FORM 10-Q

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

 

Washington, D.C.  20549

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended:  September 28, 2002

 

Commission file number:  1-11908

 

 

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         ý            No           o

 

As of September 28, 2002, 13,074,155 shares of the registrant’s common stock, par value $.01 per share, were outstanding.

 

 

PART I  -  FINANCIAL INFORMATION

 

Item 1.   Financial Statements

 

DEPARTMENT 56, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

(In thousands)

 

		SEPTEMBER 28, 2002			DECEMBER 29, 2001			SEPTEMBER 29, 2001
ASSETS
CURRENT ASSETS:
Cash and cash equivalents		$	3,535		$	48,088		$	249
Accounts receivable, net		95,521			23,584			88,611
Inventories		21,550			11,151			19,002
Other current assets		10,213			11,328			10,087
Total current assets		130,819			94,151			117,949
PROPERTY AND EQUIPMENT, net		21,519			29,749			30,657
GOODWILL, TRADEMARKS AND OTHER, net		60,118			153,963			155,163
OTHER ASSETS		2,165			1,958			2,076
		$	214,621		$	279,821		$	305,845
LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
Current portion of long-term debt		$	2,235		$	900		$	900
Borrowings on revolving credit agreement		36,000			—			31,000
Accounts payable		10,527			10,811			7,073
Other current liabilities		20,049			19,546			22,810
Total current liabilities		68,811			31,257			61,783
DEFERRED TAXES		5,409			7,717			6,176
LONG-TERM DEBT		51,765			84,100			84,100
STOCKHOLDERS’ EQUITY		88,636			156,747			153,786
		$	214,621		$	279,821		$	305,845

 

See notes to condensed consolidated financial statements.

 

2

 

DEPARTMENT 56, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

(In thousands, except per share amounts)

 

		QUARTER ENDED
		SEPTEMBER 28, 2002			SEPTEMBER 29, 2001
NET SALES		$	58,562		$	60,129
COST OF SALES		27,869			27,107
Gross profit		30,693			33,022
OPERATING EXPENSES:
Selling, general, and administrative		15,519			16,551
Amortization of goodwill, trademarks and other		58			1,290
Total operating expenses		15,577			17,841
INCOME FROM OPERATIONS		15,116			15,181
OTHER EXPENSE:
Interest expense		761			1,694
Other, net		233			3,006
INCOME BEFORE INCOME TAXES		14,122			10,481
INCOME TAX PROVISION		5,084			3,983
NET INCOME		$	9,038		$	6,498
NET INCOME PER SHARE – BASIC		$	0.69		$	0.50
NET INCOME PER SHARE – ASSUMING DILUTION		$	0.69		$	0.50
WEIGHTED AVERAGE SHARES OUTSTANDING – BASIC		13,044			12,887
WEIGHTED AVERAGE SHARES OUTSTANDING – ASSUMING DILUTION		13,181			12,916

 

See notes to condensed consolidated financial statements.

 

3

 

DEPARTMENT 56, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

(In thousands, except per share amounts)

 

		39 WEEKS ENDED
		SEPTEMBER 28, 2002			SEPTEMBER 29, 2001
NET SALES		$	150,911		$	144,423
COST OF SALES		68,126			64,309
Gross profit		82,785			80,114
OPERATING EXPENSES:
Selling, general, and administrative		48,175			46,704
Amortization of goodwill, trademarks and other		190			3,938
Total operating expenses		48,365			50,642
INCOME FROM OPERATIONS		34,420			29,472
OTHER EXPENSE (INCOME):
Interest expense		2,657			5,643
Litigation settlement		(5,388		)	—
Other, net		(21		)	2,749
INCOME BEFORE INCOME TAXES AND CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE		37,172			21,080
INCOME TAX PROVISION		13,382			8,010
INCOME BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE		23,790			13,070
CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE		(93,654		)	—
NET (LOSS) INCOME		$	(69,864	)	$	13,070
INCOME PER SHARE BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE – BASIC		$	1.83		$	1.02
CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE – BASIC		(7.22		)	—
NET (LOSS) INCOME PER SHARE – BASIC		$	(5.39	)	$	1.02
INCOME PER SHARE BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE – ASSUMING DILUTION		$	1.81		$	1.01
CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE – ASSUMING DILUTION		(7.13		)	—
NET (LOSS) INCOME PER SHARE – ASSUMING DILUTION		$	(5.32	)	$	1.01
WEIGHTED AVERAGE SHARES OUTSTANDING – BASIC		12,972			12,872
WEIGHTED AVERAGE SHARES OUTSTANDING – ASSUMING DILUTION		13,139			12,906

 

See notes to condensed consolidated financial statements.

 

4

 

DEPARTMENT 56, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(In thousands)

 

		39 WEEKS ENDED
		SEPTEMBER 28, 2002			SEPTEMBER 29, 2001
CASH FLOWS FROM OPERATING ACTIVITIES -
Net cash used in operating activities		$	(49,438	)	$	(22,443	)
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment		(1,337		)	(2,406		)
Acquisitions		—			(9,600		)
Net cash used in investing activities		(1,337		)	(12,006		)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from the exercise of common stock options		1,222			—
Borrowings on revolving credit agreement		36,000			31,000
Principal payments on long-term debt		(31,000		)	(20,000		)
Net cash provided by financing activities		6,222			11,000
NET DECREASE IN CASH AND CASH EQUIVALENTS		(44,553		)	(23,449		)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD		48,088			23,698
CASH AND CASH EQUIVALENTS AT END OF PERIOD		$	3,535		$	249
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION -
Cash paid for:
Interest		$	2,974		$	5,210
Income taxes		$	13,356		$	287

 

See notes to condensed consolidated financial statements.

 

5

 

DEPARTMENT 56, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share amounts)

 

1.        Basis of Presentation

 

The accompanying condensed consolidated balance sheet as of December 29, 2001 was derived from the audited consolidated balances as of that date.  The remaining accompanying condensed consolidated financial statements are unaudited and, in the opinion of management, include all adjustments necessary for a fair presentation.

 

The results of operations for the quarter and 39 weeks ended September 28, 2002 are not necessarily indicative of the results for the full fiscal year.  It is suggested that these financial statements be read in conjunction with the consolidated financial statements and notes thereto included in the 2001 Annual Report to Stockholders and Annual Report on Form 10-K as filed by Department 56, Inc. (the Company) with the Securities and Exchange Commission.

 

2.        Income Per Common Share

 

Net income per common share is calculated by dividing net income by the weighted average number of shares outstanding during the period.  Net income per common share assuming dilution reflects per share amounts that would have resulted had the Company’s outstanding stock options been converted to common stock.

 

3.        Legal Proceedings

 

Reference is made to Item 3, “Legal Proceedings,” of the Company’s Annual Report on Form 10-K for the fiscal year ended December 29, 2001, which Item is incorporated herein in its entirety.  On March 1, 2002, the Company received net proceeds (before income taxes) of $11.0 million in settlement of the Company’s litigation against Arthur Andersen LLP and Andersen Worldwide Société Coopérative concerning implementation of its information systems. This recovery resulted in other income of $5.4 million and a $5.6 million reduction in net depreciable assets.

 

On May 1, 2002, the United States District Court, District of Minnesota entered the order of its Chief Judge granting Department 56 and Susan Engel’s Motion to Dismiss the previously reported class action lawsuit, In Re Department 56, Inc., Securities Litigation.

 

6

 

4.        Goodwill and Indefinite Lived Intangible Assets - Adoption of SFAS No. 142

 

Effective at the beginning of fiscal year 2002, the Company adopted Statement of Financial Accounting  Standards (SFAS) No. 142, Goodwill and Other Intangible Assets.  This standard primarily addresses the accounting for acquired goodwill and intangible assets (i.e., the post-acquisition accounting).  The most significant changes made by SFAS No. 142 are: 1) goodwill and indefinite-lived intangible assets will no longer be amortized; 2) goodwill and indefinite-lived intangible assets will be tested for impairment at least annually; and 3) the amortization period of intangible assets with finite lives will no longer be limited to forty years.

 

Upon adoption of SFAS No. 142, amortization of goodwill and indefinite-lived intangible assets ceased.  The Company determined that its trademarks are indefinite-lived intangible assets and no longer amortizes them.  Recorded goodwill was tested for impairment by comparing the fair value to its carrying value.  Fair value was determined by considering discounted cash flow methodologies, industry control premiums in the marketplace and private transaction financial models.  Independent and other market valuation methods were used to determine the fair value of the Company’s trademarks and other assets.  This impairment test is required to be performed at adoption of SFAS 142 and at least annually thereafter.  As a result of the fair market value analysis, the Company recorded a $93,654 charge as a cumulative effect of change in accounting principle during the first quarter of 2002.

 

Had SFAS No. 142 been effective at the beginning of 2001, the non-amortization provisions would have had the following effect on the results of the quarter and 39 weeks ended September 29, 2001:

 

		QUARTER ENDED
(In thousands, except per share amounts)		SEPTEMBER 28, 2002			SEPTEMBER 29, 2001
Reported net income		$	9,038		$	6,498
Add back:  Goodwill amortization		—			1,119
Add back:  Trademark amortization, net of tax		—			71
Adjusted net income		$	9,038		$	7,688
Basic earnings per share:
Reported net income per share		$	0.69		$	0.50
Goodwill amortization		—			0.09
Trademark amortization		—			0.01
Adjusted net income per share – basic		$	0.69		$	0.60
Diluted earnings per share:
Reported net income per share		$	0.69		$	0.50
Goodwill amortization		—			0.09
Trademark amortization		—			0.01
Adjusted net income per share – assuming dilution		$	0.69		$	0.60

 

7

 

		39 WEEKS ENDED
(In thousands, except per share amounts)		SEPTEMBER 28, 2002			SEPTEMBER 29, 2001
Reported net (loss) income		$	(69,864	)	$	13,070
Add back:  Goodwill amortization		—			3,356
Add back:  Trademarks amortization, net of tax		—			214
Adjusted net (loss) income		(69,864		)	16,640
Add back:  Cumulative effect of change in accounting principle		93,654			—
Adjusted earnings before cumulative effect of change in accounting principle		$	23,790		$	16,640
Basic earnings per share:
Reported net (loss) income per share		$	(5.39	)	$	1.02
Goodwill amortization		—			0.26
Trademark amortization		—			0.01
Adjusted net (loss) income per share – basic		(5.39		)	1.29
Add back:  Cumulative effect of change in accounting principle		7.22			—
Adjusted earnings per share before cumulative effect of change in accounting principle – basic		$	1.83		$	1.29
Diluted earnings per share:
Reported net (loss) income per share		$	(5.32	)	$	1.01
Goodwill amortization		—			0.26
Trademark amortization		—			0.02
Adjusted net (loss) income per share – assuming dilution		(5.32		)	1.29
Add back:  Cumulative effect of change in accounting principle		7.13			—
Adjusted earnings per share before cumulative effect of change in accounting principle – assuming dilution		$	1.81		$	1.29

 

In accordance with SFAS No. 142, the Company will continue to amortize non-compete agreements (i.e. finite-lived intangible assets).  Amortization of non-compete agreements was $66, $67 and $57 during the first, second and third quarters of 2002, respectively.  Expected annual amortization expense for non-compete agreements recorded as of December 30, 2001 (fiscal 2002) is as follows:

 

2002		$	248
2003		231
2004		231
2005		196
2006		141
Thereafter		378
		$	1,425

 

The above amortization expense forecast is an estimate.  Actual amounts of amortization expense may differ from estimated amounts due to additional intangible asset acquisitions, impairment of intangible assets, accelerated amortization of intangible assets, and other events.

 

8

 

Included in goodwill, trademarks and other on the Company’s consolidated balance sheet as of the end of the third quarter, September 28, 2002, and as of the latest fiscal year end, December 29, 2001, are the following acquired intangible assets by reporting segment (net of accumulated amortization):

 

(In thousands)		SEPTEMBER 28, 2002			DECEMBER 29, 2001
WHOLESALE:
Goodwill		$	37,074		$	130,728
Trademarks		13,761			13,761
Non-compete agreements		975			1,097
		$	51,810		$	145,586
RETAIL:
Goodwill		$	7,912		$	7,912
Trademarks		137			137
Non-compete agreements		259			328
		$	8,308		$	8,377

 

9

 

5.        Segments of the Company and Related Information

 

The Company has two reportable segments — wholesale and retail.  Although the product produced and sold for each segment is similar, the type of customer for the product and the method used to distribute the product are different.  The segmentation of these operations also reflects how the Company’s chief executive officer (the CEO) currently reviews the results of these operations. Income from operations for each operating segment includes specifically identifiable operating costs such as cost of sales and selling expenses.  General and administrative expenses are generally not allocated  to specific operating segments and are therefore reflected in the other category.  Other components of the statement of operations which are classified below income from operations are also not allocated by segment.  In addition, the Company does not account for or report assets, capital expenditures or depreciation and amortization by segment.  All transactions between operating segments have been eliminated and are not included in the following table.

 

		QUARTER ENDED						39 WEEKS ENDED
(In thousands)		SEPTEMBER 28, 2002			SEPTEMBER 29, 2001			SEPTEMBER 28, 2002			SEPTEMBER 29, 2001
WHOLESALE:
Net sales		$	56,916		$	58,505		$	142,909		$	141,501
Income from operations		25,615			27,985			65,196			65,189
RETAIL:
Net sales		$	1,646		$	1,624		$	8,002		$	2,922
Loss from operations		(1,998		)	(373		)	(4,794		)	(1,211		)
OTHER -
Loss from operations		$	(8,501	)	$	(12,431	)	$	(25,982	)	$	(34,506	)
CONSOLIDATED:
Net sales		$	58,562		$	60,129		$	150,911		$	144,423
Income from operations		15,116			15,181			34,420			29,472

 

10

 

Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

RESULTS OF OPERATIONS

 

Comparison of Results of Operations for the Quarter Ended September 28, 2002 to the Quarter Ended September 29, 2001.

 

		QUARTER ENDED SEPTEMBER 28, 2002					QUARTER ENDED SEPTEMBER 29, 2001
(In millions)		Dollars			% of Net Sales		Dollars			% of Net Sales
Net sales		$	58.6		100	%	$	60.1		100	%
Gross profit		30.7			52		33.0			55
Selling, general, and administrative expenses		15.5			27		16.6			28
Amortization of goodwill, trademarks and other		0.1			—		1.3			2
Income from operations		15.1			26		15.2			25
Interest expense		0.8			1		1.7			3
Other, net		0.2			—		3.0			5
Income before income taxes		14.1			24		10.5			17
Income tax provision		5.1			9		4.0			7
Net income		9.0			15		6.5			11

 

11

 

Net Sales

 

Net sales decreased $1.6 million, or 3%, from $60.1 million in the third quarter of 2001 to $58.6 in the third quarter of 2002.  The decrease in sales was principally due to a decrease in wholesale sales to independent gift retailers (wholesale customers).

 

Wholesale sales decreased $1.6 million, or 3%, from $58.5 million in the third quarter of 2001 to $56.9 million in the third quarter of 2002.  The decrease in wholesale revenues was principally due to additional revenues received during 2001 from the Company’s 25^th Anniversary Celebration, partially offset in 2002 by the effect of a $1.0 million reduction in the provision for sales returns and credits resulting from continued favorable experience with respect to product return levels.  Wholesale sales of the Company’s Village Series products decreased $3.5 million, or 10%, while sales of General Giftware products increased $1.9 million, or 8% between the two periods.  Village Series products represented 55% of the Company’s sales during the third quarter of 2002 versus 59% during the third quarter of 2001.

 

Retail sales were $1.6 million during the third quarters of both 2001 and 2002. The Company’s retail business is comprised of its Department 56 branded year-round stores, seasonal stores operating under the name “Holidays by Department 56^™” and seasonally-operated kiosks operating under the Geppeddo^Ò brand.  Third quarter 2001 and 2002 retail sales principally reflect the operations of the three year-round stores.  The Company recognizes the majority of its retail sales in the fourth quarter during the peak holiday shopping season.

 

Gross Profit

 

Gross profit as a percentage of net sales was 54.9% and 52.4% in the third quarter of 2001 and 2002, respectively.  The decrease in gross profit as a percentage of net sales during the third quarter of 2002 compared to the third quarter of 2001 was principally due to the mix shift in wholesale product shipments within and between product lines, partially offset by reduced sales returns and credits.

 

Selling, General and Administrative Expenses

 

Selling, general and administrative expenses decreased $1.0 million, or 6%, between the third quarter of 2001 and the third quarter of 2002.  Selling, general and administrative expenses as a percentage of net sales were 28% and 27% in the third quarter of 2001 and 2002, respectively.  The decrease in selling, general and administrative expenses as a percentage of net sales in the third quarter of 2002 compared to the third quarter of 2001 was primarily the result of non-recurring expenses related to the Company’s 25^th Anniversary Celebration in 2001, cost control initiatives in the Company’s wholesale segment and decreased depreciation expense resulting from a reduction in capitalized assets that occurred upon settlement of litigation (see Note 3 to the condensed consolidated financial statements), partially offset by increased retail operations. Retail sales, which have higher selling, general and administrative expenses as a percentage of sales than wholesale sales, represented 3% of total net sales during the third quarter of 2001 and 2002.

 

12

 

Interest Expense

 

Interest expense decreased $0.9 million, or 55%, between the third quarter of 2001 and the third quarter of 2002 principally due to decreased interest rates paid by the Company and a decrease in the amount of term debt outstanding.  The Company prepaid $1.0 million of its term debt in March 2002, and $30 million in May 2002.

 

Provision for Income Taxes

 

The effective income tax rate was 38% during the third quarter of 2001 and 36% during the third quarter of 2002.  The change in the effective income tax rate reflects the change in accounting for goodwill as a result of the Company’s adoption of SFAS No. 142.

 

13

 

RESULTS OF OPERATIONS

 

Comparison of Results of Operations for the 39 Weeks Ended September 28, 2002 to the 39 Weeks Ended September 29, 2001.

 

		39 WEEKS ENDED SEPTEMBER 28, 2002					39 WEEKS ENDED SEPTEMBER 29, 2001
(In millions)		Dollars			% of Net Sales		Dollars			% of Net Sales
Net sales		$	150.9		100	%	$	144.4		100	%
Gross profit		82.8			55		80.1			55
Selling, general, and administrative expenses		48.2			32		46.7			32
Amortization of goodwill, trademarks and other		0.2			—		3.9			3
Income from operations		34.4			23		29.5			20
Interest expense		2.7			2		5.6			4
Litigation settlement		(5.4		)	4		—			—
Other, net		—			—		2.7			2
Income before income taxes and cumulative effect of change in accounting principle		37.2			25		21.1			15
Income tax provision		13.4			9		8.0			6
Income before cumulative effect of change in accounting principle		23.8			16		13.1			9
Cumulative effect of change in accounting principle		(93.7		)	N/A		—			—
Net (loss) income		(69.9		)	N/A		13.1			9

 

14

 

Net Sales

 

Net sales increased $6.5 million, or 4%, from $144.4 million in 2001 to $150.9 in 2002. The increase in sales was principally due to an increase in retail sales and an increase in wholesale sales to independent gift retailers (wholesale customers).

 

Wholesale sales increased $1.4 million, or 1%, from $141.5 million in 2001 to $142.9 million in 2002.  The increase in wholesale revenues was principally due to the effect of a $2.0 million reduction in the provision for sales returns and credits resulting from lower levels of product returns.  Wholesale sales of the Company’s Village Series products decreased $5.0 million, or 6%, while sales of General Giftware products increased $6.5 million, or 12% between the two periods.  Village Series products represented 58% of the Company’s sales during 2002 versus 63% during 2001.

 

Retail sales increased $5.1 million from $2.9 million in 2001 to $8.0 million in 2002. The Company’s retail business is comprised of its Department 56 branded year-round stores, seasonal stores operating under the name “Holidays by Department 56” and seasonally-operated kiosks operating under the Geppeddo brand.  Retail sales for 2002 benefited from the addition of ten seasonal stores and 359 seasonal kiosks during the latter part of 2001 that were open during January 2002, as well as the first quarter results of one of its year-round stores that was opened during the second quarter of 2001.  The Company’s retail operations historically generate losses in the first three quarters of the Company’s fiscal year and income from operations during the fourth quarter.

 

Gross Profit

 

Gross profit as a percentage of net sales was 55.5% and 54.9% in 2001 and 2002, respectively.  The decrease in gross profit as a percentage of net sales during 2002 compared to gross profit as a percentage of net sales for 2001 was principally due to the mix shift in wholesale product shipments noted above, partially offset by the increase in retail sales (which provide higher gross margins) and reduced sales returns and credits.  Retail sales represented 2% of sales in the first nine months of 2001 compared to 5% in the first nine months of 2002.

 

Selling, General and Administrative Expenses

 

Selling, general and administrative expenses increased $1.5 million, or 3%, between 2001 and 2002.  Selling, general and administrative expenses as a percentage of net sales were 32% in both 2001 and 2002.  The increase in selling, general and administrative expenses in 2002 compared to 2001 is principally due to increased retail operations, partially offset by the non-recurring expenses related to the Company’s 25^th Anniversary Celebration in 2001, cost control initiatives in the Company’s wholesale segment and decreased depreciation expense resulting from a reduction in capitalized assets that occurred upon settlement of litigation (see Note 3 to the condensed consolidated financial statements).  Retail selling, general and administrative expenses increased during 2002 primarily due to the acquisition of Geppeddo during the third quarter of 2001.  Retail sales have higher selling, general and administrative expenses as a percentage of sales than wholesale sales.

 

15

 

Interest Expense

 

Interest expense decreased $3.0 million, or 53%, between 2001 and 2002 principally due to decreased interest rates paid by the Company and a decrease in the amount of term debt outstanding.  The Company prepaid $20 million of its term debt in March 2001, $1.0 million in March 2002, and $30 million in May 2002.

 

Litigation Settlement

 

On March 1, 2002, the Company received net proceeds (before income taxes) of $11.0 million in settlement of the Company’s litigation against Arthur Andersen LLP and Andersen Worldwide Société Coopérative concerning implementation of its information systems. This recovery resulted in other income of $5.4 million and a $5.6 million reduction in net depreciable assets.

 

Provision for Income Taxes

 

The effective income tax rate was 38% during the 39 weeks ended September 29, 2001 and 36% during the 39 weeks ended September 28, 2002.  The change in the effective income tax rate reflects the change in accounting for goodwill noted above.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Net cash used in operating activities increased $27.0 million from $22.4 million in 2001 to $49.4 million in 2002 principally due to higher cash collections in 2001 as a result of the higher than normal accounts receivable balances at the end of 2000, an increase in the amount of sales qualifying for extended dating terms during 2002, higher inventory balances, and higher income tax payments.  This increase was partially offset by the $11.0 million net proceeds (before income taxes) received as a result of the Company’s litigation settlement (see Note 3 to the condensed consolidated financial statements).

 

Consistent with customary practice in the giftware industry, the Company offers extended accounts receivable terms to many of its wholesale customers.  This practice has typically created significant working capital requirements in the second and third quarters which the Company has generally financed with internally generated cash flow and seasonal borrowings.  The Company’s cash and cash equivalents balances peak during the first quarter of the subsequent year, following the collection of accounts receivable with extended payment terms due in November and December.

 

Accounts receivable, net of reserves, which principally consists of wholesale trade receivables, increased from $88.6 million at September 29, 2001 to $95.5 million at September 28, 2002.  The increase in accounts receivable is principally due to an increase in the amount of sales qualifying for extended dating terms as well as the decreases in the allowance for sales returns and credits noted above.  Management believes there is adequate provision for any doubtful accounts receivable and sales returns that may arise.

 

16

 

Inventories increased from $19.0 million at September 29, 2001 to $21.6 million at September 28, 2002.  The increase in inventories is principally due to the planned increase in the Company’s seasonal retail locations, which open early during the fourth quarter.  This increase was partially offset by a decrease in inventories within the Company’s wholesale segment.

 

Capital expenditures decreased $1.1 million from $2.4 million in 2001 to $1.3 million in 2002.  Capital expenditures were $0.8 million and $0.5 million in the third quarter of 2001 and 2002, respectively.  For fiscal 2002, management expects total capital expenditures to be in line with historical levels of approximately 1% to 2% of annual revenues.

 

The Company’s credit agreement provides for a revolving credit facility and a term loan facility.  The revolving credit facility provides for borrowings of up to $100 million including letters of credit.  The letters of credit are issued primarily in connection with inventory purchases. The credit agreement contains numerous financial and operating covenants, including restrictions on incurring indebtedness and liens, selling property and paying dividends.  In addition, the Company is required to satisfy consolidated net worth, interest coverage ratio and leverage ratio tests, in each case at the end of each fiscal quarter.  None of these restrictions are expected to have a material adverse effect on the Company’s ability to operate in the future.

 

As of September 28, 2002, the total term debt outstanding was $54 million.  The Company’s remaining term debt requires amortization payments of $2.2 million and $51.8 million due in March 2003 and 2004, respectively.

 

The Company believes that its internally generated cash flow and seasonal borrowings under the revolving credit facility will be adequate to fund operations and capital expenditures for the next 12 months.

 

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CREDIT, RETURN AND OTHER CRITICAL ACCOUNTING POLICIES

 

The Company has credit policies that establish specific criteria related to credit worthiness that its customers must meet prior to the shipment of product to the customer.  The Company periodically makes limited and selective exceptions to its policy of not shipping to customers with overdue balances when the particular customer has met specific criteria which are indicative of a wherewithal to pay their past due and future balances.

 

The Company does not accept returns from wholesale customers without its prior authorization.  Returns are typically accepted only for damaged or defective goods, or shipping discrepancies.  The Company reserves the right to refuse authorization of any returns and to discard any unauthorized returns.  If the Company accepts an unauthorized return or if a return is the result of a customer error, the wholesale customer may be subject to a 20% handling charge. The Company reserves the right to cancel open orders or backorders for those wholesale customers who abuse or excessively use return privileges.

 

The Company believes that the selection and application of its accounting policies are appropriately reasoned.  Management believes the following require the most difficult, subjective or complex judgments about matters that are inherently uncertain.

 

Sales Returns – An allowance is established for expenses and losses related to possible returns of product.  The amount of the allowance is based on historical ratios of returns to sales, the historical average length of time between the sale and the return, and other factors.  Changes in customers’ behavior versus historical experience or changes in the Company’s return policies are among the factors that would result in materially different amounts for this item.

 

Inventory Valuation – A reserve is established for estimated surplus and discontinued inventory items.  The amount of the reserve is determined by analyzing historical and projected sales information, plans for discontinued products and other factors.  Changes in sales volumes due to unexpected economic or competitive conditions are among the factors that would result in materially different amounts for this item.

 

Allowance for Doubtful Accounts – An allowance is established for estimated uncollectible accounts receivable. The required allowance is determined by reviewing customer accounts and making estimates of amounts that may be uncollectible.  Factors considered in determining the amount of the reserve include the age of the receivable, the financial condition of the customer, general business, economic and political conditions, and other relevant facts and circumstances.  Unexpected changes in the aforementioned factors would result in materially different amounts for this item.

 

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RECENT DEVELOPMENTS

 

Department 56 imports the majority of its products from manufacturers in the Pacific Rim through shipments primarily received via ports in California, Oregon and Washington.  These shipments are handled by shipping, stevedore and terminal companies represented by the Pacific Maritime Association (PMA) and longshoremen, marine clerks, walking bosses and foremen represented by the International Longshore and Warehouse Union (ILWU).  The previous labor contract between the PMA and ILWU expired on July 1, 2002.  Following a series of 24-hour contract extensions, negotiation between the parties broke down and a lockout ensued on September 27, shutting down the West Coast ports for 11 days.  On October 8, a federal judge issued an injunction under the Taft-Hartley Act, allowing the ports to be reopened.  The injunction imposed an 80-day cooling-off period beginning as of the date of the injunction and ending December 26, 2002, during which the full terms of the previous labor contract are reinstated and the parties are directed to continue contract negotiations with federal mediators. In the event that a contract is not signed by the end of the 80-day period (and absent Congress passing new legislation preventing labor disputes of this kind from occurring), both the ILWU and the PMA would be free to resume all economic activities they choose, including strikes, slowdowns and lockouts.

 

This 11-day lockout has caused a delay in the delivery of existing shipments to the Company’s distribution center.  The lockout further created a backlog of new shipments from the Pacific Rim across many companies and industries, making it difficult to obtain cargo containers and space on vessels.  At this time, the Company is optimistic that these delays will not have a material impact on its operating results; however, the ultimate extent of the delays by the lockout and their impact on the Company’s business has yet to be determined.

 

FOREIGN EXCHANGE

 

Approximately 97% of the Company’s sales in 2001 were denominated in United States dollars and, as a result, were not subject to changes in exchange rates.  Approximately 3% of the Company’s sales in 2001 were denominated in foreign currencies which were subject to changes in exchange rates.

 

The Company imports its product from manufacturers located in the Pacific Rim, principally China.  Although the Company generally pays for its product in United States dollars, the cost of such product may fluctuate with the value of the Chinese currency because the purchase price paid to the Company’s vendors in United States dollars would be worth more or less in the Chinese currency.  As a result, the Company’s costs could be adversely affected if the Chinese currency appreciates significantly relative to the United States dollar.  Conversely, its costs could be favorably affected if the Chinese currency depreciates significantly relative to the United States dollar.  In addition, the Company purchased less than 2% of its product from Taiwan (Republic of China) in 2001.  These purchases were denominated in New Taiwan Dollars and were subject to changes in exchange rates.

 

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The Company, from time to time, will enter into foreign exchange contracts or build foreign currency deposits as a partial hedge against currency fluctuations.  The Company intends to manage foreign exchange risks to the extent possible and take appropriate action where warranted.  The Company did not enter into any foreign exchange contracts nor have any foreign exchange contracts outstanding in 2001 and 2002.

 

RESTRICTION ON IMPORTS

 

The Company does not own or operate any manufacturing facilities and imports most of its products from manufacturers in the Pacific Rim, primarily the People’s Republic of China, Taiwan and The Philippines. The Company also imports a small percentage of its products from sources in India and Europe (primarily Germany, Poland and Czechoslovakia).

 

The Company’s ability to import products and thereby satisfy customer orders is affected by the availability of, and demand for, quality production capacity abroad.  The Company competes with other importers of specialty giftware products for the limited number of foreign manufacturing sources which can produce detailed, high-quality products at affordable prices. Foreign manufacturing and procurement of imports is subject to the following inherent risks: fluctuations in currency exchange rates; economic and political instability; cost fluctuations and delays in transportation; restrictive actions by governments; nationalizations; the laws and policies of the U.S. affecting importation of goods (including duties, quota and taxes); and foreign trade and tax laws. The Company’s costs could be adversely affected if the currencies of other countries in which the Company sources product appreciate significantly relative to the U.S. dollar.  Moreover, the Company cannot predict what relevant political, legal or regulatory changes may occur or the type or amount of any financial impact on the Company such changes may have in the future.

 

The Company’s products are subject to customs duties and regulations pertaining to the importation of goods, including requirements for the marking of certain information regarding the country of origin on the Company’s products.  In its ordinary course of business, the Company may be involved in disputes with the U.S. Customs Service regarding the amount of duty to be paid, the value of merchandise to be reported or other customs regulations with respect to certain of the Company’s imports, which may result in the payment of additional duties and/or penalties, or which may result in the refund of duties to the Company.

 

In fiscal 2001, approximately 87% of the Company’s imports were manufactured in The People’s Republic of China (China), and the Company anticipates that such percentage will hold constant or increase for the foreseeable future. China has joined the World Trade Organization and been accorded permanent “Normal Trade Relations” status by the U.S. government.

 

Various commercial and legal practices widespread in China, including the handling of intellectual properties, as well as certain political and military actions taken or suggested by China, are under review by the U.S. government. China, moreover, has been designated a Country of Particular Concern (CPC) pursuant to the International Religious Freedom Act of 1998 (IRFA). The IRFA enumerates several specific retaliatory actions which may be taken by the U.S. government, none of which the Company believes would have a material impact on its

 

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business.  The IRFA, however, also accords the President broad discretion in fashioning other or additional actions and, due to the breadth of the Presidential powers under the IRFA, the Company is unable to predict what, if any, action the President could consider taking in the future.

 

Accordingly, the ability to continue to conduct business with vendors located in China is subject to political uncertainties, the financial impact of which the Company is unable to estimate. To the extent China may have its exports or transaction of business with U.S. persons subject to political retaliation, the cost of Chinese imports could increase significantly and/or the ability to import goods from China may be materially impaired.  In such an event, there could be an adverse effect on the Company until alternative arrangements for the manufacture of its products were obtained on economic, production and operational terms at least as favorable as those currently in effect.

 

See “Recent Developments” above.

 

EFFECT OF INFLATION

 

The Company continually attempts to minimize any effect of inflation on earnings by controlling its operating costs and selling prices.  During the past few years, the rate of inflation has been low and has not had a material impact on the Company’s results of operations.

 

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SEASONALITY AND WHOLESALE CUSTOMER ORDERS

 

Wholesale Customer Orders Entered(1)

(In millions)

 

 

(1)  Customer orders entered are orders received and approved by the Company, net of any cancellation for various reasons including credit considerations, inventory shortages, and customer requests.  Wholesale customer orders entered exclude orders from company-operated retail stores.

 

Wholesale customer orders decreased $0.4 million, or 0.2%, from $176.4 million to $176.0 million through the third quarter of 2001 and 2002, respectively.  The decrease in wholesale customer orders was principally due to a continued slow erosion of the Company’s collectible account base as noted in the Company’s Annual Report on Form 10-K for the fiscal year ended December 29, 2001.  Net wholesale customer orders entered for Village Series products decreased 4% through the third quarter of 2002, while net wholesale customer orders entered for General Giftware products increased 5%.

 

Historically, due to the timing of wholesale trade shows early in the calendar year, the Company has received the majority of its total annual wholesale customer orders during the first quarter of each year.  The Company entered 62% and 68% of its total net annual wholesale customer orders during 2001 and 2000, respectively, during the first quarter of each of those years. Cancellations of total annual wholesale customer orders were approximately 8% and 7% in 2001 and 2000, respectively.  The Company’s backlog of wholesale customer orders was $40.1 million and $42.1 million at September 28, 2002 and September 29, 2001, respectively.

 

The Company receives products, pays its suppliers and ships products throughout the year, although historically the majority of wholesale shipments occur in the second and third quarters as retailers stock merchandise in anticipation of the holiday season.  As a result of this seasonal pattern, the Company generally records its highest wholesale sales during the second and third quarters of each year.  However, the Company can experience fluctuations in quarterly wholesale sales and related net income compared with the prior year due to the timing of receipt of product from suppliers and subsequent shipment of product from the Company to wholesale customers, as well as the timing of orders placed by wholesale customers.  In addition, the Company recognizes the majority of its retail sales in the fourth quarter during the peak holiday shopping season. The Company is not managed to maximize quarter-to-quarter results, but rather to achieve annual objectives designed to achieve long-term growth consistent with the Company’s business strategy.

 

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Item 3.   Quantitative and Qualitative Disclosures about Market Risk

 

There has been no significant change in the Company’s exposure to market risk since year end.  The Company’s risk is limited to interest rate risk associated with credit instruments and foreign currency exchange rate risk.

 

Item 4.   Controls and Procedures

 

Evaluation of Disclosure Controls and Procedures – The Company’s Chief Executive Officer and its Chief Financial Officer evaluated the Company’s disclosure controls and procedures (as defined in Rules 13a-14 and 15d-14 promulgated under the Securities and Exchange Act) within 90 days prior to the filing of this Quarterly Report on Form 10-Q (the Evaluation Date) and believe that as of the Evaluation Date our disclosure controls and procedures are effective in recording, processing, summarizing and reporting, within the time periods specified in the SEC’s rules and forms, the information required to be disclosed by the Company in all reports that it files or submits under the Securities Exchange Act of 1934.

 

Changes in Internal Controls – There were no significant changes in the Company’s internal controls (as embodied in Section 13(b)(2)(B) of the Securities Exchange Act of 1934), or in other factors that could significantly affect these controls subsequent to the Evaluation Date.

 

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PART II  -  OTHER INFORMATION

 

Item 1.   Legal Proceedings

 

Reference is made to Item 3, “Legal Proceedings,” of the Company’s Annual Report on Form 10-K for the fiscal year ended December 29, 2001, which Item is incorporated herein in its entirety.  On March 1, 2002, the Company received net proceeds (before income taxes) of $11.0 million in settlement of the Company’s litigation against Arthur Andersen LLP and Andersen Worldwide Société Coopérative concerning implementation of its information systems. This recovery resulted in other income of $5.4 million and a $5.6 million reduction in net depreciable assets.

 

On May 1, 2002, the United States District Court, District of Minnesota entered the order of its Chief Judge granting Department 56 and Susan Engel’s Motion to Dismiss the previously reported class action lawsuit, In Re Department 56, Inc., Securities Litigation.

 

 

Notes concerning forward-looking statements:

 

Any conclusions or expectations expressed in, or drawn from, the statements in this filing concerning matters that are not historical corporate financial results are “forward-looking statements” that involve risks and uncertainties.  These statements are based on management’s estimates, assumptions and projections as of today and are not guarantees of future performance.  Actual results may vary materially from forward-looking statements and the assumptions on which they are based.  The Company undertakes no obligation to update or publish in the future any forward-looking statements. Please read the bases, assumptions and factors set out in Item 7 in the Company’s Form 10-K for 2001 dated March 28, 2002 and filed under the Securities Exchange Act of 1934, all of which is incorporated herein by reference and applicable to the forward-looking statements set forth herein.

 

 

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Item 6.   Exhibits and Reports on Form 8-K

 

(a)     The following documents are filed as exhibits to this Report.

 

11.1    Computation of net income per share.

 

(b)     Reports on Form 8-K.

 

The Company filed the following Current Reports on Form 8-K during the third quarter of 2002:

 

•  Form 8-K dated August 9, 2002.

•         Form 8-K dated July 26, 2002 containing a Company press release and financial statements.

 

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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.

 

 

		DEPARTMENT 56, INC.
Date:	November 7, 2002	/s/ Susan E. Engel
		Susan E. Engel
		Chairwoman of the Board, Chief Executive Officer and Director (Principal Executive Officer)
Date:	November 7, 2002	/s/ Timothy J. Schugel
		Timothy J. Schugel
		Chief Financial Officer and Executive Vice President (Principal Financial Officer)

 

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CERTIFICATIONS

 

I, Susan E. Engel, certify that:

 

1. I have reviewed this quarterly report on Form 10-Q of Department 56, Inc.;

 

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

 

3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

 

4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:

 

a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

 

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

 

c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

 

5. The Registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

 

a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

 

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

 

6. The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

 

 

 

Date:	November 7, 2002	/s/ Susan E. Engel
		Susan E. Engel
		Chairwoman of the Board, Chief Executive Officer and Director (Principal Executive Officer)

 

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CERTIFICATIONS

 

I, Timothy J. Schugel, certify that:

 

1. I have reviewed this quarterly report on Form 10-Q of Department 56, Inc.;

 

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

 

3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

 

4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:

 

a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

 

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

 

c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

 

5. The Registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

 

a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

 

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

 

6. The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

 

 

 

Date:	November 7, 2002	/s/ Timothy J. Schugel
		Timothy J. Schugel
		Chief Financial Officer and Executive Vice President (Principal Financial Officer)

 

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EXHIBIT INDEX

 

Exhibit Number		Exhibit Name		Page Number
11.1		Computation of net income per share.

 

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