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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934.
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2005
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
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TARRANT APPAREL GROUP
(Exact Name of Registrant as Specified in Its Charter)
CALIFORNIA 95-4181026
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification Number)
3151 EAST WASHINGTON BOULEVARD
LOS ANGELES, CALIFORNIA 90023
(Address of Principal Executive Offices) (Zip Code)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (323) 780-8250
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes |X| No |_|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes |_| No |X|
Number of shares of Common Stock of the registrant outstanding as of May 13,
2005: 29,010,076.
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TARRANT APPAREL GROUP
FORM 10-Q
INDEX
PART I. FINANCIAL INFORMATION
PAGE
----
Item 1. Financial Statements (Unaudited)
Consolidated Balance Sheets at March 31, 2005 (Unaudited)
and December 31, 2004 (Audited)............................... 3
Consolidated Statements of Operations and Comprehensive
Loss for the Three Months Ended March 31, 2005 and
March 31, 2004................................................ 4
Consolidated Statements of Cash Flows for the Three Months
Ended March 31, 2005 and March 31, 2004....................... 5
Notes to Consolidated Financial Statements.................... 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations .................................... 16
Item 3. Quantitative and Qualitative Disclosures About Market Risk ... 33
Item 4. Controls and Procedures....................................... 33
PART II. OTHER INFORMATION
Item 1. Legal Proceedings............................................. 34
Item 6. Exhibits...................................................... 34
SIGNATURES.................................................... 35
CAUTIONARY LEGEND REGARDING FORWARD-LOOKING STATEMENTS
Some of the information in this Quarterly Report on Form 10-Q may
constitute forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934,
both as amended. These forward-looking statements are subject to various risks
and uncertainties. The forward-looking statements include, without limitation,
statements regarding our future business plans and strategies and our future
financial position or results of operations, as well as other statements that
are not historical. You can find many of these statements by looking for words
like "will", "may", "believes", "expects", "anticipates", "plans" and
"estimates" and for similar expressions. Because forward-looking statements
involve risks and uncertainties, there are many factors that could cause the
actual results to differ materially from those expressed or implied. These
include, but are not limited to, economic conditions. This Quarterly Report on
Form 10-Q contains important cautionary statements and a discussion of many of
the factors that could materially affect the accuracy of Tarrant's
forward-looking statements and such statements and discussions are incorporated
herein by reference. Any subsequent written or oral forward-looking statements
made by us or any person acting on our behalf are qualified in their entirety by
the cautionary statements and factors contained or referred to in this section.
We do not intend or undertake any obligation to update any forward-looking
statements to reflect events or circumstances after the date of this document or
the date on which any subsequent forward-looking statement is made or to reflect
the occurrence of unanticipated events.
2
PART I -- FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
TARRANT APPAREL GROUP
CONSOLIDATED BALANCE SHEETS
MARCH 31, DECEMBER 31,
2005 2004
------------- -------------
(Unaudited) (Restated)
ASSETS
Current assets:
Cash and cash equivalents ............................... $ 201,036 $ 1,214,944
Accounts receivable, net ................................ 43,283,267 37,759,343
Due from related parties ................................ 7,335,683 10,651,914
Inventory ............................................... 18,277,980 19,144,105
Current portion of notes receivable from related parties 5,323,733 5,323,733
Prepaid expenses ........................................ 1,134,290 1,251,684
Prepaid royalties ....................................... 3,396,970 2,257,985
Income taxes receivable ................................. 173,231 144,796
------------- -------------
Total current assets ...................................... 79,126,190 77,748,504
Property and equipment, net ............................. 1,734,994 1,874,893
Notes receivable - related party, net of current portion 39,890,114 40,107,337
Equity Method investment ................................ 2,043,592 1,880,281
Deferred financing cost, net ............................ 1,124,805 1,203,259
Other assets ............................................ 186,676 414,161
Goodwill, net ........................................... 8,582,845 8,582,845
------------- -------------
Total assets .............................................. $ 132,689,216 $ 131,811,280
============= =============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Short-term bank borrowings .............................. $ 12,659,031 $ 17,951,157
Accounts payable ........................................ 18,526,575 24,394,553
Accrued expenses ........................................ 11,753,512 11,243,179
Income taxes ............................................ 16,902,810 16,826,383
Current portion of long-term obligations ................ 31,484,275 19,628,701
------------- -------------
Total current liabilities ................................. 91,326,203 90,043,973
Long-term obligations ...................................... 2,124,905 2,544,546
Convertible Debentures, net ................................ 8,469,609 8,330,483
Deferred tax liabilities ................................... 161,773 213,784
Minority interest in UAV and PBG7 .......................... -- --
Commitments and contingencies
Shareholders' equity:
Preferred stock, 2,000,000 shares authorized; no shares
(2005) and (2004) issued and outstanding ............. -- --
Common stock, no par value, 100,000,000 shares
authorized; 28,814,763 shares (2005) and 28,814,763
shares (2004) issued and outstanding .................. 111,515,091 111,515,091
Warrant to purchase common stock ........................ 2,846,833 2,846,833
Contributed capital ..................................... 9,965,591 9,965,591
Accumulated deficit ..................................... (91,288,779) (91,182,959)
Notes receivable from officer/shareholder ............... (2,432,010) (2,466,062)
------------- -------------
Total shareholders' equity ................................ 30,606,726 30,678,494
------------- -------------
Total liabilities and shareholders' equity ................ $ 132,689,216 $ 131,811,280
============= =============
The accompanying notes are an integral part of these consolidated financial
statements
3
TARRANT APPAREL GROUP
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(Unaudited)
THREE MONTHS ENDED MARCH 31,
------------------------------
2005 2004
------------ ------------
Net sales .................................. $ 44,830,291 $ 42,154,905
Cost of sales .............................. 35,884,573 34,654,837
------------ ------------
Gross profit ............................... 8,945,718 7,500,068
Selling and distribution expenses .......... 2,561,854 2,642,399
General and administrative expenses ........ 5,855,823 10,779,151
------------ ------------
Income (loss) from operations .............. 528,041 (5,921,482)
Interest expense ........................... (813,185) (793,783)
Interest income ............................ 553,223 94,271
Other income ............................... 227,868 3,496,732
Other expense .............................. (300,604) (359,202)
Minority interest .......................... -- 880,548
------------ ------------
Income (loss) before provision for
income taxes ............................ 195,343 (2,602,916)
Provision for income taxes ................. 301,163 370,615
------------ ------------
Net loss ................................... $ (105,820) $ (2,973,531)
============ ============
Net loss per share - Basic and Diluted ..... $ (0.00) $ (0.10)
============ ============
Weighted average common and common
equivalent shares:
Basic and Diluted ....................... 28,814,763 28,485,093
============ ============
Net loss ................................... $ (105,820) $ (2,973,531)
Foreign currency translation adjustment .... -- 936,863
------------ ------------
Total comprehensive loss ................... $ (105,820) $ (2,036,668)
============ ============
The accompanying notes are an integral part of these consolidated financial
statements
4
TARRANT APPAREL GROUP
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
THREE MONTHS ENDED MARCH 31,
----------------------------
2005 2004
------------ ------------
Operating activities:
Net loss .................................................. $ (105,820) $ (2,973,531)
Adjustments to reconcile net loss to net cash (used in)
provided by operating activities:
Deferred taxes ......................................... (52,011) 22,294
Depreciation and amortization .......................... 568,165 3,823,071
Unrealized gain on foreign currency .................... -- (542,621)
Compensation expense related to stock option ........... -- 53,679
Provision for returns and discounts .................... 254,040 292,929
Income from investments ................................ (163,311) (365,733)
Gain on sale of fixed assets ........................... (849) --
Minority interest ...................................... -- (880,548)
Changes in operating assets and liabilities:
Restricted cash ...................................... -- 2,759,742
Accounts receivable .................................. (5,777,964) 5,607,999
Due to/from related parties .......................... 1,237,215 (3,531,602)
Inventory ............................................ 866,125 3,643,250
Temporary quota rights ............................... -- (2,567,686)
Prepaid expenses ..................................... (1,120,844) (470,274)
Accounts payable ..................................... (5,867,978) (2,891,778)
Accrued expenses and income tax payable .............. 586,759 2,953,301
------------ ------------
Net cash (used in) provided by operating activities .. (9,576,473) 4,932,492
Investing activities:
Purchase of fixed assets ............................... (70,631) (23,271)
Increase in other assets ............................... -- (327,497)
Collection on notes receivable ......................... 217,222 --
Collection of advances from shareholders/officers ...... 2,334,053 1,650
------------ ------------
Net cash provided by (used in) investing activities .. 2,480,644 (349,118)
Financing activities:
Short-term bank borrowings, net ........................ (5,292,126) (1,464,122)
Proceeds from long-term obligations .................... 50,602,423 27,677,749
Payment of long-term obligations and bank borrowings ... (39,228,376) (36,991,080)
Proceeds from issuance of common stock and warrant ..... -- 3,667,765
------------ ------------
Net cash provided by (used in) financing activities .. 6,081,921 (7,109,688)
Effect of exchange rate on cash ........................... -- 56,860
------------ ------------
Decrease in cash and cash equivalents ..................... (1,013,908) (2,469,454)
Cash and cash equivalents at beginning of period .......... 1,214,944 3,319,964
------------ ------------
Cash and cash equivalents at end of period ................ $ 201,036 $ 850,510
============ ============
The accompanying notes are an integral part of these consolidated financial
statements
5
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. ORGANIZATION AND BASIS OF CONSOLIDATION
The accompanying financial statements consist of the consolidation of
Tarrant Apparel Group, a California corporation, and its majority owned
subsidiaries located primarily in the U.S., Mexico, and Asia. At March 31, 2005,
we own 50.1% of United Apparel Ventures ("UAV") and 75% of PBG7, LLC ("PBG7").
We consolidate these entities and reflect the minority interests in earnings
(losses) of the ventures in the accompanying financial statements. All
inter-company amounts are eliminated in consolidation. The 49.9% minority
interest in UAV is owned by Azteca Production International, a corporation owned
by the brothers of our Chairman, Gerard Guez. The 25% minority interest in PBG7
is owned by BH7, LLC, an unrelated party.
We serve specialty retail, mass merchandise and department store chains
and major international brands by designing, merchandising, contracting for the
manufacture of, and selling casual apparel for women, men and children under
private label. Commencing in 1999, we expanded our operations from sourcing
apparel to sourcing and operating our own vertically integrated manufacturing
facilities. In August 2003, we determined to abandon our strategy of being both
a trading and vertically integrated manufacturing company, and effective
September 1, 2003, we leased and outsourced operation of our manufacturing
facilities in Mexico to affiliates of Mr. Kamel Nacif, a shareholder at the time
of the transaction. In August 2004, we entered into a purchase and sale
agreement to sell these facilities to affiliates of Mr. Nacif, which transaction
was consummated in the fourth quarter of 2004.
Historically, our operating results have been subject to seasonal
trends when measured on a quarterly basis. This trend is dependent on numerous
factors, including the markets in which we operate, holiday seasons, consumer
demand, climate, economic conditions and numerous other factors beyond our
control. Generally, the second and third quarters are stronger than the first
and fourth quarters. There can be no assurance that the historic operating
patterns will continue in future periods.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accompanying unaudited financial statements have been prepared in
accordance with accounting principles generally accepted in the United States
for interim financial information and with the instructions to Form 10-Q and
Article 10 of Regulation S-X. Accordingly, they do not include all of the
information and footnotes required by accounting principles generally accepted
in the United States for complete financial statements. In the opinion of
management, all adjustments (consisting of normal recurring accruals) considered
necessary for a fair presentation of the results of operations for the periods
presented have been included.
The consolidated financial data at December 31, 2004 is derived from
audited financial statements which are included in our Annual Report on Form
10-K for the year ended December 31, 2004, and should be read in conjunction
with the audited financial statements and notes thereto. Interim results are not
necessarily indicative of results for the full year.
The accompanying unaudited consolidated financial statements include
all majority-owned subsidiaries in which we exercise control. Investments in
which we exercise significant influence, but which we do not control, are
accounted for under the equity method of accounting. The equity method of
accounting is used when we have a 20% to 50% interest in other entities, except
for variable interest entities for which we are considered the primary
beneficiary under Financial Accounting Standards Board ("FASB") Interpretation
No. 46, "Consolidation of Variable Interest Entities," an interpretation of ARB
No. 51. Under the equity method, original investments are recorded at cost and
adjusted by our share of undistributed earnings or losses of these entities. All
significant intercompany transactions and balances have been eliminated from the
consolidated financial statements.
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Significant estimates used by us in
preparation of the consolidated financial statements include: (i) allowance for
returns, discounts and bad debts, (ii) inventory, (iii) valuation of long lived
and intangible assets and goodwill, and (iv) income taxes. Actual results could
differ from those estimates.
6
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Certain 2004 amounts have been reclassified to conform to the 2005
presentation.
3. STOCK BASED COMPENSATION
We have adopted the disclosure provisions of Statement of Financial
Accounting Standards ("SFAS") No. 148, "Accounting for Stock-Based Compensation
- - Transition and Disclosure," an amendment of FASB Statement No. 123. This
pronouncement requires prominent disclosures in both annual and interim
financial statements regarding the method of accounting for stock-based employee
compensation and the effect of the method used on reported results. We account
for stock compensation awards under the intrinsic value method of Accounting
Principles Board ("APB") Opinion No. 25, rather than the alternative fair-value
accounting method. Under the intrinsic-value method, if the exercise price of
the employee's stock options equals the market price of the underlying stock on
the date of the grant, no compensation expense is recognized. For the three
months ended March 31, 2005 and 2004, $0 and $54,000 was recorded, respectively,
as an expense related to our stock options.
For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period. Our pro forma
information follows:
THREE MONTHS ENDED
MARCH 31,
-------------------------
2005 2004
----------- -----------
Net loss as reported .............................. $ (105,820) $(2,973,531)
Add stock-based employee compensation charges
reported in net loss ........................... -- 53,679
Pro forma compensation expense, net of tax ........ (76,509) (1,344,072)
----------- -----------
Pro forma net loss ................................ $ (182,329) $(4,263,924)
=========== ===========
Net loss per share as reported -- Basic and Diluted $ (0.00) $ (0.10)
Add stock-based employee compensation charges
reported in net loss - Basic and Diluted ....... -- --
Pro forma compensation expense per share
Basic and diluted .............................. (0.00) (0.05)
----------- -----------
Pro forma loss per share -- Basic and Diluted ..... $ (0.00) $ (0.15)
=========== ===========
The fair value of each option grant is estimated on the date of grant
using the Black-Scholes option-pricing model with the following weighted average
assumptions used for grants in 2005 and 2004: weighted-average volatility
factors of the expected market price of our common stock of 0.55 and 0.51 for
the three months ended March 31, 2005 and 2004, respectively, weighted-average
risk-free interest rates of 4% and 3% for the three months ended March 31, 2005
and 2004, respectively, dividend yield of 0% and weighted-average expected life
of the options of 4 years. These pro forma results may not be indicative of the
future results for the full fiscal year due to potential grants, vesting and
other factors.
7
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
4. ACCOUNTS RECEIVABLE
Accounts receivable consists of the following:
MARCH 31, DECEMBER 31,
2005 2004
------------ ------------
United States trade accounts receivable ........ $ 2,718,355 $ 3,248,887
Foreign trade accounts receivable .............. 15,219,052 17,148,600
Due from factor ................................ 27,146,811 19,452,756
Other receivables .............................. 897,850 346,965
Allowance for returns, discounts and bad debts . (2,698,801) (2,437,865)
------------ ------------
$ 43,283,267 $ 37,759,343
============ ============
5. INVENTORY
Inventory consists of the following:
MARCH 31, DECEMBER 31,
2005 2004
------------ ------------
Raw materials - fabric and trim accessories .... $ 909,101 $ 1,164,977
Finished goods shipments-in-transit ............ 5,629,690 9,283,022
Finished goods ................................. 11,739,189 8,696,106
----------- ------------
$ 18,277,980 $ 19,144,105
============ ============
6. EQUITY METHOD INVESTMENT - AMERICAN RAG
In the second quarter of 2003, we acquired a 45% equity interest in the
owner of the trademark "American Rag CIE" and the operator of American Rag
retail stores for $1.4 million, and our subsidiary, Private Brands, Inc.,
acquired a license to certain exclusive rights to this trademark. We have
guaranteed the payment to the licensor of minimum royalties of $10.4 million
over the initial 10-year term of the agreement. Private Brands also entered into
a multi-year exclusive distribution agreement with Macy's Merchandising Group,
LLC ("MMG"), the sourcing arm of Federated Department Stores, to supply MMG with
American Rag CIE, a new casual sportswear collection for juniors and young men.
Private Brands will design and manufacture American Rag apparel, which will be
distributed by MMG exclusively to Federated stores across the country. Beginning
in August 2003, the American Rag collection was available in approximately 100
select Macy's, the Bon Marche, Burdines, Goldsmith's, Lazarus and Rich's-Macy's
locations. The investment in American Rag CIE, LLC totaling $2.0 million at
March 31, 2005, is accounted for under the equity method and included in equity
method investment on the accompanying consolidated balance sheets. Income from
the equity method investment is recorded in the United States geographical
segment. The change in investment in American Rag during the three month ended
March 31, 2005 was as follows:
Balance as of December 31, 2004 ..... $ 1,880,281
Share of income...................... 163,311
-------------
Balance as of March 31, 2005......... $ 2,043,592
=============
7. DEBT
Short-term bank borrowings consist of the following:
MARCH 31, DECEMBER 31,
2005 2004
----------- -----------
Import trade bills payable - UPS, DBS Bank
and Aurora Capital .......................... $ 5,683,482 $ 3,902,714
Bank direct acceptances - UPS .................. 4,030,869 10,447,855
Other Hong Kong credit facilities - UPS and
DBS Bank .................................... 2,944,680 3,600,588
----------- -----------
$12,659,031 $17,951,157
=========== ===========
8
Long-term obligations consist of the following:
MARCH 31, DECEMBER 31,
2005 2004
------------ ------------
Vendor financing ................... $ -- $ 135,145
Loan from Max Azria ................ 3,750,000 --
Equipment financing ................ 75,064 78,038
Term loan - UPS .................... 4,583,333 5,000,000
Debt facility - GMAC ............... 25,200,783 16,960,064
------------ ------------
33,609,180 22,173,247
Less current portion ............... (31,484,275) (19,628,701)
------------ ------------
$ 2,124,905 $ 2,544,546
============ ============
IMPORT TRADE BILLS PAYABLE, BANK DIRECT ACCEPTANCES AND OTHER HONG KONG CREDIT
FACILITIES
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
6.75% per annum at March 31, 2005. 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 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 March 31, 2005, $7.1
million was outstanding under this facility with UPS (classified above as
follows: $1.3 million in import trade bills payable; $4.0 million in bank direct
acceptances and $1.8 million in other Hong Kong facilities) and an additional
$3.8 million was available for future borrowings. In addition, $4.1 million of
open letters of credit was outstanding as of March 31, 2005.
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 March 31, 2005, $2.6 million
was outstanding under this facility. In addition, $1.2 million of open letters
of credit was outstanding and $45,000 was available for future borrowings as of
March 31, 2005. 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 March
31, 2005, $671,000 was outstanding under this loan.
As of March 31, 2005, the total balance outstanding under the DBS Bank
credit facilities was $3.3 million (classified above as follows: $2.1 million in
import trade payable and $1.2 million in other Hong Kong facilities).
From time to time, we open letters of credit under an uncommitted line
of credit from Aurora Capital Associates who issues these letters of credits out
of Israeli Discount Bank. As of March 31, 2005, $2.3 million was outstanding
under this facility (classified above under import trade bills payable) and $2.1
million of letters of credit were open under this arrangement. We pay a
commission fee of 2.25% on all letters of credits issued under this arrangement.
LOAN FROM MAX AZRIA
On February 14, 2005, we borrowed $5.0 million from Max Azria, which
amount bears interest at the rate of 4% per annum and is payable in weekly
installments of $250,000 beginning on February 28, 2005 and continuing each
Monday until July 11, 2005. This is an unsecured loan. As of March 31, 2005,
$3.8 million was outstanding.
9
VENDOR FINANCING
During 2000, we financed equipment purchases for a manufacturing
facility with certain vendors. A total of $16.9 million was financed with
five-year promissory notes, which bear interest ranging from 7.0% to 7.5%, and
are payable in semiannual payments commencing in February 2000. The debt was
paid off in February 2005. A portion of the debt was denominated in Euros.
Unrealized transaction (loss) gain associated with the debt denominated in Euros
totaled $0, and $543,000 for the three months ended March 31, 2005 and 2004,
respectively. These amounts were recorded in other income (expense) in the
accompanying consolidated statements of operations.
EQUIPMENT FINANCING
We had two equipment loans outstanding at March 31, 2005 totaling
$75,000 bearing interest at 6% payable in installments through 2009.
TERM LOAN - UPS
On December 31, 2004, our Hong Kong subsidiaries 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 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 March 31, 2005, $4.6 million was outstanding and we
were in compliance with the covenants. The obligations under the loan agreement
are collateralized by the same security interests and guarantees provided under
our letter of credit facility with UPS. 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, our Chairman, of 4.6
million shares of our common stock.
DEBT FACILITY- GMAC
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) extended the expiration date of the
facility to September 30, 2007 and added 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 to 90% of our accounts on which GMAC has the risk of loss and (b)
forty million dollars, minus in each case, any amount owed to GMAC by any
Tarrant Party. Pursuant to the terms of the PBG7 factoring agreement, PBG7
agreed to assign and sell to GMAC, as factor, all accounts, which arise from
PBG7's sale of merchandise or rendition of services created on a going-forward
basis. At PBG7's request, GMAC, in its discretion, may make advances to PBG7 up
to the lesser of (a) up to 90% of PBG7's accounts on which GMAC has the risk of
loss, and (b) five million minus in each case, any amounts owed to GMAC by PBG7.
Under both factoring agreement, any amounts, which GMAC advances in excess of
the purchase price
10
of the relevant accounts, are considered to be loans and are chargeable to the
Tarrant Parties' or PBG7's when paid. Each of the parties only become obligated
to GMAC for a direct financial obligation in the event that GMAC makes and
advance in excess of the purchase price of the relevant accounts, and any such
obligations are payable on demand. This facility bears interest at 6% per annum
at March 31, 2005. Restrictive covenants under the revised facility include a
limit on quarterly capital expenses of $800,000 and tangible net worth of $20
million at September 30, 2004, $22 million at December 31, 2004 and March 31,
2005 and $25 million at the end of each fiscal quarter thereafter beginning on
June 30, 2005. As of March 31, 2005 we were in compliance with the new tangible
net worth and capital expense covenants. A total of $25.2 million was
outstanding under the GMAC facility at March 31, 2005.
In May 2005, we amended our factoring agreement with GMAC to permit our
subsidiaries party thereto and us, to borrow up to the lesser of $3 million or
fifty percent (50%) of the value of eligible inventory (as defined). The maximum
borrowing availability under the factoring agreement, based on a borrowing base
formula, remained $40 million. Our subsidiaries party thereto and we granted
GMAC a lien on certain of our inventory located in the United States.
The credit facility with GMAC and the credit facility with UPS carry
cross-default clauses. A breach of a financial covenant set by GMAC or UPS
constitutes an event of default under the other credit facility, entitling both
financial institutions to demand payment in full of all outstanding amounts
under their respective debt and credit facilities.
GUARANTEES
Guarantees have been issued since 2001 in favor of YKK, Universal
Fasteners, and RVL Inc. for $750,000, $500,000 and an unspecified amount,
respectively, to cover trim purchased by Tag-It Pacific Inc. on our behalf. We
have not reported a liability for these guarantees. We issued the guarantees to
cover trim purchased by Tag-It in order to ensure our production in a timely
manner. If Tag-It ever defaults, we would have to pay the outstanding liability
due to these vendors by Tag-It for purchases made on our behalf. We have not had
to perform under these guarantees since inception. It is not predictable to
estimate the fair value of the guarantee; however, we do not anticipate that we
will incur losses as a result of these guarantees. As of March 31, 2005, Tag-It
Pacific Inc. had approximately $94,000 due to Universal Fasteners. In April
2005, we terminated these guarantees with respect to Tag-It's obligations
arising after the date of termination.
8. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In December 2004, the FASB issued SFAS No. 123 (revised 2004),
"Share-Based Payment," which addresses the accounting for employee stock
options. SFAS No. 123R eliminates the ability to account for shared-based
compensation transactions using APB Opinion No. 25 and generally would require
instead that such transactions be accounted for using a fair value-based method.
SFAS No. 123R also requires that tax benefits associated with these share-based
payments be classified as financing activities in the statement of cash flow
rather than operating activities as currently permitted. SFAS No. 123R becomes
effective for the first annual period beginning after June 15, 2005.
Accordingly, we are required to apply SFAS No. 123R beginning in the quarter
ending March 31, 2006. SFAS No. 123R offers alternative methods of adopting this
final rule. We have not yet determined which alternative method we will use.
In November 2004, the FASB issued SFAS No. 151, "Inventory Costs, an
amendment of ARB No. 43, Chapter 4," SFAS No. 151 clarifies that abnormal
inventory costs such as costs of idle facilities, excess freight and handling
costs, and wasted materials (spoilage) are required to be recognized as current
period costs. The provisions of SFAS No. 151 are effective for our fiscal 2006.
We are currently evaluating the provisions of SFAS No. 151 and do not expect
that adoption will have a material effect on our financial position, results of
operations or cash flows.
9. INCOME TAXES
Our effective tax rate differs from the statutory rate principally due
to the following reasons: (1) A full valuation allowance has been provided for
deferred tax assets as a result of the operating losses in the United States and
Mexico, since recoverability of those assets has not been assessed as more
likely than not; (2) although we have taxable losses in Mexico, we are subject
to a minimum tax; and (3) the earnings of our Hong Kong subsidiary are taxed at
a rate of 17.5% versus the 35% U.S. federal rate. The impairment charge in
Mexico did not result in a tax benefit due to an increase in the
11
valuation allowance against the future tax benefit. We believe it is more likely
than not that the tax benefit will not be realized based on our future business
plans in Mexico.
In January 2004, the Internal Revenue Service ("IRS") 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. 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. This adjustment would also result in
additional state taxes and interest. We believe that we have meritorious
defenses to and intend to vigorously contest the proposed adjustments. If the
proposed adjustments are upheld through the administrative and legal process,
they could have a material impact on our earnings and cash flow. We believe we
have provided adequate reserves for any reasonably foreseeable outcome related
to these matters on the 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.
10. NET LOSS PER SHARE
A reconciliation of the numerator and denominator of basic earnings
(loss) per share and diluted earnings (loss) per share is as follows:
THREE MONTHS ENDED MARCH 31,
------------------------------
Basic and Diluted EPS Computation: 2005 2004
------------ ------------
Numerator .................................. $ (105,820) $ (2,973,531)
Denominator:
Weighted average common shares
outstanding - Basic and Diluted ........ 28,814,763 28,485,093
Basic and Diluted EPS ...................... $ (0.00) $ (0.10)
============ ============
Basic and diluted loss per share has been computed in accordance with
SFAS No. 128, "Earnings Per Share". All options and warrants have been excluded
from the computation in the three months ended March 31, 2005 and 2004,
respectively, as the impact would be anti-dilutive.
The following potentially dilutive securities were not included in the
computation of loss per share, because to do so would have been anti-dilutive:
THREE MONTHS ENDED MARCH 31,
-------------------------------
Basic and Diluted EPS Computation: 2005 2004
--------- ---------
Options ............................ 6,994,787 8,937,287
Warrants ........................... 2,361,732 911,732
--------- ---------
Total .............................. 9,356,519 9,849,019
========= =========
11. RELATED PARTY TRANSACTIONS
As of March 31, 2005, related party affiliates were indebted to us in
the amounts of $9.8 million. These include amounts due from Gerard Guez, our
Chairman. From time to time in the past, we borrowed funds from, and advanced
funds to, Mr. Guez. The greatest outstanding balance of such advances to Mr.
Guez in the first quarter of 2005 was
12
approximately $4,766,000. In the first quarter of 2005, Mr. Guez repaid $2.3
million of this indebtedness. At March 31, 2005, the entire balance due from Mr.
Guez totaling $2.4 million is payable on demand and had been shown as reductions
to shareholders' equity. All advances to, and borrowings from, Mr. Guez bore
interest at the rate of 7.75% during the period. Total interest paid by Mr. Guez
was $74,000 and $93,000 for the three months ended March 31, 2005 and 2004,
respectively. Mr. Guez paid expenses on our behalf of approximately $108,000 and
$94,000 for the three months ended March 31, 2005 and 2004, respectively, which
amounts were applied to reduce accrued interest and principal on Mr. Guez's
loan. Since the enactment of the Sarbanes-Oxley Act in 2002, no further personal
loans (or amendments to existing loans) have been or will be made to officers or
directors of Tarrant.
In February 2004, our Hong Kong subsidiary entered into a 50/50 joint
venture with Auto Enterprises Limited, an unrelated third party, to source
products for Seven Licensing Company, LLC and our Private Brands subsidiary in
mainland China. On May 31, 2004, after realizing an accumulated loss from the
venture of approximately $200,000 (our share being half), we sold our interest
for $1 to Asia Trading Limited, a company owned by Jacqueline Rose, wife of
Gerard Guez. The venture owed us $221,000 as of December 31, 2004. This amount
was repaid in the first quarter of 2005.
On July 1, 2001, we formed an entity to jointly market, share certain
risks and achieve economics of scale with Azteca Production International, Inc.
("Azteca"), a corporation owned by the brothers of Gerard Guez, our Chairman,
called United Apparel Ventures, LLC ("UAV"). This entity was created to
coordinate the production of apparel for a single customer of our branded
business. UAV is owned 50.1% by Tag Mex, Inc., our wholly owned subsidiary, and
49.9% by Azteca. Results of the operation of UAV have been consolidated into our
results since July 2001 with the minority partner's share of gain and losses
eliminated through the minority interest line in our financial statements. Due
to the restructuring of our Mexico operations, we discontinued manufacturing for
UAV customers in the second quarter of 2004. UAV made purchases from two related
parties in Mexico, an affiliate of Azteca and Tag-It Pacific, Inc.
Commencing in June 2003, UAV began selling to Seven Licensing Company,
LLC ("Seven Licensing"), jeans wear bearing the brand "Seven7", which was
ultimately purchased by Express. Seven Licensing is beneficially owned by Gerard
Guez. In the third quarter of 2004, in order to strengthen our own private brand
business, we decided to discontinue sourcing for Seven7. Total sales to Seven7
in the three months ended March 31, 2005 and 2004 were $0 and $2.2 million,
respectively. In 1998, a California limited liability company owned by our
Chairman and Vice Chairman purchased 2,300,000 shares of the common stock of
Tag-It Pacific, Inc. ("Tag-It") (or approximately 37% of such common stock then
outstanding). Tag-It is a provider of brand identity programs to manufacturers
and retailers of apparel and accessories. Commencing in 1998, Tag-It assumed the
responsibility for managing and sourcing all trim and packaging used in
connection with products manufactured by or on behalf of us in Mexico. Due to
the restructuring of our Mexico operations, Tag-It no longer manages our trim
and packaging requirements. We purchased $0 and $200,000 of trim inventory from
Tag-It in the three months ended March 31, 2005 and 2004, respectively. We
purchased $135,000 and $4.1 million of finished goods and service from Azteca
and its affiliates in the three months ended March 31, 2005 and 2004,
respectively. Our total sales of fabric and service to Azteca in the three
months ended March 31, 2005 and 2004 were $63,000 and $586,000, respectively.
Pursuant to the operating agreement for UAV, two and one half percent of gross
sales of UAV were paid to each of the members of UAV as management fees. Net
amount due from these related parties as of March 31, 2005 was $6.7 million.
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, including the
equipment and facilities we previously leased to Mr. Nacif's affiliates in
October 2003, for an aggregate purchase price consisting of: a) $105,400 in cash
and $3,910,000 by delivery of unsecured promissory notes bearing interest at
5.5% per annum; and b) $40,204,000, by delivery of secured promissory notes
bearing interest at 4.5% per annum, maturing on December 31, 2014, and payable
in equal monthly installments of principal and interest over the term of the
notes. Included in the $45.2 million notes receivable - related party on the
accompanying balance sheet as of March 31, 2005 was $1.3 million of Mexico
valued added taxes on the real property component of this transaction. The
future maturities of the note receivable from the purchasers, including the
Mexican value added tax to be paid by the purchasers. Upon consummation of the
sale, we entered into a purchase commitment agreement with the purchasers,
pursuant to which we have agreed to purchase annually
13
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. We
purchased $840,000 and $1.5 million of fabric from Acabados y Terminados in the
three months ended March 31, 2005 and 2004. Net amount due from these related
parties as of March 31, 2005 was $247,000.
Under lease agreements we entered into between two entities, GET and
Lynx International Limited, owned by our Chairman and Vice Chairman, we paid
$255,000 and $332,000 in the three months ended March 31, 2005 and 2004,
respectively, for office and warehouse facilities. We currently lease both
facilities on a month-to-month basis.
We reimbursed Mr. Guez, our Chairman, for fuel and related expenses
incurred by 477 Aviation LLC, a company owned by Mr. Guez, when our executives
used this company's aircraft for business purposes.
At March 31, 2005, we had various employee receivables totaling
$395,000 included in due from related parties.
In the second quarter of 2003, we acquired a 45% equity interest in the
owner of the trademark "American Rag CIE" and the operator of American Rag
retail stores for $1.4 million, and our subsidiary, Private Brands, Inc.,
acquired a license to certain exclusive rights to this trademark. The investment
in American Rag Cie, LLC totaling $2.0 million at March 31, 2005 was accounted
for under the equity method and included in equity method of investment on the
accompanying consolidated balance sheets.
We believe the each of the transactions described above has been
entered into on terms no less favorable to us than could have been obtained from
unaffiliated third parties.
12. COMMITMENTS AND CONTINGENCIES
On January 3, 2005, Private Brands, Inc, our wholly owned subsidiary,
entered into an agreement with Beyond Productions, LLC and Kids Headquarters to
collaborate on the design, manufacturing and distribution of women's
contemporary, large sizes and junior apparel bearing the brand name "House of
Dereon", Couture, Kick and Soul. This agreement has an initial three-year term,
and provided we are in compliance with the terms of the agreement, is renewable
for one additional three-year term. Minimum net sales are $10 million in year 1,
$20 million in year 2 and $30 million in year 3. The agreement provides for
royalty payments of 8% on net sales, and a marketing fund commitment of 3% of
net sales, for a total minimum payment obligation of $6.6 million over the
initial term of the agreement. As of March 31, 2005, we have advanced $1.2
million as payment for the first year's minimum royalty and marketing fund
commitment.
On October 17, 2004, Private Brands, Inc entered into an agreement with
J. S. Brand Management to design, manufacture and distribute Jessica Simpson
branded jeans and casual apparel in missy, juniors and large sizes. This
agreement has an initial three-year term, and provided we are in compliance with
the terms of the agreement, is renewable for one additional two-year term.
Minimum net sales are $20 million in year 1, $25 million in year 2 and $30
million in year 3. The agreement provides for payment of a sales royalty and
advertising royalty at the rate of 8% and 3%, respectively, of net sales, for a
total minimum payment obligation of $8.3 million over the initial term of the
agreement. As of March 31, 2005, we have advanced $2.2 million as payment for
the first year's minimum royalties.
In the second quarter of 2003, we acquired a 45% equity interest in the
owner of the trademark "American Rag CIE" and the operator of American Rag
retail stores for $1.4 million, and our subsidiary, Private Brands, Inc.,
acquired a license to certain exclusive rights to this trademark. We have
guaranteed the payment to the licensor of minimum royalties of $10.4 million
over the initial 10-year term of the agreement. At March 31, 2005, the total
commitment on royalties remaining on the term was $9.5 million.
In August 2004, we entered into an Agreement for Purchase of Assets
with affiliates of Mr. Kamel Nacif, a shareholder at the time of the
transaction, with 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, including the
equipment and facilities we previously leased to Mr. Nacif's affiliates. Upon
consummation of the sale, we entered into a purchase commitment agreement with
the purchasers, pursuant to which we have agreed to purchase annually
14
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.
13. OPERATIONS BY GEOGRAPHIC AREAS
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. Information about our
operations in the United States, Asia, and Mexico is presented below.
Inter-company revenues and assets have been eliminated to arrive at the
consolidated amounts.
ADJUSTMENTS
AND
UNITED STATES ASIA MEXICO ELIMINATIONS TOTAL
------------ ------------ ------------ ------------ ------------
THREE MONTHS ENDED
MARCH 31, 2005
Sales ....................... $ 44,600,000 $ 224,000 $ 6,000 $ -- $ 44,830,000
Inter-company sales ......... -- 26,835,000 -- (26,835,000) --
------------ ------------ ------------ ------------ ------------
Total revenue ............... $ 44,600,000 $ 27,059,000 $ 6,000 $(26,835,000) $ 44,830,000
============ ============ ============ ============ ============
Income (loss) from operations $ (401,000) $ 1,133,000 $ (204,000) $ -- $ 528,000
============ ============ ============ ============ ============
THREE MONTHS ENDED
MARCH 31, 2004
Sales ....................... $ 39,162,000 $ 797,000 $ 2,196,000 $ -- $ 42,155,000
Inter-company sales ......... -- 18,168,000 4,418,000 (22,586,000) --
------------ ------------ ------------ ------------ ------------
Total revenue ............... $ 39,162,000 $ 18,965,000 $ 6,614,000 $(22,586,000) $ 42,155,000
============ ============ ============ ============ ============
Income (loss) from operations $ (1,726,000) $ 1,040,000 $ (5,235,000) $ -- $ (5,921,000)
============ ============ ============ ============ ============
14. RESTATEMENT OF FINANCIAL RESULTS
As a result of a review by Securities and Exchange Commission in
connection with our filing of a registration statement, we have reviewed our
accounting treatment of our private placement transaction in October 2003,
pursuant to which we sold shares of convertible preferred stock. As a result, we
have revised our accounting treatment for this transaction to record a
beneficial conversion feature in accordance with EITF No. 98-5. We initially
reviewed the transaction in light of EITF No. 98-5 and concluded in good faith
that the convertible preferred stock issued did not contain a beneficial
conversion feature that should be recognized and measured separately. However,
based on further guidance from the SEC, we have determined to restate our
financial statements for the fiscal years ended December 31, 2003 and 2004 to
reflect the beneficial conversion feature of the convertible preferred stock.
The reclassification will result in changes in classification of certain items
included within shareholders' equity on our balance sheet as of December 31,
2003 and 2004, and a reduction to our earnings per share calculations for the
year ended December 31, 2003. The reclassification has no impact on total
assets, liabilities, total shareholders' equity, net income or cash flows. The
restatement will not have any effect on reported earnings for future periods.
We have restated our 2004 financial statements to reflect the recording
of a beneficial conversion feature of $7.4 million. The beneficial conversion
feature relates to issuance of 881,732 shares of Series A convertible preferred
stock in fiscal 2003. As noted above, we have concluded that the convertible
preferred security contained an embedded conversion feature that was not
recorded in 2003. The beneficial conversion feature of the preferred shares in
the amount of $7.4 million will be recorded in the fourth quarter of 2003,
resulting in an increase in loss per share to common shareholders for the year
ended December 31, 2003 to $(2.38) per share from the previously reported
$(1.97) per share. The beneficial conversion feature will not change our
reported earnings (loss) per share for the year ended December 31, 2004 or any
subsequent period. The effect of recording the beneficial conversion feature on
the December 31, 2004 financial statements was an increase in the accumulated
deficit of $7.4 million and an offsetting increase in contributed capital. The
restatement did not change total stockholders' equity at December 31, 2004 or
March 31, 2005. We expect to file revised financial statements by May 23, 2005,
although no assurance can be given that such review and audit will be completed
within that time period and no assurance can be given that additional revisions
will not be required.
15
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
BUSINESS OVERVIEW AND RECENT DEVELOPMENTS
We are 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 major 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. Our private brands include
American Rag Cie, JS by Jessica Simpson, Princy by Jessica Simpson, House of
Dereon by Beyonce Knowles, No! Jeans, Alain Weiz, and Gear 7.
During the first quarter of 2005, we extended our agreement with Macy's
Merchandising Group for six years, pursuant to which we exclusively distribute
our American Rag Cie brand through Macy's Merchandising Group's national
Department Store organization of more than 300 stores. During the first quarter
of 2005, we also began shipping Gear 7 to 1,500 Kmart stores, and shipped plus
sizes of the Alain Weiz collection to over 150 Dillard's Department Stores. We
have entered into apparel licensing agreements to design, produce and sell
apparel under the Jessica Simpson and House of Dereon by Beyonce Knowles brands.
We expect these brands to be available in retail stores commencing in the second
half of 2005.
The success of our Private Brands collections has opened opportunities
within the Private Label business to create value in the development and
marketing of new initiatives for Sears, Mothers Work, Avenue, Chico's, and other
retailers. These initiatives were launched during the first quarter and had no
material sales contribution.
RESTATEMENT OF FINANCIAL RESULTS
As a result of a review by Securities and Exchange Commission in
connection with our filing of a registration statement, we have reviewed our
accounting treatment of our private placement transaction in October 2003,
pursuant to which we sold shares of convertible preferred stock. As a result, we
have revised our accounting treatment for this transaction to record a
beneficial conversion feature in accordance with EITF No. 98-5. We initially
reviewed the transaction in light of EITF No. 98-5 and concluded in good faith
that the convertible preferred stock issued did not contain a beneficial
conversion feature that should be recognized and measured separately. However,
based on further guidance from the SEC, we have determined to restate our
financial statements for the fiscal years ended December 31, 2003 and 2004 to
reflect the beneficial conversion feature of the convertible preferred stock.
The reclassification will result in changes in classification of certain items
included within shareholders' equity on our balance sheet as of December 31,
2003 and 2004, and a reduction to our earnings per share calculations for the
year ended December 31, 2003. The reclassification has no impact on total
assets, liabilities, total shareholders' equity, net income or cash flows. The
restatement will not have any effect on reported earnings for future periods.
We have restated our 2004 financial statements to reflect the recording
of a beneficial conversion feature of $7.4 million. The beneficial conversion
feature relates to issuance of 881,732 shares of Series A convertible preferred
stock in fiscal 2003. As noted above, we have concluded that the convertible
preferred security contained an embedded conversion feature that was not
recorded in 2003. The beneficial conversion feature of the preferred shares in
the amount of $7.4 million will be recorded in the fourth quarter of 2003,
resulting in an increase in loss per share to common shareholders for the year
ended December 31, 2003 to $(2.38) per share from the previously reported
$(1.97) per share. The beneficial conversion feature will not change our
reported earnings (loss) per share for the year ended December 31, 2004 or any
subsequent period. The effect of recording the beneficial conversion feature on
the December 31, 2004 financial statements was an increase in the accumulated
deficit of $7.4 million and an offsetting increase in contributed capital. The
restatement did not change total stockholders' equity at December 31, 2004 or
March 31, 2005. We expect to file revised financial statements by May 23, 2005,
although no assurance can be given that such review and audit will be completed
within that time period and no assurance can be given that additional revisions
will not be required.
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
16
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.
EXCHANGE TRANSACTION
In April 2005, we entered into a letter of intent with Qorus.com, Inc.
("Qorus"), to exchange all the outstanding shares of our wholly-owned
subsidiary, Private Brands, Inc., for shares of Qorus. Qorus is a publicly
traded company quoted on the Over-the-Counter Bulletin Board under the symbol
QRUS. Under the terms of the proposed transaction, in exchange for all of the
outstanding capital stock of Private Brands, Qorus would issue shares of its
convertible preferred stock to us in such amount so that, upon completion of the
transaction, we would own in the aggregate 97% of the issued and outstanding
shares of common stock of Qorus on a fully diluted and as-converted basis. The
current stockholders of Qorus are expected to own 3% of the issued and
outstanding common stock on a fully diluted and as-converted basis after
completion of the exchange transaction. The closing of the exchange transaction
would be subject to Private Brands' ability to obtain additional financing, and
the effect of any such financing would reduce the percentage ownership in Qorus
of both us and the current stockholders of Qorus. The exchange transaction is
subject to a number of additional conditions, including, but not limited to, the
negotiation and execution of a definitive acquisition agreement, the delivery of
audited financial statements of Private Brands, the approval of the transaction
by the boards of directors of Qorus, Private Brands and our company, and the
receipt of required third party consents and approvals. Accordingly, there can
be no assurance that the exchange transaction will be completed.
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.
We believe 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
17
and other accounting policies, see Note 1 of the "Notes to Consolidated
Financial Statements" included in our Annual Report on Form 10-K for the year
ended December 31, 2004.
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 our collection experience deteriorates (for example, due to an
unexpected material adverse change in a major customer's ability to meet its
financial obligations to us), the estimates of the recoverability of amounts due
us could be reduced by a material amount.
As of March 31, 2005, the balance in the allowance for returns,
discounts and bad debts reserves was $2.7 million.
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 assessment of impairment applied
on a fair-value-based test on an annual basis or more frequently if an event
occurs or circumstances change that would more likely than not reduce the fair
value of a reporting unit below its carrying amount.
We utilized the discounted cash flow methodology to estimate fair
value. As of March 31, 2005, we have a goodwill balance of $8.6 million, and a
net property and equipment balance of $1.7 million.
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
18
current tax expense along with assessing temporary differences resulting from
differing treatment of items for book and tax purposes. These timing differences
result in deferred tax assets and liabilities, which are included in our
consolidated balance sheet. Management records a valuation allowance to reduce
our net deferred tax assets to the amount that is more likely than not to be
realized. Management has considered future taxable income and ongoing tax
planning strategies in assessing the need for the valuation allowance. Increases
in the valuation allowance result in additional expense to be reflected within
the tax provision in the consolidated statement of operations.
In addition, accruals are also estimated for ongoing audits regarding
U.S. Federal tax issues that are currently unresolved, based on our estimate of
whether, and the extent to which, additional taxes will be due. We routinely
monitor the potential impact of these situations and believe that amounts are
properly accrued for. If we ultimately determine that payment of these amounts
is unnecessary, we will reverse the liability and recognize a tax benefit during
the period in which we determine that the liability is no longer necessary. We
will record an additional charge in our provision for taxes in any period we
determine that the original estimate of a tax liability is less than we expect
the ultimate assessment to be. See Note 9 of the "Notes to Consolidated
Financial Statements" for a discussion of current tax matters.
DEBT COVENANTS
Our debt agreements require certain covenants including a minimum level
of net worth as discussed in Note 7 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 obtain 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,
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.
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 8 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 operations as a percentage of net sales:
THREE MONTHS ENDED
MARCH 31,
-------------------------
2005 2004
---------- ----------
Net sales ....................................... 100.0% 100.0%
Cost of sales ................................... 80.0 82.2
---------- ----------
Gross profit .................................... 20.0 17.8
Selling and distribution expenses ............... 5.7 6.3
General and administration expenses ............. 13.1 25.5
---------- ----------
Income (loss) from operations ................... 1.2 (14.0)
Interest expense ................................ (1.8) (1.9)
Interest income ................................. 1.2 0.2
Other income .................................... 0.5 8.3
Other expense ................................... (0.6) (0.9)
Minority interest ............................... 0.0 2.1
---------- ----------
Income (loss) before taxes ...................... 0.5 (6.2)
Income taxes .................................... 0.7 0.9
---------- ----------
Net loss ........................................ (0.2)% (7.1)%
========== ==========
19
FIRST QUARTER 2005 COMPARED TO FIRST QUARTER 2004
Net sales increased by $2.7 million, or 6.3%, to $44.8 million in first
quarter of 2005 from $42.2 million in the first quarter of 2004. The increase in
net sales in the first quarter of 2005 was primarily due to increased sales in
Private Brands, which was $11.1 million in the first quarter of 2005 compared to
$6.7 million in the same period of 2004. Gear 7 and Alain Weiz recorded their
first significant sales contributions in the first quarter of 2005. Private
Label sales for the first quarter of 2005 were $33.7 million compared to $35.5
million in the first quarter of 2004, with the decrease resulting primarily from
a decrease in the sale of close-out inventory and fabric of $5.1 million in the
first quarter of 2004 compared to $0.5 million in the first quarter of 2005.
Gross profit consists of net sales less product costs, direct labor,
manufacturing overhead, duty, quota, freight in, brokerage, and warehousing
expense. Gross profit increased by $1.4 million to $8.9 million in the first
quarter of 2005 from $7.5 million in the first quarter of 2004. The increase in
gross profit occurred primarily because of an increase in sales and gross
margin. As a percentage of net sales, gross profit increased from 17.8% in the
first quarter of 2004 to 20.0% in the first quarter of 2005. The improvement in
gross margin is primarily attributable to the change of mix driven by Private
Brands and the reduction of close-out inventory and fabric sales in the first
quarter of 2005.
Selling and distribution expenses decreased by $81,000, or 3.0%, to
$2.56 million in the first quarter of 2005 from $2.64 million in the first
quarter of 2004. As a percentage of net sales, these expenses decreased to 5.7%
in the first quarter of 2005 from 6.3% in the first quarter of 2004 due to the
increase in sales during the first quarter of 2005.
General and administrative expenses decreased by $4.9 million, or
45.7%, to $5.9 million in the first quarter of 2005 from $10.8 million in the
first quarter of 2004. The decrease was primarily due to the depreciation and
amortization of our Mexico assets of $3.4 million and $1.1 million of severance
paid to the Mexican workers in the first quarter of 2004 as compared to no such
expense in the first quarter of 2005 after we had disposed of our fixed assets
in Mexico. As a percentage of net sales, these expenses decreased to 13.1% in
the first quarter of 2005 from 25.5% in the first quarter of 2004.
Operating income in the first quarter of 2005 was $528,000, or 1.2% of
net sales, compared to operating loss of $5.9 million, or (14.0)% of net sales,
in the comparable period of 2004, because of the factors discussed above.
Interest expense increased by $19,000, or 2.4%, to $813,000 in the
first quarter of 2005 from $794,000 in the first quarter of 2004. As a
percentage of net sales, this expense decreased to 1.8% in the first quarter of
2005 from 1.9% in the first quarter of 2004. Interest income increased by
$459,000 or 1.0% of net sales, to $553,000 in the first quarter of 2005 from
$94,000 in the first quarter of 2004. The increase was primarily due to the
interest earned from the notes receivable related to the sale of our fixed
assets in Mexico of $478,000 during the first quarter of 2005, compared to no
such income in the first quarter of 2004. Other income was $228,000 in the first
quarter of 2005, compared to $3.5 million in the first quarter of 2004. This
reduction in other income was due primarily to $2.8 million of lease income
received for the lease of our facilities and equipment in Mexico in the first
quarter of 2004, compared to no such income in the first quarter of 2005 due to
the sale of our Mexico operations in the fourth quarter of 2004. Other expense
was $301,000 in the first quarter of 2005, compared to $359,000 in the first
quarter of 2004.
Losses allocated to minority interests in the first quarter of 2004
were $881,000, representing the minority partner's share of losses in UAV
totaling $223,000, and the minority shareholder's share of losses in Tarrant
Mexico totaling $658,000. Earnings from the equity method investments, UAV and
PBG7, totaled approximately $57,000 for the first quarter of 2005. None of the
profit in the equity method investments was allocated to the minority members
because we previously absorbed losses in excess of the minority members'
investment.
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
20
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.
Cash flows for the three months ended March 31, 2005 and 2004 were as
follows (dollars in thousands):
CASH FLOWS: 2005 2004
- -------------------------------------------------------- ------- -------
Net cash provided by (used in) operating activities .... $(9,576) $ 4,932
Net cash provided by (used in) investing activities .... $ 2,481 $ (349)
Net cash provided by (used in) financing activities .... $ 6,082 $(7,110)
During the first three months of 2005, net cash used in operating
activities was $9.6 million, as compared to net cash provided by operating
activities of $4.9 million for the same period in 2004. Net cash used in
operating activities in the first quarter of 2005 resulted primarily from a net
loss of $106,000, and increase of $5.8 million in accounts receivable and $1.1
million in prepaid expenses, and a decrease of $5.9 million in accounts payable,
partially offset by depreciation and amortization expense of $568,000, and
decreases in inventory of $866,000 and due to/from related parties of $1.2
million. The increase in accounts receivable was primarily due to the increase
in sales in the first quarter of 2005, and the decrease in accounts payable
resulted from the pay down of payables from net proceeds raised from financing
activities.
During the first three months of 2005, net cash provided by investing
activities was $2.5 million, as compared to net cash used in investing
activities of $349,000 in 2004. Net cash provided by investing activities in the
first quarter 2005 included approximately $2.3 million of collection of advances
from our Chairman.
During the first three months of 2005, net cash provided by financing
activities was $6.1 million, as compared to net cash used in financing
activities of $7.1 million in 2004. Net cash provided by financing activities in
2005 included $5.3 million net repayment of our short-term bank borrowings and
$7.6 million net proceeds from our credit facilities and $3.8 million net
proceeds from Max Azria.
21
CONTRACTUAL OBLIGATIONS AND COMMITMENTS
Following is a summary of our contractual obligations and commercial
commitments available to us as of March 31, 2005 (in millions):
PAYMENTS DUE BY PERIOD
----------------------------------------------------
Less than Between Between After
CONTRACTUAL OBLIGATIONS TOTAL 1 year 2-3 years 4-5 years 5 years
- ---------------------------------- ------ ------ ------ ------ ------
Long-term debt(1) ................ $ 33.6 $ 31.5 $ 2.1 $ -- $ --
Contractual obligations .......... 10.0 -- 10.0 -- --
Operating leases ................. 0.5 0.2 0.3 -- --
Minimum royalties ................ 24.3 3.9 13.0 1.9 5.5
Purchase commitment .............. 50.0 5.0 10.0 10.0 25.0
------ ------ ------ ------ ------
Total Contractual Cash Obligations $118.4 $ 40.6 $ 35.4 $ 11.9 $ 30.5
- ----------
(1) Excludes interest on long-term debt obligations. Based on outstanding
borrowings as of March 31, 2005, and assuming all such indebtedness
remained outstanding and the interest rates remained unchanged, we
estimate that our interest cost on long-term debt would be
approximately $3.5 million.
AMOUNT OF COMMITMENT
EXPIRATION PER PERIOD
TOTAL -------------------------------------
AMOUNTS LESS BETWEEN BETWEEN
COMMERCIAL COMMITMENTS COMMITTED THAN 2-3 4-5 AFTER
AVAILABLE TO US TO US 1 YEAR YEARS 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
6.75% per annum at March 31, 2005. 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 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 March 31, 2005, $7.1
million was outstanding under this facility with UPS and an additional $3.8
million was available for future borrowings. In addition, $4.1 million of open
letters of credit was outstanding as of March 31, 2005.
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 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 March 31, 2005, $4.6 million was outstanding and we
were in compliance with the covenants. The obligations under the loan agreement
are collateralized by the same security interests and guarantees provided under
our letter of credit facility with UPS. 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, our Chairman, of 4.6
million shares of our common stock.
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
22
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 March 31, 2005, $2.6 million
was outstanding under this facility. In addition, $1.2 million of open letters
of credit was outstanding and $45,000 was available for future borrowings as of
March 31, 2005. 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 March
31, 2005, $671,000 was outstanding under this loan.
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) extended the expiration date of the
facility to September 30, 2007 and added 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 to 90% of our accounts on which GMAC has the risk of loss and (b)
forty million dollars, minus in each case, any amount owed to GMAC by any
Tarrant Party. Pursuant to the terms of the PBG7 factoring agreement, PBG7
agreed to assign and sell to GMAC, as factor, all accounts, which arise from
PBG7's sale of merchandise or rendition of services created on a going-forward
basis. At PBG7's request, GMAC, in its discretion, may make advances to PBG7 up
to the lesser of (a) up to 90% of PBG7's accounts on which GMAC has the risk of
loss, and (b) five million minus in each case, any amounts owed to GMAC by PBG7.
Under both factoring agreement, any amounts, which GMAC advances in excess of
the purchase price of the relevant accounts, are considered to be loans and are
chargeable to the Tarrant Parties' or PBG7's when paid. Each of the parties only
become obligated to GMAC for a direct financial obligation in the event that
GMAC makes and advance in excess of the purchase price of the relevant accounts,
and any such obligations are payable on demand. This facility bears interest at
6% per annum at March 31, 2005. Restrictive covenants under the revised facility
include a limit on quarterly capital expenses of $800,000 and tangible net worth
of $20 million at September 30, 2004, $22 million at December 31, 2004 and March
31, 2005 and $25 million at the end of each fiscal quarter thereafter beginning
on June 30, 2005. As of March 31, 2005 we were in compliance with the new
tangible net worth and capital expense covenants. A total of $25.2 million was
outstanding under the GMAC facility at March 31, 2005.
In May 2005, we amended our factoring agreement with GMAC to permit our
subsidiaries party thereto and us, to borrow up to the lesser of $3 million or
fifty percent (50%) of the value of eligible inventory (as defined). The maximum
borrowing availability under the factoring agreement, based on a borrowing base
formula, remained $40 million. Our subsidiaries party thereto and we granted
GMAC a lien on certain of our inventory located in the United States.
The credit facility with GMAC and the credit facility with UPS carry
cross-default clauses. A breach of a financial covenant set by GMAC or UPS
constitutes an event of default under the other credit facility, entitling both
financial institutions to demand payment in full of all outstanding amounts
under their respective debt and credit facilities.
The amount we can borrow under the new factoring facility with GMAC is
determined based on a defined borrowing base formula related to eligible
accounts receivable. A significant decrease in eligible accounts receivable due
to the aging of receivables, can have an adverse effect on our borrowing
capabilities under our credit facility, which may adversely affect the adequacy
of our working capital. In addition, we have typically experienced
23
seasonal fluctuations in sales volume. These seasonal fluctuations result in
sales volume decreases in the first and fourth quarters of each year due to the
seasonal fluctuations experienced by the majority of our customers. During these
quarters, borrowing availability under our credit facility may decrease as a
result of decrease in eligible accounts receivables generated from our sales.
On December 14, 2004, we completed a $10 million financing through the
issuance of 6% Secured Convertible Debentures ("Debentures") and warrants to
purchase up to 1,250,000 shares of our common stock. Prior to maturity, the
investors may convert the Debentures into shares of our common stock at a price
of $2.00 per share. The warrants have a term of five years and an exercise price
of $2.50 per share. The Debentures bear interest at a rate of 6% per annum and
have a term of three years. We may elect to pay interest on the Debentures in
shares of our common stock if certain conditions are met, including a minimum
market price and trading volume for our common stock. The Debentures contain
customary events of default and permit the holders thereof to accelerate the
maturity if the full principal amount together with interest and other amounts
owing upon the occurrence of such events of default. The Debentures are secured
by a subordinated lien on certain of our accounts receivable and related assets.
The placement agent in the financing, for its services were paid $620,000 in
cash and issued five year warrants to purchase up to 200,000 shares of our
common stock at an exercise price of $2.50 per share.
On February 14, 2005, we borrowed $5.0 million from Max Azria, which
amount bears interest at the rate of 4% per annum and is payable in weekly
installments of $250,000 beginning on February 28, 2005 and continuing each
Monday until July 11, 2005. This is an unsecured loan. As of March 31, 2005,
$3.8 million was outstanding.
We had two equipment loans outstanding at March 31, 2005 totaling
$75,000 bearing interest at 6% payable in installments through 2009
During 2000, we financed equipment purchases for a manufacturing
facility with certain vendors. A total of $16.9 million was financed with
five-year promissory notes, which bear interest ranging from 7.0% to 7.5%, and
are payable in semiannual payments commencing in February 2000. The debt was
paid off in February 2005. A portion of the debt was denominated in Euros.
Unrealized transaction (loss) gain associated with the debt denominated in Euros
totaled $0, and $543,000 for the three months ended March 31, 2005 and 2004,
respectively. These amounts were recorded in other income (expense) in the
accompanying consolidated statements of operations.
From time to time, we open letters of credit under an uncommitted line
of credit from Aurora Capital Associates who issues these letters of credits out
of Israeli Discount Bank. As of March 31, 2005, $2.3 million was outstanding
under this facility and $2.1 million of letters of credit were open under this
arrangement. We pay a commission fee of 2.25% on all letters of credits issued
under this arrangement.
We have financed our operations from our cash flow from operations,
borrowings under our bank and other credit facilities, issuance of long-term
debt (including debt to or arranged by vendors of equipment purchased for our
Mexican twill and production facility), the proceeds from the exercise of stock
options and from time to time shareholder advances. Our short-term funding
relies very heavily on our major customers, banks, suppliers and major
shareholders. From time to time, we have had temporary over-advances from our
banks. Any withdrawal of support from these parties will have serious
consequences on our liquidity.
From time to time in the past, we borrowed funds from, and advanced
funds to, certain officers and principal shareholders, including Gerard Guez and
Todd Kay. See disclosure under "-Related Party Transactions" below.
The Internal Revenue Service has proposed adjustments to our Federal
income tax returns to increase our income tax payable for the years ended
December 31, 1996 through 2001. 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. 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. We believe that we have meritorious defenses to and intend to
vigorously contest the proposed adjustments. If the proposed adjustments are
upheld through the administrative and legal process, they could have a material
impact on our
24
earnings and, in particular, cash flow. We may not have an adequate cash reserve
to pay the final adjustments resulting from the IRS examination. As a result, we
may be required to arrange for payments over time or raise additional capital in
order to meet these obligations. 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.
We may seek to finance future capital investment programs through
various methods, including, but not limited to, borrowings under our bank credit
facilities, issuance of long-term debt, sales of equity securities, leases and
long-term financing provided by the sellers of facilities or the suppliers of
certain equipment used in such facilities. To date, there is no plan for any
major capital expenditure.
We do not believe that the moderate levels of inflation in the United
States in the last three years have had a significant effect on net sales or
profitability.
RELATED PARTY TRANSACTIONS
We lease our principal offices and warehouse located in Los Angeles,
California from GET and office space in Hong Kong from Lynx International
Limited. GET and Lynx International Limited are each owned by Gerard Guez, our
Chairman of the Board of Directors, and Todd Kay, our Vice Chairman of the Board
of Directors. We believe, at the time the leases were entered into, the rents on
these properties were comparable to then prevailing market rents. We are
currently leasing both of these facilities on a month-to-month basis. We paid
$255,000 and $332,000 in the three months ended March 31, 2005 and 2004,
respectively, for office and warehouse facilities.
In February 2004, our Hong Kong subsidiary entered into a 50/50 joint
venture with Auto Enterprises Limited, an unrelated third party, to source
products for Seven Licensing Company, LLC and our Private Brands subsidiary in
mainland China. On May 31, 2004, after realizing an accumulated loss from the
venture of approximately $200,000 (our share being half), we sold our interest
for $1 to Asia Trading Limited, a company owned by Jacqueline Rose, wife of
Gerard Guez. The venture owed us $221,000 as of December 31, 2004. This amount
was repaid in the first quarter of 2005.
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, including the
equipment and facilities we previously leased to Mr. Nacif's affiliates in
October 2003, for an aggregate purchase price consisting of: a) $105,400 in cash
and $3,910,000 by delivery of unsecured promissory notes bearing interest at
5.5% per annum; and b) $40,204,000, by delivery of secured promissory notes
bearing interest at 4.5% per annum, maturing on December 31, 2014, and payable
in equal monthly installments of principal and interest over the term of the
notes. Included in the $45.2 million notes receivable - related party on the
accompanying balance sheet as of March 31, 2005 was $1.3 million of Mexico
valued added taxes on the real property component of this transaction. The
future maturities of the note receivable from the purchasers, including the
Mexican value added tax to be paid by the purchasers. 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. We purchased $840,000
and $1.5 million of fabric from Acabados y Terminados in the three months ended
March 31, 2005 and 2004. Net amount due from these related parties as of March
31, 2005 was $247,000.
From time to time in the past, we borrowed funds from, and advanced
funds to, Mr. Guez. The greatest outstanding balance of such advances to Mr.
Guez in the first quarter of 2005 was approximately $4,766,000. Mr. Guez paid
our expenses of approximately $108,000 and $94,000 for the three months ended
March 31, 2005 and 2004, respectively, which amounts were applied to reduce
accrued interest and principle on Mr. Guez's loan. In the first quarter of 2005,
Mr. Guez repaid $2.3 million of this indebtedness. The remaining balance of $2.4
million is
25
payable on demand and had been shown as reductions to shareholders' equity as of
March 31, 2005. All advances to, and borrowings from, Mr. Guez bore interest at
the rate of 7.75% during the period. Total interest paid by Mr. Guez was $74,000
and $93,000 for the three months ended March 31, 2005 and 2004, respectively.
Since the enactment of the Sarbanes-Oxley Act in 2002, no further personal loans
(or amendments to existing loans) have been or will be made to officers or
directors of Tarrant.
On July 1, 2001, we formed an entity to jointly market, share certain
risks and achieve economies of scale with Azteca Production International, Inc.
("Azteca"), called United Apparel Ventures, LLC ("UAV"). Azteca is owned by
Hubert Guez, the brother of Gerard Guez, our Chairman. This entity was created
to coordinate the production of apparel for a single customer of our branded
business. UAV is owned 50.1% by Tag Mex, Inc., our wholly owned subsidiary, and
49.9% by Azteca. Results of the operation of UAV have been consolidated into our
results since July 2001 with the minority partner's share of all gains and
losses eliminated through the minority interest line in our financial
statements. Due to the restructuring of our Mexico operations, we discontinued
manufacturing for UAV customers in the second quarter of 2004. Two and one half
percent of gross sales as management fees were paid to each of the members of
UAV, per the operating agreement. The amount paid to Azteca, the minority member
of UAV, totaled $0 and $121,000 in the three months ended March 31, 2005 and
2004, respectively. We purchased $135,000 and $4.1 million of finished goods and
service from Azteca and its affiliates in the three months ended March 31, 2005
and 2004, respectively. Our total sales of fabric and service to Azteca in the
three months ended March 31, 2005 and 2004 were $63,000 and $586,000,
respectively.
Commencing in June 2003, UAV began selling to Seven Licensing Company,
LLC ("Seven Licensing"), jeans wear bearing the brand "Seven7", which was
ultimately purchased by Express. Seven Licensing is beneficially owned by Gerard
Guez. In the third quarter of 2004, in order to strengthen our own private brand
business, we decided to discontinue sourcing for Seven7. Total sales to Seven7
in the three months ended March 31, 2005 and 2004 were $0 and $2.2 million,
respectively.
At December 31, 2004, Messrs. Guez and Kay beneficially owned 961,000
and 1,003,500 shares, respectively, of common stock of Tag-It Pacific, Inc.
("Tag-It"), collectively representing 10.8% of Tag-It Pacific's common stock at
December 31, 2004. Tag-It is a provider of brand identity programs to
manufacturers and retailers of apparel and accessories. Commencing in 1998,
Tag-It assumed the responsibility for managing and sourcing all trim and
packaging used in connection with products manufactured by or on our behalf in
Mexico. Due to the restructuring of our Mexico operations, Tag-It no longer
manages our trim and packaging requirements. We purchased $0 and $200,000 of
trim inventory from Tag-It in the three months ended March 31, 2005 and 2004,
respectively. From time to time we have guaranteed the indebtedness of Tag-It
for the purchase of trim on our behalf. See Note 7 of the "Notes to Consolidated
Financial Statements."
We believe the each of the transactions described above has been
entered into on terms no less favorable to us than could have been obtained from
unaffiliated third parties. We have adopted a policy that any transactions
between us and any of our affiliates or related parties, including our executive
officers, directors, the family members of those individuals and any of their
affiliates, must (i) be approved by a majority of the members of the Board of
Directors and by a majority of the disinterested members of the Board of
Directors and (ii) be on terms no less favorable to us than could be obtained
from unaffiliated third parties.
FACTORS THAT MAY AFFECT FUTURE RESULTS
This Quarterly Report on Form 10-Q contains forward-looking statements,
which are subject to a variety of risks and uncertainties. Our actual results
could differ materially from those anticipated in these forward-looking
statements as a result of various factors, including those set forth below.
26
RISKS RELATED TO OUR BUSINESS
WE DEPEND ON A GROUP OF KEY CUSTOMERS FOR A SIGNIFICANT PORTION OF OUR SALES. A
SIGNIFICANT ADVERSE CHANGE IN A CUSTOMER RELATIONSHIP OR IN A CUSTOMER'S
FINANCIAL POSITION COULD HARM OUR BUSINESS AND FINANCIAL CONDITION.
Kohl's accounted for 19.6% and 16.3% of our net sales for the first
three months of 2005 and 2004, respectively. Mervyn's accounted for 9.8% and
16.2% of our net sales for the first three months of 2005 and 2004,
respectively. Lerner New York accounted for 8.5% and 8.0% of our net sales for
the first three months of 2005 and 2004, respectively. Affiliated department
stores owned by Federated Department Stores accounted for approximately 13.8%
and 10.7% of our net sales for the first three months of 2005 and 2004,
respectively. Wet Seal accounted for approximately 3.3% and 4.5% of our net
sales for the first three months of 2005 and 2004, respectively. We believe that
consolidation in the retail industry has centralized purchasing decisions and
given customers greater leverage over suppliers like us, and we expect this
trend to continue. If this consolidation continues, our net sales and results of
operations may be increasingly sensitive to deterioration in the financial
condition of, or other adverse developments with, one or more of our customers.
While we have long-standing customer relationships, we generally do not
have long-term contracts with them. Purchases generally occur on an
order-by-order basis, and relationships exist as long as there is a perceived
benefit to both parties. A decision by a major customer, whether motivated by
competitive considerations, financial difficulties, and economic conditions or
otherwise, to decrease its purchases from us or to change its manner of doing
business with us, could adversely affect our business and financial condition.
In addition, during recent years, various retailers, including some of our
customers, have experienced significant changes and difficulties, including
consolidation of ownership, increased centralization of purchasing decisions,
restructurings, bankruptcies and liquidations.
These and other financial problems of some of our retailers, as well as
general weakness in the retail environment, increase the risk of extending
credit to these retailers. A significant adverse change in a customer
relationship or in a customer's financial position could cause us to limit or
discontinue business with that customer, require us to assume more credit risk
relating to that customer's receivables, limit our ability to collect amounts
related to previous purchases by that customer, or result in required prepayment
of our receivables securitization arrangements, all of which could harm our
business and financial condition.
FAILURE OF THE TRANSPORTATION INFRASTRUCTURE TO MOVE SEA FREIGHT IN ACCEPTABLE
TIME FRAMES COULD ADVERSELY AFFECT OUR BUSINESS.
Because the bulk of our freight is designed to move through the West
Coast ports in predictable time frames, we are at risk of cancellations and
penalties when those ports operate inefficiently creating delays in delivery. We
experienced such delays from June 2004 until November 2004, and we may continue
to experience similar delays in the future especially during peak seasons. There
can be no assurances of, and we have no control over a return to timely
deliveries. Unpredictable timing for shipping may cause us to utilize air
freight or may result in customer penalties for late delivery, any of which
could reduce our operating margins and adversely effect our results of
operations.
FAILURE TO MANAGE OUR GROWTH AND EXPANSION COULD IMPAIR OUR BUSINESS.
Since our inception, we have experienced periods of rapid growth. No
assurance can be given that we will be successful in maintaining or increasing
our sales in the future. Any future growth in sales will require additional
working capital and may place a significant strain on our management, management
information systems, inventory management, sourcing capability, distribution
facilities and receivables management. Any disruption in our order processing,
sourcing or distribution systems could cause orders to be shipped late, and
under industry practices, retailers generally can cancel orders or refuse to
accept goods due to late shipment. Such cancellations and returns would result
in a reduction in revenue, increased administrative and shipping costs and a
further burden on our distribution facilities.
27
FAILURE TO MANAGE OUR RESTRUCTURING IN MEXICO COULD IMPAIR OUR BUSINESS.
We determined to cease directly operating a substantial majority of our
equipment and fixed assets in Mexico, and to lease a large portion of our
facilities and operations in Mexico to a related third party, which we
consummated effective September 1, 2003. Subsequently, in August 2004, we
entered into a purchase and sale agreement to sell substantially all of our
assets and real property in Mexico, including the equipment and facilities
previously leased to Mr. Nacif's affiliates, which transaction was consummated
in the fourth quarter of 2004. As a consequence, we have become primarily a
trading company, relying on third party manufacturers to produce the merchandise
we sell to our customers and as a result assume the risks associated with
contracting these services.
OUR OPERATING RESULTS MAY FLUCTUATE SIGNIFICANTLY.
We have experienced, and expect to continue to experience, substantial
variations in our net sales and operating results from quarter to quarter. We
believe that the factors which influence this variability of quarterly results
include the timing of our introduction of new product lines, the level of
consumer acceptance of each new product line, general economic and industry
conditions that affect consumer spending and retailer purchasing, the
availability of manufacturing capacity, the seasonality of the markets in which
we participate, the timing of trade shows, the product mix of customer orders,
the timing of the placement or cancellation of customer orders, the weather,
transportation delays, quotas, the occurrence of charge backs in excess of
reserves and the timing of expenditures in anticipation of increased sales and
actions of competitors. Due to fluctuations in our revenue and operating
expenses, we believe that period-to-period comparisons of our results of
operations are not a good indication of our future performance. It is possible
that in some future quarter or quarters, our operating results will be below the
expectations of securities analysts or investors. In that case, our stock price
could fluctuate significantly or decline.
THE FINANCIAL CONDITION OF OUR CUSTOMERS COULD AFFECT OUR RESULTS OF OPERATIONS.
Certain retailers, including some of our customers, have experienced in
the past, and may experience in the future, financial difficulties, which
increase the risk of extending credit to such retailers and the risk that
financial failure will eliminate a customer entirely. These retailers have
attempted to improve their own operating efficiencies by concentrating their
purchasing power among a narrowing group of vendors. There can be no assurance
that we will remain a preferred vendor for our existing customers. A decrease in
business from or loss of a major customer could have a material adverse effect
on our results of operations. There can be no assurance that our factor will
approve the extension of credit to certain retail customers in the future. If a
customer's credit is not approved by the factor, we could assume the collection
risk on sales to the customer itself, require that the customer provide a letter
of credit, or choose not to make sales to the customer.
WE DEPEND ON OUR COMPUTER AND COMMUNICATIONS SYSTEMS.
As a multi-national corporation, we rely on our computer and
communication network to operate efficiently. Any interruption of this service
from power loss, telecommunications failure, weather, natural disasters or any
similar event could have a material adverse affect on our business and
operations. Additionally, hackers and computer viruses have disrupted operations
at many major companies. We may be vulnerable to similar acts of sabotage, which
could have a material adverse effect on our business and operations.
WE MAY REQUIRE ADDITIONAL CAPITAL IN THE FUTURE.
We may not be able to fund our future growth or react to competitive
pressures if we lack sufficient funds. Currently, we believe we have sufficient
cash on hand and cash available through our bank credit facilities, issuance of
long-term debt, proceeds from loans from affiliates, and proceeds from the
exercise of stock options to fund existing operations for the foreseeable
future. However, in the future we may need to raise additional funds through
equity or debt financings or collaborative relationships. This additional
funding may not be available or, if available, it may not be available on
economically reasonable terms. In addition, any additional funding may result in
significant dilution to existing shareholders. If adequate funds are not
available, we may be required to curtail our
28
operations or obtain funds through collaborative partners that may require us to
release material rights to our products.
OUR BUSINESS IS SUBJECT TO RISKS ASSOCIATED WITH IMPORTING PRODUCTS.
Substantially all of our import operations are subject to tariffs
imposed on imported products and quotas imposed by trade agreements. In
addition, the countries in which our products are manufactured or imported may
from time to time impose additional new duties, tariffs or other restrictions on
our imports or adversely modify existing restrictions. Adverse changes in these
import costs and restrictions, or our suppliers' failure to comply with customs
or similar laws, could harm our business. We cannot assure that future trade
agreements will not provide our competitors with an advantage over us, or
increase our costs, either of which could have an adverse effect on our business
and financial condition.
Our operations are also subject to the effects of international trade
agreements and regulations such as the North American Free Trade Agreement, and
the activities and regulations of the World Trade Organization. Generally, these
trade agreements benefit our business by reducing or eliminating the duties
assessed on products manufactured in a particular country. However, trade
agreements can also impose requirements that adversely affect our business, such
as limiting the countries from which we can purchase raw materials and setting
duties or restrictions on products that may be imported into the United States
from a particular country. In addition, the World Trade Organization may
commence a new round of trade negotiations that liberalize textile trade by
further eliminating or reducing tariffs. The elimination of quotas on World
Trade Organization member countries in 2005 has resulted in explosive growth in
textile imports from China, and could result in safeguard measures such as
duties or embargo of China country of origin products, which may be disruptive
or have a negative impact on margins.
OUR DEPENDENCE ON INDEPENDENT MANUFACTURERS REDUCES OUR ABILITY TO CONTROL THE
MANUFACTURING PROCESS, WHICH COULD HARM OUR SALES, REPUTATION AND OVERALL
PROFITABILITY.
We depend on independent contract manufacturers to secure a sufficient
supply of raw materials and maintain sufficient manufacturing and shipping
capacity in an environment characterized by declining prices, labor shortage,
continuing cost pressure and increased demands for product innovation and
speed-to-market. This dependence could subject us to difficulty in obtaining
timely delivery of products of acceptable quality. In addition, a contractor's
failure to ship products to us in a timely manner or to meet the required
quality standards could cause us to miss the delivery date requirements of our
customers. The failure to make timely deliveries may cause our customers to
cancel orders, refuse to accept deliveries, impose non-compliance charges
through invoice deductions or other charge-backs, demand reduced prices or
reduce future orders, any of which could harm our sales, reputation and overall
profitability. We do not have material long-term contracts with any of our
independent contractors and any of these contractors may unilaterally terminate
their relationship with us at any time. To the extent we are not able to secure
or maintain relationships with independent contractors that are able to fulfill
our requirements, our business would be harmed.
We have initiated a factory compliance agreement with our suppliers,
and monitor our independent contractors' compliance with applicable labor laws,
but we do not control our contractors or their labor practices. The violation of
federal, state or foreign labor laws by one of the our contractors could result
in our being subject to fines and our goods that are manufactured in violation
of such laws being seized or their sale in interstate commerce being prohibited.
From time to time, we have been notified by federal, state or foreign
authorities that certain of our contractors are the subject of investigations or
have been found to have violated applicable labor laws. To date, we have not
been subject to any sanctions that, individually or in the aggregate, have had a
material adverse effect on our business, and we are not aware of any facts on
which any such sanctions could be based. There can be no assurance, however,
that in the future we will not be subject to sanctions as a result of violations
of applicable labor laws by our contractors, or that such sanctions will not
have a material adverse effect on our business and results of operations. In
addition, certain of our customers, require strict compliance by their apparel
manufacturers, including us, with applicable labor laws and visit our facilities
often. There can be no assurance that the violation of applicable labor laws by
one of our contractors will not have a material adverse effect on our
relationship with our customers.
29
OUR BUSINESS IS SUBJECT TO RISKS OF OPERATING IN A FOREIGN COUNTRY AND TRADE
RESTRICTIONS.
Approximately 90% of our products sold in the first quarter of 2005
were imported from outside the U.S. We are subject to the risks associated with
doing business in foreign countries, including, but not limited to,
transportation delays and interruptions, political instability, expropriation,
currency fluctuations and the imposition of tariffs, import and export controls,
other non-tariff barriers and cultural issues. Any changes in those countries'
labor laws and government regulations may have a negative effect on our
profitability.
RISK ASSOCIATED WITH OUR INDUSTRY
OUR SALES ARE HEAVILY INFLUENCED BY GENERAL ECONOMIC CYCLES.
Apparel is a cyclical industry that is heavily dependent upon the
overall level of consumer spending. Purchases of apparel and related goods tend
to be highly correlated with cycles in the disposable income of our consumers.
Our customers anticipate and respond to adverse changes in economic conditions
and uncertainty by reducing inventories and canceling orders. As a result, any
substantial deterioration in general economic conditions, increases in interest
rates, acts of war, terrorist or political events that diminish consumer
spending and confidence in any of the regions in which we compete, could reduce
our sales and adversely affect our business and financial condition.
OUR BUSINESS IS HIGHLY COMPETITIVE AND DEPENDS ON CONSUMER SPENDING PATTERNS.
The apparel industry is highly competitive. We face a variety of
competitive challenges including:
o anticipating and quickly responding to changing consumer
demands;
o developing innovative, high-quality products in sizes, colors
and styles that appeal to consumers of varying age groups and
tastes;
o competitively pricing our products and achieving customer
perception of value; and
o the need to provide strong and effective marketing support.
WE MUST SUCCESSFULLY GAUGE FASHION TRENDS AND CHANGING CONSUMER PREFERENCES TO
SUCCEED.
Our success is largely dependent upon our ability to gauge the fashion
tastes of our customers and to provide merchandise that satisfies retail and
customer demand in a timely manner. The apparel business fluctuates according to
changes in consumer preferences dictated in part by fashion and season. To the
extent we misjudge the market for our products, our sales may be adversely
affected. Our ability to anticipate and effectively respond to changing fashion
trends depends in part on our ability to attract and retain key personnel in our
design, merchandising and marketing staff. Competition for these personnel is
intense, and we cannot be sure that we will be able to attract and retain a
sufficient number of qualified personnel in future periods.
OUR BUSINESS IS SUBJECT TO SEASONAL TRENDS.
Historically, our operating results have been subject to seasonal
trends when measured on a quarterly basis. This trend is dependent on numerous
factors, including the markets in which we operate, holiday seasons, consumer
demand, climate, economic conditions and numerous other factors beyond our
control. There can be no assurance that our historic operating patterns will
continue in future periods as we cannot influence or forecast many of these
factors.
OTHER RISKS RELATED TO AN INVESTMENT IN OUR COMMON STOCK
THE ULTIMATE RESOLUTION OF THE INTERNAL REVENUE SERVICE'S EXAMINATION OF OUR TAX
RETURNS MAY REQUIRE US TO INCUR AN EXPENSE BEYOND WHAT HAS BEEN RESERVED FOR ON
OUR BALANCE SHEET OR MAKE CASH PAYMENTS BEYOND WHAT WE ARE THEN ABLE TO PAY.
30
In January 2004, the Internal Revenue Service proposed adjustments to
increase our federal income tax payable for the years ended December 31, 1996
through 2001. This adjustment would also result in additional state taxes,
penalties 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. 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. The maximum amount of loss in
excess of the amount accrued in the financial statements is $12.6 million. If
the amount of any actual liability, however, exceeds our reserves, we would
experience an immediate adverse earnings impact in the amount of such additional
liability, which could be material. Additionally, we anticipate that the
ultimate resolution of these matters will require that we make significant cash
payments to the taxing authorities. Presently we do not have sufficient cash or
borrowing ability to make any future payments that may be required. No assurance
can be given that we will have sufficient surplus cash from operations to make
the required payments. Additionally, any cash used for these purposes will not
be available for other corporate purposes, which could have a material adverse
effect on our financial condition and results of operations.
INSIDERS OWN A SIGNIFICANT PORTION OF OUR COMMON STOCK, WHICH COULD LIMIT OUR
SHAREHOLDERS' ABILITY TO INFLUENCE THE OUTCOME OF KEY TRANSACTIONS.
As of March 31, 2005, our executive officers and directors and their
affiliates owned approximately 45% of the outstanding shares of our common
stock. Gerard Guez, our Chairman, and Todd Kay, our Vice Chairman, alone own
approximately 35.1% and 8.9%, respectively, of the outstanding shares of our
common stock at March 31, 2005. Accordingly, our executive officers and
directors have the ability to affect the outcome of, or exert considerable
influence over, all matters requiring shareholder approval, including the
election and removal of directors and any change in control. This concentration
of ownership of our common stock could have the effect of delaying or preventing
a change of control of us or otherwise discouraging or preventing a potential
acquirer from attempting to obtain control of us. This, in turn, could have a
negative effect on the market price of our common stock. It could also prevent
our shareholders from realizing a premium over the market prices for their
shares of common stock.
WE HAVE ADOPTED A NUMBER OF ANTI-TAKEOVER MEASURES THAT MAY DEPRESS THE PRICE OF
OUR COMMON STOCK.
Our shareholders rights plan, our ability to issue additional shares of
preferred stock and some provisions of our articles of incorporation and bylaws
could make it more difficult for a third party to make an unsolicited takeover
attempt of us. These anti-takeover measures may depress the price of our common
stock by making it more difficult for third parties to acquire us by offering to
purchase shares of our stock at a premium to its market price without approval
of our board of directors.
OUR STOCK PRICE HAS BEEN VOLATILE.
Our common stock is quoted on the NASDAQ National Market System, and
there can be substantial volatility in the market price of our common stock. The
market price of our common stock has been, and is likely to continue to be,
subject to significant fluctuations due to a variety of factors, including
quarterly variations in operating results, operating results which vary from the
expectations of securities analysts and investors, changes in financial
estimates, changes in market valuations of competitors, announcements by us or
our competitors of a material nature, loss of one or more customers, additions
or departures of key personnel, future sales of common stock and stock market
price and volume fluctuations. In addition, general political and economic
conditions such as a recession, or interest rate or currency rate fluctuations
may adversely affect the market price of our common stock.
31
In addition, the stock market in general has experienced extreme price
and volume fluctuations that have affected the market price of our common stock.
Often, price fluctuations are unrelated to operating performance of the specific
companies whose stock is affected. In the past, following periods of volatility
in the market price of a company's stock, securities class action litigation has
occurred against the issuing company. If we were subject to this type of
litigation in the future, we could incur substantial costs and a diversion of
our management's attention and resources, each of which could have a material
adverse effect on our revenue and earnings. Any adverse determination in this
type of litigation could also subject us to significant liabilities.
ABSENCE OF DIVIDENDS COULD REDUCE OUR ATTRACTIVENESS TO YOU.
Some investors favor companies that pay dividends, particularly in
general downturns in the stock market. We have not declared or paid any cash
dividends on our common stock. We currently intend to retain any future earnings
for funding growth, and we do not currently anticipate paying cash dividends on
our common stock in the foreseeable future. Additionally, we cannot pay
dividends on our common stock unless the terms of our bank credit facilities and
outstanding preferred stock, if any, permit the payment of dividends on our
common stock. Because we may not pay dividends, your return on this investment
likely depends on your selling our stock at a profit.
32
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
FOREIGN CURRENCY RISK. Our earnings are affected by fluctuations in the
value of the U.S. dollar as compared to foreign currencies as a result of doing
business in foreign jurisdictions. As a result, we bear the risk of exchange
rate gains and losses that may result in the future. At times we use forward
exchange contracts to reduce the effect of fluctuations of foreign currencies on
purchases and commitments. These short-term assets and commitments are
principally related to trade payables positions and fixed asset purchase
obligations. We do not utilize derivative financial instruments for trading or
other speculative purposes. We actively evaluate the creditworthiness of the
financial institutions that are counter parties to derivative financial
instruments, and we do not expect any counter parties to fail to meet their
obligations.
INTEREST RATE RISK. Because our obligations under our various credit
agreements bear interest at floating rates (primarily LIBOR rates), we are
sensitive to changes in prevailing interest rates. Any major increase or
decrease in market interest rates that affect our financial instruments would
have a material impact on earning or cash flows during the next fiscal year.
Our interest expense is sensitive to changes in the general level of
U.S. interest rates. In this regard, changes in U.S. interest rates affect
interest paid on our debt. A majority of our credit facilities are at variable
rates.
ITEM 4. CONTROLS AND PROCEDURES.
EVALUATION OF CONTROLS AND PROCEDURES
Members of the company's management, including our Chief Executive
Officer and Chief Financial Officer have evaluated the effectiveness of our
disclosure controls and procedures, as defined by paragraph (e) of Exchange Act
Rules 13a-15 or 15d-15, as of March 31, 2005, the end of the period covered by
this report. Based upon that evaluation, the Chief Executive Officer and Chief
Financial Officer concluded that our disclosure controls and procedures are
effective.
CHANGES IN CONTROLS AND PROCEDURES
During the first quarter of 2005, there were no significant changes in
our internal controls or in other factors known to the Chief Executive Officer
or the Chief Financial Officer that materially affected, or are reasonably
likely to materially effect, our internal control over financial reporting.
33
PART II -- OTHER INFORMATION
ITEM 1. 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 was submitted to and approved by the court.
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 6. EXHIBITS.
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------------------------------------------------------------
10.18.2 Amendment No. 2 to Exclusive Distribution Agreement dated as of
March 7, 2005, between Macy's Merchandising Group, LLC and
Private Brands, Inc.
10.18.3 Trademark Sublicense Agreement dated as of March 7, 2005, between
Macy's Merchandising Group, LLC and Private Brands, Inc.
10.43 Promissory Note in the principal amount of $5,000,000 dated as of
February 15, 2005, issued by Tarrant Apparel Group in favor of
Max Azria.
31.1 Certificate of Chief Executive Officer pursuant to Rule 13a-14(a)
under the Securities and Exchange Act of 1934, as amended.
31.2 Certificate of Chief Financial Officer pursuant to Rule 13a-14(a)
under the Securities and Exchange Act of 1934, as amended.
32.1 Certificate of Chief Executive Officer pursuant to Rule 13a-14(b)
under the Securities and Exchange Act of 1934, as amended.
32.2 Certificate of Chief Financial Officer pursuant to Rule 13a-14(b)
under the Securities and Exchange Act of 1934, as amended.
34
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
TARRANT APPAREL GROUP
Date: May 16, 2005 By: /s/ Corazon Reyes
-------------------------------
Corazon Reyes,
Chief Financial Officer
Date: May 16, 2005 By: /s/ Barry Aved
-------------------------------
Barry Aved,
Chief Executive Officer
35