003 and in the third quarter of 2002. As a percentage of net
sales, these expenses decreased slightly to 3.0% in the third quarter of 2003
from 3.1% in the third quarter of 2002.
General and administrative expenses decreased by $506,000, or 6.6%, to
$7.2 million in the third quarter of 2003 from $7.7 million in the third quarter
of 2002. As a percentage of net sales, these expenses decreased to 7.4% in the
third quarter of 2003 from 8.2% in the third quarter of 2002. The decrease in
such expenses is primarily due to a reduction of reserve for accounts receivable
of $332,000 in the third quarter of 2003 compared to an increase of such reserve
of $362,000 in the third quarter of 2002.
Operating income in the third quarter of 2003 was $1.4 million, or 1.5%
of net sales, compared to operating income of $3.6 million, or 3.8% of net
sales, in the comparable period of 2002, because of the factors discussed above.
Interest expense increased by $216,000, or 15.7%, to $1.6 million in
the third quarter of 2003 from $1.4 million in the third quarter of 2002. As a
percentage of net sales, these expenses increased to 1.6% in the third quarter
of 2003 from 1.4% in the third quarter of 2002. Other income was $1.1 million in
the third quarter of 2003, compared to $1.0 million in the third quarter of
2002. This income consisted mainly of lease income of $917,000 in the third
quarter of 2003 versus a realized exchange gain relating to Euro denominated
debts of $457,000 and a $301,000 settlement gain from litigation with Fortis
Bank and NCM in the third quarter of 2002. Other expense was $707,000 in the
third quarter of 2003 compared to $755,000 in the third quarter of 2002. This
expense consisted mainly of loss incurred from disposal of fixed assets of
$680,000 and royalty expense of $127,000 in third quarter of 2003 compared to an
unrealized exchange loss of $456,000 and royalty expense of $202,000 in the
third quarter of 2002.
Net income from minority interest in the third quarter of 2003 was
$283,000 representing $518,000 profit shared by the 49.9% minority partner in
the UAV joint venture, offset by $801,000 attributed to the minority shareholder
in Tarrant Mexico for his 25% share in operating losses. In the third quarter of
2002, minority interest expense was $741,000 made up of profit shared by the
minority partner in the UAV joint venture.
FIRST NINE MONTHS OF 2003 COMPARED TO FIRST NINE MONTHS OF 2002
Net sales decreased by $1.4 million, or 0.6%, to $253.4 million in the
first nine months of 2003 from $254.8 million in the first nine months of 2002.
The decrease in net sales included a decrease of $20.0 million to Lane Bryant /
Charming Shoppes, and $18.0 million to Tommy Hilfiger, which decreases were
offset by increase in sales included new business of $14.5 million from our
private brands business, an increase of $5.0 million to Federated Stores, $2.5
million to Levis and $6.8 million to Abercrombie & Fitch and Hollister.
Gross profit decreased by $17.2 million, or 46.4%, to $19.9 million, or
7.8% of net sales in the first nine months of 2003 from $37.1 million, or 14.5%
of net sales in the first nine months of 2002. The decrease in gross profit was
due primarily to a special inventory write-down of $11 million in the second
quarter of 2003. Before this inventory write-down, gross profit decreased by
$6.2 million, or 16.7%, to $30.9 million, or 12.2% of net sales for the first
nine months of 2003. This decrease was caused primarily by low capacity
utilizations at the Mexican plants and the negative impact of closeouts and
fabric sales at low or negative margins.
Selling and distribution expenses increased by $750,000, or 9.4%, to
$8.7 million in the first nine months of 2003 from $8.0 million in the first
nine months of 2002. As a percentage of net sales, these expenses increased from
3.1% for the first nine months of 2002 to 3.4% for the first nine months of
2003.
General and administrative expenses increased by $1.6 million, or 7.4%,
to $23.1 million in the first nine months of 2003 from $21.5 million in the
first nine months of 2002. As a percentage of net sales, these expenses
increased to 9.1% in the first nine months of 2003 from 8.4% in the first nine
months of 2002. The increase in such expenses is primarily due to an increase of
reserves for accounts receivable to $1.3 million in the first nine months of
2003 compared to $936,000 in the first nine months of 2002, and the addition of
$925,000 of additional payroll, pre-production, legal and accounting expenses
related to the launch of our private brand strategy in the first nine months of
2003.
Impairment of assets expense was $22.3 million in the first nine months
of 2003, compared to no expense in the first nine 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 8 to our consolidated financial statements.
20
Operating loss for the first nine months of 2003 was $34.2 million, or
(13.5)% of net sales, compared to operating income of $7.6 million, or 3.0% of
net sales, in the comparable prior period of 2002 as a result of the factors
discussed above.
Interest expense increased by $558,000, or 14.1%, to $4.5 million in
the first nine months of 2003 from $4.0 million in the first nine 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 nine months of 2002 to 1.7% for the same period in 2003. Interest income
was $263,000 in the first nine months of 2003, compared to $230,000 in the first
nine months of 2002. Other income was $1.6 million in the first nine months of
2003, compared to $1.9 million in the first nine months of 2002. This income
consisted mainly of lease income of $917,000 and a realized exchange gain
relating to Euro denominated debts of $124,000 in the first nine months of 2003
versus a realized exchange gains relating to Euro denominated debts of $907,000
and a $301,000 settlement gain from the litigation with Fortis Bank and NCM in
the first nine months of 2002. Other expense was $1.2 million in the first nine
months of 2003, compared to $1.6 million in the first nine months of 2002. This
expense consisted mainly of loss incurred from disposal of fixed assets for
$687,000 and royalty expense of $196,000 in the first nine months of 2003
compared to an unrealized exchange loss of $839,000 and royalty expense of
$534,000 in the first nine months of 2002.
Net income from minority interest in the first nine months of 2003 was
$3.8 million representing $2.6 million of profit shared by the 49.9% minority
partner in the UAV joint venture, offset by $2.0 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 nine months of 2002, minority interest expense
was $2.6 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
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 September 30, 2003 (in millions):
CONTRACTUAL OBLIGATIONS PAYMENTS DUE BY PERIOD
- -------------------------------- ----------------------------------------------
LESS BETWEEN BETWEEN AFTER
THAN 2-3 4-5 5
TOTAL 1 YEAR YEARS 4- YEARS YEARS
------ ------ ------ ------ ------
Long-term debt ................. $ 62.2 $ 17.7 $ 44.5 $ 0 $ 0
Operating leases ............... 10.4 2.3 2.6 2.6 2.9
------ ------ ------ ------ ------
Total contractual cash
obligations .................. $ 72.6 $ 20.0 $ 47.1 $ 2.6 $ 2.9
====== ====== ====== ====== ======
Guarantees have been issued since 2001 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.
21
AMOUNT OF COMMITMENT EXPIRATION PER PERIOD
--------------------------------------------
TOTAL
COMMERCIAL COMMITMENTS AMOUNTS
AVAILABLE TO US AS OF COMMITTED LESS THAN BETWEEN BETWEEN AFTER
SEPTEMBER 30, 2003 TO US 1 YEAR 2-3 YEARS 4- 5 YEARS 5 YEARS
- ----------------------- ------- -------- --------- ---------- -------
Lines of credit........ $ 125.0 $ 42.0 $ 83.0 $ -- $ --
Letters of credit
(within lines of
credit).............. $ 27.9 $ 27.9 $ -- $ -- $ --
Total commercial
commitments.......... $ 125.0 $ 42.0 $ 83.0 $ -- $ --
During the first nine months of 2003, net cash provided by operating
activities was $5.2 million, as compared to $7.5 million for the same period in
2002. Net cash inflow from operating activities in 2003 was caused by the
operating loss of $36.3 million offset by depreciation and amortization of $11.9
million, asset impairment of $22.3 million and inventory write-down of $11.0
million. In addition, increases of $6.2 million in accounts receivable and $11.1
million in inventory were offset by increases of $17.5 million in accounts
payable and $3.0 million in accrued expenses and income tax payable.
During the first nine months of 2003, net cash used in investing
activities was $1.3 million, as compared to $2.7 million for the same period in
2002. Cash used in investing activities in 2003 included approximately $1.8
million of increase in other assets and $759,000 of repayments of advances from
shareholders/officers.
During the first nine months of 2003, net cash used in financing
activities was $4.4 million, as compared to $4.3 million for the same period in
2002. Cash provided by financing activities in 2003 included $11.8 million of
short-term bank borrowings and $193.8 million of proceeds from long-term
obligations, offset by cash used of $209.4 million of payments of long-term
obligations and bank borrowings.
As of September 30, 2003, Tarrant Mexico, Famian division had paid down
all advances from Banco Bilbao Vizcaya. 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. The repayment schedule was
revised to $250,000 per month in September 2003. As of September 30, 2003, $2.9
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 September
30, 2003 were $4.3 million due to GE Capital and $1.3 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 of $30 million,
leverage ratio of not more than two times at the end of each financial year, and
no losses for two consecutive quarters. As additional collateral to secure
repayment of amounts outstanding under the GE Capital facilities, Gerard Guez
and Todd Kay agreed to provide GE Capital with a second lien on the Company's
headquarters, which is owned by Messrs. Guez and Kay. The second lien on the
Company's headquarters will be released upon Company returning to profitability
in the third and fourth quarter of 2003. The BOA facility is subject to certain
financial benchmarks on debt service coverage and a leverage ratio. In October
2003, the Company paid off the BOA facility in its entirety.
On January 21, 2000, we entered into a 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
million, including a letter of credit facility not to exceed $20 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 our 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 million facility to $90 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 October 2003, we
established new financial covenants with GMAC for the period ended September
30,2003 and the remainder of fiscal 2003 based on our projections. Tangible Net
Worth, Fixed Charge Ratio and Leverage Ratio were fixed at $65 million, 0.75
22
to 1 and 3 to 1 respectively for the third quarter and $65 million, 0.74 to 1
and 2.55 to 1 respectively for the fourth quarter of 2003. A total of $49.2
million was outstanding under the Debt Facility at September 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 plus the deposit of
$15 million worth of export letters of credit. This temporary facility expired
on September 1, 2003 while the expiry date of the main credit line of $25
million has been extended to December 1, 2003. In October 2003, UPS and we
established new financial covenants for the period ended September 30, 2003 and
the remainder of the fiscal year based on our projections. Tangible Net Worth,
Fixed Charge Ratio and Leverage Ratio were fixed at $65 million, 0.75 to 1 and 3
to 1 respectively for the third quarter and $65 million, 0.74 to 1 and 2.55 to 1
respectively for the fourth quarter of 2003. As of September 30, 2003, $27.8
million was outstanding under this facility of which $14.9 million was letters
of credit.
Since March 2003, DBS Bank (Hong Kong) Limited (formerly known as Dao
Heng Bank) 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, which
is owned by Gerard Guez and Todd Kay and the Company's guarantee. The facility
was increased to HKD 23 million (equivalent to US $3.0 million) in August 2003.
As of September 30, 2003, $2.0 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,
$4.6 million was outstanding as of September 30, 2003. Of the $4.6 million, $3.0
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.
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 September 30, 2003, $6.0 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 third quarter of 2003 was $384,000. The greatest outstanding
balance of such advances to Mr. Guez during the third quarter of 2003 was
approximately $4,856,000. As of September 30, 2003, we were indebted to Mr. Kay
and Mr. Nacif in the amount of $366,000 and $5.6 million, respectively. Mr. Guez
had an outstanding advance from us in the amount of $4,843,000 as of September
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.
23
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, Vice Chairman 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 $997,000 in the nine months period ended September 30, 2003, for rent for
office and warehouse facilities.
On October 16, 2003, we leased to affiliates of Mr. Kamel Nacif, a
substantial portion of our manufacturing facilities and operations in Mexico
including real estate and equipment. We leased our twill mill in Tlaxcala,
Mexico, and our sewing plant in Ajalpan, Mexico, for a period of 6 years and for
an annual rental fee of $11 million. Mr. Nacif is a significant stockholder of
the Company. In connection with this transaction, we also entered into a
management services agreement pursuant to which Mr. Nacif's affiliates will
manage the operation of our remaining facilities in Mexico. The term of the
management services agreement is also for a period of 6 years. We have agreed to
purchase annually, 6 million yards of fabric manufactured at the facilities
leased and/or operated by Mr. Nacif's affiliates at negotiated market price.
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 third quarter of 2003 was $384,000. The greatest outstanding
balance of such advances to Mr. Guez during the third quarter of 2003 was
approximately $4,856,000. As of September 30, 2003, we were indebted to Mr. Kay
and Mr. Nacif in the amount of $366,000 and $5.6 million, respectively. Mr. Guez
had an outstanding advance from us in the amount of $4,843,000 as of September
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.
Since June 2003, United Apparel Venture LLC has been selling to Seven
Licensing Company, LLC ("Seven Licensing"), jeans wear bearing the brand
"Seven7", which is ultimately purchased by Express. Seven Licensing is
beneficially owned by Gerard Guez. In the nine months period ended September 30,
2003, total sales was $8.4 million and $2.5 million was open as trade receivable
as of September 30, 2003.
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 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
24
shares became convertible into three million shares of common stock following
approval by our common stockholders of the conversion; (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.
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 $14.3 million of trim inventory
from Tag-It during the nine months ended September 30, 2003. We also sold Tag-It
$1.6 million from our trim inventory during the nine months ended September 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.
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 13.5% and 10.2% of our net sales for the
first nine months of 2003 and 2002, respectively. Lane Bryant accounted for
25
12.2% and 20.0% of our net sales for the first nine months of 2003 and 2002,
respectively. Lerner New York accounted for 7.2% and 10.7% of our net sales for
the first nine months of 2003 and 2002, respectively. Kohl accounted for 6.1%
and 5.4% of our net sales for the first nine 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. 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 consummated
effective September 1, 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, which would have an
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;
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.