UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

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

 

For the quarterly period ended August 28, 2004

 

OR

 

o 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:  0-18926

 

INNOVO GROUP INC.

(Exact name of registrant as specified in its charter)

 

 

(323) 725-5516

(Registrant’s telephone number, including area code)

 

NO CHANGE

(Former name, former address and former fiscal year, if changed since last report)

 

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.                       ý Yes                 o No

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).                     o Yes                 ý No

 

As of October 8, 2004, there were 29,189,390 shares of the issuer’s only class of common stock outstanding.

 

 

INNOVO GROUP INC.

 

QUARTERLY REPORT ON FORM 10-Q

 

PART I.	FINANCIAL INFORMATION
Item 1.	Financial Statements
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures about Market Risk
Item 4.	Controls and Procedures
PART II.	OTHER INFORMATION
Item 1.	Legal Proceedings
Item 2.	Changes in Securities and Use of Proceeds
Item 3.	Defaults Upon Senior Securities
Item 4.	Submission of Matters to a Vote of Security Holders
Item 5.	Other Information
Item 6.	Exhibits and Reports on Form 8-K
	Signatures

 

 

PART I – FINANCIAL INFORMATION

Item 1.                                                           Financial Statements.

 

INNOVO GROUP INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

 

		08/28/04			11/29/03
		(unaudited)			(audited)
ASSETS
CURRENT ASSETS
Cash and cash equivalents		$	397		$	7,248
Accounts receivable and due from factor, net of allowance for customer credits and allowances of $1,254 (2004) and $2,158 (2003)		2,704			1,683
Inventories		9,293			7,524
Prepaid expenses and other current assets		458			2,115
Assets of discontinued operations		599			1,217
TOTAL CURRENT ASSETS		13,451			19,787
PROPERTY and EQUIPMENT, net		484			850
GOODWILL		12,592			12,592
INTANGIBLE ASSETS, NET		12,032			13,058
OTHER ASSETS		80			78
TOTAL ASSETS		$	38,639		$	46,365
LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES
Accounts payable and accrued expenses		$	5,855		$	6,128
Due to factor		—			332
Due to related parties		386			579
Convertible note payables, net		2,386			—
Note payable to officer		500			500
Current portion of related party long-term debt		267			—
Liabilities of discontinued operations		402			476
TOTAL CURRENT LIABILITIES		9,796			8,015
RELATED PARTY LONG-TERM DEBT		9,033			21,868
Commitments and Contingencies
8% Redeemable preferred stock, $0.10 par value: Authorized shares 5,000,  194 shares (2004) and (2003)		—			—
STOCKHOLDERS’ EQUITY
Common stock, $0.10 par – shares, Authorized 40,000 Issued and outstanding 29,166 (2004), and 25,785 (2003)		2,917			2,579
Additional paid-in capital		71,701			59,077
Accumulated deficit		(51,517		)	(41,824		)
Promissory note-officer		(703		)	(703		)
Treasury stock, 77 shares (2004) and (2003)		(2,588		)	(2,588		)
Accumulated other comprehensive loss		—			(59		)
TOTAL STOCKHOLDERS’ EQUITY		19,810			16,482
TOTAL LIABILITIES and STOCKHOLDERS’ EQUITY		$	38,639		$	46,365

 

The accompanying notes are an integral part of these financial statements

 

1

 

INNOVO GROUP INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

 

		Three Months Ended						Nine Months Ended
		08/28/04			08/30/03			08/28/04			08/30/03
		(unaudited)			(unaudited)			(unaudited)			(unaudited)
NET SALES		$	41,122		$	21,906		$	87,748		$	45,834
COST OF GOODS SOLD		32,824			18,013			73,080			35,275
Gross profit		8,298			3,893			14,668			10,559
OPERATING EXPENSES
Selling, general and administrative		5,579			5,202			21,223			11,614
Depreciation and amortization		394			704			1,219			831
		5,973			5,906			22,442			12,445
INCOME (LOSS) FROM OPERATIONS		2,325			(2,013		)	(7,774		)	(1,886		)
Interest Expense		(338		)	(394		)	(1,018		)	(749		)
Other income		30			189			36			346
Other expense		—			(7		)	(53		)	(1		)
INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE INCOME TAXES		2,017			(2,225		)	(8,809		)	(2,290		)
INCOME TAXES		—			22			(6		)	69
INCOME (LOSS) FROM CONTINUING OPERATIONS		$	2,017		$	(2,247	)	$	(8,803	)	$	(2,359	)
LOSS FROM DISCONTINUED OPERATIONS, NET OF TAX		(13		)	(65		)	(890		)	(165		)
NET INCOME (LOSS)		$	2,004		$	(2,312	)	$	(9,693	)	$	(2,524	)
EARNINGS (LOSS) PER COMMON SHARE (BASIC)
Earnings (loss) from continuing operations		$	0.07		$	(0.13	)	$	(0.32	)	$	(0.15	)
Loss from discontinued operations		0.00			(0.01		)	(0.03		)	(0.01		)
EARNINGS (LOSS) PER COMMON SHARE (BASIC)		$	0.07		$	(0.14	)	$	(0.35	)	$	(0.16	)
EARNINGS (LOSS) PER COMMON SHARE (DILUTED)
Earnings (loss) from continuing operations		$	0.07		$	(0.13	)	$	(0.32	)	$	(0.15	)
Loss from discontinued operations		$	(0.00	)	$	(0.01	)	$	(0.03	)	$	(0.01	)
EARNINGS (LOSS) PER COMMON SHARE (DILUTED)		$	0.07		$	(0.14	)	$	(0.35	)	$	(0.16	)
WEIGHTED AVERAGE SHARES OUTSTANDING
Basic		29,089			17,076			27,884			15,646
Diluted		30,615			17,076			27,884			15,646

 

The accompanying notes are an integral part of these financial statements

 

2

 

INNOVO GROUP INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 

		Nine Months Ended
		08/28/04			08/30/03
		(unaudited)			(unaudited)
CASH USED IN OPERATING ACTIVITIES		$	(9,233	)	$	(7,683	)
CASH PROVIDED IN DISCONTINUED ACTIVITIES		74			68
CASH USED IN OPERATING ACTIVITIES		(9,159		)	(7,615		)
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from sale of fixed assets		4			6
Proceeds from investment in real estate		98			853
Redemption of preferred shares		—			(368		)
Purchases of fixed assets		(134		)	(530		)
Cash used in investing activities		$	(32	)	$	(39	)
CASH FLOWS FROM FINANCING ACTIVITIES
Purchase of treasury stock		$	—		$	(28	)
Payments on notes payables and long term debt		(68		)	(501		)
Proceeds from issuance of convertible notes payable		2,500			—
Repayments of factor borrowings		(332		)	—
Proceeds from note payable to officer		—			500
Proceeds from issuance of stock and exercise of stock options, net of expense		314			9,928
Cash provided by financing activities		$	2,414		$	9,899
Cash used in discontinued activities		(74		)	(67		)
Cash provided by financing activities		2,340			9,832
Effect of exchange rate on cash		—			10
NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS		$	(6,851	)	$	2,188
CASH AND CASH EQUIVALENTS, at beginning of period		7,248			222
CASH AND CASH EQUIVALENTS, at end of period		$	397		$	2,410

 

The accompanying notes are an integral part of these financial statements

 

3

 

INNOVO GROUP INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

NOTE 1 - BASIS OF PRESENTATION

 

The condensed consolidated financial statements of Innovo Group, Inc., which include the accounts of its wholly-owned subsidiaries, for the three and nine months ended August 30, 2003 and August 28, 2004 and the related footnote information are unaudited and have been prepared on a basis substantially consistent with Innovo Group’s audited consolidated financial statement as of November 29, 2003 contained in Innovo Group’s Annual Report on Form 10-K and Amendment No. 1 to Annual Report on Form 10-K for the year ended November 29, 2003, or the Annual Report.  Innovo Group’s subsidiaries include the following entities:  Innovo, Inc., or Innovo, Joe’s Jeans Inc., or Joe’s, Innovo Azteca Apparel, Inc., or IAA, Leaseall Management, Inc., or Leaseall, and Innovo Realty, Inc., or IRI.  All significant inter-company transactions have been eliminated.

 

These unaudited condensed consolidated 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.  These financial statements should be read in conjunction with the audited consolidated financial statements and the related notes thereto contained in Innovo Group’s Annual Report.  In the opinion of management, the accompanying unaudited financial statements contain all adjustments (consisting of normal recurring adjustments), which management considers necessary to present fairly Innovo Group’s financial position, results of operations and cash flow for the interim periods presented.  The results for the three months and nine months ended August 28, 2004 are not necessarily indicative of the results anticipated for the entire year ending November 27, 2004.

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statement.  Actual results may differ from those estimates.  Certain amounts in prior period financial statements have been reclassified to conform to the current period presentation.

 

NOTE 2 – INVENTORY

 

Inventories are stated at the lower of cost, which is determined by the first-in-first-out method or market.  Inventories consisted of the following (in thousands):

 

		08/28/04			11/29/03
		(in thousands)
Finished goods		$	7,409		$	10,189
Work in progress		1,066			199
Raw materials		1,998			1,329
		10,473			11,717
Less allowance for obsolescence and slow moving items		(1,180		)	(4,193		)
		$	9,293		$	7,524

 

4

 

NOTE 3 – LOSS FROM DISCONTINUED OPERATIONS

 

During the third quarter of fiscal 2004, management decided to sell Innovo Group’s commercial rental property that served as its former headquarters located in Springfield, Tennessee and engaged a commercial real estate broker to assist with the sale.  In accordance with the provisions of SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets,” the accompanying condensed consolidated financial statements reflect the results of operations and financial position of Leaseall separately as a discontinued operation.  The assets and liabilities of the discontinued operation are presented in the condensed consolidated balance sheet under the captions “Assets of Discontinued Operations” and “Liabilities of Discontinued Operations.”  Innovo Group believes that the sale of this property can be completed within a twelve month period.  The underlying assets and liabilities of the discontinued operations for the periods presented are as follows:

 

		08/28/04			11/29/03
		(in thousands)
Building, land and improvements		$	1,656		$	1,656
Less accumulated depreciation and amortization		(483		)	(439		)
Less asset impairment charge		(574		)	—
Assets of discontinued operations		$	599		$	1,217
Liabilities of discontinued operations		$	402		$	476

 

The following table sets forth the loss from the discontinued operations of each period presented.  During the second quarter of fiscal 2004, Innovo Group recorded a $574,000 impairment loss on long-lived assets related to this property.

 

		Three Months Ended				Nine Months Ended
		8/28/04		8/30/03		8/28/04		8/30/03
		(in thousands)
Selling, general and administrative		(28	)	(26	)	(271	)	(45	)
Depreciation		—		(19	)	(44	)	(56	)
Interest expense		(7	)	(9	)	(26	)	(21	)
Other income		13		8		40		25
Other expense		(6	)	(17	)	(18	)	(61	)
Asset impairment charge		—		—		(574	)	—
Tax (expense)/benefit		15		(2	)	3		(7	)
Loss from discontinued operations		(13	)	(65	)	(890	)	(165	)

 

5

 

NOTE 4 – LONG-TERM DEBT

 

A summary of our long-term debt follows (in thousands):

 

		08/28/04			11/29/03
		(in thousands)
First mortgage loan on Springfield property		$	402		$	476
Promissory note to Azteca (Blue Concepts)		9,300			21,800
Promissory note to Azteca (Knit Div.)		—			68
Total long-term debt		9,702			22,344
Less: Liabilities of discontinued operations		402			476
Current portion of related party long-term debt		267			—
Total related party long-term debt		$	9,033		$	21,868

 

As used herein, Azteca means Azteca Production International, Inc., an entity in which two of our substantial stockholders, Hubert Guez and Paul Guez, have a controlling interest.

 

NOTE 5 – DUE FROM FACTOR AND SHORT TERM DEBT

 

CIT Commercial Services

 

On June 1, 2001, Innovo Group’s subsidiaries, Innovo and Joe’s, entered into accounts receivable factoring agreements with CIT Commercial Services, a unit of CIT Group, Inc. (CIT).  Under the terms of the agreements, Innovo or Joe’s has the option to factor receivables with CIT on a non-recourse basis, provided that CIT approves the receivable in advance.  Innovo or Joe’s may, at their option, also factor non-approved receivables on a recourse basis.  Innovo or Joe’s continues to be obligated in the event of product defects and other disputes, unrelated to the credit worthiness of the customer.  Innovo or Joe’s has the ability to obtain advances against factored receivables up to 85% of the face amount of the factored receivables.  The agreement calls for a 0.8% factoring fee on invoices factored with CIT and a per annum rate equal to the greater of the Chase prime rate plus 0.25% or 6.5% on funds borrowed against the factored receivables.  On September 10, 2001, IAA entered into a similar factoring agreement with CIT upon the same terms.

 

On or about August 20, 2002, each of Innovo and Joe’s entered into certain amendments to their respective factoring agreements, which included inventory security agreements, to permit the subsidiaries to obtain advances of up to 50% of the eligible inventory up to $400,000 each.  According to the terms of the agreements, amounts loaned against inventory are to bear an interest rate equal to the greater of the bank’s prime rate plus 0.75% or 6.5% per annum.

 

On or about June 10, 2003, the existing financial facilities with CIT for each of Innovo and Joe’s were amended, to be effective as of April 11, 2003, primarily to remove the fixed aggregate cap of $800,000 on their inventory security agreement to allow for Innovo and Joe’s to borrow up to 50% of the value of certain eligible inventory calculated on the basis of the lower of cost or market, with cost calculated on the first-in-first-out basis.  In connection with these amendments, IAA, entered into an inventory security agreement with CIT based on the same terms as Joe’s and Innovo also with no fixed aggregate cap.  IAA did not previously have an inventory security agreement with CIT.  Under the factoring arrangements, Innovo Group though its subsidiaries may borrow up to 85% of the value of eligible factored receivables outstanding.  The factoring rate that Innovo Group pays to CIT to factor accounts, on which CIT bears some or all of the credit risk, was lowered to 0.4% and the interest rate

 

6

 

associated with borrowings under the inventory lines and factoring facility were reduced to the bank’s prime rate.  Innovo Group has also established a letter of credit facility with CIT whereby Innovo Group can open letters of credit, for 0.125% of the face value, with international and domestic suppliers provided Innovo Group has availability on its inventory line of credit.  In addition, Innovo Group also may elect to factor with CIT its receivables by utilizing an adjustment of the interest rate as set on a case-by-case basis, whereby certain allocation of risk would be borne by Innovo Group, depending upon the interest rate adjustment.  On June 10, 2003, cross guarantees were executed by and among Innovo, Joe’s, and IAA and Innovo Group entered into a guarantee for its subsidiaries’ obligations in connection with the amendments to the existing credit facilities.  In connection with the agreements with CIT, all of our inventory, merchandise, and/or goods, including raw materials through finished goods and receivables are pledged to CIT.

 

These agreements may be terminated by CIT upon 60 days prior written notice or immediately upon the occurrence of an event of default, as defined in the agreement.  The agreements may be terminated by each of Innovo, IAA or Joe’s, upon 60 days advanced written notice prior to June 30, 2005 or earlier provided that the minimum factoring fees have been paid for the respective period.

 

Innovo Group records its accounts receivable on the balance sheet net of receivables factored with CIT, since the factoring of receivables is non-recourse to Innovo Group.  Further, in the event Innovo Group’s loan balance with CIT exceeds the face value of the receivables factored with CIT, Innovo Group records the difference between the face value of the factored receivables and the outstanding loan balance as a liability on Innovo Group’s balance sheet as “Due to Factor.”  On August 28, 2004, Innovo Group’s loan balance with CIT was $10,599,000 and no open letters of credit were outstanding.

 

7

 

NOTE 6 – EARNINGS 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						Nine Months Ended
		(in thousands, except per share data)						(in thousands, except per share data)
		08/28/04			08/30/03			08/28/04			08/30/03
Basic Earnings per share Computation:
Numerator
Income (loss) from continuing operations		$	2,017		$	(2,247	)	$	(8,803	)	$	(2,359	)
Loss from discontinued operations		(13		)	(65		)	(890		)	(165		)
Net income (loss)		$	2,004		$	(2,312	)	$	(9,693	)	$	(2,524	)
Denominator:
Weighted average common shares outstanding		29,089			17,076			27,884			15,646
Earnings (loss) per Common Share - Basic
Income (loss) from continuing operations		$	0.07		$	(0.13	)	$	(0.32	)	$	(0.15	)
Loss from discontinued operations		(0.00		)	0.00			(0.03		)	(0.01		)
Net income (loss)		$	0.07		$	(0.13	)	$	(0.35	)	$	(0.16	)
Diluted Earnings per share Computation:
Numerator
Income (loss) from continuing operations		$	2,017		$	(2,247	)	$	(8,803	)	$	(2,359	)
Loss from discontinued operations		(13		)	(65		)	(890		)	(165		)
Interest impact of convertible notes		35			—			—			—
Net income (loss)		$	2,039		$	(2,312	)	$	(9,693	)	$	(2,524	)
Denominator:
Weighted average common shares outstanding		29,089			17,076			27,884			15,646
Effect of dilutive securities:
Options and warrants		212			—			—			—
Convertible notes		1,314			—			—			—
Dilutive potential common shares		30,615			17,076			27,884			15,646
Earnings (loss) per Common Share - Dilutive
Income (loss) from continuing operations		$	0.07		$	(0.13	)	$	(0.32	)	$	(0.15	)
Loss from discontinued operations		(0.00		)	0.00			(0.03		)	(0.01		)
Net income (loss)		$	0.07		$	(0.13	)	$	(0.35	)	$	(0.16	)

 

A total of 3,238,000 options and warrants were excluded from calculation of diluted EPS for the three month ended August 28, 2004, because these options and warrants had an exercise price in excess of the average market price of Innovo Group’s common stock during the quarter.

 

A total of 4,204,000 options and warrants were excluded from calculation of diluted EPS for the nine month ended August 28, 2004, because these options and warrants either had an exercise price in excess of the average market price of Innovo Group’s common stock during the quarter or their effect would have been anti-dilutive.

 

8

 

NOTE 7 – OTHER INCOME AND EXPENSE

 

Other Income and Expense consists of the following:

 

		Three Months Ended						Nine Months Ended
		(in thousands)						(in thousands)
		08/28/04			08/30/03			08/28/04			08/30/03
		(in thousands)
Rental, real estate, and management fee income		$	—		$	85		$	—		$	244
Unrealized gain on foreign currency		—			100			—			74
Other		30			4			36			28
Total other income		$	30		$	189		$	36		$	346
Realized/unrealized loss on foreign currency		$	(1	)	$	—		$	49		$	—
Other		—			7			—			1
Loss on fixed asset disposal		1			—			4			—
Total other expense		$	—		$	7		$	53		$	1

 

In connection with the termination of Joe’s Jeans Japan’s operations, during the nine months ended August 28, 2004, the accumulated other comprehensive loss resulting from the translation of the subsidiary’s financial statements from yen to dollars was reclassified to the statement of operations, resulting in a $52,000 loss during the nine months.

 

NOTE 8 –INCOME TAXES

 

Innovo Group’s income tax expense for the nine months ended August 28, 2004 and August 30, 2003, respectively, represents estimated state and foreign income and franchise tax expense.  For the 2004 period, Innovo Group recorded $6,000 of income tax benefit, which represents estimated state taxes net of a tax benefit from the recovery of previously paid state taxes and taxes in Japan.  For the 2004 and 2003 periods, the effective tax rate differs from the statutory rate primarily as a result of the accrual for state and foreign taxes and the recording of a valuation allowance which fully offset the benefit of the losses for the period.

 

9

 

NOTE 9 – STOCK COMPENSATION

 

Statement of Financial Accounting Standards No. 123, “Accounting for Stock Based Compensation” (SFAS No. 123), encourages, but does not require, companies to record compensation cost for stock-based employee compensation plans at fair value.  Innovo Group has chosen to continue to account for employee stock-based compensation using the method prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations.  Innovo Group has adopted the disclosure-only provisions of SFAS No. 123.  Accordingly, no compensation expense has been recorded in conjunction with the fair value of the options at the grant date and amortized over the option’s vesting period, consistent with the method prescribed by SFAS No. 123, Innovo Group’s net income (loss) would have been increased to the pro forma amounts indicated below for the three and nine months ended August 28, 2004 and August 30, 2003:

 

		Three Months Ended						Nine Months Ended
		(in thousands, except per share data)						(in thousands, except per share data)
		08/28/04			08/30/03			08/28/04			08/30/03
Net income (loss) as reported		$	2,004		$	(2,312	)	$	(9,693	)	$	(2,524	)
Add:
Stock based employee compensation expense included in reported net income (loss), net of related tax effects		—			25			—			76
Deduct:
Total stock based employee compensation expense determined under fair market value based method for all awards, net of related tax effects		159			101			345			403
Pro forma net income (loss)		$	1,845		$	(2,388	)	$	(10,038	)	$	(2,851	)
Net income (loss) per share
As reported - basic		$	0.07		$	(0.13	)	$	(0.35	)	$	(0.16	)
As reported - diluted		$	0.07		$	(0.13	)	$	(0.35	)	$	(0.16	)
Pro forma - basic		$	0.06		$	(0.14	)	$	(0.36	)	$	(0.18	)
Pro forma - diluted		$	0.06		$	(0.14	)	$	(0.36	)	$	(0.18	)

 

The fair value of each option granted is estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions used for grants in 2003 and 2004:

 

		2004		2003
Estimated dividend yield		0.0	%	0.0	%
Expected stock price volatility		74	%	48	%
Risk-free interest rate		5.0	%	5.0	%
Expected life of options		4 yrs		4 yrs

 

The Black-Scholes model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable.  In addition, option valuation models require the input of highly subjective assumptions, including, the expected stock price volatility.  Because Innovo Group’s employee stock options have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimates, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.

 

10

 

NOTE 10 – BLUE CONCEPT ACQUISITION

 

On July 17, 2003, our IAA subsidiary entered into an asset purchase agreement, or APA with Azteca, Hubert Guez and Paul Guez, whereby IAA acquired the Blue Concept Division of Azteca.  The Blue Concept Division sells primarily denim jeans to American Eagle Outfitters, Inc., or AEO, a national retailer.  Hubert Guez and Paul Guez, two of our substantial stockholders and parties to the APA, together have a controlling interest in Azteca.

 

Pursuant to the terms of the APA, IAA paid $21.8 million for the Blue Concept Division, subject to adjustment as noted below.  Pursuant to the APA, IAA employed all 30 of the existing employees of the Blue Concept Division, but did not assume any of the Blue Concept Division’s or Azteca’s existing liabilities.  The purchase price was paid through the issuance of a seven-year, partially convertible promissory note, or the Blue Concept Note.  The Blue Concept Note bears interest at a rate of 6% and requires payment of interest only during the first 24 months and then is fully amortized over the remaining five-year period.  The terms of the transaction further allowed Innovo Group, upon stockholder approval, to convert a portion of the Blue Concept Note into 3,125,000 shares of common stock valued at the greater of $4.00 per share or the market value of Innovo Group’s common stock at the date stockholder approval is obtained.  On March 5, 2004, Innovo Group conducted a special meeting of its stockholders to convert up to $12.5 million of the debt into up to 4,166,667 shares of common stock.  The conversion was approved by stockholders and as a result, Azteca has initially been issued 3,125,000 shares of common stock at a conversion price of $4.00 per share with the possible issuance of up to 1,041,667 additional shares of common stock upon the occurrence of certain contingencies described in the Blue Concept APA.  As a result of this conversion, the Blue Concept Note was reduced from $21.8 million to $9.3 million and the shares issued pursuant to the conversion are subject to certain lock-up periods.  See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Debt Conversions” for a further discussion of the conversion of the Blue Concept Note.

 

In the event that sales of the Blue Concept Division fall below $70 million during the first 17 month period, or Period I, following the closing of the acquisition, or $65 million during the 12 month period, or Period II, following Period I, certain terms of the APA allow for a reduction in the purchase price through a decrease in the principal balance of the Blue Concept Note and/or the return of certain locked-up shares of Innovo Group’s common stock.  In the event the Blue Concept Note is reduced during Period I and the sales of the Blue Concept Division in Period II are greater than $65 million, the Blue Concept Note shall be increased by half of the amount greater than the decrease in Period I.  As of August 28, 2004, the revenue targets for Period I have been met.

 

In the event that principal amount of the Blue Concept Note needs to be reduced beyond the outstanding principal balance of such Blue Concept Note, then an amount of the locked-up shares equal to the balance of the required reduction shall be returned to Innovo Group.  For these purposes, the locked-up shares shall be valued at $4.00 per share.  Additionally, if during the 12-month period following the closing, AEO is no longer a customer of IAA, the locked-up shares will be returned to Innovo Group, and any amount remaining on the balance of the Blue Concept Note will be forgiven.

 

In the event the revenues of the Blue Concept Division decrease to $35 million or less during Period I or Period II, IAA shall have the right to sell the purchased assets back to Azteca, and Azteca shall have the right to buy back the purchased assets for the remaining balance of the Blue Concept Note and any and all Locked Up Shares shall be returned to Innovo Group.  In addition, IAA will pay to Sweet Sportswear, LLC, an entity owned by Hubert Guez and Paul Guez who were parties to the Blue Concept asset purchase agreement, an amount equal to 2.5% of IAA’s net revenues generated as a result of sales to AEO.

 

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As part of the transaction, IAA and AZT International SA de CV, a Mexico corporation and wholly-owned subsidiary of Azteca, or AZT, entered into a two-year, renewable, non-exclusive supply agreement, or the Supply Agreement, for products to be sold by Blue Concept Division.  Under the terms of the Supply Agreement, Innovo Group has agreed to market and sell the products to be purchased from AZT to Innovo Group’s customers, more particularly the customers of the Blue Concept Division.  In addition to the customary obligations, the Supply Agreement requires that:  (i) Innovo Group shall submit written purchase orders to AZT on a monthly basis specifying (x) the products to be supplied and (y) a specified shipping date for products to be shipped; (ii) Innovo Group shall give AZT reasonable time allowances upon placing its purchase orders with AZT prior to delivery of the products by AZT; (iii) AZT shall receive payment immediately upon receipt by Innovo Group of invoices for its purchase orders; (iv) Innovo Group shall have a guaranteed profit margin of 15% on a “per unit” basis; and (v) the products to be supplied shall be subject to quality control measures by Innovo Group and by the customer of the Blue Concept Division.

 

The results of operations of the Blue Concept Division have been included in Innovo Group’s statement of operations from July 17, 2003.

 

The following table shows Innovo Group’s unaudited pro forma consolidated results of operations for the three and nine months ended August 28, 2004 and August 30, 2003 assuming the Blue Concept Division acquisition had occurred at the beginning of the respective fiscal years:

 

		Three Months Ended						Nine Months Ended
		(in thousands, except per share data)						(in thousands, except per share data)
		08/28/04			08/30/03			08/28/04			08/30/03
Net sales		$	41,122		$	28,600		$	87,748		$	91,888
Net income (loss)		2,004			(2,177		)	(9,693		)	(598		)
Earnings (loss) per share:
Basic		$	0.07		$	(0.11	)	$	(0.35	)	$	(0.03	)
Diluted		$	0.07		$	(0.11	)	$	(0.35	)	$	(0.03	)

 

Management and the board of directors entered into the Blue Concept acquisition for the following reasons:  (i) Innovo Group was able to enter into an acquisition with a seller with which Innovo Group has a long-standing relationship; (ii) Innovo Group was able to acquire a profitable business that has a financial history of producing conservative profit margins with significant revenues; (iii) Blue Concept had a strong customer relationship with AEO, (iv) the manufacturing relationships with Azteca to produce effectively and efficiently; and (v) was able to acquire the personnel and talent of a profitable business.  Further, although there can be no assurance, the Blue Concept Division is expected to increase Innovo Group’s revenue growth and is expected to maintain positive cash flows.  For the nine months ended August 28, 2004, the Blue Concept Division accounted for $45,965,000 or 52% of our net revenue.  Furthermore, the APA protects Innovo Group if revenue expectations are not realized by providing “downside” protections, such as guaranteed sales minimums, and a buy-sell provision that allows for the sale of the business if revenues do not reach $35 million.

 

The acquisition of the Blue Concept Division was accounted for under the purchase method of accounting.  Of the $21.8 million purchase price, $13.2 million was recorded as an intangible asset representing the value of the customer relationship, $361,000 was recorded as an intangible asset representing the fair value of the existing purchase orders at the closing of the acquisitions and the balance of the purchase price of $8.32 million was recorded as goodwill.  The purchase price allocation was based upon a third party valuation.

 

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NOTE 11 – REPORTABLE SEGMENTS

 

Current Operating Segments

 

During the nine months ended August 28, 2004, Innovo Group continued to operate in three segments, craft and accessories, apparel and other.  The craft and accessories segment represents Innovo Group’s historical line of business as conducted by Innovo.  The apparel segment is comprised of the operations of Joe’s and IAA, both of which began in fiscal 2001, as a result of acquisitions.  Innovo Group’s real estate transactions and its other corporate activities are categorized under “other” and are represented by the operations of Innovo Group and Innovo Realty Inc., or IRI, which conducts its real estate operations.  Innovo Group’s real estate operations do not currently require a substantial allocation of our resources and are not a significant part of management’s daily operational functions.

 

Innovo Group evaluates performance and allocates resources based on gross profits, and profit or loss from operations before interest and income taxes.  The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies.

 

Information for each reportable segment during each of the periods ending August 28, 2004 and August 30, 2003 is as follows:

 

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Three Months Ended 8/28/04		Crafts & Accessories			Apparel			Other			Total
		(in thousands)
Net Sales		$	5,072		$	36,050		$	—		$	41,122
Gross Profit		842			7,456			—			8,298
Depreciation & Amortization		21			366			7			394
Income (loss) from Operations		(249		)	3,804			(1,230		)	2,325
Loss from discontinued operations		—			—			(13		)	(13		)
Total Assets		100			34,104			4,435			38,639

 

Three Months Ended 8/30/03		Crafts & Accessories			Apparel			Other			Total
		(in thousands)
Net Sales		$	4,400		$	17,506		$	—		$	21,906
Gross Profit		1,039			2,854			—			3,893
Depreciation & Amortization		8			689			7			704
Income (loss) from Operations		294			(1,613		)	(694		)	(2,013		)
Loss from discontinued operations		—			—			(65		)	(65		)
Total Assets		4,008			34,652			2,430			41,090

 

Nine Months Ended 8/28/04		Crafts & Accessories			Apparel			Other			Total
		(in thousands)
Net Sales		$	13,164		$	74,584		$	—		$	87,748
Gross Profit		2,755			11,913			—			14,668
Depreciation & Amortization		58			1,143			18			1,219
Income (loss) from Operations		(320		)	(4,065		)	(3,389		)	(7,774		)
Loss from discontinued operations		—			—			(890		)	(890		)
Total Assets		100			34,104			4,435			38,639

 

Nine Months Ended 8/30/03		Crafts & Accessories			Apparel			Other			Total
		(in thousands)
Net Sales		$	10,329		$	35,505		$	—		$	45,834
Gross Profit		2,632			7,927			—			10,559
Depreciation & Amortization		21			793			17			831
Income (loss) from Operations		418			(456		)	(1,848		)	(1,886		)
Loss from discontinued operations		—			—			(165		)	(165		)
Total Assets		4,008			34,652			2,430			41,090

 

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NOTE 12 – CONVERTIBLE NOTES AND WARRANTS

 

On June 15, 2004, Innovo Group’s Board of Directors authorized Innovo Group to raise up to $4,000,000 dollars through the sale of convertible promissory notes and common stock purchase warrants.  On June 15, 2004, June 18, 2004 and June 22, 2004, Innovo Group executed agreements for the sale of convertible promissory notes and common stock purchase warrants for 312,500 shares of common stock which resulted in aggregate gross proceeds of $2,500,000 and up to an additional $452,000 in aggregate gross proceeds in the event of the exercise of the warrants.

 

The convertible promissory note issued to each purchaser bears interest at a rate of 7.5% per annum and has a maturity date twelve months from the date of issuance.  The convertible promissory note is convertible at any time from the date of issuance into shares of common stock at a price per share equal to 110% of the average of the closing price of Innovo Group’s common stock for the five trading days immediately prior to the date of issuance, which, for each purchaser, resulted in a conversion price of $1.53, $1.41 and $1.35, respectively.  Innovo Group will pay interest only payments until the maturity date of the convertible note, unless it is converted or prepaid.  Innovo Group has an option to make one prepayment of the note, in whole or in part, without penalty at any time after three months from the effective date of the note.  However, in the event that Innovo Group elects to prepay all or a portion of the convertible note, a purchaser may elect within 3 days to convert all or a portion of the note into common stock and thus prevent Innovo Group’s prepayment of the convertible note.

 

Each purchaser was also issued warrants to purchase shares of common stock.  The number of shares that the purchaser will be eligible to purchase is equal to 12.5% of the aggregate amount of the convertible promissory note and the exercise price of the warrants on a per share basis is equal to 110% of the average of the closing price of Innovo Group’s common stock for the five trading days immediately prior to the date of issuance of the warrant, which, for each purchaser, resulted in an exercise price of $1.53, $1.41 and $1.35, respectively.  The warrants expire five years from the date of issuance and are exercisable immediately.  The aggregate fair value of these warrants were valued at $143,000 using the Black Scholes pricing model with the following assumptions:

 

Estimated dividend yield		0.0	%
Expected stock price volatility		74	%
Risk-free interest rate		5.0	%
Expected life of warrant		2 yrs

 

The value of the warrants has been treated as a debt discount and is being amortized over the life of the convertible note.  The unamortized deferred financing cost as of August 28, 2004 was $114,000.  In connection with both the convertible notes and the warrants, Innovo Group entered into a registration rights agreement with each of the purchasers, whereby Innovo Group agreed to register for resale the shares underlying the convertible notes and warrants.

 

On September 27, 2004, Innovo Group’s Board of Directors authorized Innovo Group to raise up to an additional $1,500,000, for an aggregate of $5,500,000, through the sale of additional convertible promissory notes and common stock purchase warrants.  On October 4, 2004, Innovo Group raised an additional $1,885,000 under substantially similar terms.  See “Note 16 – Subsequent Events” for a further discussion of the terms of this additional sale of convertible notes and warrants.

 

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NOTE 13 – TERMINATION OF LICENSE AGREEMENTS

 

Innovo Group has been re-evaluating the license agreements associated with its branded label apparel operating segments since the beginning of fiscal 2004.  As a result of this re-evaluation process, two of its branded label apparel licenses were terminated in the second quarter of fiscal 2004.  In the fourth quarter of fiscal 2004, Innovo agreed to the early termination of its license for the Bongo® mark and IAA terminated its license for the Shago® mark.  See “Note 16 – Subsequent Events” for a further discussion on the termination of these license agreements.

 

Fetish™

 

On May 13, 2004, IAA mutually agreed to terminate the license agreement for the manufacture and sale of apparel and accessories bearing the Fetish™ mark with Blondie Rockwell, Inc., the licensor of entertainment personality Eve’s Fetish™ mark.

 

On May 25, 2004, the parties executed a definitive Settlement Agreement and Release.  Under the terms of the settlement, the license agreement was immediately terminated; however, IAA continued to have the ability to market, distribute and sell the 2004 summer Fetish™ line, other excess apparel inventory and unsold and returned merchandise to certain approved customers until December 31, 2004.  Furthermore, IAA agreed to pay to Blondie Rockwell a termination fee, which included unpaid accrued royalties, in three installments over a three month period.  As of October 12, 2004, Innovo Group has made all three installment payments totaling $837,000.  In exchange for the termination fee and unpaid owed royalties, IAA has no further obligation to pay any additional fees or royalties on sales from the 2004 Fetish™ summer line, excess apparel inventory or unsold or returned merchandise.  In addition, IAA continues to have the right to finish the production, marketing, distribution and sale of Fetish™ accessories identified in the Settlement Agreement through March 31, 2005, and will pay a royalty in the amount of 8% on all such accessory sales.  As part of the Settlement Agreement and Release, Innovo Group executed a Guaranty Agreement to and in favor of Blondie Rockwell, Inc. guaranteeing payment in full and performance of all of IAA’s obligations and liabilities in the Settlement Agreement and Release.

 

In connection with the termination of the Fetish™ license agreement, IAA recorded a charge in the second quarter of 2004 in the amount of $750,000 to reflect the termination payment as well as $1,355,000 representing the write-off of fixed assets related to the licensed brand and prepaid advertising license expenses. IAA also recorded a charge of $1,707,000 related to the write-down to estimated net realizable value of the Fetish™ inventory during the second quarter ended May 29, 2004.

 

Hot Wheels®

 

In July of 2002, IAA entered into a license agreement with Mattel, Inc. for Hot Wheels® branded adult apparel and accessories.  Since that time, due to lack of interest in the consumer marketplace, IAA did not have any sales under this license agreement.  Due to these and other factors, IAA terminated the license agreement for Hot Wheels® branded apparel and accessory products.  In connection with the termination, IAA paid $70,000, representing the final payment of royalty obligations to Mattel.  Due to the termination, IAA reversed an accrual of approximately $224,000 during the second quarter of fiscal 2004 which represented the maximum contractual future royalty obligations originally due under the license agreement.

 

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NOTE 14 – EXERCISE OF WARRANTS

 

During the first and second quarter of fiscal 2004, Innovo Group issued 251,500 shares of its common stock in connection with the exercise of certain previously issued warrants.  These warrants ranged in exercise price from $0.90 to $2.50 and resulted in aggregate gross proceeds of $447,000 to Innovo Group.

 

NOTE 15 – NEW YORK SHOWROOM LEASE OBLIGATION

 

Pursuant to a sublease agreement, Innovo Group rents approximately 11,000 square feet in New York which we used primarily as showroom and office space for support for our Fetish™, Shago®, and Joe’s® branded apparel lines.  While Innovo Group continue to occupy and utilize portions of the space for general administrative and sales purposes, we are currently not utilizing the space for its originally intended purpose as a result of the elimination of the Fetish® and Shago® brands.  Innovo Group has engaged a real estate broker to assist in evaluating our options in obtaining a prospective tenant for all or a portion of the space.  Currently, Innovo Group pays $29,000 per month and is obligated pursuant to the lease agreement until July 31, 2009.

 

NOTE 16 –SUBSEQUENT EVENTS

 

Sale of Convertible Notes and Warrants

 

On October 4, 2004, Innovo Group executed substantially similar transaction documents as described in “Note 12 – Convertible Notes and Warrants” with six additional accredited investors, resulting in aggregate gross proceeds of $1,885,000 million and up to an additional $537,000 in aggregate gross proceeds upon exercise of all 235,625 common stock purchase warrants.  The conversion price for the convertible notes and exercise price of the warrants for each purchaser was $2.28.

 

Termination of License Agreements

 

Bongo®

 

On September 1, 2004, Innovo Group’s accessory subsidiary, Innovo Inc., executed a letter agreement with IP Holdings LLC, the assignee of the Bongo® mark to provide for the early termination of its accessory license for bags and small leather/pvc goods bearing the Bongo® mark.  The parties mutually agreed to the early termination of the license agreement to be effective as of December 31, 2004.  In addition, the parties agreed to a reduced royalty rate of two and one-half percent of net sales instead of the five percent royalty rate in the original license agreement for product shipped between August 1, 2004 and December 31, 2004.  Innovo will continue to pay a two percent advertising royalty on net sales, but has no further obligation to contribute money to produce product samples, fees or for the participation of staff members in all brand events and tradeshows.  Both parties will be absolved of all other contractual matters as of December 31, 2004.

 

Shago®

 

On or about October 1, 2004, IAA agreed to enter into a Settlement and Release Agreement with LBW, Inc., the master licensor, whereby the parties will agree to a mutual termination and release for the license agreement to manufacture and sell toddler, boys, girls, and junior apparel and coordinating accessories featuring the Shago® and other professional names, visual images or representations based upon the real life image of the artist known as “Lil’ Bow Wow.”  Pursuant to the proposed settlement agreement, IAA will be

 

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obligated to pay an aggregate amount of $146,000 of unpaid owed royalties to LBW in exchange for the immediate termination and mutual release by the parties.  Upon payment of all unpaid owed royalties, there will be no further obligations by IAA to LBW.  Innovo Group does not expect any future net sales from this agreement and it does not have any significant Shago® inventory on hand.  The parties are in the process of executing a final settlement agreement.

 

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

 

Forward-Looking Statements

 

When used in this Quarterly Report on Form 10-Q, the words “may,” “will,” “expect,” “anticipate,” “intend,” “estimate,” “continue,” “believe” and similar expressions are intended to identify forward-looking statements.  Similarly, statements that describe our future expectations, objectives and goals or contain projections of our future results of operations or financial condition are also forward-looking statements.  Statements looking forward in time are included in this Quarterly Report on Form 10-Q pursuant to the “safe harbor” provision of the Private Securities Litigation Reform Act of 1995.  Such statements are subject to certain risks and uncertainties, which could cause actual results to differ materially, including, without limitation, continued acceptance of our product, product demand, competition, capital adequacy and the potential inability to raise additional capital if required, and the risk factors contained in our reports filed with the Securities and Exchange Commission pursuant to the Securities Exchange Act of 1934, as amended, including our Annual Report on Form 10-K and Amendment No. 1 to our Annual Report of Form 10-K for the year ended November 29, 2003.  Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof.  Our future results, performance or achievements could differ materially from those expressed or implied in these forward-looking statements.  We do not undertake and specifically decline any obligation to publicly revise these forward-looking statements to reflect events or circumstances occurring after the date hereof or to reflect the occurrence of unanticipated events.

 

The following discussion provides information and analysis of our results of operations for the three and nine month period ended August 28, 2004 and August 30, 2003, and our liquidity and capital resources.  The following discussion and analysis should be read in conjunction with our Notes to Consolidated Condensed Financial Statements included elsewhere herein.

 

We completed our acquisition of the Blue Concept Division from Azteca Production International, Inc., on July 17, 2003.  The results of operations of the Blue Concept Division are included in our operating results from the date of acquisition.  Accordingly, the financial position and results of operations presented and discussed herein are not directly comparable between years.  See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Recent Acquisitions and Licenses” for a further discussion of the Blue Concept Division Acquisition.

 

Introduction

 

This discussion and analysis summarizes the significant factors affecting our results of operations and financial conditions during the three and nine month periods ended August 28, 2004 and August 30, 2003.  This discussion should be read in conjunction with our Consolidated Condensed Financial Statements, Notes to Consolidated Condensed Financial Statements and supplemental information in Item 1 of this Quarterly Report on Form 10-Q for the period ended August 28, 2004.  The discussion and analysis contains statements that may be considered forward-looking.  These statements contain a number of risks and uncertainties as discussed here, under the heading “Forward-Looking Statements” of this Quarterly Report on Form 10-Q for the period ended August 28, 2004 that could cause actual results to differ materially.

 

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Executive Overview

 

Our principal business activity involves the design, development and worldwide marketing of high quality consumer products for the apparel and accessory markets.  We do not manufacture any apparel or accessory products, but may, from time to time at our cost, produce sample apparel and accessory products for new or existing customers or internal use.  We sell our products to many retail, distributors and private label customers around the world.  Retail customers and distributors purchase finished goods directly from us.  Retail customers then sell the products through their retail stores and distributors sell our products to retailers in the international market place.  Private label customers outsource the production and sourcing of their private label products to us and then sell through their own distribution channels.  Private label customers are generally retail chains who desire to sell apparel and accessory products under their own brand name.  We work with our private label customers to create their own brand image by custom designing products.  In creating a unique brand, our private label customers may provide samples to us or may select styles already available in our showrooms.  We believe we have established a reputation among these private label buyers for the ability to arrange for the manufacture of apparel and accessory products on a reliable, expeditious and cost-effective basis.

 

Throughout fiscal 2004, we continued our process of re-evaluating our principal business activities in both the apparel and accessory markets.  Based upon this re-evaluation, we have begun scaling down certain segments of our accessory and apparel activities, including the termination of certain branded label accessory and non-denim apparel products.  We are conducting a re-evaluation process which we believe but will result in a better allocation of our resources to fund growth in other areas, such as denim apparel.

 

Our branded label accessories and apparel products are designed, developed and marketed by us internally pursuant to the license agreement under which we have licensed the brand and/or mark or as a company-owned brand, such as Joe’s® Jeans, Betsey Johnson® and indie™ for apparel and Fetish™, Bongo®, Friendship™ and Clear Gear™ for accessories.  We then outsource the manufacturing and distribution of the branded products.  We sell our branded products to retail customers or distributors.  We are then obligated to pay a certain percentage of royalties on our net sales of the branded products to the licensor, if it is a licensed product.  Since the beginning of the second quarter of fiscal 2004, we have scaled back certain of our non-denim branded apparel and accessory operations through the termination of our license agreements for Fetish™, Hot Wheels® and Shago® apparel and accessories and Bongo® accessories.  Without these non-denim branded licenses, as well as their respective royalty obligations, we have been able to reduce our headcount and direct our resources to focus primarily on denim wear.  While there can be no assurance that this direction will result in profitability, we believe that these changes represent steps for growth and profitability in areas of proven ability.  We continue to retain our branded accessory licenses for Fetish™ on a limited basis until March 31, 2005 and Bongo® until December 31, 2004.  Our licenses for our branded denim and denim related apparel, such as Joe’s Jeans®, Betsey Johnson® and our company-owned line, indie™, continue to be our focus as our principal business activities focus on branded and private label denim and denim-related apparel.

 

Reportable Segments

 

For the periods ended August 28, 2004 and August 30, 2003, we operated in three segments:  craft and accessories, apparel and other.  Our craft and accessory segment, which represents our historical business, is conducted by our Innovo, Inc., or Innovo, subsidiary and includes craft and accessory products.  Our apparel segment consists of two revenue streams:  branded and private label apparel.  Our apparel segment is conducted through our Joe’s Jeans, Inc., or Joe’s, and Innovo Azteca Apparel, Inc., or IAA, subsidiaries, both of which are involved in the design, development and marketing of apparel

 

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products.  The craft and accessory and apparel operating segments have been classified based upon the nature of their respective operations, customer base and the nature of the products sold.

 

Our real estate transactions and our other corporate activities are categorized under “other” and are represented by the operations of Innovo Group Inc., or IGI, the parent company and wholly owned subsidiary, Innovo Realty Inc., or IRI, which conducts our real estate operations.  Our real estate operations do not currently require a substantial allocation of our resources and are not a significant part of management’s daily operational functions.

 

Our Principal Sources of Revenue

 

Craft & Accessories

 

Our craft and accessory business is conducted through our Innovo subsidiary.  We produce craft accessories to sell to large retailers such as Wal-Mart and Michaels Stores, Inc, as well as private label and branded label accessories through license agreements under which we have licensed brands, such as Bongo® and Fetish™, or as company-owned brands, such as Friendship™ and Clear Gear ™. While we intend to continue certain aspects of our craft and accessory business, we are re-evaluating the overall craft and accessory operations.  As part of this re-evaluation, we retained a limited license for the right to continue to finish the production and sale of accessories under the Fetish™ brand through March 31, 2005 and agreed to the early termination for our license agreement for Bongo® accessory products on December 31, 2004.  These two branded accessory licenses accounted for approximately 95% of our branded accessories net sales to date during fiscal 2004.  Further, beginning in the fourth quarter of fiscal 2004, we ceased taking orders for future deliveries of private label accessories.

 

Apparel

 

Our branded apparel business is conducted through our Joe’s and IAA subsidiary.  We produce branded apparel products under license agreements for brands such as Joe’s Jeans®, Betsey Johnson® and or as company-owned brands, such as indie™.  As discussed in more detail below, we have recently terminated our license agreements for Fetish™, Hot Wheels® and Shago® branded apparel, which only accounted for 3% of our branded apparel sales in the third quarter of fiscal 2004.

 

Since its introduction in 2001, Joe’s has gained national and international recognition, primarily in the women’s denim market.  In fiscal 2003, Joe’s expanded its offerings to include women’s sportswear and men’s denim and apparel items.  In fiscal 2004, under the direction of Joe’s Jeans design team, we are introducing a new branded apparel line under the name indie™.  indie™ will initially include women’s denim jeans and skirts, tops and jackets, with the collection targeted for the Fall/Holiday season in 2004 on a limited basis and a full launch to better department and specialty stores for spring of 2005.

 

Since the beginning of fiscal 2004, we have been re-evaluating certain of the license agreements that we previously classified under our IAA branded label apparel operating segments.  On May 25, 2004, we entered into a settlement agreement, or Settlement Agreement, whereby we terminated our license agreement for Fetish™ branded apparel with Blondie Rockwell, Inc., the licensor of entertainment personality Eve’s Fetish™ mark.  Under the terms of the Settlement Agreement, we continue to have the ability to market, distribute and sell the 2004 summer Fetish™ line, other excess apparel inventory and unsold and returned merchandise to certain approved customers until December 31, 2004 with no obligation to pay additional royalties on sales, in exchange for a termination fee, which included unpaid owed royalty payments.  IAA agreed to pay to Blondie Rockwell the termination fee and unpaid owed royalty payments in three installments over a three month period. To date, we have fulfilled our payment

 

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obligations under the Settlement Agreement.  In addition, we continue to have the right to finish the production of, market, distribute and sell Fetish™ accessories already identified by the parties through March 31, 2005, and will pay royalties in the amount of 8% on net sales, as originally defined in the license agreement, on all such accessory sales.

 

In June of 2004, we also terminated our license agreement with Mattel, Inc., or Mattel, for Hot Wheels® branded apparel and accessory products.  Because we did not have any sales in fiscal 2003 or through the second quarter of fiscal 2004 under this license agreement due to lack of interest in the consumer marketplace, we terminated the license agreement.  In connection with the termination, we paid $70,000, representing the final payment of royalty obligations to Mattel.  Due to the termination, we reversed an accrual of approximately $224,000 during the second quarter of fiscal 2004, which represents the maximum contractual future royalty obligations due under the original license agreement.

 

On or about October 1, 2004, we agreed to enter into a Settlement and Release Agreement with LBW, Inc., or LBW, the master licensor, whereby the parties will agree to a mutual termination and release for the license agreement to manufacture and sell toddler, boys, girls, and junior apparel and coordinating accessories featuring the Shago® and other professional names, visual images or representations based upon the real life image of the artist known as “Lil’ Bow Wow.”  Pursuant to the proposed settlement agreement, we will be obligated to pay an aggregate amount of $146,000 of unpaid owed royalties to LBW in exchange for the immediate termination and mutual release by the parties.  Upon payment of all unpaid owed royalties, there will be no further obligations to LBW.  We do not expect any future net sales from this agreement and we do not have any significant Shago® inventory on hand.  The parties are in the process of executing the final settlement agreement.

 

Although we have recently terminated licenses in our non-core business areas, on February 6, 2004, we entered into an assignment with Blue Concept LLC, which is controlled by Paul Guez, one of our significant stockholders, for all the rights, benefits and obligations of a license agreement between Blue Concept LLC and B.J. Vines, Inc., the licensor of the Betsey Johnson® apparel brand.  The license agreement provides for the exclusive right to design, market and distribute women’s jeans and coordinating denim related apparel, such as t-shirts and tops, under the Betsey Johnson® brand name in the United States, its territories and possessions, and Canada.  We anticipate our first shipment of product to be delivered in October 2004 based on outstanding sales orders received to date.  We believe this license agreement, because it is limited to denim and denim-related apparel, will allow us to utilize our core business strength in the denim and denim-related apparel market.  We did not compensate Paul Guez for this assignment due to our relationship with him, as discussed below.

 

We also design and market private label apparel products under other non-licensed arrangements, such as purchase orders primarily under our IAA subsidiary.  The private label business represents our largest source of sales, both under IAA and in the aggregate of all our subsidiaries. We believe our knowledge, resources and experience particularly within the denim business enables us to attract private label business.  Through private label arrangements, we sell denim products primarily to American Eagle Outfitters, Inc., or AEO, Kmart Corporation and Target Corporation.  We anticipate growth in private label sales throughout fiscal 2004 compared to previous reporting periods, primarily because we will have conducted a full fiscal year of sales to AEO as a result of the acquisition of the Blue Concept Division from Azteca.

 

Strategic relationship with two of our significant stockholders, Hubert Guez and Paul Guez, and affiliated companies

 

Beginning in the summer of 2000, we entered into a series of transactions with two of our significant stockholders, Hubert Guez and Paul Guez, and their affiliated companies, such as Azteca Production International, Inc., or Azteca, and/or Commerce Investment Group LLC, or Commerce.  The

 

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Guez brothers and their affiliated companies have in the aggregate more that fifty years of experience in the apparel industry with a specialty in denim apparel and related products.  As discussed in greater detail below, our strategic relationship with the Guez brothers and their affiliated companies has had many tangible benefits for us.

 

Our relationship with the Guez brothers began in the summer of 2000 when the Guez brothers through their affiliated company, Commerce, which the Guez brothers control, invested in our company.  Pursuant to a stock and warrant purchase agreement, Commerce acquired 2,863,637 shares of our common stock and 3,300,000 common stock purchase warrants.  An investor rights agreement also provides Commerce with a contractual right to nominate three individuals to our board of directors.  Commerce has not exercised this right at this time.

 

As part of Commerce’s equity investment in our company, we entered into several other arrangements with Commerce in order to reduce our manufacturing and distribution costs and to increase the effectiveness and capacity of our distribution network.  Pursuant to a craft supply agreement and distribution agreement with Commerce, we agreed to purchase all of our craft products, which at the time primarily consisted of denim tote bags and aprons, from Commerce and to have Commerce distribute these craft products out of its Los Angeles distribution facility.  Commerce manufactures our craft products out of its facilities in Mexico.  These agreements were automatically renewed in August 2004 for an additional two-year term and thereafter will continue to be automatically renewed for additional two-year terms unless terminated by either party with 90 days notice.

 

Our strategic relationship with Commerce allowed us to close our domestic manufacturing and distribution facilities and to move forward with diversifying our product mix and offerings to include apparel products in addition to accessory products.  In an effort to enter the apparel market quickly and efficiently we, through IAA, acquired Azteca’s knit apparel division in August 2001 in exchange for 700,000 shares of our common stock and promissory notes in the amount of $3.6 million.  To further solidify our presence in the apparel market and enhance and complement our existing private label business, in July 2003, we acquired the Blue Concept Division from Azteca in exchange for a convertible promissory note in the original amount of $21.8 million dollars, or the Blue Concept Note.  In connection with the acquisition of the Blue Concept Division, we obtained the rights relating to the design, manufacture and wholesaling of denim jeans to AEO.  On March 5, 2004, our stockholders approved the conversion of $12.5 million of principal amount of the Blue Concept Note into 3,125,000 shares of our common stock initially, with the potential issuance of up to 1,041,667 additional shares of our common stock upon the occurrence of certain contingencies described in the purchase agreement.  As a result of this conversion, the Blue Concept Note has been reduced to $9.3 million.  Additionally, by virtue of this strategic relationship, we were able to secure an assignment for the license for women’s jeans and coordinating denim related apparel under the Betsey Johnson® brand name from Paul Guez.

 

During fiscal 2003, we moved our headquarters and principal executive offices from 5900 S. Eastern Avenue, Suite 120, Commerce, California 90040 to 5804 East Slauson Avenue, Commerce, California 90040.  The 5804 East Slauson Avenue space is utilized under a verbal agreement with Azteca, pursuant to which we pay to Azteca a fee of $62,000 per month for allocated expenses associated with our use of office and warehouse space and expenses incurred in connection with maintaining such office and warehouse space.  These allocated expenses include, but are not limited to: rent, security, office supplies, machine leases and utilities.  In addition, we have verbal agreements with Azteca and/or its affiliates regarding the supply and distribution of other apparel products we sell.

 

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Results of Continuing Operations

 

We completed our acquisition of the Blue Concept Division from Azteca on July 17, 2003.  The results of operations of the Blue Concept Division are included in our operating results from the date of acquisition.

 

Accordingly, the financial position and results of operations presented and discussed herein are not directly comparable between years.  See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Recent Acquisitions and Licenses” for a further discussion of the Blue Concept acquisition.

 

The following table sets forth certain statements of operations data for the three and nine month periods as indicated:

 

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		Three Months Ended
		(in thousands)
		08/28/04			08/30/03			$ Change			% Change
Net Sales		$	41,122		$	21,906		$	19,216		88	%
Cost of Goods Sold		32,824			18,013			14,811			82	%
Gross Profit		8,298			3,893			4,405			113	%
Selling, General & Administrative		5,579			5,202			377			7	%
Depreciation & Amortization		394			704			(310		)	-44	%
Income (loss) from Operations		2,325			(2,013		)	4,338			-215	%
Interest Expense		(338		)	(394		)	56			-14	%
Other Income & Expense		30			182			(152		)	-84	%
Income (loss) from continuing operations, before taxes		2,017			(2,225		)	4,242			-191	%
Income taxes (benefit)		—			22			(22		)	-100	%
Income from continuing operations		2,017			(2,247		)	4,264			-190	%
Loss from discontinuing operations, net of tax		(13		)	(65		)	52			-80	%
Net income (loss)		$	2,004		$	(2,312	)	$	4,316		-187	%

 

		Nine Months Ended
		(in thousands)
		08/28/04			08/30/03			$ Change			% Change
Net Sales		$	87,748		$	45,834		$	41,914		91	%
Cost of Goods Sold		73,080			35,275			37,805			107	%
Gross Profit		14,668			10,559			4,109			39	%
Selling, General & Administrative		21,223			11,614			9,609			83	%
Depreciation & Amortization		1,219			831			388			47	%
Income (loss) from Operations		(7,774		)	(1,886		)	(5,888		)	312	%
Interest Expense		(1,018		)	(749		)	(269		)	36	%
Other Income & Expense		(17		)	345			(362		)	-105	%
Income (loss) from continuing operations, before taxes		(8,809		)	(2,290		)	(6,519		)	285	%
Income taxes (benefit)		(6		)	69			(89		)	-107	%
Income from continuing operations		(8,803		)	(2,373		)	(6,430		)	271	%
Loss from discontinuing operations, net of tax		(890		)	(165		)	(725		)	439	%
Net income (loss)		$	(9,693	)	$	(2,524	)	$	(7,155	)	282	%

 

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Loss From Discontinued Operations

 

During the third quarter of fiscal 2004, we decided to sell our commercial rental property that served as our former headquarters located in Springfield, Tennessee and engaged a commercial real estate broker to assist us with the sale.  In accordance with the provisions of SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets,” the accompanying condensed financial statements reflect the results of operations and financial position of Leaseall Management Inc., or Leaseall separately as a discontinued operation.  The assets and liabilities of the discontinued operations are presented in the condensed consolidated balance sheet under the captions “Assets of Discontinued Operations” and “Liabilities of Discontinued Operations.”  We believe the sale of this property can be completed within a twelve month period.  During the second quarter of fiscal 2004 we recorded a $574,000 impairment loss on long-lived assets related to this property.

 

Comparison of Three Months Ended August 28, 2004 to Three Months Ended August 30, 2003

 

Three Months Ended August 28, 2004 Overview

 

For the three months ended August 28, 2004, or the third quarter of fiscal 2004, our net sales increased to $41,122,000 from $21,906,000 for the three months ended August 30, 2003, or the third quarter fiscal 2003, or an 88% increase.  We generated a income from continuing operations of $2,017,000 for the third quarter of fiscal 2004 compared to a loss from continuing operations of $2,247,000 for the third quarter fiscal 2003, or a 187% increase.

 

The primary reasons for our income from continuing operations from the third quarter of fiscal 2004 compared to a loss from continuing operations in the third quarter of fiscal 2003 were the following:

 

•                  An increase in net sales in both our apparel and accessory segments, primarily attributable to:

•                  our private label customers in both the apparel and accessories segments, a large portion of which is attributable to sales generated as a result of the Blue Concept Division acquisition acquired in the middle of the third quarter of fiscal 2003;

•                  growth in sales of Joe’s Jeans® branded apparel in both the domestic and international markets;

•                  overall strong demand for denim apparel products in the marketplace;

•      improved production and delivery performance;

•      sale of slow moving Fetish™ apparel inventory; and

•      an increase in sales to its private label customers and sales of Fetish™ branded accessory products.

 

•                  An increase in gross margins in our apparel segment as a result of higher gross margins from our branded apparel;

•                  Lower SG&A expenses as a percentage of net sales; and

•                  Lower depreciation and amortization costs.

 

As discussed above, we classify our business in three reportable segments.  The following table sets forth certain statements of operations data by segment for the periods indicated.

 

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Three Months Ended 8/28/04		Crafts & Accessories			Apparel			Other			Total
		(in thousands)
Net Sales		$	5,072		$	36,050		$	—		$	41,122
Gross Profit		842			7,456			—			8,298
Selling, General & Administrative		1,070			3,684			825			5,579
Depreciation & Amortization		21			366			7			394
Interest Expense		(30		)	(232		)	(76		)	(338		)

 

Three Months Ended 8/30/03		Crafts & Accessories			Apparel			Other			Total
		(in thousands)
Net Sales		$	4,400		$	17,506		$	—		$	21,906
Gross Profit		1,039			2,854			—			3,893
Selling, General & Administrative		737			3,777			688			5,202
Depreciation & Amortization		8			689			7			704
Interest Expense		(70		)	(314		)	(10		)	(394		)

 

Three Months Ended 8/28/04 to 8/30/03		Crafts & Accessories					Apparel					Other					Total
		$	Change		% Change		$	Change		% Change		$	Change		% Change		$	Change		% Change
		(dollars in thousands)
Net Sales		$	672		15	%	$	18,544		106	%	$	—		N/A		$	19,216		88	%
Gross Profit		(197		)	(19	)	4,602			161		—			N/A		4,405			113
Selling, General & Administrative		333			45		(93		)	(2	)	137			20		377			7
Depreciation & Amortization		13			163		(323		)	(47	)	—			N/A		(310		)	(44	)
Interest Expense		40			(57	)	82			(26	)	(66		)	N/A		56			(14	)

 

Net Sales

 

Our net sales increased to $41,122,000 in the third quarter of fiscal 2004 from $21,906,000 in the third quarter of fiscal 2003, or an 88% increase.  The primary reasons for this increase in our net sales were due to:  (i) increased sales to our private label customers in both the apparel and accessories segments, a large portion of which is attributable to sales generated as a result of the Blue Concept Division acquisition; (ii) growth in sales of Joe’s Jeans in both the domestic and international markets; (iii) overall strong demand for denim apparel products in the marketplace; (iv) improved production and delivery performance; (v) sale of slow moving Fetish™ apparel inventory; and (vi) an increase in sales to our private label customers and sales of Fetish™ branded accessory products.  As previously discussed, we terminated our license agreement for Fetish™ branded apparel and accessory products on May 25, 2004.  Based upon the termination of this and other branded apparel and accessory license agreements, we expect our net sales attributed to licensed branded labels to become less significant in subsequent quarters compared to our private label net sales.

 

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