UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS
PURSUANT TO SECTIONS 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2003
or
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ______ to _______
Commission File Number: 0-26430
TARRANT APPAREL GROUP
(Exact name of registrant as specified in its charter)
CALIFORNIA 95-4181026
(State or other jurisdiction (I.R.S. Employer
of 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
Securities registered pursuant to Section 12(b) of the Act:
NONE
Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK
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 if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [_]
Indicate by check mark whether the registrant is an accelerated
filer (as defined in Rule 12b-2 of the Act). Yes [_] No [X]
As of June 30, 2003, the aggregate market value of the Common Stock
held by non-affiliates of the Registrant was approximately $16,804,979 based
upon the closing price of the Common Stock on that date.
Number of shares of Common Stock of the Registrant outstanding as of
March 26, 2004: 28,814,763.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's definitive Proxy Statement to be filed
with the Securities and Exchange Commission pursuant to Regulation 14A in
connection with the 2004 Annual Meeting of Shareholders are incorporated by
reference into Part III of this Report.
PART I
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
This 2003 Annual Report on Form 10-K contains statements which
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. Those statements include statements regarding our intent,
belief or current expectations. Prospective investors are cautioned that any
such forward-looking statements are not guarantees of future performance and
involve risks and uncertainties, and that actual results may differ materially
from those projected in the forward-looking statements. Such risks and
uncertainties include, among other things, our ability to face stiff
competition, profitably manage a sourcing and distribution business, the
financial strength of our major customers, the continued acceptance of our
existing and new products by our existing and new customers, dependence on key
customers, the risks of foreign manufacturing, competitive and economic factors
in the textile and apparel markets, the availability of raw materials, the
ability to manage growth, weather-related delays, dependence on key personnel,
general economic conditions, China's entry into World Trade Organization, or
"WTO", global manufacturing costs and restrictions, and other risks and
uncertainties that may be detailed herein. See "Item 7. Management's Discussion
and Analysis of Financial Condition and Results of Operations--Factors That May
Affect Future Results."
ITEM 1. BUSINESS
OVERVIEW
Tarrant Apparel Group is a leading provider of casual apparel, serving
mass merchandisers, department stores, branded wholesalers and specialty chains
located primarily in the United States by designing, merchandising, contracting
for the manufacture of, manufacturing directly and selling casual apparel for
women, men and children. Our major customers include specialty retailers, such
as Express, a division of The Limited, as well as Lane Bryant, Lerner New York,
J.C. Penney, K-Mart, Kohl's, Mervyn's and Wal-Mart. Our products are
manufactured in a variety of woven and knit fabrications and include jeans wear,
casual pants, t-shirts, shorts, blouses, shirts and other tops, dresses and
jackets.
In 2001, our net sales decreased by 16.4% to $330 million. In 2002, our
net sales increased by 5.2% to $347 million. In 2003, our net sales decreased by
7.8% to $320 million. In 2001 and 2002, we experienced a net loss of $2.9
million and $1.2 million, respectively, before cumulative effect of accounting
change due to our adoption of SFAS No. 142, and $2.9 million and $6.1 million,
respectively, after the cumulative effect of accounting change. In 2003, we
experienced a net loss of $35.9 million. See "Item 7. Management's Discussion
and Analysis of Financial Condition and Results of Operations--Results of
Operations."
During 2003, we launched our private brands initiative, where we
acquire ownership of or exclusively license rights to a brand name and sell
apparel products under this brand to a single retail company within a geographic
region. In the second quarter of 2003, we acquired an equity interest in the
owner of the trademark "American Rag CIE," and the operator of American Rag
retail stores, and our subsidiary, Private Brands, Inc., acquired a license to
certain exclusive rights to this trademark. Private Brands then 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 designs and manufactures a full collection of American Rag
apparel exclusively for sale in Federated stores across the country. Beginning
in August 2003, the American Rag collection is available in approximately 100
select Macy's, the Bon Marche, Burdines, Goldsmith's, Lazarus and
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Rich's-Macy's locations. During 2003, we also began selling products under our
own brand "No Jeans" exclusively to Wet Seal.
Commencing September 1, 2003, we ceased directly operating nearly all
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, one of our shareholders. See "-- 2003 Restructuring."
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 million,
after payment of commissions and expenses. We used the proceeds of this offering
to accounts payable and reduce debts. The preferred stock was converted into an
aggregate of 8,817,320 shares of common stock following a special meeting of
shareholders held on December 4, 2003.
2003 RESTRUCTURING
At inception, we relied on independent contract manufacturers located
primarily in the Far East to produce the merchandise we sold to our customers.
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 vertically integrated manufacturing company, and commencing
September 1, 2003, we ceased directly operating nearly all 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,
one of our shareholders. We made our determination based on many factors,
including the following:
o Our vertical integration strategy in Mexico required
significant working capital, which required us to
significantly increase debt to finance our Mexico operations.
Such financing was not available to us on commercially
reasonable terms.
o We faced 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 reduced our
overall average gross margin.
o The elimination of quotas on WTO, member countries by 2005,
and the other effects of trade agreements among WTO countries,
would soon 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.
3
Our withdrawal from our owned and operated facilities in Mexico on
September 1, 2003, has reduced our working capital requirements, eliminated the
need to accept low or negative margin orders to fill production capacity, and
permitted us to source production in the best locations world-wide. We 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 at reduced
prices. See Note 7 of the "Notes to Consolidated Financial Statements."
BUSINESS STRATEGY
We believe that the following trends are currently affecting apparel
retailing and manufacturing:
o There is a decline in the dominance of the casual apparel
trend and the emergence of more upscale looks, which has put
pressure on the moderately priced casual apparel segment.
o Consolidation among apparel retailers has increased their
ability to demand value-added services from apparel
manufacturers, including fashion expertise, rapid response,
just-in-time delivery, Electronic Data Interchange and
favorable pricing.
o Increased competition among retailers due to consolidation has
resulted in an increased demand for private label and private
brand apparel, which generally offers retailers higher margins
and permits them to differentiate their products.
o The current fashion cycle requires more design and product
development, in addition to quickly responding to emerging
trends. Apparel manufacturers that offer these capabilities
are in demand.
We believe that we have the capabilities to take advantage of these
trends and remain a principal value-added supplier of casual, moderately priced
apparel as well as increase our share of the more upscaled market segment due to
the following:
DESIGN EXPERTISE. As one of the very few sourcing companies with our
own design team, we believe that we have established a reputation with our
customers as a fashion resource and manufacturer that is capable of providing
design assistance to customers in the face of rapidly changing fashion trends.
RESEARCH AND DEVELOPMENT CAPABILITIES. We believe our design team and
our two sample rooms in Los Angeles and China have made significant
contributions to customers in developing new fabrics, washes and finishes.
SAMPLE-MAKING AND MARKET-TESTING CAPABILITIES. We seek to support
customers with our design expertise, sample-making capability and ability to
rapidly produce small test orders of products.
ON-TIME DELIVERY. We have developed a diversified network of
international contract manufacturers and fabric suppliers which enable us to
accept orders of varying sizes and delivery schedules and to produce a broad
range of garments at varying prices depending upon lead time and other
requirements of the customer.
QUALITY AND COMPETITIVELY PRICED PRODUCTS. We believe that our long
time presence in the Far East and our experienced product management teams
provide a superior supply chain that enables us to meet the individual needs of
our customers in terms of quality and lead time.
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PRODUCT DIVERSIFICATION. Our experiencing in designing and delivering
complete apparel collections for some of our customers has improved our overall
ability to deliver product classifications beyond our core casual bottoms
offerings, which has further diversified the merchandise we offer to other
customers.
PRODUCTS
Women's jeans historically have been, and continue to be, our principal
product. In recent years, we have expanded our sales of moderately priced
women's apparel to include casual, denim and non-denim, including twill, woven
tops and bottoms, and in 1998, we commenced the sales of men's and children's
apparel. Our women's apparel products currently include jeans wear, casual
pants, t-shirts, shorts, blouses, shirts, knits and sweaters, dresses and
jackets. These products are manufactured in petite, standard and large sizes and
are sold at a variety of wholesale prices generally ranging from less than $3.0
to over $50.0 per garment.
Over the past three years, approximately 72% of net sales were derived
from the sales of pants and jeans, approximately 7% from the sale of shorts and
approximately 5% from the sale of shirts. The balance of net sales consisted of
sales of skirts, dresses, jackets and other products.
CUSTOMERS
We generally market our products to high-volume retailers that we
believe can grow into major accounts. By limiting our customer base to a select
group of larger accounts, we seek to build stronger long-term relationships and
leverage our operating costs against large bulk orders. Although we continue to
diversify our customer base, the majority of any growth in sales is expected to
come from existing customers.
The following table shows the percentage of our net sales in fiscal
years 2001, 2002 and 2003 attributable to each customer that accounted for more
than 5% of net sales.
PERCENTAGE OF NET SALES
---------------------------------
CUSTOMER 2001 2002 2003
- ------------------------------------ ------ ------ ------
The Limited (1) .................... 14.3 12.7 15.3
Lane Bryant ........................ 20.5 17.6 12.1
Lerner New York (2) ................ 8.5 9.9 8.3
Wal-Mart ........................... 12.2 9.7 8.7
Tommy Hilfiger ..................... 7.8 17.4 6.7
Kohl's ............................. 1.7 5.1 6.6
Mervyn's ........................... 7.9 7.3 5.9
- ----------
(1) Includes Express and Limited stores.
(2) Sold by Limited Brands Inc. in November 2002.
In the same periods, virtually all of our sales were of private label
apparel and several major international brands. We currently serve over 25
customers, which, in addition to those identified above, include, Wet Seal, J.C.
Penney, K-Mart, and Seven Licensing Company, LLC. During 2003, we launched our
private brands initiative, where we acquire ownership of or exclusively license
rights to a brand name and sell apparel products under this brand to a single
retail company within a geographic region. We sell products under our
company-owned brand "No Jeans" exclusively to Wet Seal, and our licensed brand
"American Rag Cie" to Federated stores. Additionally, we manufacture branded
merchandise for several major designers.
5
We do not have long-term contracts with any of our customers and,
therefore, there can be no assurance that any customer will continue to place
orders with us of the same magnitude as it has in the past, or at all. In
addition, the apparel industry historically has been subject to substantial
cyclical variation, with consumer spending for purchases of apparel and related
goods tending to decline during recessionary periods. To the extent that these
financial difficulties occur, there can be no assurance that our financial
condition and results of operations would not be adversely affected. See "Item
7. Management's Discussion and Analysis of Financial Condition and Results of
Operations--Factors That May Affect Future Results."
DESIGN, MERCHANDISING AND SALES
While many private label producers only arrange for the bulk production
of styles specified by their customers, we not only design garments, but also
assist some of our customers in market testing new designs. We believe that our
design, sample-production and test-run capabilities give us a competitive
advantage in obtaining bulk orders from our customers. We also often receive
bulk orders for garments we have not designed because many of our customers
allocate bulk orders among more than one producer.
We have developed integrated teams of design, merchandising and support
personnel, some of whom serve on more than one team, that focus on designing and
producing merchandise that reflects the style and image of their customers.
Teams are divided between private label and private brands for sourcing
operations.
Each team is responsible for all aspects of its customer's needs,
including designing products, developing product samples and test items,
obtaining orders, coordinating fabric choices and procurement, monitoring
production and delivering finished products. The team seeks to identify
prevailing fashion trends that meet its customer's retail strategies and design
garments incorporating those trends. The team also works with the buyers of its
customer to revise designs as necessary to better reflect the style and image
that the customer desires to project to consumers. During the production
process, the team is responsible for informing the customer about the progress
of the order, including any difficulties that might affect the timetable for
delivery. In this way, our customer and we can make appropriate arrangements
regarding any delay or other change in the order. We believe that this team
approach enables our employees to develop an understanding of the customer's
distinctive styles and production requirements in order to respond effectively
to the customer's needs. During 2000, we opened an office in Bentonville,
Arkansas to support this approach and better service the needs of Wal-Mart.
As part of our merchandising strategy, we produce, at our own expense,
four collections a year in order to offer new designs and fabrics for customers
that rely on us for fashion direction. We produce samples at our facilities in
Guangdong Province, China and in Los Angeles, California. The facilities in
China and Los Angeles currently furnish the majority of our sample requirements.
From time to time and at scheduled seasonal meetings, we present these
samples to the customer's buyers who determine which, if any, of the samples
will be produced on a test run or a bulk order. Samples are often presented in
coordinated groupings or as part of a product line. Some customers, particularly
specialty retail stores such as divisions of The Limited, may require that a
product be tested before placing a bulk order. Testing involves the production
of as few as several hundred copies of a given sample in different size, fabric
and color combinations. The customer pays for these test items, which are placed
in selected stores to gauge consumer response. The production of test items
enables our customers to identify garments that may appeal to consumers and also
provides us with important information regarding the cost and feasibility of the
bulk production of the tested garment. If the test is determined to be
successful, we generally receive a significant percentage of the customer's
total bulk
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order of the tested item. In addition, as is typical in the private label
business, we receive bulk production orders to produce merchandise designed by
our competitors or other designers, since most customers allocate bulk orders
among a number of suppliers.
SOURCING
GENERAL
When bidding for or filling an order, our international sourcing
network enables us to choose from among a number of suppliers and manufacturers
based on the customer's price requirements, product specifications and delivery
schedules. Historically, we manufactured our products through independent
cutting; sewing and finishing contractors located primarily in Hong Kong and
China, and have purchased our fabric from independent fabric manufacturers with
weaving mills located primarily in Hong Kong and China. In recent years, we have
expanded our network to include suppliers and manufacturers located in a number
of additional countries, including India, Peru, Thailand, Egypt and Mexico.
Before we ceased manufacturing in Mexico on September 1, 2003, we sourced more
than 50% of our merchandise annually from our factories in Mexico. Our sourcing
strategy is based on a strong presence in Hong Kong and China, and expansion of
our Indonesia and India manufacturing network in the Far East. We are also
expanding our Western Hemisphere production in Peru and other Central and South
American countries, and continue to source production in Mexico. The following
table sets forth the percentage of our merchandise, on the basis of the free on
board cost at the supplier's plant, or FOB Basis, by country for the periods
indicated:
2001 2002 2003
----- ----- -----
INTERNATIONAL SOURCING:
Hong Kong and China ............... 29.3% 25.3% 28.6%
Other (1) ......................... 9.5% 13.3% 24.4%
DOMESTIC SOURCING:
United States ..................... 9.3% 6.1% 4.4%
Mexico and Central America ........ 51.9% 55.3% 42.6%
----------
(1) In 2003, such countries consisted of Thailand, Egypt, Bangladesh,
Macau, Mongolia, Nepal, the Philippines and Vietnam.
DEPENDENCE ON CONTRACT MANUFACTURERS
The use of contract manufacturers and the resulting lack of direct
control over the production of our products could result in our failure to
receive timely delivery of products of acceptable quality. Although we believe
that alternative sources of cutting, sewing and finishing services are readily
available, the loss of one or more contract manufacturers could have a
materially adverse effect on our results of operations until an alternative
source can be located and commence producing our products.
Although we have adopted a code of vendor conduct and monitor the
compliance of our independent contractors with our code of conduct and
applicable labor laws, we do not control our contractors or their labor
practices. The violation of federal, state or foreign labor laws by one of our
contractors can result in us being subject to fines and our goods, which are
manufactured in violation of such laws, being seized or their sale in interstate
commerce being prohibited. Additionally, certain of our customers may refuse to
do business with us based on our contractors' labor practices. From time to
time, we have been notified by federal, state or foreign authorities that
certain of our contractors are the subject of investigations or have been found
to have violated applicable labor laws. To date, we have not been subject to any
sanctions that, individually or in the aggregate, have had or could have a
material
7
adverse effect upon us, and we are not aware of any facts on which any such
sanctions could be based. There can be no assurance, however, that in the future
we will not be subject to sanctions or lose business from our customers as a
result of violations of applicable labor laws by our contractors, or that such
sanctions or loss of business will not have a material adverse effect on us. In
addition, our customers require strict compliance by their apparel
manufacturers, including us, with applicable labor laws. To that end, we are
regularly inspected by some of our major customers. There can be no assurance
that the violation of applicable labor laws by one of our contractors will not
have a material adverse effect on our relationship with our customers.
Except for a commitment to purchase six million yards of fabric
annually manufactured at the facilities in Mexico which we have leased to a
related third party, we do not have any long-term contracts with independent
fabric suppliers. The loss of any of our major fabric suppliers could have a
material adverse effect on our financial condition and results of operations
until alternative arrangements are secured.
DIVERSIFIED PRODUCTION NETWORK
We believe that we have the ability, through our production network, to
operate on production schedules with lead times as short as 30 days. Typically,
our specialty retail customers attempt to respond quickly to changing fashion
trends and are increasingly less willing to assume the risk that goods ordered
on long lead times will be out of fashion when delivered. These retailers,
including divisions of The Limited, frequently require production schedules with
lead times ranging from 30 to 120 days. Although mass merchandisers, such as
Wal-Mart, are beginning to operate on shorter lead times, they are occasionally
able to estimate their needs as much as six months to nine months in advance for
"program" business--basic products that do not change in style significantly
from season to season. Our ability to operate on production schedules with a
wide range of lead times helps us to meet our customers' varying needs.
By allocating an order among different manufacturers, we seek to fill
the high-volume orders of our customers, while meeting their delivery
requirements. Upon receiving an order, we determine which of our suppliers and
manufacturers (both owned and third party contractors) can best fill the order
and meet the customer's price, quality and delivery requirements. We consider,
among other things, the price charged by each manufacturer and the
manufacturer's available production capacity to complete the order, as well as
the availability of quota for the product from various countries and the
manufacturer's ability to produce goods on a timely basis subject to the
customer's quality specifications. Our personnel also consider the
transportation lead times required to deliver an order from a given manufacturer
to the customer. In addition, some customers prefer not to carry excess
inventory and therefore require that we stagger the delivery of products over
several weeks.
INTERNATIONAL SOURCING
We conduct and monitor our sourcing operations from our international
offices. At December 31, 2003, we had offices in Hong Kong, Thailand and Mexico.
The staffs at these locations have extensive knowledge about, and experience
with, sourcing and production in their respective regions, including purchasing,
manufacturing and quality control. Several times each year, members of our
senior management, including local staff, visit and inspect the facilities and
operations of our international suppliers and manufacturers.
Foreign manufacturing is subject to a number of risk factors,
including, among other things, transportation delays and interruptions,
political instability, expropriation, currency fluctuations and the imposition
of tariffs, import and export controls, other non-tariff barriers (including
changes in the
8
allocation of quotas), natural disasters and cultural issues Each of these
factors could have a material adverse effect on us.
While we are in the process of establishing business relationships with
manufacturers and suppliers located in countries other than Hong Kong or China,
such as in India, Peru, Thailand and Central America, we still primarily
contract with manufacturers and suppliers located in Hong Kong and China for our
international sourcing needs, and currently expect that we will continue to do
so for the foreseeable future. Any significant disruption in our operations or
our relationships with our manufacturers and suppliers located in Hong Kong or
China could have a material adverse effect on us.
THE IMPORT SOURCING PROCESS
As is customary in the apparel industry, we do not have any long-term
contracts with our manufacturers. During the manufacturing process, our quality
control personnel visit each factory to inspect garments when the fabric is cut,
as it is being sewn and as the garment is being finished. Daily information on
the status of each order is transmitted from the various manufacturing
facilities to our offices in Hong Kong and Los Angeles. We, in turn, keep our
customers apprised, often through daily telephone calls and frequent written
reports. These calls and reports include candid assessments of the progress of a
customer's order, including a discussion of the difficulties, if any, that have
been encountered and our plans to rectify them.
We often arrange, on behalf of manufacturers, for the purchase of
fabric from a single supplier. We have the fabric shipped directly to the
cutting factory and invoice the factory for the fabric. Generally, the factories
pay us for the fabric with offsets against the price of the finished goods. For
our longstanding program business, we may purchase or produce fabric in advance
of receiving the order, but in accordance with the customer's specifications. By
procuring fabric for an entire order from one source, we believe that production
costs per garment are reduced and customer specifications as to fabric quality
and color can be better controlled.
The anti-terrorist measures adopted by the U.S. government and in
particular, by the U.S. Customs, have meant more stringent inspection processes
before imported goods are cleared for delivery into the U.S. In some instances,
these measures have caused delays in the pre-planned delivery of products to
customers.
DISTRIBUTION
Based on our world wide sourcing capability and in order to properly
fulfill orders, we have tailored our distribution system to meet the needs of
the customer. Some customers, like Wal-Mart and Kohl's, use Electronic Data
Interchange, or "EDI", to send orders and receive merchandise and invoices. The
EDI distribution function has been centralized in our Los Angeles corporate
headquarters in order to expedite and control the flow of merchandise and
electronic information, and to insure that the special requirements of our EDI
customers are met.
For orders sourced outside the United States and Mexico, the
merchandise is shipped from the production facility by truck to a port where it
is consolidated and loaded on containerized vessels for ocean transport to the
United States. For customers with West Coast and Mid West distribution centers,
the merchandise is brought into the port of Los Angeles. After Customs
clearance, the merchandise is shipped by truck to either our Los Angeles
warehouse facility or an independent bonded warehouse in Ohio. Proximity to the
customer's distribution center is important for customer support. For
merchandise produced in the Middle East and destined for an East Coast customer
distribution center, the port of entry is New York. After Customs clearance, the
merchandise is trucked to an independent public warehouse
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in New Jersey. The independent warehouses are instructed in writing by the Los
Angeles office when to ship the merchandise to the customer.
BACKLOG
As of March 22, 2004, we had unfilled customer orders of approximately
$67 million as compared to approximately $135 million as of February 26, 2003.
We believe that all of our backlog of orders as of March 22, 2004 will be filled
before the end of the third quarter of fiscal 2004. Backlog is based on our
estimates derived from internal management reports. The amount of unfilled
orders at a particular time is affected by a number of factors, including the
scheduling of manufacturing and shipping of the product, which in some
instances, depends on the customer's requirements. Accordingly, a comparison of
unfilled orders from period to period is not necessarily meaningful and may not
be indicative of eventual annual bookings or actual shipments. Our experience
has been that the cancellations, rejections or returns of orders have not
materially reduced the amount of sales realized from our backlog.
SEGMENT INFORMATION
Our predominant business is the design, distribution and importation of
private label and private brand casual apparel. Substantially all our revenues
are from the sales of apparel. We are organized into three geographic regions:
the United States, Asia and Mexico. We evaluate performance of each region based
on profit or loss from operations before income taxes not including the
cumulative effect of change in accounting principles. For information regarding
the revenues and assets associated with our geographic regions, see Note 15 of
the "Notes to Consolidated Financial Statements."
IMPORT RESTRICTIONS
QUOTAS
We imported approximately 96% of our products sold in 2003.
Approximately 37% of this merchandise was imported from Mexico, which is subject
to special rules under NAFTA. NAFTA allows for the duty and quota free entry
into the United States of certain qualifying merchandise. We have been able to
avail ourselves of such preferential duty treatment for many of the products we
import from Mexico. While quotas have expired on non-qualifying Mexican origin
apparel at the end of 2003, most of such merchandise remains subject to duty.
A majority of the balance of the merchandise imported by us in 2003 was
manufactured in various countries (e.g., China) with which the U.S. has entered
into bilateral trade agreements. These agreements impose, among other things,
certain quantitative restraints (i.e., quotas) on textile and apparel in various
categories that can be imported into the U.S. from that country during a
particular quota year. Accordingly, our operations are subject to the
restrictions imposed by these trade agreements.
As of 2005, quota on apparel from all WTO countries, including China,
will be eliminated. As China is now a member of the WTO, its exports of textiles
and apparel to the U.S. will be covered by the WTO Agreement on Textiles and
Clothing, see "Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations." However, various statutory mechanisms
exist which could be invoked by the United States in order to impose "safeguard"
measures (i.e., additional duties or quotas) upon imports of products from
China. These measures arise out of the accession agreement that allowed China to
join the WTO. For example, the China textile "safeguard" authorizes the
imposition of quotas in response to a textile or apparel product of China being
imported into the United States in such increased quantities or under such
conditions as to cause or threaten to cause market disruption.
10
In 2003, approximately 22% of the product imported by us was of Hong
Kong origin, for which Hong Kong quota was utilized upon import. Certain
non-origin conferring production operations were performed in China in
connection with a large portion of our imported products of Hong Kong origin,
under the so-called Outward Processing Arrangement ("OPA").
DUTIES AND TARIFFS
As with all goods imported into the U.S., our imported merchandise is
subject to duty (unless statutorily exempt from duty) at rates established by
U.S. law. These rates range, depending on the type of product, from
approximately 2% to 61% of the appraised value of the product. In addition to
duties, in the ordinary course of our business, we are occasionally subject to
claims by the U.S. Bureau of Customs and Border Protection for penalties,
liquidated damages and other charges relating to import activities. Similarly,
we are at times entitled to refunds from Customs, resulting from the overpayment
of duties.
Products imported from China into the United States receive the same
preferential tariff treatment accorded goods from other countries granted Normal
Trade Relations ("NTR") status. This status has been in place conditionally for
a number of years and is now guaranteed on a more permanent basis by China's
accession to WTO membership in December 2001.
Our continued ability to source products from foreign countries may be
adversely affected by (or benefited by) future trade agreements and
restrictions, changes in U.S. trade policy, significant decreases in import
quotas, embargoes, the disruption of trade from exporting countries as a result
of political instability or the imposition of additional duties, taxes and other
charges or restrictions on all imports or specified classes of imports.
COMPETITION
There is intense competition in the sectors of the apparel industry in
which we participate. We compete with many other manufacturers, many of which
are larger and have greater resources than us. We also face competition from our
own customers and potential customers, many of which have established, or may
establish, their own internal product development and sourcing capabilities. For
example, The Limited's wholly owned subsidiary, Mast Industries, Inc., competes
with us and other private label apparel suppliers for orders from divisions of
The Limited. We believe that we compete favorably on the basis of design and
sample capabilities, the quality and value of our products, price, and the
production flexibility that we enjoy as a result of our sourcing network.
EMPLOYEES
At December 31, 2003, we had approximately 150 full-time employees in
the United States, 900 in Mexico, 140 in Hong Kong, 110 in China and 10 in
Thailand.
ITEM 2. PROPERTIES
We currently conduct our operations from 15 facilities, 10 of which are
leased. Our executive offices are located at 3151 East Washington Boulevard, Los
Angeles, California 90023. We lease this facility for an annual rent of
approximately $650,000 from a California corporation, which is owned by Mr. Guez
and Mr. Kay. The lease for this facility, under which we are responsible for the
payment of taxes, utilities and insurance, terminated in December 2003. The
lease is currently on a month-to-month basis pending to our planned relocation
to new premises. We also sublease an office at 9000 Sunset Boulevard, Los
Angeles at a base rent of $374,000 per year. Furthermore, we lease 146,000
square feet of warehouse space in South Gate, California for an annual rent of
$399,630 from an unrelated third
11
party. The lease for this facility terminates in March 2004. In Bentonville,
Arkansas, we opened an administrative office during 2000 to handle business
related to Wal-Mart. This facility is leased until 2004 for approximately 2,000
square feet at an annual rent of approximately $32,000. In Columbus, Ohio we
opened an administrative office during 1999 to handle business related to The
Limited. This facility is leased until 2004, for approximately 6,000 square feet
at an annual rental of approximately $74,000. We lease approximately 36,000
square feet of warehouse and office space in Hong Kong for an annual rent of
$674,000 from a Hong Kong corporation that is owned by Mr. Guez and Mr. Kay. The
base rent is subject to increase every two years in accordance with market
rates. The lease for this facility, under which we are responsible for the
payment of taxes, utilities and insurance, expires in June 2004. We lease
approximately 50,000 square feet, which we use to operate our sample-making
facility in Guangdong Province, China. The lease for this facility terminates in
June 2004 and the annual rent is $60,000. We also lease office space in Bangkok,
Thailand to house the small staff we maintain there. We own two facilities in
Ruleville, Mississippi with an aggregate of 70,000 square feet. We also lease
one location in New York City for showroom and sales operations. The square
footage of this location is approximately 9,000 with an annual base rent of
approximately $350,000. This lease expires in 2010. Subsequent to December 31,
2003, we exchanged this lease with a tenant in the same building for a 4,000
square foot office with an annual base rental of approximately $146,000 for 2004
and $150,000 for 2005 to 2007, which lease will expire in 2007. We are currently
renting one storage facility at Tehuacan, Mexico at a monthly rental of $3,500.
No long-term contract has been signed for this lease. See Note 10 and Note 14 in
the relevant section of "Notes to Consolidated Financial Statements" for
additional information with respect to these facilities.
On April 18, 1999, we acquired a 250,000 square foot denim mill in
Puebla, Mexico with an annual capacity of approximately 18 million meters of
denim. On March 29, 2001, we completed the acquisition of a sewing facility in
Ajalpan, Mexico. This facility contains 98,702 square feet. On December 31,
2002, we completed the acquisition of a twill mill facility, which has 1,700,000
square feet, and a capacity of 18 million meters of denim or twill. Commencing
on September 1, 2003, we leased a substantial majority of these premises to an
affiliate of Mr. Kamel Nacif, one of our shareholders, for an annual rental of
$11 million. We have agreed to purchase annually, six million yards of fabric
manufactured at the facilities leased or operated by Mr. Nacif's affiliates at
market prices to be negotiated.
We believe that all of our existing facilities are well maintained, in
good operating condition and adequate to meet our current and foreseeable needs.
ITEM 3. LEGAL PROCEEDINGS
PATRICK BENSIMON
Subsequent to December 31, 2003, we reached a settlement with Patrick
Bensimon relating to claims Mr. Bensimon made against Jane Doe International,
LLC relating to his employment agreement with this company. Jane Doe
International, LLC, which was beneficially owned 51% by us and 49% by Needletex
Inc., was formed for the purpose of acquiring assets from Needletex, Inc., a
company owned by Mr. Bensimon, pursuant to the terms of an Asset Purchase
Agreement. On January 21, 2003, Mr. Bensimon obtained an arbitration award of
$1,425,655 for salary and bonus plus interest accrued thereon and legal fees and
costs to be determined. On April 7, 2003, the panel issued a final award in
favor of Mr. Bensimon confirming the prior interim award and awarding Mr.
Bensimon costs and attorneys fees in the amount of $489,640. On April 28, 2003,
Mr. Bensimon sought a court order confirming the final award. We asked the court
to vacate or modify the final award.
In January 2004, we settled the employment issue with Mr. Bensimon for
$1.2 million in cash and forgiveness of approximately $859,000 in debts owed by
Needletex Inc. As part of the settlement, we received the remaining 49% interest
in Jane Doe International, LLC. An additional expense of approximately $379,000
was made in the fourth quarter of 2003 to cover the forgiveness of debts.
12
At the outset of the dispute, we tendered the claim by Mr. Bensimon to
our insurance carrier, which accepted the tender with a reservation of rights as
to whether coverage existed for the claim. After the interim arbitration award
was made, the insurance carrier denied coverage. After the final award by the
arbitration panel, we made demand on the insurance carrier, which was denied. We
then commenced suit against the insurance carrier in the Los Angeles County
Superior Court for breach of contract and related claims. Subsequent to December
31, 2003, the carrier has settled the case with a cash payment of $330,000.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On December 4, 2003, we held a Special Meeting of Shareholders. At the
Special Meeting, there were 18,597,443 shares entitled to vote, and 14,012,698
shares (75%) were represented at the meeting in person or by proxy. The
following summarizes the vote results for those matters submitted to our
shareholders for action at the Special Meeting:
1. Proposal to approve the issuance of 8,817,320 shares of common
stock issuable upon conversion of the outstanding shares of Series A Convertible
Preferred Stock.
FOR AGAINST ABSTAIN BROKER NON-VOTES
10,076,862 56,393 20,716 3,858,727
2. Proposal to approve an amendment to the Tarrant's Articles of
Incorporation to increase the authorized number of shares of common stock from
35,000,000 to 100,000,000.
FOR AGAINST ABSTAIN BROKER NON-VOTES
13,554,357 245,925 20,816 191,600
3. Proposal to approve the grant of options to purchase 400,000
shares of common stock to Barry Aved, our President.
FOR AGAINST ABSTAIN BROKER NON-VOTES
8,285,152 119,803 25,016 5,582,727
13
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY
NASDAQ NATIONAL MARKET
Our common stock began trading on The NASDAQ Stock Market's National
Market under the symbol "TAGS" on July 24, 1995.
The following table sets forth, for the periods indicated, the range of
high and low sale prices for our common stock as reported by NASDAQ.
Low High
---- ----
2002
- ----
First Quarter................................... 4.65 5.49
Second Quarter.................................. 4.95 6.49
Third Quarter................................... 4.79 6.45
Fourth Quarter.................................. 3.99 5.00
2003
- ----
First Quarter................................... 3.61 4.29
Second Quarter.................................. 2.83 4.03
Third Quarter................................... 2.72 4.10
Fourth Quarter.................................. 3.40 4.70
On March 26, 2004, the last reported sale price of our common stock as
reported by NASDAQ was $1.73. As of March 26, 2004, we had 36 shareholders of
record.
DIVIDEND POLICY
We have not declared dividends on our common stock during either of the
last two fiscal years. We intend to retain any future earnings for use in our
business and, therefore, do not anticipate declaring or paying any cash
dividends in the foreseeable future. The declaration and payment of any cash
dividends in the future will depend upon our earnings, financial condition,
capital needs and other factors deemed relevant by the Board of Directors. In
addition, our credit agreement prohibits the payment of dividends during the
term of the agreement.
14
EQUITY COMPENSATION PLAN INFORMATION
The following table sets forth certain information regarding our equity
compensation plans as of December 31, 2003.
NUMBER OF SECURITIES TO WEIGHTED-AVERAGE EXERCISE NUMBER OF SECURITIES
BE ISSUED UPON EXERCISE PRICE OF OUTSTANDING REMAINING AVAILABLE FOR
OF OUTSTANDING OPTIONS, OPTIONS, WARRANTS AND FUTURE ISSUANCE UNDER EQUITY
WARRANTS AND RIGHTS RIGHTS COMPENSATION PLANS
----------------------- ------------------------- ----------------------------
Equity compensation
plans approved by
security holders ..... 8,926,087 $7.13 2,573,913
Equity compensation
plans not approved by
security holders ..... 881,732 $4.65 --
----------------------- ------------------------- ----------------------------
Total 9,807,819 $6.91 2,573,913
MATERIAL FEATURES OF INDIVIDUAL EQUITY COMPENSATION PLANS NOT APPROVED BY
SHAREHOLDERS
Sanders Morris Harris Inc. acted as placement agent in connection with
our October 2003 private placement financing transaction. As partial
consideration for their services as placement agent, we issued to Sanders Morris
Harris a warrant to purchase 881,732 shares of our common stock at an exercise
price of $4.65 per share. The warrant has a term of 5 years. The warrant vests
and becomes exercisable in full on April 17, 2004. See Note 12 to the "Notes to
Consolidated Financial Statements."
RECENT SALE OF UNREGISTERED SECURITIES
In October 2003, we issued and sold 881,732 shares of Series A
Convertible Preferred Stock (the "Series A Shares"), at $38 per share, to a
group of institutional investors and high net worth individuals and raised an
aggregate of approximately $31 million, after payment of commissions and
expenses. The Series A Shares were converted into an aggregate of 8,817,320
shares of common stock following approval of the conversion by our shareholders
at a special meeting held on December 4, 2003 in accordance with the original
conversion terms. Each of the investors represented to us that the investor was
an "accredited investor" within the meaning of Rule 501 of Regulation D under
the Securities Act of 1933, and that the investor was purchasing the securities
for investment and not in connection with a distribution thereof. The issuance
and sale of the Series A Shares was exempt from the registration and prospectus
delivery requirements of the Securities Act pursuant to Section 4(2) of the
Securities Act and Regulation D promulgated thereunder as a transaction not
involving any public offering. The issuance and sale of the common stock upon
conversion of the Series A Shares was exempt from the registration and
prospectus delivery requirements of the Securities Act pursuant to Section
3(a)(9) of the Securities Act.
In November 2003, we issued an aggregate of 200,000 shares of common
stock to Antonio Haddad Haddad, Miguel Angel Haddad Yunes, Mario Alberto Haddad
Yunes, and Marco Antonio Haddad Yunes in partial settlement of the balance of
approximately $2.5 million in obligations owed these parties arising from our
acquisition of their factories in 1998. Each of these investors represented to
us that the investor was an "accredited investor" within the meaning of Rule 501
of Regulation D under the Securities Act of 1933, and that the investor was
purchasing the securities for investment and not in connection with a
distribution thereof. The issuance and sale of the common stock was exempt from
the registration and prospectus delivery requirements of the Securities Act
pursuant to Section 4(2) of the Securities Act and Regulation D promulgated
thereunder as a transaction not involving any public offering. See Note 12 to
the "Notes to Consolidated Financial Statements."
15
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data is qualified in its entirety by,
and should be read in conjunction with, the other information and financial
statements, including the notes thereto, appearing elsewhere herein.
Year Ended December 31,
------------------------------------------------
1999 2000 2001 2002 2003
-------- -------- -------- -------- --------
(In thousands, except per share data)
Income Statement Data:
Net sales................... $395,341 $395,169 $330,253 $347,391 $320,423
Cost of sales............... 329,131 332,333 277,525 302,082 288,445
-------- -------- -------- -------- --------
Gross profit.............. 66,210 62,836 52,728 45,309 31,978
Selling and distribution
expenses................... 13,692 17,580 14,345 10,757 11,329
General and administrative
expenses................... 25,259 40,327 33,136 30,082 31,767
Amortization of
intangibles(1)(3).......... 2,312 2,840 3,317 -- --
Impairment of assets........ -- -- -- -- 22,277
-------- -------- -------- -------- --------
Income from operations.... 24,947 2,089 1,930 4,470 (33,395)
Interest expense............ (5,771) (9,850) (7,808) (5,444) (5,603)
Interest income............. 396 1,295 3,256 4,748 425
Minority interest........... -- 1,313 (412) (4,581) 3,461
Other income(2)............. 920 1,350 1,853 2,648 4,784
Other expense(2)............ (172) (193) (856) (2,004) (1,425)
-------- -------- -------- -------- --------
Income before provision for
income taxes and cumulative
effect of accounting change 20,320 (3,996) (2,037) (163) (31,753)
Provision for income taxes.. (7,439) 1,478 852 1,051 4,132
-------- -------- -------- -------- --------
Income (loss) before
cumulative effect of
accounting change.......... $ 12,881 $ (2,518) $ (2,889) $ (1,214) $(35,885)
Cumulative effect of
accounting change(3)....... -- -- -- (4,871) --
-------- -------- -------- -------- --------
Net income (loss)........... $ 12,881 $ (2,518) $ (2,889) $ (6,085) $(35,885)
======== ======== ======== ======== ========
Net income (loss) per share -
Basic:
Before cumulative effect of
accounting change......... $ 0.85 $ (0.16) $ (0.18) $ (0.08) $ (1.97)
Cumulative effect of
accounting change......... -- -- -- (0.30) --
-------- -------- -------- -------- --------
After cumulative effect of
accounting change......... $ 0.85 $ (0.16) $ (0.18) $ (0.38) $ (1.97)
Net income (loss) per share -
Diluted:
Before cumulative effect of
accounting change......... $ 0.79 $ (0.16) $ (0.18) $ (0.08) $ (1.97)
Cumulative effect of
accounting change......... -- -- -- (0.30) --
-------- -------- -------- -------- --------
After cumulative effect of
accounting change......... $ 0.79 $ (0.16) $ (0.18) $ (0.38) $ (1.97)
Weighted average shares
outstanding (000)
Basic...................... 15,200 15,815 15,825 15,834 18,215
Diluted.................... 16,314 15,815 15,825 15,834 18,215
As of December 31,
------------------------------------------------
1999 2000 2001 2002 2003
-------- -------- -------- -------- --------
(In thousands)
Balance Sheet Data:
Working capital............. $ 25,196 $ 27,957 $ 25,109 $ 11,731 $(18,018)
Total assets................ 295,042 308,092 288,467 316,444 253,105
Bank borrowings and
long-term obligations...... 99,072 114,439 111,336 106,937 68,587
Shareholders' equity........ 139,403 130,489 125,164 121,161 107,709
- ----------
(1) See "Item 1. Business--Acquisitions."
(2) Major components of Other income (expense) (as presented above) include
rental and lease income, and foreign currency gains or losses. See "Item 7.
Management's Discussion and Analysis of Financial Condition and Results of
Operations".
(3) 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.
16
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis should be read together with the
Consolidated Financial Statements of Tarrant Apparel Group and the "Notes to
Consolidated Financial Statements" included elsewhere in this Form 10-K. This
discussion summarizes the significant factors affecting the consolidated
operating results, financial condition and liquidity and cash flows of Tarrant
Apparel Group for the fiscal years ended December 31, 2001, 2002 and 2003.
Except for historical information, the matters discussed in this Management's
Discussion and Analysis of Financial Condition and Results of Operations are
forward looking statements that involve risks and uncertainties and are based
upon judgments concerning various factors that are beyond our control. See
"Cautionary Statement Regarding Forward-Looking Statements."
OVERVIEW
Tarrant Apparel Group is a leading provider of casual apparel, serving
mass merchandisers, department stores, branded wholesalers and specialty chains
located primarily in the United States by designing, merchandising, contracting
for the manufacture of, manufacturing directly and selling casual apparel for
women, men and children.
We generate revenues from the sale of apparel merchandise to our
customers that we manufacture or have manufactured by third party contract
manufacturers located outside of the United States. Revenues and net loss for
the years ended December 31, 2001, 2002 and 2003 were as follows (dollars in
thousands):
REVENUES AND NET LOSS: 2001 2002 2003
--------- --------- ---------
Net sales ............................... $ 330,253 $ 347,391 $ 320,423
Net loss before cumulative effect of
accounting change .................... $ (2,889) $ (1,214) $ (35,885)
Net loss after cumulative effect of
accounting change .................... $ (2,889) $ (6,085) $ (35,885)
Cash flows for the years ended December 31, 2001, 2002 and 2003 were as
follows (dollars in thousands):
CASH FLOWS: 2001 2002 2003
-------- -------- --------
Net cash provided by operating activities .. $ 30,051 $ 15,493 $ 9,484
Net cash used in investing activities ...... $(15,445) $ (5,670) $ (1,053)
Net cash used in financing activities ...... $(15,916) $ (8,435) $ (6,295)
SIGNIFICANT DEVELOPMENTS IN 2003
RESTRUCTURING OF MEXICAN OPERATIONS
In August 2003, we determined to abandon our strategy of being both a
trading and vertically integrated manufacturing company, and commencing
September 1, 2003, we ceased directly operating nearly all 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,
one of our shareholders. We made our determination based on many factors,
including the following:
17
o Our vertical integration strategy in Mexico required
significant working capital, which required us to
significantly increase debt to finance our Mexico operations.
Such financing was not available to us on commercially
reasonable terms.
o We faced 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 reduced our
overall average gross margin.
o The elimination of quotas on WTO member countries by 2005, and
the other effects of trade agreements among WTO countries,
would soon 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 our owned and operated facilities in Mexico on
September 1, 2003, has reduced our working capital requirements, eliminated the
need to accept low or negative margin orders to fill production capacity, and
permitted us to source production in the best locations world-wide. We 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 at reduced
prices. We will receive $11 million per annum from the lessor of our equipment
and facilities in Mexico over the 6-year term of the leases. We have agreed to
purchase annually, six million yards of fabric manufactured at the facilities
leased and/or operated by Mr. Nacif's affiliates at market prices to be
negotiated. See Note 7 and Note 14 of the "Notes to Consolidated Financial
Statements."
EQUITY FINANCINGS
In October 2003, we sold an aggregate of 881,732 shares of the Series A
Convertible Preferred Stock, at $38 per share, to a group of institutional
investors and high net worth individuals and raised an aggregate of
approximately $31 million, after payment of commissions and expenses. We used
the proceeds of this offering to pay accounts payable and reduce debts . The
preferred stock was converted into an aggregate of 8,817,320 shares of common
stock following a special meeting of shareholders held on December 4, 2003. We
have registered the shares of common stock issued upon conversion of the Series
A Preferred Stock with the Securities and Exchange Commission for resale by the
investors. In conjunction with the private placement transaction, we issued a
warrant to purchase 881,732 shares of common stock to the placement agent. The
warrant is exercisable beginning April 17, 2004 through October 17, 2008 and has
a per share exercise price of $4.65.
In January 2004, we sold an aggregate of 1,200,000 shares of our common
stock at a price of $3.35 per share, for aggregate proceeds to us of
approximately $3.7 million after payment of placement agent fees and other
offering expenses. We used the proceeds of this offering for working capital
purposes. The securities sold in the offering were registered under the
Securities Act of 1933, as amended, pursuant to our effective shelf registration
statement. In conjunction with this public offering, we issued a warrant to
purchase 30,000 shares of our common stock to the placement agent, the warrant
has an exercise price of $3.35 per share, is fully vested and exercisable and
has a term of five years.
PRIVATE BRANDS INITIATIVE
During 2003, we launched our private brands initiative, where we
acquire ownership of or exclusively license rights to a brand name and sell
apparel products under this brand to a single retail company within a geographic
region. In the second quarter of 2003, we acquired an equity interest in the
owner of the trademark "American Rag CIE," and the operator of American Rag
retail stores, and our subsidiary, Private Brands, Inc., acquired a license to
certain exclusive rights to this trademark. Private Brands then entered into a
multi-year exclusive distribution
18
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. Beginning in August 2003, the
American Rag collection is available in approximately 100 select Macy's, the Bon
Marche, Burdines, Goldsmith's, Lazarus and Rich's-Macy's locations. During 2003,
we also began selling products under our owned brand "No Jeans" exclusively to
Wet Seal.
With a private brand relationship, we own and control the brand and
thus build equity in the brand as the product gains acceptance by consumers. In
a private label relationship, we source products for our customers who own and
control the brand and thus benefit from any increase in value of the brand. We
also control the production of private brand merchandise, unlike private label
merchandise where the brand owner controls sourcing. For instance, we
experienced a significant loss of business from Lane Bryant due to a change in
their management and the subsequent shift in their sourcing strategy.
We believe that forming private brand alliances with premier retailers
allows us greater penetration of apparel categories in addition to our core
casual bottoms business. In addition to the increased breadth of
classifications, we have improved our ability to compete for private label from
our private brand. We also receive higher margins for private branded
merchandise, which allows us to be more profitable on the same level of unit
sales.
INTERNAL REVENUE SERVICE AUDIT
In January 2004, the Internal Revenue Service completed its examination
of our Federal income tax returns for the years ended December 31, 1996 through
2001. The IRS has proposed adjustments to increase our income tax payable for
the six years under examination by an aggregate of approximately $14.5 million.
This adjustment would also result in additional state taxes and interest of
approximately $12.6 million. We believe that we have meritorious defenses to and
intend to vigorously contest the proposed adjustments. If the proposed
adjustments are upheld through the administrative and legal process, they could
have a material impact on our earnings and cash flow. We believe we have
provided adequate reserves for any reasonably foreseeable outcome related to
these matters on the balance sheet included in the Consolidated Financial
Statements under the caption "Income Taxes." 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.
While we do not anticipate any requirement to make significant cash
payments in the coming 12 to 18 months to the taxing authorities, we intend to
accumulate a contingency cash reserve from operations to meet a potential cash
outflow upon the ultimate resolution of these matters. Building this cash
reserve will require us to set aside on a periodic basis a significant portion
of our cash from operations, which we do not intend on using for other purposes.
LABOR DIFFICULTIES IN MEXICO
In connection with the restructuring of our Mexican operations, and the
resulting reduction in our Mexican work force, a group of laid off workers
attempted to form a new labor union and organized walkouts and demonstrations at
one of our sewing plants in Ajalpan, Mexico. These demonstrations took place in
August 2003 and were short-lived, but very well publicized. Workers rights
groups picked up the story and began an Internet campaign to publicize the
workers' grievances. In October 2003, a local labor board denied the group's
application to organize a new union. Nevertheless, we have remained the target
of workers rights activists who have picketed our customers, stuffed electronic
mailboxes with inaccurate, protest e-mails, and threatened customers with
retaliation for continuing business with us. While we have defended our position
to our customers, some of our larger customers for Mexico produced jeans wear
have been reluctant to place orders with us in response to actions taken and
contemplated by these activist
19
groups. As a consequence, we project a loss of approximately $75 million in
revenue from sales of Mexico-produced merchandise in 2004.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Management's discussion and analysis of our financial condition and
results of operations are based upon our consolidated financial statements,
which have been prepared in accordance with accounting principles generally
accepted in the United States of America. The preparation of these financial
statements requires us to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenues and expenses, and related disclosures
of contingent assets and liabilities. 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 of the "Notes to Consolidated Financial
Statements."
ACCOUNTS RECEIVABLE--ALLOWANCE FOR RETURNS, DISCOUNTS AND BAD DEBTS
We evaluate the collectibility of accounts receivable and chargebacks
(disputes from the customer) based upon a combination of factors. In
circumstances where we are aware of a specific customer's inability to meet its
financial obligations (such as in the case of bankruptcy filings or substantial
downgrading of credit sources), a specific reserve for bad debts is taken
against amounts due to reduce the net recognized receivable to the amount
reasonably expected to be collected. For all other customers, we recognize
reserves for bad debts and chargebacks based on our historical collection
experience. If collection experience deteriorates (for example, due to an
unexpected material adverse change in a major customer's ability to meet its
financial obligations to us), the estimates of the recoverability of amounts due
us could be reduced by a material amount.
As of December 31, 2003, the balance in the allowance for returns,
discounts and bad debts reserves was $4.2 million, compared to $4.3 million at
December 31, 2002.
INVENTORY
Our inventories are valued at the lower of cost or market. Under
certain market conditions, we use estimates and judgments regarding the
valuation of inventory to properly value inventory. Investory 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:
20
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 December 31, 2003, we have a goodwill balance of $8.6 million, and a
net property and equipment balance of $135.6 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 "-- Significant Developments in 2003 -
Restructuring of Mexican Operations" and Note 7 of the "Notes to 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.
In addition, accruals are also estimated for ongoing audits regarding
U.S. Federal tax issues that are currently unresolved, based on our estimate of
whether, and the extent to which, additional taxes will be due. We routinely
monitor the potential impact of these situations and believe that amounts are
properly accrued for. If we ultimately determine that payment of these amounts
is unnecessary, we will reverse the liability and recognize a tax benefit during
the period in which we determine that the liability is no longer necessary. We
will record an additional charge in our provision for taxes in any period we
determine that the original estimate of a tax liability is less than we expect
the ultimate assessment to be. See Note 9 of the "Notes to Consolidated
Financial Statements" for a discussion of current tax matters.
DEBT COVENANTS
Our debt agreements require the maintenance of certain financial ratios
and a minimum level of net worth as discussed in Note 8 of the "Notes to
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 80% 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 also believe that our lenders would
provide waivers if necessary. However, our expectations
21
of future operating results and continued compliance with other debt covenants
cannot be assured and our lenders' actions are not controllable by us. If
projections of future operating results are not achieved and the debt is placed
in default, we would be required to reduce our expenses, including by curtailing
operations, and to raise capital through the sale of assets, issuance of equity
or otherwise, any of which could have a material adverse effect on our financial
condition and results of operations.
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:
Year Ended
December 31,
-----------------------
2001 2002 2003
----- ----- -----
Net sales........................................... 100.0% 100.0% 100.0%
Cost of sales....................................... 84.0 87.0 90.0
----- ----- -----
Gross profit........................................ 16.0 13.0 10.0
Selling and distribution expenses................... 4.4 3.1 3.5
General and administration expenses................. 10.0 8.6 9.9
Amortization expense(1)(2).......................... 1.0 -- --
Impairment of assets................................ -- -- 7.0
----- ----- -----
Income (loss) from operations....................... 0.6 1.3 (10.4)
Interest expense.................................... (2.4) (1.6) (1.7)
Interest income..................................... 1.0 1.4 0.1
Minority interest................................... (0.1) (1.3) 1.0
Other income........................................ 0.6 0.8 1.5
Other expense....................................... (0.3) (0.6) (0.4)
----- ----- -----
Loss before provision for income taxes
and cumulative effect of accounting change........ (0.6) 0.0 (9.9)
Income taxes........................................ (0.3) (0.3) (1.3)
----- ----- -----
Loss before cumulative effect of accounting
change............................................ (0.9) (0.3) (11.2)
Cumulative effect of accounting change(2)........... -- (1.4) --
----- ----- -----
Net loss............................................ (0.9)% (1.7)% (11.2)%
===== ===== =====
- ----------
(1) Reflects amortization of the excess of cost over fair value of assets.
(2) Reflects the adoption of SFAS No. 142
COMPARISON OF 2003 TO 2002
Net sales decreased by $27.0 million, or 7.8%, from $347.4 million in
2002 to $320.4 million in 2003. The decrease in net sales was largely
attributable to a decrease in Mexican sourced sales from $186.9 million in 2002
to $139.1 million in 2003. The decrease in net sales was offset by additional
revenue of $20.5 million from our private brands.
Gross profit (which consists of net sales less product costs, direct
labor, manufacturing overhead, duty, quota, freight in, brokerage, and
warehousing) for 2003 was $32.0 million, or 10.0% of net sales,
22
compared to $45.3 million, or 13.0 % of net sales, for 2002, representing a
decrease of $13.3 million or 29.4%. The decrease in gross profit as a percentage
of net sales occurred primarily because of an inventory write-down of $11
million in the second quarter of 2003 and severance payments to Mexican workers
of approximately $2.5 million included as part of cost of goods sold in 2003.
This increase in cost of goods sold was partially offset by a reclassification
of depreciation and amortization in fourth quarter of 2003 of $3.2 million to
general and administration expense. Excluding the inventory write-down,
severance payments and reclassification of depreciation and amortization in
2003, gross profit would have decreased by $3.0 million or 6.6% to $42.3 million
or 13.2%.
Selling and distribution expenses increased by $572,000, or 5.3%, from
$10.8 million in 2002 to $11.3 million in 2003. As a percentage of net sales,
these variable expenses increased from 3.1% in 2002 to 3.5% in 2003. The
increase was primarily caused by an overall increase in warehousing and
distribution cost due to the private brands in smaller size shipments.
General and administrative expenses increased by $1.7 million, or 5.6%,
from $30.1 million in 2002 to $31.8 million in 2003. As a percentage of net
sales, these expenses increased from 8.6% in 2002 to 9.9% in 2003. This increase
was primarily caused by the reclassification of $3.2 million of depreciation
from cost of goods sold in the fourth quarter of 2003. The charge for the change
in the allowances for returns and discounts for 2003 was $183,000, or 0.1% of
sales, compared to such charge of $867,000, or 0.2% of sales, during 2002.
Impairment of assets expense was $22.3 million in 2003, compared to
$4.9 million in 2002 being classified as a cumulative effect of accounting
change in accordance with SFAS 142. This expense in 2003 is primarily due to our
decision to cease directly operating a substantial majority of our equipment and
fixed assets in Mexico commencing in the third quarter of 2003. See Note 7 to
the "Notes to Consolidated Financial Statements."
Loss from operations was $33.4 million in 2003, or (10.4)% of net
sales, compared to income from operations of $4.5 million in 2002, or 1.3% of
net sales, due to the factors described above.
Interest expense increased by $159,000, or 2.9%, from $5.4 million in
2002 to $5.6 million in 2003. This increase in interest expense was a result of
an increase in interest rate applicable to our main credit facility. Interest
income was $425,000 in 2003 compared to $4.7 million in 2002. Included in
interest income for 2002 was approximately $4.5 million from a related party
note receivable related to the sale of certain equipment pertaining to the twill
mill which we re-acquired in December 2002. Other income increased by $2.1
million, or 80.7%, from $2.6 million in 2002 to $4.8 million in 2003, due to
$3.7 million of lease income received for our facilities and equipment in Mexico
starting September 1, 2003, offset by a reduction of realized gain on foreign
currency of $819,000. Other expenses decreased from $2.0 million in 2002 to $1.4
million in 2003 due to a reduction in unrealized loss on foreign currency of
$454,000.
Losses allocated to minority interests in 2003 was $3.5 million,
representing the minority partner's share of profit in UAV of $3.5 million,
offset by $7.0 million attributed to the minority shareholder in Tarrant Mexico
for his 25% share in the loss including $4.4 million for his share in the
special write-down on goodwill and inventory of Tarrant Mexico. In 2002, we
allocated $4.6 million of profit to minority interest, which consisted of profit
shared by the minority partner in the UAV joint venture.
Loss before taxes and cumulative effect of accounting change was
$163,000 in 2002 and $31.8 million in 2003, representing 0.0% and (9.9)% of net
sales, respectively. The increase in loss before taxes and cumulative effect of
accounting change was due to the factors discussed above.
Provision for income taxes was $1.1 million in 2002 versus $4.1 million
in 2003. The increase in income tax expense is due to adjustments to the accrual
for potential IRS audits and increases in the valuation allowance.
23
Loss after taxes and cumulative effect of accounting change was $6.1
million in 2002 and $35.9 million in 2003, representing (1.7)% and (11.2)% of
net sales, respectively. Included in the $6.1 million loss in 2002 was a
non-cash charge of $4.9 million to reduce the carrying value of goodwill to the
estimated fair value, resulting from adoption of SFAS No. 142, "Goodwill and
Other Intangible Assets." Included in the $35.9 million loss in 2003 were
non-cash charges of $22.3 million for the impairment of assets and an inventory
write-down of $11 million.
COMPARISON OF 2002 TO 2001
Net sales increased by $17.1 million, or 5.2%, from $330.3 million in
2001 to $347.4 million in 2002, primarily due to the success of United Apparel
Venture, LLC. The increase in net sales was attributed to $34.6 million increase
in sales to Tommy Hilfiger, one of the two customers of UAV, and $12 million to
Kohl's. The increase in sales to these two customers was offset by decreases of
$6.4 million in sales to Charming group, $2.9 million to mass merchandisers, and
$6.5 million to outlets, and the rest among other less significant accounts.
Gross profit (which consists of net sales less product costs, direct
labor, manufacturing overhead, duty, quota, freight in, brokerage, and
warehousing) for 2002 was $45.3 million, or 13% of net sales, compared to $52.7
million, or 16.0 % of net sales, for 2001, representing a decrease of 14.1%. The
decrease of $7.4 million in gross profit occurred primarily because of the
increase in quota prices from Hong Kong imports and insufficient capacity
utilization in Mexico in the first and fourth quarters.
Selling and distribution expenses decreased from $14.3 million in 2001
to $10.8 million in 2002 due to better control of overhead and reduction in
distribution costs. As a percentage of sales, these variable expenses decreased
from 4.4% in 2001 to 3.1% in 2002. General and administrative expenses decreased
from $33.1 million in 2001 to $30.1 million in 2002. As a percentage of net
sales these expenses decreased from 10.0% in 2001 to 8.6% in 2002. Included in
these expenses for 2002 was a charge of $1.3 million for a litigation reserve.
See "Item 3. Legal Proceeding." The charge for the change in the allowances for
returns and discounts for 2002 was $867,000, or 0.2% of sales, compared to such
charge of $2.7 million, or 0.8% of sales, during 2001. The higher allowance
expenses in 2001 were caused by a special reserve of $2.4 million for bad debt
related to a particular customer. After adjusting for the reduction in the
allowance expense for discounts and returns and the reserve for the litigation,
general and administrative expenses decreased by $2.6 million in 2002 as
compared to 2001. This decrease was due to our continuing cost cutting efforts.
Income from operations was $4.5 million in 2002, or 1.3% of net sales,
compared to $1.9 million in 2001, or 0.6% of net sales, due to the factors
described above.
Interest expense decreased from $7.8 million in 2001 to $5.4 million in
2002. This decrease in interest expense was as a result of reduced borrowings
due to the pay down of certain debt facilities during 2002 and interest rate
reductions positively impacting the variable rate debt. Interest income was $4.7
million in 2002 compared to $3.3 million in 2001. Included in interest income
were approximately $4.5 million for 2002 and $3.2 million for 2001 from the
related party note receivable related to the sale of certain equipment
pertaining to the twill mill which we re-acquired in December 2002. This
interest income was recorded on a cash collected basis. Other income increased
from $1.9 million in 2001 to $2.6 million in 2002 while other expenses increased
from $856,000 to $2.0 million in 2002.
Minority interest expense was $(4.6) million in 2002 as compared to
($412,000) in 2001. The minority interest in 2001 and 2002 represented the
minority holder's share of the UAV subsidiary's income.
24
Loss before taxes and cumulative effect of accounting change was $2.0
million in 2001 and $163,000 in 2002, representing 0.6% and 0.0% of net sales,
respectively. The decrease in loss before taxes as a percentage of net sales was
due to the factors discussed above.
Provision for income taxes was $852,000 in 2001 versus $1.1 million in
2002.
Loss after taxes and cumulative effect of accounting change was $2.9
million in 2001 and $6.1 million in 2002, representing 0.9% and 1.7% of net
sales, respectively.
QUARTERLY RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, certain
items in our consolidated statements of income in millions of dollars and as a
percentage of net sales:
Quarter Ended
----------------------------------------------------------------------------------------
Mar. 31, June 30, Sept. 30, Dec. 31, Mar. 31, June 30, Sept. 30, Dec. 31,
2002 2002 2002 2002 2003 2003 2003 2003
------- ------- ------- ------- ------- ------- ------- -------
(In millions)
Net sales ...... $ 65.2 $ 95.3 $ 94.3 $ 92.6 $ 78.7 $ 78.2 $ 96.5 $ 67.0
Gross profit ... 8.4 14.5 14.2 8.2 8.8 (0.4) 11.5 12.1
Operating income
(loss) ........ (0.8) 4.8 3.6 (3.1) (1.3) (34.4) 1.4 0.8
Net income
(loss) ........ (6.6) 1.3 1.1 (1.9) (3.9) (32.6) 0.1 0.4
Quarter Ended
----------------------------------------------------------------------------------------
Mar. 31, June 30, Sept. 30, Dec. 31, Mar. 31, June 30, Sept. 30, Dec. 31,
2002 2002 2002 2002 2003 2003 2003 2003
------- ------- ------- ------- ------- ------- ------- -------
Net sales ...... 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Gross profit ... 12.9 15.1 15.1 8.9 11.2 (0.6) 11.9 18.0
Operating income
(loss) ........ (1.3) 5.0 3.8 (3.4) (1.7) (44.0) 1.5 1.2
Net income
(loss) ........ (10.1) 1.4 1.2 (2.1) (4.9) (41.7) 0.1 0.6
As is typical for us, quarterly net sales fluctuated significantly
because our customers typically place bulk orders with us, and a change in the
number of orders shipped in any one period may have a material effect on the net
sales for that period.
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,
sales of equity securities, borrowing from affiliates and the proceeds from the
exercise of stock options.
25
Our liquidity is dependent, in part, on customers paying on time. Any
abnormal chargebacks 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.
Cash flows for the years ended December 31, 2001, 2002 and 2003 were as
follows (dollars in thousands):
CASH FLOWS: 2001 2002 2003
-------- -------- --------
Net cash provided by operating activities .. $ 30,051 $ 15,493 $ 9,484
Net cash used in investing activities ...... $(15,445) $ (5,670) $ (1,053)
Net cash used in financing activities ...... $(15,916) $ (8,435) $ (6,295)
Net cash provided by operating activities was $9.5 million in 2003, as
compared to net cash provided by operations in 2002 of $15.5 million and $30.1
million in 2001. Net cash provided by operations in 2003 resulted primarily from
a net loss of $35.9 million offset by depreciation and amortization of $16.1
million, asset impairment of $22.3 million and inventory write-down of $11.0
million. In addition to these items, the components of working capital impacting
cash from operations included a decrease of $7.9 million in accounts receivable,
a decrease of $9.6 million in inventory, a decrease of $4.2 million in accounts
payable and an increase of $14.8 million in due from affiliates. Changes from
prior years were a result of net income provided and changes in working capital.
During 2003, cash flow used in investing activities was $1.1 million,
as compared to $5.7 million in 2001 and $15.4 million in 2001. Cash used in
investing activities in 2003 included approximately $984,000 for purchase of
other assets.
During 2003, cash used in financing activities was $6.3 million as
compared to $8.4 million in 2002 and $15.9 million in 2001. Cash used in
financing activities in 2003 included $36.5 million net repayment of
indebtedness under our credit facilities offset by $31.0 million of proceeds
from a private placement of equity securities.
26
CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
Following is a summary of our contractual obligations and commercial
commitments available to us as of December 31, 2003 (in millions):
PAYMENTS DUE BY PERIOD
----------------------------------------------------
CONTRACTUAL OBLIGATIONS Less than Between Between After
Total 1 year 2-3 years 4-5 years 5 years
- ------------------------ -------- ------- ------- ------- -------
Long-term debt ......... $ 39.3 $ 38.7 $ 0.6 $ 0 $ 0
Operating leases ....... $ 1.3 $ 0.8 $ 0.4 $ 0.1 $ 0
Minimum royalites ...... $ 10.1 $ 0.5 $ 1.2 $ 1.6 $ 6.8
Purchase commitment .... $ 108.0 $ 18.0 $ 36.0 $ 36.0 $ 18.0
Employment contracts ... $ 3.8 $ 1.4 $ 2.4 $ 0 $ 0
Total Contractual
Cash Obligations ..... $ 162.5 $ 59.4 $ 40.6 $ 37.7 $ 24.8
TOTAL AMOUNT OF COMMITMENT EXPIRATION PER PERIOD
OTHER COMMERCIAL AMOUNTS ------------------------------------------
COMMITMENTS AVAILABLE COMMITTED Less than Between Between After
TO US TO US 1 year 2-3 years 4-5 years 5 years
- ------------------------ -------- ------- ------- ------- -------
Lines of credit ........ $ 123.1 $ 37.3 $ 85.8 -- --
Letters of credit
(within lines
of credit) .......... $ 27.9 $ 27.9 -- -- --
Total Commercial
Commitments ......... $ 123.1 $ 37.3 $ 85.8 -- --
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 and our
subsidiaries, Fashion Resource (TCL) Inc. and Tarrant Luxembourg Sarl, Gerard
Guez, our Chairman, also signed a guarantee of $5 million in favor of UPS to
secure this facility. This facility bears interest at 4.5% per annum at December
31, 2003. Under this facility, we are subject to certain restrictive covenants,
including that we maintain a specified tangible net worth, fixed charge ratio,
and leverage ratio. We were in compliance with all the covenants in the third
quarter of 2002. In the fourth quarter of 2002, we violated the fixed charge
ratio covenant and obtained a waiver at a cost of $5,000. In the first quarter
of 2003, we were in violation of the no-consecutive-quarterly-losses covenant
and the fixed charge ratio covenant and obtained a waiver for the quarter for a
fee of $10,000. In the second quarter of 2003, we breached all the financial
covenants and obtained a waiver for the quarter for a fee of $25,000. In October
2003, we established new financial convenants with UPS for the period ended
September 30, 2003 and the remainder of fiscal 2003 based on our projections. We
were in compliance with all the covenants in the third and fourth quarters of
2003. Tangible net worth, fixed charge ratio and leverage ratio were fixed at
$65 million, 0.74 to 1 and 2.55 to 1, respectively, for the fourth quarter of
2003. Capital Expenditures were capped at $800,000 per quarter. In December
2003, a temporary additional line of credit consisting of a $2.8 million standby
letter of credit was made available to us against a restricted deposit of $2.8
million. This temporary facility was cancelled in February 2004 and the deposit
has since been released. The expiration date of our main credit facility with
UPS has been extended to December 31, 2004 with certain conditions. One of the
conditions requires that on or before May 31, 2004, we have to refinance the
Debt Facility currently provided by GMAC Commercial Credit LLC. If we fail to
satisfy this condition, we will incur a penalty of $100,000 payable to UPS. As
of December 31, 2003, $23.7 million was outstanding under this facility, and an
additional $350,000 was available for future borrowings. In addition, $1.2
million of open letters of credit was outstanding as of December 31, 2003.
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 Tarrant's guarantee. In August 2003,
the letter of
27
credit facility increased to HKD 23 million (equivalent to US $3.0 million). In
December 2003, a tax loan for HKD 2 million (equivalent to US $256,000) was also
made available to our Hong Kong subsidiaries. As of December 31, 2003, $2.9
million was outstanding under this facility. In addition, $0.3 million of open
letters of credit was outstanding as of December 31, 2003.
We are party to a revolving credit, factoring and security agreement
(the "Debt Facility") with GMAC Commercial Credit, LLC. The Debt Facility
provides a revolving facility of $90 million, including a letter of credit
facility not to exceed $20 million, and matures on January 31, 2005. The Debt
Facility also provides a term loan of $25 million, which is being repaid in
monthly installments of $687,500. The Debt Facility provides for interest at
LIBOR plus the LIBOR rate margin determined by the Total Leverage Ratio (as
defined), and is collateralized by our receivables, intangibles, inventory and
various other specified non-equipment assets. This facility bears interest at 6%
per annum at December 31, 2003. Under the facility, we are subject to various
financial covenants on tangible net worth, interest coverage, fixed charge ratio
and leverage ratio, and are prohibited from paying dividends. In 2002, we
violated the net worth and fixed charge covenants in the third quarter and
obtained a waiver for the quarter for a fee of $50,000. We complied with all the
covenants in the other three quarters. In the first and second quarters of 2003,
we were in violation of all the financial covenants and obtained waivers from
GMAC for each quarter at the cost of $45,000 and $100,000 respectively. 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. We were in compliance with all the covenants in the third and
fourth quarters of 2003. Tangible net worth, fixed charge ratio and leverage
ratio in the final quarter were fixed at $65 million, 0.74 to 1 and 2.55 to 1,
respectively.
The amount we can borrow under the Debt Facility is determined based on
a defined borrowing base formula related to eligible accounts receivable and
inventories. Our borrowing base availability ranged from approximately $30
million to $75 million from January 1, 2003 to December 31, 2003. A significant
decrease in eligible accounts receivable and inventories due to the aging of
receivables and inventories, among other factors, can have an adverse effect on
our borrowing capabilities under our credit facility, which may adversely affect
the adequacy of our working capital. In addition, we have typically experienced
seasonal fluctuations in sales volume. These seasonal fluctuations result in
sales volume decreases in the first and fourth quarters of each year due to the
seasonal fluctuations experienced by the majority of our customers. During these
quarters, borrowing availability under our credit facility may decrease as a
result of decreases in eligible accounts receivables generated from our sales. A
total of $31.6 million (of which $4.8 million related to the term portion) was
outstanding under the Debt Facility at December 31, 2003. Based on the borrowing
base formula, no additional amounts were available for borrowing under the Debt
Facility at December 31, 2003.
At December 31, 2003, Tarrant Mexico S. de R.L. de C.V., Famian
division is indebted to Banco Nacional de Comercio Exterior SNC in the amount of
$2.1 million pursuant to a credit facility assumed by Tarrant Mexico following
its merger with Grupo Famian. We are now repaying $250,000 plus interest (LIBOR
plus 6%) monthly on this facility.
We have an equipment loan with an initial borrowing of $16.25 million
from GE Capital Leasing ("GE Capital"), which matures in November 2005. The loan
is secured by equipment located in Puebla and Tlaxcala, Mexico. As of December
31, 2003, this facility had a balance of $3.6 million. Interest accrues at a
rate of 2.5% over LIBOR. Under this facility, we 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. In
the first quarter of 2002, we breached the no-consecutive-quarterly-losses
covenant and obtained a waiver at a cost of $10,000. We complied with all the
covenants in the other three quarters. In the first and second quarters of 2003,
we were in violation of the no-consecutive-quarterly-losses covenant and
obtained waivers at the cost of $25,000 and $50,000 respectively. We were in
compliance with all the covenants in the third and fourth quarters of 2003. The
waiver for breach of covenants in the previous quarter required additional
collateral in the form of a second lien on our headquarters, which is owned by
Messrs. Guez, our Chairman of the Board and Kay, our Vice Chairman. Due to an
objection by the first-lien holder to the second lien, we have agreed to
accelerate the monthly repayment installment by approximately $75,000 commencing
January 2004 in lieu of the additional collateral.
We also had an equipment loan of $5.2 million from Bank of America
Leasing ("BOA"). The amount outstanding as of December 31, 2002 was $2.4
million. In October 2003, we paid off the BOA facility in its entirety.
The Debt Facility with GMAC and the credit facilities with UPS and GE
Capital all carry cross-default clauses. A breach of a financial covenant set by
GMAC, UPS or GE Capital constitutes an event of default under all of the credit
facilities, entitling these financial institutions to demand payment in full of
all outstanding amounts under their respective debt and credit facilities.
28
During 2000, we 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 commencing in February 2000. Of this amount,
$4.0 million was outstanding as of December 31, 2003. Of the $4.0 million, $2.7
million is denominated in the Euro, and the remainder is payable in U.S.
dollars.
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 December 31, 2003, $564,000 was outstanding
under this facility and $3.9 million of letters of credit were open under this
arrangement.
Unrealized losses of $1.0 million and $561,000 were recorded at
December 31, 2002 and 2003, respectively, related to foreign currency
fluctuations and were recorded in other income (expense) in the accompanying
statement of operations.
The effective interest rates on short-term bank borrowing as of
December 31, 2002 and 2003 were 4.1% and 5.3%, respectively.
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 2003 was $487,000. The greatest outstanding balance of such
advances to Mr. Guez during 2003 was approximately $4,879,000. As of December
31, 2003, we were indebted to Mr. Nacif and his affiliates in the amount of $5.4
million. Mr. Guez had an outstanding advance from us in the amount of $4,796,000
as of December 31, 2003 payable on demand. All advances to, and borrowings from,
Messrs. Guez and Kay bore interest at the rate of 7.75% during the period. Total
interest paid by Messrs. Guez and Kay were $368,000 and $374,000 for the years
ended December 31, 2002 and 2003, respectively. 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.
We intend to accumulate a cash reserve to meet any payment obligations
we have to taxing authorities relating to the Internal Revenue Services'
examination of our Federal income tax returns for the years ended December 31,
1996 through 2001. We intend to fund this cash reserve from operations, which
will require us to set aside on a periodic basis a significant amount of our
cash, which cannot be used for other purposes. See "--Significant Developments
in 2003 -- Internal Revenue Service Audit."
We may seek to finance future capital investment programs through
various methods, including, but not limited to, borrowings under our bank credit
facilities, issuance of long-term debt, sales of equity securities, leases and
long-term financing provided by the sellers of facilities or the suppliers of
certain equipment used in such facilities. To date, there is no plan for any
major capital expenditure.
We do not believe that the moderate levels of inflation in the United
States in the last three years have had a significant effect on net sales or
profitability.
29
RELATED PARTY TRANSACTIONS
We lease our principal offices and warehouse located in Los Angeles,
California and office space in Hong Kong from corporations owned by Gerard Guez,
our Chairman and Chief Executive Officer, and Todd Kay, our Vice Chairman of the
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 $1,330,000 in 2003 for rent for office and warehouse facilities at these
locations.
On October 16, 2003, we leased to affiliates of Mr. Kamel Nacif, one of
our shareholders, 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. The assets subject to
these leases have a net book value of approximately $92 million as of December
31, 2003. 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 in exchange for the use of such
facilities. The term of the management services agreement is also for a period
of 6 years. We have agreed to purchase annually, six million yards of fabric
manufactured at the facilities leased and/or operated by Mr. Nacif's affiliates
at market prices to be negotiated. Based on current market price, the purchase
commitment would be approximately $18 million annually.
From time to time, 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
2003 was $487,000. The greatest outstanding balance of such advances to Mr. Guez
during 2003 was approximately $4,879,000. As of December 31, 2003, we were
indebted to Mr. Nacif and his affiliates in the net amount of $5.4 million for
working capital lent by him to us to support our Mexican operations. Mr. Guez
had an outstanding advance from us in the amount of $4,796,000 as of December
31, 2003 payable upon demand. All advances to, and borrowings from, Messrs. Guez
and Kay bore interest at the rate of 7.75% during the period. Total interest
paid by the Chairman and Vic