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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2004
or
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from ______ to _______
Commission File Number: 0-26006
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]
The aggregate market value of the Common Stock held by non-affiliates
of the Registrant is approximately $23,495,688 based upon the closing price of
the Common Stock on June 30, 2004.
Number of shares of Common Stock of the Registrant outstanding as of
March 31, 2005: 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 2005 Annual Meeting of Shareholders are incorporated by
reference into Part III of this Report.
TARRANT APPAREL GROUP
INDEX TO FORM 10-K
PART I PAGE
----
Item 1. Business.................................................... 1
Item 2. Properties.................................................. 12
Item 3. Legal Proceedings........................................... 13
Item 4. Submission of Matters to a Vote of Security Holders......... 13
PART II
Item 5. Market for Registrant's Common Equity, Related
Stockholder Matters and Issuer Purchases
of Equity Securities..................................... 14
Item 6. Selected Financial Data..................................... 15
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations...................... 17
Item 7A. Quantitative and Qualitative Disclosures about Market Risk . 41
Item 8. Financial Statements and Supplementary Data................. 42
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure...................... 42
Item 9A. Controls and Procedures..................................... 42
PART III
Item 10. Directors and Executive Officers of the Registrant.......... 43
Item 11. Executive Compensation...................................... 43
Item 12. Security Ownership of Certain Beneficial Owners and
Management and Related Stockholder Matters............... 43
Item 13. Certain Relationships and Related Transactions.............. 43
Item 14. Principal Accounting Fees and Services...................... 43
PART IV
Item 15. Exhibits and Financial Statement Schedules.................. 43
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PART I
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
This 2004 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 design and sourcing company for private
label and private brand casual apparel serving mass merchandisers, department
stores, branded wholesalers and specialty chains located primarily in the United
States. Our major customers include specialty retailers, such as Chico's, Macy's
Merchandising Group, the Avenue, 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 2002, our net sales increased by 5.2% to $347 million. In 2003, our
net sales decreased by 7.8% to $320 million. In 2004, our net sales decreased by
51.5% to $155 million. In 2002, we experienced a net loss of $1.2 million before
cumulative effect of accounting change due to our adoption of SFAS No. 142, and
$6.1 million after the cumulative effect of accounting change. In 2003, we
experienced a net loss of $35.9 million, which included non-cash charges of
inventory write-down of $11 million and an impairment of asset charge of $22.3
million. In 2004, we experienced a net loss of $104.7 million, which included
non-cash charges of $22.8 million of foreign currency translation loss and $78.0
million of asset impairments. See "Item 7. Management's Discussion and Analysis
of Financial Condition and Results of Operations."
During 2003, we launched our private brands initiative, where we
acquire ownership of or license rights to a brand name and sell apparel products
under the brand to a single retail company within a geographic region. At March
31, 2005, we owned or licensed rights to the following brands for apparel
products sold at the following retailers:
BRAND STORES
-------------------------- --------------------------
American Rag CIE Macy's Merchandising Group
Alan Weiz Dillard's
Gear 7 K-Mart, Sears
Jessica Simpson collection Charming Shoppes
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BRAND STORES
-------------------------- --------------------------
Princy, JS by Jessica, Department stores and better
Sweet Kisses specialty stores
Beyonce - House of Dereon Better specialty stores
NO! Jeans Sears
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, a shareholder at the time of the transaction. In November 2004,
we sold substantially all our fixed assets and real property in Mexico to Mr.
Nacif's affiliates. See "--Restructuring and Sale of Mexico Operations."
In connection with the restructuring of our Mexican operations, and the
resulting reduction in our Mexican work force, we became 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 groups. As a consequence of these actions, we experienced a
significant decline in revenue of approximately $75 million from sales of
Mexico-produced merchandise during 2004 as compared to 2003.
RESTRUCTURING AND SALE OF MEXICO OPERATIONS
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,
a shareholder at the time of the transaction. 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.
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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 Mexican operations did not represent an independent cash flow
generating entity. It was a component of our vertical integration business
strategy and its sales were primarily to the United States reportable segment.
In connection with our restructuring of our Mexico operations, we
incurred $2.5 million and $1.1 million of severance costs in 2003 and 2004,
respectively, in the Mexico reportable segment. We did not relocate any
employees in connection with this restructuring and therefore did not incur any
relocation costs. In addition, we did not incur any contract termination costs.
There was no ending liability balance for the severance costs incurred in 2003
and 2004 since such amounts were all paid in 2003 and 2004. Severance costs
incurred in 2003 were included in costs of goods sold and such costs incurred in
2004 were included in general and administrative expenses in the accompanying
consolidated statements of operations.
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."
In August 2004, through Tarrant Mexico, S. de R.L. de C.V., our
majority owned and controlled subsidiary in Mexico, we entered into an Agreement
for Purchase of Assets with affiliates of Mr. Kamel Nacif, a shareholder at the
time of the transaction, which agreement was amended in October 2004. Pursuant
to the agreement, as amended, on November 30, 2004, we sold to the purchasers
substantially all of our assets and real property in Mexico which include
equipment and facilities previously leased to Mr. Nacif's affiliates in 2003,
for an aggregate purchase price consisting of the following:
o $105,400 in cash and $3,910,000 by delivery of unsecured
promissory notes bearing interest at 5.5% per annum; and
o $40,204,000, by delivery of secured promissory notes bearing
interest at 4.5% per annum, maturing on December 31, 2014
payable in equal installments of principal and interest over
the term of the notes.
Upon consummation of the sale, we entered into a purchase commitment
agreement with the purchasers, pursuant to which we have agreed to purchase
annually over the ten-year term of the agreement, $5 million of fabric
manufactured at our former facilities acquired by the purchasers at negotiated
market prices. This agreement replaced an existing purchase commitment agreement
whereby we were obligated to purchase annually from Mr. Nacif's affiliates, 6
million yards of fabric (or approximately $19.2 million of fabric at today's
market prices) manufactured at these same facilities through October 2009.
In accordance with SFAS 144, we evaluated the long-lived assets in
Mexico for recoverability and concluded that the book value of the asset group
was significantly higher than the expected future cash flows and that impairment
had occurred. Accordingly, we recognized a non-cash impairment loss of
approximately $78 million in the second quarter of 2004. The impairment charge
was the difference between the carrying value and fair value of the impaired
assets. Fair value was determined based on independent appraisals of the
property and equipment obtained in June 2004. There was no tax benefit
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recorded with the impairment loss due to a full valuation allowance recorded
against the future tax benefit as of June 30, 2004.
Our disposition of our facilities in Mexico 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 worldwide. 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.
BUSINESS STRATEGY
We believe that the following trends are currently affecting apparel
retailing and manufacturing:
o There is a need for a marketing catalyst such as celebrity
endorsed, or celebrity branded apparel, which brings attention
and credibility to clothing collections through the
association of entertainment and fashion.
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.
PRIVATE BRANDS. 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
business from our private brand customers. We also receive higher margins for
private branded merchandise, which allows us to be more profitable on the same
level of unit sales.
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 $3.00
to over $50.00 per garment.
Over the past three years, approximately 71% of net sales were derived
from the sales of pants and jeans, approximately 5% from the sale of shorts,
approximately 9% from the sale of shirts, blouses and tops and approximately 7%
from the sale of skirts and skort-alls. The balance of net sales consisted of
sales of 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.
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The following table shows the percentage of our net sales in fiscal
years 2002, 2003 and 2004 attributable to each customer that accounted for more
than 5% of net sales.
PERCENTAGE OF NET SALES
-----------------------------------
CUSTOMER 2002 2003 2004
- ------------------------------------ ------- ------- -------
Kohl's.............................. 5.1 6.6 16.4
Mervyn's............................ 7.3 5.9 15.4
Lerner New York (2)................. 9.9 8.3 15.0
Federated........................... 0.5 5.2 10.3
Wet Seal............................ 0.8 3.3 7.9
Wal-Mart............................ 9.7 8.7 5.9
The Limited (1)..................... 12.7 15.3 4.6
Lane Bryant......................... 17.6 12.1 2.0
Tommy Hilfiger...................... 17.4 6.7 0.0
- ----------
(1) Includes Express and Limited stores.
(2) Sold by Limited Brands Inc. in November 2002.
In 2002, virtually all of our sales were of private label apparel. In
2003 and 2004, we experienced Private Brand sales of approximately 6% and 14%,
respectively. We currently serve over 25 customers, which in addition to those
identified above, include, Chico's, Dillard's, J.C. Penney, Mothers Work,
K-Mart, and the Avenue. During 2003, we launched our private brands initiative,
where we acquire ownership of or 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 Sears,
our licensed brand "American Rag Cie" to Macy's Merchandising Group, and "Gear
7" to K-Mart.
We do not have long-term contracts with any of our customers except for
Macy's Merchandising Group for American Rag Cie and, therefore, there can be no
assurance that other customers 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
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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 facility in Los
Angeles, California and subcontract with a third party for the production of
samples in China.
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, 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 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, Nepal, Cambodia, 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
a continued presence in Southeast Asia. We also 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:
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2002 2003 2004
------ ------ ------
INTERNATIONAL SOURCING:
Hong Kong and China.................... 25.3 % 28.6 % 46.6 %
Other (1).............................. 13.3 % 24.4 % 33.7 %
DOMESTIC SOURCING:
United States.......................... 6.1 % 4.4 % 7.1 %
Mexico and Central America............. 55.3 % 42.6 % 12.6 %
- ----------
(1) In 2004, such countries consisted mainly of Egypt, Mongolia, Thailand,
Nepal, Vietnam and India.
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 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 $5 million of fabric annually
manufactured at facilities in Mexico that we previously owned and sold to
affiliates of Mr. Nacif, a shareholder at the time of transaction, in 2004, 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 a production network that is capable of
servicing a wide range of customer needs. Some customers place a priority on
"speed to market," and are willing to pre-approve several different fabric
styles, and pay air freight in order to quickly get the most current styling
into their stores. Other customers seek lower costs, and are willing to source
production from more remote areas with long lead-times. 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
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season to season. Our ability to operate on different production schedules 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, 2004, we had offices in Hong Kong, Mexico and Thailand.
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 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, Nepal, Cambodia, Peru, Thailand and Egypt, 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
9
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 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, 2005, we had unfilled customer orders of approximately
$73 million as compared to approximately $67 million as of March 22, 2004. We
believe that all of our backlog of orders as of March 22, 2005 will be filled
before the end of the third quarter of fiscal 2005. 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 of 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 16 of the "Notes to Consolidated Financial Statements."
10
IMPORT RESTRICTIONS
QUOTAS
We imported approximately 91% of our products sold in 2004.
Approximately 10% 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.
A majority of the balance of the merchandise imported by us in 2004 was
manufactured in various countries (e.g., China) with which the U.S. had entered
into bilateral trade agreements.
As of January 1, 2005, quota on apparel from all WTO countries,
including China, was eliminated. As China is now a member of the WTO, its
exports of textiles and apparel to the U.S. are covered by the WTO Agreement on
Textiles and Clothing. Various statutory mechanisms remain, 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.
In 2004, approximately 40% 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 33% 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 or improved by future trade agreements and restrictions,
changes in U.S. trade policy, 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. We
11
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.
TRADEMARKS
As part of Private Brands strategy, we acquire ownership of or rights
to a brand name and sell apparel products under this brand. We have ownership
rights to the registered trademarks "American Rag Cie," "Gear7" and "NO! Jeans."
In addition, we have acquired license rights to design, market and distribute
certain apparel products under the Cynthia Rowley, Alan Weiz, Jessica Simpson
and Beyonce's House of Dereon brands.
SEASONALITY
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.
EMPLOYEES
At December 31, 2004, we had approximately 128 full-time employees in
the United States, 26 in Mexico, 118 in Hong Kong, 83 in China and 9 in
Thailand. None of our employees are unionized. We consider our relations with
our employees to be satisfactory in all areas of our operations with the
exception of our prior Mexico operations, where we experienced labor
difficulties in 2003 and early 2004 following our decision to restructure our
Mexican operations.
ITEM 2. PROPERTIES
At March 31, 2005, we conducted our operations from 9 facilities, 7 of
which were leased. Our leased facilities included:
Annual
Location Purpose Rental Amount Expiration
- ------------------ -------------------- ------------- --------------
Los Angeles, CA Executive offices $656,000 Monthly
(Washington Blvd.)
New York, NY Showroom $150,000 August 2007
Bentonville, AK Office -- $35,000 September 2005
Wal-Mart Business
Ruleville, MS Office and warehouse Own
Hong Kong Office and warehouse $674,000 Monthly
Hong Kong Warehouse $12,000 September 2005
Bangkok Office $6,000 March 2005
Tehuacan, Mexico Storage $18,000 Monthly
We lease our executive offices in Los Angeles, California from GET, a
corporation which is owned by Gerard Guez and Todd Kay, our Chairman and Vice
Chairman, respectively. Additionally, we lease our warehouse and office space in
Hong Kong from Lynx International Limited, a Hong Kong corporation that is owned
by Messrs. Guez and Kay.
12
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, for an annual rental of $11 million. In November
2004, we sold our Mexican assets, including these facilities, to affiliates of
Mr. Kamel Nacif.
We own two facilities in Ruleville, Mississippi with an aggregate of
70,000 square feet.
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
On December 10, 2004 and December 14, 2004, Mr. Benjamin Dominguez
Gonzalez brought suits against our Mexico Subsidiary, Tarrant Mexico, S. de R.L.
de C.V., in Puebla, Puebla, Mexico: (a) "Juicio Ejecutivo Mercantil 887/2004,
Juzgado Dicimo de lo Civil del Estado de Puebla, Puebla, Mexico, Dominguez
Gonzalez Benjamin vs. Tarrant Mexico S. de R.L. de C.V. e Inmobiliaria Cuadros
S.A. de C.V."; (b) "Juicio Ejecutivo Mercantil 889/2004, Juzgado Noveno de lo
Civil del Estado de Puebla, Puebla, Mexico, Dominguez Gonzalez Benjamin vs.
Tarrant Mexico S. de R.L. de C.V. e Inmobiliaria Cuadros S.A. de C.V.", for the
non-payment of approximately $14 million in principal amount and accrued
interest on two promissory notes, which Mr. Gonzalez asserts were issued by
Tarrant Mexico. The amounts Mr. Gonzalez claimed were due and owing under the
notes previously had been paid in full. In April 2005, Mr. Gonzalez agreed to
dismiss his claims, which agreement has been submitted to and is pending final
approval of the court.
Other than the above lawsuits, from time to time, we are involved in
various routine legal proceedings incidental to the conduct of our business. Our
management does not believe that any of these legal proceedings will have a
material adverse impact on our business, financial condition or results of
operations, either due to the nature of the claims, or because our management
believes that such claims should not exceed the limits of the our insurance
coverage.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of our shareholders during
the fourth quarter of 2004.
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
-------- --------
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
2004
- ----
First Quarter...................................... 1.68 3.73
Second Quarter..................................... 1.45 2.53
Third Quarter...................................... 0.79 1.57
Fourth Quarter..................................... 0.78 2.44
On March 24, 2005, the last reported sale price of our common stock as
reported by NASDAQ was $1.91. As of March 24, 2005, we had 28 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 agreements prohibit the payment of dividends during the
term of the agreements.
14
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,
-------------------------------------------------------------
2000 2001 2002 2003 2004
--------- --------- --------- --------- ---------
(in thousands, except per share data)
INCOME STATEMENT DATA:
Net sales ....................... $ 395,169 $ 330,253 $ 347,391 $ 320,423 $ 155,453
Cost of sales ................... 332,333 277,525 302,082 288,445 134,492
--------- --------- --------- --------- ---------
Gross profit ................. 62,836 52,728 45,309 31,978 20,961
Selling and distribution expenses 17,580 14,345 10,757 11,329 9,291
General and administrative
expenses ..................... 40,327 33,136 30,082 31,767 32,084
Amortization of intangibles(1)(3) 2,840 3,317 -- -- --
Impairment charges (4) .......... -- -- -- 22,277 77,982
Cumulative translation loss (5) . -- -- -- -- 22,786
--------- --------- --------- --------- ---------
Income (loss) from operations $ 2,089 1,930 4,470 (33,395) (121,182)
Interest expense ................ (9,850) (7,808) (5,444) (5,603) (2,857)
Interest income ................. 1,295 3,256 4,748 425 377
Minority interest ............... 1,313 (412) (4,581) 3,461 15,331
Other income(2) ................. 1,350 1,853 2,648 4,784 7,136
Other expense(2) ................ (193) (856) (2,004) (1,425) (1,134)
--------- --------- --------- --------- ---------
Loss before provision for
income taxes and cumulative
effect of accounting change .. (3,996) (2,037) (163) (31,753) (102,329)
Provision for income taxes ...... 1,478 (852) (1,051) (4,132) (2,348)
--------- --------- --------- --------- ---------
Loss before cumulative
effect of accounting change $ (2,518) $ (2,889) $ (1,214) $ (35,885) $(104,677)
Cumulative effect of
accounting change(3) ......... -- -- (4,871) -- --
--------- --------- --------- --------- ---------
Net loss ........................ $ (2,518) $ (2,889) $ (6,085) $ (35,885) $(104,677)
========= ========= ========= ========= =========
Net loss per share -
Basic:
Before cumulative effect of
accounting change .......... $ (0.16) $ (0.18) $ (0.08) $ (1.97) $ (3.64)
Cumulative effect of
accounting change .......... -- -- (0.30) -- --
After cumulative effect of
accounting change .......... $ (0.16) $ (0.18) $ (0.38) $ (1.97) $ (3.64)
Net loss per share -
Diluted:
Before cumulative effect of
accounting change .......... $ (0.16) $ (0.18) $ (0.08) $ (1.97) $ (3.64)
Cumulative effect of
accounting change .......... -- -- (0.30) -- --
After cumulative effect of
accounting change .......... $ (0.16) $ (0.18) $ (0.38) $ (1.97) $ (3.64)
Weighted average shares
outstanding (000)
Basic ........................ 15,815 15,825 15,834 18,215 28,733
Diluted ...................... 15,815 15,825 15,834 18,215 28,733
15
AS OF DECEMBER 31,
----------------------------------------------------------
2000 2001 2002 2003 2004
- ---------------------------- --------- --------- --------- --------- ---------
(in thousands)
BALANCE SHEET DATA:
Working capital ............ $ 27,957 $ 25,109 $ 11,731 $ (18,018) $ (12,295)
Total assets ............... 308,092 288,467 316,444 253,105 131,811
Bank borrowings, convertible
debenture and long-term
obligations ............. 114,439 111,336 106,937 68,587 48,455
Shareholders' equity ....... 130,489 125,164 121,161 107,709 30,678
- ----------
(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.
(4) The expense in 2004 was the impairment of long-lived assets of our
Mexico operations due to our decision to sell the manufacturing
operations in Mexico. The expense in 2003 was the impairment of our
goodwill and intangible assets and write-off of prepaid expenses 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 5 and Note 7 of the "Notes to Consolidated Financial
Statements."
(5) Cumulative translation loss attributable to liquidated Mexico
operations in 2004 was due to our decision to cease our Mexico
operations.
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, 2002, 2003 and 2004.
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 design and sourcing provider of private
label and private brand casual apparel for women, men and children, serving mass
merchandisers, department stores, branded wholesalers and specialty chains
located primarily in the United States.
We generate revenues from the sale of apparel merchandise to our
customers that we have manufactured by third party contract manufacturers
located outside of the United States. Revenues and net loss for the years ended
December 31, 2002, 2003 and 2004 were as follows (dollars in thousands):
REVENUES AND NET LOSS: 2002 2003 2004
- ----------------------------------------- --------- --------- ----------
Net sales................................ $ 347,391 $ 320,423 $ 155,453
Net loss before cumulative
effect of accounting change........... $ (1,214) $ (35,885) $ (104,677)
Net loss after cumulative
effect of accounting change........... $ (6,085) $ (35,885) $ (104,677)
Cash flows for the years ended December 31, 2002, 2003 and 2004 were as
follows (dollars in thousands):
CASH FLOWS: 2002 2003 2004
- ----------------------------------------- --------- --------- ----------
Net cash provided by operating
activities............................ $ 15,493 $ 9,484 $ 12,168
Net cash provided by (used in)
investing activities.................. $ (5,670) $ (1,053) $ 1,250
Net cash used in financing
activities............................ $ (8,435) $ (6,295) $ (15,552)
SIGNIFICANT DEVELOPMENTS IN 2004
RESTRUCTURING AND SALE OF MEXICO 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,
a shareholder at the time of the transaction. 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.
17
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 Mexican operations did not represent an independent cash flow
generating entity. It was a component of our vertical integration business
strategy and its sales were primarily to the United States reportable segment.
In connection with our restructuring of our Mexico operations, we
incurred $2.5 million and $1.1 million of severance costs in 2003 and 2004,
respectively, in the Mexico reportable segment. We did not relocate any
employees in connection with this restructuring and therefore did not incur any
relocation costs. In addition, we did not incur any contract termination costs.
There was no ending liability balance for the severance costs incurred in 2003
and 2004 since such amounts were all paid in 2003 and 2004. Severance costs
incurred in 2003 were included in costs of goods sold and such costs incurred in
2004 were included in general and administrative expenses in the accompanying
consolidated statements of operations.
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."
In August 2004, through Tarrant Mexico, S. de R.L. de C.V., our
majority owned and controlled subsidiary in Mexico, we entered into an Agreement
for Purchase of Assets with Mr. Nacif's affiliates, which agreement was amended
in October 2004. Pursuant to the agreement, as amended, on November 30, 2004, we
sold to the purchasers substantially all of our assets and real property in
Mexico which include equipment and facilities previously leased to Mr. Nacif's
affiliates in 2003, for an aggregate purchase price consisting of the following:
o $105,400 in cash and $3,910,000 by delivery of unsecured
promissory notes bearing interest at 5.5% per annum; and
o $40,204,000, by delivery of secured promissory notes bearing
interest at 4.5% per annum, maturing on December 31, 2014
payable in equal installments of principal and interest over
the term of the notes.
Upon consummation of the sale, we entered into a purchase commitment
agreement with the purchasers, pursuant to which we have agreed to purchase
annually over the ten-year term of the agreement, $5 million of fabric
manufactured at our former facilities acquired by the purchasers at negotiated
market prices. This agreement replaced an existing purchase commitment agreement
whereby we were obligated to purchase annually from Mr. Nacif's affiliates, 6
million yards of fabric (or approximately $19.2 million of fabric at today's
market prices) manufactured at these same facilities through October 2009.
In accordance with SFAS 144, we evaluated the long-lived assets in
Mexico for recoverability and concluded that the book value of the asset group
was significantly higher than the expected future
18
cash flows and that impairment had occurred. Accordingly, we recognized a
non-cash impairment loss of approximately $78 million in the second quarter of
2004. The impairment charge was the difference between the carrying value and
fair value of the impaired assets. Fair value was determined based on
independent appraisals of the property and equipment obtained in June 2004.
There was no tax benefit recorded with the impairment loss due to a full
valuation allowance recorded against the future tax benefit as of June 30, 2004.
Our disposition of our facilities in Mexico 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 worldwide. 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.
PRIVATE BRANDS INITIATIVE
During 2003, we launched our private brands initiative, where we
acquire ownership of or license rights to a brand name and sell apparel products
under this brand to a single retail company within a geographic region. During
2004, we made significant progress in our private brands initiative, as follows:
o Amended our agreement with Macy's Merchandising Group
(formerly Federated Merchandising Group) to exclusively
distribute American Rag Cie;
o Established an exclusive distribution with Dillard's
Department Stores for Alain Weiz;
o Added Gear 7 for distribution at K-Mart;
o Began discussions with, and subsequently entered into apparel
license agreement for House of Dereon by Beyonce; and
o Entered into apparel license agreement for Jessica Simpson.
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. This adjustment would also result in additional
state taxes and interest. In addition, in July 2004, the IRS initiated an
examination of our Federal income tax return for the year ended December 31,
2002. In March 2005, the IRS proposed an adjustment to our taxable income of
approximately $6 million related to similar issues identified in their audit of
the 1996 through 2001 federal income tax returns. The proposed adjustments to
our 2002 federal income tax return would not result in additional tax due for
that year due to the tax loss reported in the 2002 federal return. However, it
could reduce the amount of net operating losses available to offset taxes due
from the preceding tax years. We believe that we have meritorious defenses to
and intend to vigorously contest the proposed adjustments made to our federal
income tax returns for the years ended 1996 through 2002. 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 consolidated balance sheets included in the Consolidated
Financial Statements under the caption "Income Taxes". The maximum amount of
loss in excess of the amount accrued in the financial statements is $12.6
million. 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 consolidated balance sheets.
19
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 groups. As a consequence of these actions, we
experienced a significant decline in revenue of approximately $75 million from
sales of Mexico-produced merchandise in 2004 as compared to 2003.
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. We are required to make assumptions about
matters, which are highly uncertain at the time of the estimate. Different
estimates we could reasonably have used or changes in the estimates that are
reasonably likely to occur could have a material effect on our financial
condition or result of operations. Estimates and assumptions about future events
and their effects cannot be determined with certainty. 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 assumptions
believed to be applicable and reasonable under the circumstances. These
estimates may change as new events occur, as additional information is obtained
and as our operating environment changes. In addition, management is
periodically faced with uncertainties, the outcomes of which are not within its
control and will not be known for prolonged period of time.
Management believes our financial statements are fairly stated in
accordance with accounting principles generally accepted in the United States of
America and provide a meaningful presentation of our financial condition and
results of operations.
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
20
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, 2004, the balance in the allowance for returns,
discounts and bad debts reserves was $2.4 million, compared to $4.2 million at
December 31, 2003.
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. Inventory adjustments are
made for the difference between the cost of the inventory and the estimated
market value and charged to operations in the period in which the facts that
give rise to the adjustments become known.
VALUATION OF LONG-LIVED AND INTANGIBLE ASSETS AND GOODWILL
We assess the impairment of identifiable intangibles, long-lived assets
and goodwill whenever events or changes in circumstances indicate that the
carrying value may not be recoverable. Factors considered important that could
trigger an impairment review include, but are not limited to, the following:
o a significant underperformance relative to expected historical
or projected future operating results;
o a significant change in the manner of the use of the acquired
asset or the strategy for the overall business; or
o a significant negative industry or economic trend.
Effective January 1, 2002, we adopted Statement of Financial Accounting
Standards No. 142, "Goodwill and Other Intangible Assets." According to this
statement, goodwill and other intangible assets with indefinite lives are no
longer subject to amortization, but rather an annual assessment of impairment
applied on a fair-value-based test. We adopted SFAS No. 142 in fiscal 2002 and
performed our first annual assessment of impairment, which resulted in an
impairment loss of $4.9 million.
We utilized the discounted cash flow methodology to estimate fair
value. At December 31, 2004, we have a goodwill balance of $8.6 million, and a
net property and equipment balance of $1.9 million, as compared to a goodwill
balance of $8.6 million and a net property and equipment balance of $135.6
million at December 31, 2003. Our goodwill balance reflects the write off of
$19.5 million of goodwill in 2003 as discussed in "-- Significant Developments
in 2004 - Restructuring and Sale of Mexico Operations" and Note 5 and Note 7 of
the "Notes to Consolidated Financial Statements." Our net property and equipment
balance at December 31, 2004 reflects the disposal of our Mexico fixed assets of
$123.3 million in the fourth quarter of 2004.
We assess the carrying value of long-lived assets In accordance with
SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets."
In 2004, we evaluated the long-lived assets in Mexico for recoverability and
concluded that the book value of the asset group was significantly higher than
the expected future cash flows and that impairment had occurred. Accordingly, we
recognized a non-cash impairment loss of approximately $78 million in the second
quarter of 2004. The impairment charge was the difference between the carrying
value and fair value of the impaired assets. Our determination of fair value was
determined based on independent appraisals of the property and equipment
obtained in June 2004.
21
FOREIGN CURRENCY TRANSLATION
Assets and liabilities of our Mexico and Hong Kong subsidiaries are
translated at the rate of exchange in effect on the balance sheet date; income
and expenses are translated at the average rates of exchange prevailing during
the respective periods. The functional currency in which we transact business in
Hong Kong is the Hong Kong dollar and in Mexico is the peso.
Foreign currency gains and losses resulting from translation of assets
and liabilities are included in other comprehensive income (loss). Transaction
gains or losses, other than inter-company debt deemed to be of a long-term
nature, are included in net income (loss) in the period in which they occur.
Upon the sale in November 2004 of our fixed assets in Mexico, the foreign
currency translation adjustment related to our Mexico subsidiaries of
approximately $22.8 million of loss was reclassified and charged to income in
the fourth quarter of 2004.
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 sheets. 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 10 of the "Notes to Consolidated
Financial Statements" for a discussion of current tax matters.
DEBT COVENANTS
Our debt agreements require certain covenants including 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 our debt agreements,
substantially all 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 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.
22
NEW ACCOUNTING PRONOUNCEMENTS
For a description of recent accounting pronouncements including the
respective expected dates of adoption and effects on results of operations and
financial condition, see Note 1 of the "Notes to Consolidated Financial
Statements."
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:
YEARS ENDED DECEMBER 31,
-----------------------------
2002 2003 2004
------- ------- -------
Net sales ................................... 100.0 % 100.0 % 100.0 %
Cost of sales ............................... 87.0 90.0 86.5
------- ------- -------
Gross profit ................................ 13.0 10.0 13.5
Selling and distribution expenses ........... 3.1 3.5 6.0
General and administration expenses ......... 8.6 9.9 20.6
Impairment charges .......................... -- 7.0 50.2
Cumulative translation loss ................. -- -- 14.7
------- ------- -------
Income (loss) from operations ............... 1.3 (10.4) (78.0)
Interest expense ............................ (1.6) (1.7) (1.8)
Interest income ............................. 1.4 0.1 0.2
Minority interest ........................... (1.3) 1.0 9.9
Other income ................................ 0.8 1.5 4.6
Other expense ............................... (0.6) (0.4) (0.7)
------- ------- -------
Loss before provision for income taxes
and cumulative effect of accounting
change ................................... 0.0 (9.9) (65.8)
Income taxes ................................ (0.3) (1.3) (1.5)
------- ------- -------
Loss before cumulative effect of
accounting change ........................ (0.3) (11.2) (67.3)
Cumulative effect of accounting change(1) ... (1.4) -- --
------- ------- -------
Net loss .................................... (1.7)% (11.2)% (67.3)%
======= ======= =======
- ----------
(1) Reflects the adoption of SFAS No. 142
COMPARISON OF 2004 TO 2003
Net sales decreased by $165.0 million, or 51.5%, from $320.4 million in
2003 to $155.5 million in 2004. The decrease in net sales was largely
attributable to a decrease in Mexican sourced sales from $139.1 million in 2003
to $19.5 million. Several of our larger customers for Mexico produced jeans wear
refused to place orders with us following the restructuring of our Mexico
operations and resulting labor unrest in Mexico, which resulted in a decline in
revenue of approximately $75 million from sales of Mexico-produced merchandise
during 2004 as compared to 2003. Additionally, in 2004 we experienced a decline
in sales to certain customers of Mexico-sourced merchandise that was unrelated
to the labor unrest. In 2004, we also experienced a reduction of sales of fabric
to Mexican manufacturers of
23
approximately $17 million. We also experienced a reduction of sales from our
import operations in the Far East of approximately $40 million, due in part to
several of our larger customers reducing their back-to-school and holiday order
placements.
Gross profit consists of net sales less product costs, direct labor,
manufacturing overhead, duty, quota, freight in, brokerage, and warehousing
expense. Gross profit for 2004 was $21.0 million, or 13.5% of net sales,
compared to $32.0 million, or 10.0 % of net sales, for 2003, representing a
decrease of $11.0 million or 34.5%. The decrease in gross profit for 2004 was
primarily due to the substantial decrease in sales volume. The lower gross
profit, especially in the fourth quarter, was primarily due to unplanned air
freight costs and higher quota costs in some categories coupled with additional
inventory markdowns. The increase in gross profit as a percentage of net sales
for 2004 when compared to 2003 was primarily because of an inventory write-down
of $11 million and severance payments to Mexican workers of approximately $2.5
million included in cost of goods sold in 2003. Excluding the inventory
write-down and severance payments in 2003, gross profit as a percentage of net
sales for 2003 was 14.2% compared to 13.5% for 2004.
Selling and distribution expenses decreased by $2.0 million, or 18%,
from $11.3 million in 2003 to $9.3 million in 2004. As a percentage of net
sales, these variable expenses increased from 3.5% in 2003 to 6.0% in 2004 due
to the significant decline in sales during 2004.
General and administrative expenses increased by $317,000, or 1.0%,
from $31.8 million in 2003 to $32.1 million in 2004. As a percentage of net
sales, these expenses increased from 9.9% in 2003 to 20.6% in 2004 due to
significant decline in sales during 2004. This increase was partly caused by the
reclassification of $3.2 million of depreciation of our Mexican facilities from
cost of goods sold in the fourth quarter of 2003, compared to $6.8 million of
depreciation and $1.1 million of severance payments to Mexican workers in 2004.
Impairment charges were $78.0 million in 2004, compared to $22.3
million in 2003. The expense in 2004 was the impairment of long-lived assets of
our Mexico operations due to our decision to sell the manufacturing operations
in Mexico. The expense in 2003 included $19.5 million of the impairment of our
goodwill and intangible assets and $2.8 million of write-off of prepaid expenses
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 5 and Note 7 of the "Notes to Consolidated Financial Statements."
Cumulative translation loss attributable to liquidated Mexico
operations was $22.8 million in 2004, or (14.7)% of net sales, compared to no
such expense in 2003. As discussed above, we incurred this charge upon the sale
of our fixed assets in Mexico in the fourth quarter of 2004.
Loss from operations was $121.2 million in 2004, or (78.0)% of net
sales, compared to $33.4 million in 2003, or (10.4)% of net sales, due to the
factors described above.
Interest expense decreased by $2.7 million, or 49.0%, from $5.6 million
in 2003 to $2.9 million in 2004. This decrease in interest expense was a result
of a decrease of the amount we financed under our main credit facility in 2004.
Interest income was $378,000 in 2004 compared to $425,000 in 2003. Other income
increased by $2.4 million, or 49.2%, from $4.8 million in 2003 to $7.1 million
in 2004, due to $3.7 million of lease income received for our facilities and
equipment in Mexico in 2003, compared to $5.5 million in 2004. Other expenses
decreased from $1.4 million in 2003 to $1.1 million in 2004.
Losses allocated to minority interests in 2004 was $15.3 million,
representing $471,000 attributed to the minority shareholder in United Apparel
Ventures, LLC, for its 49.9% share in the loss and $14.8 million attributed to
the minority shareholder in Tarrant Mexico for its 25% share in the loss. Losses
24
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 its 25%
share in the loss including $4.4 million for its share in the special write-down
on goodwill and inventory of Tarrant Mexico.
Loss before provision for income taxes was $102.3 million in 2004 and
$31.8 million in 2003, representing (65.8)% and (9.9)% of net sales,
respectively. The increase in loss before provision for income was due to the
factors discussed above.
Provision for income taxes was $2.3 million in 2004 versus $4.1 million
in 2003, representing (1.5)% and (1.3)% of net sales, respectively.
Loss after taxes and cumulative effect of accounting change was $104.7
million in 2004 and $35.9 million in 2003, representing (67.3)% and (11.2)% of
net sales, respectively. Included in the $104.7 million loss in 2004 were
charges of $78.0 million for the impairment of long-lived assets and $22.8
million of cumulative translation loss attributable to liquidated Mexico
operations. 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 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. This decrease in net sales was primarily a result of
the cessation of our manufacturing operations in Mexico in September 2003 and
the labor difficulties and workers' rights activities we experienced following
the reduction of our Mexico work force. The decrease in net sales was partially
offset by additional revenue of $20.5 million from sales of private brands,
which we started to develop during 2003. However, the private brand revenue was
not sufficient to cover the loss of sales volume from Mexican-sourced products.
Gross profit for 2003 was $32.0 million, or 10.0% of net sales,
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 in 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 sale of private brands apparel 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.
25
Impairment charge 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 of 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 of 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 United Apparel Ventures,
LLC of $3.5 million, offset by $7.0 million attributed to the minority
shareholder in Tarrant Mexico for its 25% share in the loss including $4.4
million for its 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.
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.
26
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 JUN.30 SEP.30 DEC.31 MAR.31 JUN.30 SEP.30 DEC.31
2003 2003 2003 2003 2004 2004 2004 2004
------- ------- ------- ------- ------- ------- ------- -------
Net Sales ....... $ 78.7 $ 78.2 $ 96.5 $ 67.0 $ 42.2 $ 38.5 $ 38.1 $ 36.7
Gross profit .... 8.8 (0.4) 11.5 12.1 7.5 5.3 4.1 4.1
Operating income
(loss) ......... (1.3) (34.4) 1.4 0.8 (5.9) (84.4) (3.4) (27.5)
Net income (loss) (3.9) (32.6) 0.1 0.4 (3.0) (68.6) (4.0) (29.1)
QUARTER ENDED
--------------------------------------------------------------------------
MAR.31 JUN.30 SEP.30 DEC.31 MAR.31 JUN.30 SEP.30 DEC.31
2003 2003 2003 2003 2004 2004 2004 2004
- ----------------- ------ ------ ------ ------ ------ ------ ------ ------
Net sales ....... 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Gross profit .... 11.2 (0.6) 11.9 18.0 17.8 13.7 10.9 11.1
Operating income
(loss) ......... (1.7) (44.0) 1.5 1.2 (14.0) (219.2) (9.0) (74.7)
Net income (loss) (4.9) (41.7) 0.1 0.6 (7.1) (178.1) (10.5) (79.3)
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.
27
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, issuance of long-term debt, sales of equity and debt securities, and
vendor financing. In the near term, we expect that our operations and borrowings
under bank and other credit facilities will provide sufficient cash to fund our
operating expenses, capital expenditures and interest payments on our debt. In
the long-term, we expect to use internally generated funds and external sources
to satisfy our debt and other long-term liabilities.
Our liquidity is dependent, in part, on customers paying on time. Any
abnormal chargebacks or returns may affect our source of short-term funding. 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.
Other principal factors that could affect the availability of our
internally generated funds include:
o deterioration of sales due to weakness in the markets in which
we sell our products;
o decreases in market prices for our products;
o increases in costs of raw materials; and
o changes in our working capital requirements.
Principal factors that could affect our ability to obtain cash from
external sources include:
o financial covenants contained in our current or future bank
and debt facilities; and
o volatility in the market price of our common stock or in the
stock markets in general.
The disposition of our Mexico operations has enabled us to return to
the business model that was profitable prior to implementation of our vertically
integrated manufacturing operations that required major capital expenditures and
substantial working capital. The lease and subsequent sale of our Mexican
facilities significantly reduced our working capital requirements due to fewer
employees and the elimination of fixed overhead. Investment in inventory also
was substantially reduced as we no longer need to purchase raw materials, such
as cotton, at commencement of the manufacturing process and carry the costs of
such materials until finished goods are shipped to our customers. Reduced
working capital and capital expenditures in Mexico has resulted in a
corresponding reduction of outstanding indebtedness and interest payments.
Furthermore, we no longer need to accept orders with low or negative margins to
fill production capacity in slow seasons, which should improve margins and allow
us to source production in the best locations worldwide.
28
Cash flows for the years ended December 31, 2002, 2003 and 2004 were as
follows (dollars in thousands):
CASH FLOWS: 2002 2003 2004
- -------------------------------------------- -------- -------- --------
Net cash provided by operating activities .. $ 15,493 $ 9,484 $ 12,168
Net cash provided by (used in) investing
activities .............................. $ (5,670) $ (1,053) $ 1,250
Net cash used in financing activities ...... $ (8,435) $ (6,295) $(15,552)
Net cash provided by operating activities was $12.2 million in 2004, as
compared to net cash provided by operations in 2003 of $9.5 million and $15.5
million in 2002. Net cash provided by operations in 2004 resulted primarily from
a net loss of $104.7 million offset by depreciation and amortization of $8.3
million, asset impairment of $78.0 million and cumulative translation of $22.8
million. In addition to these items, the components of working capital impacting
cash from operations included a decrease of $21.2 million in accounts receivable
and a decrease of $4.2 million in inventory.
During 2004, cash flow provided by investing activities was $1.3
million, as compared to net cash used in investing activities of $1.1 million in
2003 and $5.7 million in 2002. Cash provided by investing activities in 2004
included approximately $1.2 million of proceeds from the sale of fixed assets.
During 2004, net cash used in financing activities was $15.6 million as
compared to $6.3 million in 2003 and $8.4 million in 2002. Net cash used in
financing activities in 2004 included $11.3 million net repayment of our
short-term bank borrowings and $17.2 million net repayment of indebtedness under
our credit facilities, partially offset by $9.4 million of net proceeds from the
issuance of convertible debentures and $3.6 million of net proceeds from the
issuance of preferred stock and warrant.
CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
Following is a summary of our contractual obligations and commercial
commitments available to us as of December 31, 2004 (in millions):
PAYMENTS DUE BY PERIOD
------------------------------------------------
Between Between
Less than 2-3 4-5 After
CONTRACTUAL OBLIGATION Total 1 year years years 5 years
-------- ------- ------- ------- -------
Long-term debt(1) ................ $ 22.2 $ 19.6 $ 2.6 $ -- $ --
Convertible debentures, net ...... $ 10.0 $ -- $ 10.0 $ -- $ --
Operating leases ................. $ 0.6 $ 0.3 $ 0.3 $ -- $ --
Minimum royalties ................ $ 17.9 $ 2.8 $ 7.5 $ 1.9 $ 5.7
Purchase commitment .............. $ 50.0 $ 5.0 $ 10.0 $ 10.0 $ 25.0
-------- ------- ------- ------- -------
Total Contractual Cash Obligations $ 100.7 $ 27.7 $ 30.4 $ 11.9 $ 30.7
- ----------
(1) Excludes interest on long-term debt obligations. Based on outstanding
borrowings as of December 31, 2004, and assuming all such indebtedness
remained outstanding during 2005 and the interest rates remained
unchanged, we estimate that our interest cost on long-term debt would be
approximately $3.2 million.
29
AMOUNT OF COMMITMENT
EXPIRATION PER PERIOD
TOTAL AMOUNTS ----------------------------------------------
OTHER COMMERCIAL COMMITTED Less than Between Between After
COMMITMENTS AVAILABLE TO US TO US 1 year 2-3 years 4-5 years 5 years
- ------------------------------------------ ------------- ---------- --------- --------- -------
Lines of credit........................... $63.9 $63.9 -- -- --
Letters of credit (within lines of credit) $18.9 $18.9 -- -- --
Total Commercial Commitments.............. $63.9 $63.9 -- -- --
On June 13, 2002, we entered into a letter of credit facility of $25
million with UPS Capital Global Trade Finance Corporation ("UPS"). Under this
facility, we may arrange for the issuance of letters of credit and acceptances.
The facility is collateralized by the shares and debentures of all of our
subsidiaries 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
6.25% per annum at December 31, 2004. 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. On December 31, 2004, we
amended the letter of credit facility with UPS to reduce the maximum amount of
borrowings under the facility to $15 million and extend the expiration date of
the facility to June 30, 2005. Under the amended letter of credit facility, we
are subject to restrictive financial covenants of maintaining tangible net worth
of $22 million at each of December 31, 2004 and March 31, 2005 and $25 million
as of the last day of each fiscal quarter thereafter. There is also a provision
capping maximum capital expenditures per quarter of $800,000. As of December 31,
2004, $12.6 million was outstanding under this facility with UPS, and an
additional $1.3 million was available for future borrowings. In addition, $1.1
million of open letters of credit was outstanding as of December 31, 2004.
On December 31, 2004, our Hong Kong subsidiaries also entered into a
new loan agreement with UPS pursuant to which UPS made a $5 million term loan,
the proceeds of which were used to repay $5 million of indebtedness owed to UPS
under the letter of credit of facility. The principal amount of this loan is due
and payable in 24 equal monthly installments of approximately $208,333 each,
plus interest equivalent to the "prime rate" plus 2% commencing on February 1,
2005. Under the loan agreement, we are subject to restrictive financial
covenants of maintaining tangible net worth of $22 million at each of December
31, 2004 and March 31, 2005 and $25 million as of the last day of each fiscal
quarter thereafter. There is also a provision capping maximum capital
expenditure per quarter at $800,000. As of December 31, 2004, we were in
compliance with the covenants. The obligations under the loan agreement are
collateralized by the same security interests and guarantees as the letter of
credit facility. Additionally, the term loan is secured by two promissory notes
payable to Tarrant Luxembourg Sarl in the amounts of $2,550,000 and $1,360,000
and a pledge by Gerard Guez of 4.6 million shares of our common stock to secure
the obligations.
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, our Chairman and Todd Kay, our Vice Chairman, and by
our guarantee. The letter of credit facility was increased to HKD 30 million
(equivalent to US$3.9 million) in June 2004. As of December 31, 2004, $3.4
million was outstanding under this facility. In addition, $1.4 million of open
letters of credit was outstanding as of December 31, 2004. In October 2004, a
tax loan for HKD 7.725 million (equivalent to US $977,000) was also made
available to our Hong Kong subsidiaries. As of December 31, 2004, $916,000 was
outstanding under this tax loan.
30
We were previously party to a revolving credit, factoring and security
agreement (the "Debt Facility") with GMAC Commercial Credit, LLC ("GMAC"). This
Debt Facility provided a revolving facility of $90 million, including a letter
of credit facility not to exceed $20 million, and was scheduled to mature on
January 31, 2005. The Debt Facility also provided a term loan of $25 million,
which was being repaid in monthly installments of $687,500. The Debt Facility
provided for interest at LIBOR plus the LIBOR rate margin determined by the
Total Leverage Ratio (as defined in the Debt Facility agreements), and was
collateralized by our receivables, intangibles, inventory and various other
specified non-equipment assets. In May 2004, the maximum facility amount was
reduced to $45 million in total and we established new financial covenants with
GMAC for the fiscal year of 2004.
On October 1, 2004, we amended and restated the Debt Facility dated
January 21, 2000 by and among us, our subsidiaries, TagMex, Inc. Fashion
Resource (TCL) Inc and United Apparel Ventures, LLC and GMAC. The amended and
restated agreement (the Factoring agreement) adds as parties our subsidiaries
Private Brands, Inc and No! Jeans, Inc. In addition, in connection with the
factoring agreement, our indirect majority-owned subsidiary, PBG7, LLC. entered
into a separate factoring agreement with GMAC. Pursuant to the terms of the
factoring agreement, we and our subsidiaries agree to assign and sell to GMAC,
as factor, all accounts which arise from the Tarrant Parties' sale of
merchandise or rendition of service created on a going forward basis. At
Tarrant's request, GMAC, in its discretion, may make advances to Tarrant Parties
up to the lesser of (a) up