UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-Q

 

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

 

For the quarterly period ended:  October 2, 2004

 

Commission file number:     1-11908

 

Department 56, Inc.
(Exact name of registrant as specified in its charter)
Delaware	13-3684956
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
One Village Place, 6436 City West Parkway, Eden Prairie, MN 55344
(Address of principal executive offices)
(Zip Code)
(952) 944-5600
(Registrant’s telephone number, including area code)

 

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

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).

 

Yes

ý

No

o

 

As of October 29, 2004, 13,514,320 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
(In thousands)

 

		OCTOBER 2, 2004			JANUARY 3, 2004			OCTOBER 4, 2003
		(UNAUDITED)						(UNAUDITED)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents		$	2,277		$	17,457		$	1,234
Accounts receivable, net		82,977			20,999			91,205
Inventories		18,090			12,189			20,555
Other current assets		6,818			7,274			7,207
Current assets of discontinued operations		—			11,657			6,626
Total current assets		110,162			69,576			126,827
PROPERTY AND EQUIPMENT, net		16,710			17,664			17,875
GOODWILL		37,074			37,074			37,074
TRADEMARKS AND OTHER INTANGIBLES, net		14,452			14,557			14,593
OTHER ASSETS		3,190			3,433			2,814
NONCURRENT ASSETS OF DISCONTINUED OPERATIONS		—			—			9,235
		$	181,588		$	142,304		$	208,418
LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
Current portion of long-term debt								$	22,000
Borrowings on revolving credit agreement		$	15,000					41,000
Accounts payable		5,772			$	6,322		5,647
Income tax payable		7,009			3,513			5,041
Other current liabilities		7,393			6,379			7,570
Current liabilities of discontinued operations		—			3,938			2,298
Total current liabilities		35,174			20,152			83,556
OTHER LIABILITIES		2,883			3,015			2,433
DEFERRED TAXES		4,754			4,841			4,515
NONCURRENT LIABILITIES OF DISCONTINUED OPERATIONS		—			—			600
STOCKHOLDERS’ EQUITY		138,777			114,296			117,314
		$	181,588		$	142,304		$	208,418

 

See notes to condensed consolidated financial statements.

 

2

 

DEPARTMENT 56, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

(In thousands, except per share amounts)

 

		13 WEEKS ENDED OCTOBER 2, 2004			13 WEEKS ENDED OCTOBER 4, 2003
NET SALES		$	53,151		$	54,631
COST OF SALES		24,659			26,204
Gross profit		28,492			28,427
OPERATING EXPENSES:
Selling, general, and administrative		14,161			14,294
OPERATING INCOME FROM CONTINUING OPERATIONS		14,331			14,133
OTHER EXPENSE (INCOME):
Interest expense		220			451
Other, net		(278		)	42
INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES		14,389			13,640
INCOME TAX PROVISION		5,180			4,910
INCOME FROM CONTINUING OPERATIONS		9,209			8,730
LOSS FROM DISCONTINUED OPERATIONS, NET OF TAX		—			(454		)
NET INCOME		$	9,209		$	8,276
INCOME (LOSS) PER SHARE – BASIC:
INCOME PER SHARE FROM CONTINUING OPERATIONS		$	0.69		$	0.66
LOSS PER SHARE FROM DISCONTINUED OPERATIONS		—			(0.03		)
NET INCOME PER SHARE – BASIC		$	0.69		$	0.63
INCOME (LOSS) PER SHARE – ASSUMING DILUTION:
INCOME PER SHARE FROM CONTINUING OPERATIONS		$	0.68		$	0.66
LOSS PER SHARE FROM DISCONTINUED OPERATIONS		—			(0.03		)
NET INCOME PER SHARE – ASSUMING DILUTION		$	0.68		$	0.62
WEIGHTED AVERAGE SHARES OUTSTANDING:
BASIC		13,433			13,138
ASSUMING DILUTION		13,617			13,294

 

See notes to condensed consolidated financial statements.

 

3

 

DEPARTMENT 56, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

(In thousands, except per share amounts)

 

		39 WEEKS ENDED OCTOBER 2, 2004			40 WEEKS ENDED OCTOBER 4, 2003
NET SALES		$	122,376		$	137,699
COST OF SALES		56,853			63,355
Gross profit		65,523			74,344
OPERATING EXPENSES:
Selling, general, and administrative		39,276			40,408
OPERATING INCOME FROM CONTINUING OPERATIONS		26,247			33,936
OTHER EXPENSE (INCOME):
Interest expense		449			1,389
Litigation settlement		(6,871		)	—
Other, net		(195		)	(585		)
INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES		32,864			33,132
INCOME TAX PROVISION		11,832			11,928
INCOME FROM CONTINUING OPERATIONS		21,032			21,204
LOSS FROM DISCONTINUED OPERATIONS, NET OF TAX		(1,372		)	(1,653		)
NET INCOME		$	19,660		$	19,551
INCOME (LOSS) PER SHARE – BASIC:
INCOME PER SHARE FROM CONTINUING OPERATIONS		$	1.58		$	1.62
LOSS PER SHARE FROM DISCONTINUED OPERATIONS		(0.10		)	(0.13		)
NET INCOME PER SHARE – BASIC		$	1.48		$	1.49
INCOME (LOSS) PER SHARE – ASSUMING DILUTION:
INCOME PER SHARE FROM CONTINUING OPERATIONS		$	1.56		$	1.61
LOSS PER SHARE FROM DISCONTINUED OPERATIONS		(0.10		)	(0.13		)
NET INCOME PER SHARE – ASSUMING DILUTION		$	1.46		$	1.48
WEIGHTED AVERAGE SHARES OUTSTANDING:
BASIC		13,303			13,100
ASSUMING DILUTION		13,489			13,189

 

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 OCTOBER 2, 2004			40 WEEKS ENDED OCTOBER 4, 2003
CASH FLOWS FROM OPERATING ACTIVITIES -
Net cash used in operating activities		$	(38,695	)	$	(48,133	)
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment		(1,905		)	(1,577		)
Net cash used in investing activities		(1,905		)	(1,577		)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from the exercise of common stock options		4,125			845
Purchases of treasury stock		(52		)	(115		)
Borrowings on revolving credit agreement		15,000			41,000
Principal payments on long-term debt		—			(32,000		)
Net cash provided by financing activities		19,073			9,730
Net cash provided by discontinued operations		6,347			6,722
NET DECREASE IN CASH AND CASH EQUIVALENTS		(15,180		)	(33,258		)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD		17,457			34,492
CASH AND CASH EQUIVALENTS AT END OF PERIOD		$	2,277		$	1,234
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION -
Cash paid for:
Interest		$	314		$	1,193
Income taxes		3,929			9,433

 

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 January 3, 2004 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 October 2, 2004 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 2003 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. Comprehensive income for the periods ended October 2, 2004 and October 4, 2003 was equivalent to reported net income.

 

Reclassifications – Certain reclassifications were made to the fiscal 2003 condensed consolidated financial statements in order to conform to the presentation of the fiscal 2004 condensed consolidated financial statements. These reclassifications had no impact on consolidated net income or retained earnings as previously reported.

 

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 dilutive outstanding stock options been converted to common stock.

 

3.                                      Litigation Settlement

 

On May 5, 2004, the Company agreed to settle tort and warranty claims it brought against a third party. Under the settlement, the Company received net cash proceeds (before income taxes) of $6,871.

 

4.                                      Discontinued Operations

 

In December 2003, the Company committed to a plan to cease operations of its Geppeddo seasonal kiosk business. Geppeddo ceased operations during the first quarter of 2004, and in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the Company has reclassified Geppeddo’s results into discontinued operations for all periods

 

6

 

presented. Geppeddo’s sales for the third quarter and first nine months of 2004 were $0 and $3,396, compared to $9 and $5,477 during the third quarter and first nine months of 2003, respectively.

 

5.                                      Stock-Based Compensation

 

The Company accounts for its stock option plans using the intrinsic value method and has adopted the “disclosure only” provisions of SFAS No. 123, as amended by SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure. Accordingly, no compensation cost has been recognized for stock options granted. Had compensation cost been determined based upon fair value (using the Black-Scholes option-pricing method) at the grant date for awards under these plans, the Company’s net earnings and earnings per share would have been reduced as follows:

 

								39 WEEKS			40 WEEKS
		QUARTER ENDED						ENDED			ENDED
		OCTOBER 2,			OCTOBER 4,			OCTOBER 2,			OCTOBER 4,
(In thousands, except per share amounts)		2004			2003			2004			2003
Net income:
As reported		$	9,209		$	8,276		$	19,660		$	19,551
Stock-based compensation, net of related tax effects		(194		)	(379		)	(1,286		)	(1,522		)
Pro forma		$	9,015		$	7,897		$	18,374		$	18,029
Net income per common share – basic:
As reported		$	0.69		$	0.63		$	1.48		$	1.49
Pro forma		0.67			0.60			1.38			1.37
Net income per common share – assuming dilution:
As reported		$	0.68		$	0.62		$	1.46		$	1.48
Pro forma		0.66			0.59			1.36			1.36

 

6.                                      Goodwill and Other Intangible Assets

 

Effective at the beginning of fiscal year 2002, the Company adopted SFAS No. 142, Goodwill and Other Intangible Assets. 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 ceased amortization.

 

During the fourth quarter of 2003, the Company performed its annual review of goodwill and other intangible assets for possible impairment as required by SFAS No. 142. The Company evaluated the goodwill and other intangible assets related to its wholesale operating segment and determined there was no impairment. As a result of its decision to cease operations at Geppeddo, the Company recognized an $8,193 charge to write-off all of the goodwill, trademarks and non-compete agreements related to Geppeddo. See Note 4.

 

7

 

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 for the third quarter and first nine months of 2004 was $35 and $105, compared to $35 and $108 during the third quarter and first nine months of 2003, respectively. Expected annual amortization expense for non-compete agreements recorded as of January 3, 2004 is as follows:

 

(In thousands)
2004		$	140
2005		140
2006		140
2007		140
2008		140
Thereafter		96
		$	796

 

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.

 

Included in Goodwill, Trademarks and Other on the Company’s condensed consolidated balance sheets as of October 2, 2004, January 3, 2004 and October 4, 2003, are the following acquired intangible assets by operating segment (net of accumulated amortization). Accumulated amortization of non-compete agreements was $2,014, $1,909 and $2,069 as of October 2, 2004, January 3, 2004 and October 4, 2003, respectively.

 

(In thousands)		OCTOBER 2, 2004			JANUARY 3, 2004			OCTOBER 4, 2003
WHOLESALE:
Goodwill		$	37,074		$	37,074		$	37,074
Trademarks		13,761			13,761			13,761
Non-compete agreements		691			796			832
		$	51,526		$	51,631		$	51,667
RETAIL:
Goodwill		$	—		$	—		$	7,912
Trademarks		—			—			137
Non-compete agreements		—			—			167
		$	—		$	—		$	8,216

 

8

 

7.                                      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. Operating income (loss) from continuing 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 operating income (loss) from continuing 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.

 

								39 WEEKS			40 WEEKS
		QUARTER ENDED						ENDED			ENDED
		OCTOBER 2,			OCTOBER 4,			OCTOBER 2,			OCTOBER 4,
(In thousands)		2004			2003			2004			2003
WHOLESALE:
Village sales		$	18,443		$	23,352		$	53,451		$	68,845
Giftware sales		31,836			29,477			62,878			64,556
Net sales		$	50,279		$	52,829		$	116,329		$	133,401
Operating income from continuing operations		22,733			22,947			51,568			59,129
RETAIL:
Net sales		$	2,872		$	1,802		$	6,047		$	4,298
Operating loss from continuing operations		(420		)	(421		)	(2,222		)	(1,986		)
OTHER -
Operating loss from continuing operations		$	(7,982	)	$	(8,393	)	$	(23,099	)	$	(23,207	)
CONSOLIDATED:
Net sales		$	53,151		$	54,631		$	122,376		$	137,699
Operating income from continuing operations		14,331			14,133			26,247			33,936

 

9

 

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 October 2, 2004 to the Quarter Ended October 4, 2003.

 

		QUARTER ENDED OCTOBER 2, 2004					QUARTER ENDED OCTOBER 4, 2003
(In millions)		Dollars			% of Net Sales		Dollars			% of Net Sales
Net sales		$	53.2		100	%	$	54.6		100	%
Gross profit		28.5			54		28.4			52
Selling, general, and administrative expenses		14.2			27		14.3			26
Operating income from continuing operations		14.3			27		14.1			26
Interest expense		0.2			—		0.5			1
Other expense (income), net		(0.3		)	1		—			—
Income from continuing operations before income taxes		14.4			27		13.6			25
Income tax provision		5.2			10		4.9			9
Income from continuing operations		9.2			17		8.7			16
Loss from discontinued operations, net of tax		—			—		(0.5		)	1
Net income		9.2			17		8.3			15

 

10

 

Net Sales

 

Net sales decreased $1.5 million, or 3%, from $54.6 million in 2003 to $53.2 in 2004. The decrease in sales was principally due to a decrease in wholesale sales to independent gift retailers (wholesale customers).

 

Wholesale sales decreased $2.5 million, or 5%, from $52.8 million in 2003 to $50.3 million in 2004. The decrease in wholesale sales was principally due to the lower wholesale order rate and the timing of receipt of product from overseas vendors at the Company’s distribution center. Wholesale sales of the Company’s Village Series products of $18.4 million decreased $4.9 million, or 21%, while sales of Giftware products of $31.8 million increased $2.4 million, or 8% between the two periods. Village Series products represented 44% and 37% of the Company’s wholesale sales during 2003 and 2004, respectively.

 

Retail sales increased $1.1 million, or 59%, from $1.8 million in 2003 to $2.9 million in 2004. The increase in retail sales was principally due to the opening of two new stores during the second half of 2003, a third new store opened during the second quarter of 2004 and increased Time to Celebrate operations. Comparable sales from the Company’s retail stores that were open more than a year increased 3%. The Company’s retail operations historically generate losses from operations 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 52.0% and 53.6% in the third quarter of 2003 and 2004, respectively. The increase in the gross profit percentage was principally due to the increase in retail sales (which carry higher gross profit margins than wholesale sales), partially offset by the shift in the mix of wholesale product shipments.

 

Selling, General and Administrative Expenses

 

Selling, general and administrative expenses decreased $0.1 million, or 1%, between 2003 and 2004. The decrease in selling, general and administrative expenses in 2004 compared to 2003 was principally due to corporate-level cost reductions and lower bad debt expense, partially offset by a $0.7 million charge for severance costs related to staff reductions and an increase in retail operations.

 

Interest Expense

 

Interest expense decreased $0.2 million, or 51%, between 2003 and 2004 principally due to a decrease in the amount of debt outstanding.

 

Provision for Income Taxes

 

The effective income tax rate was 36% during the third quarter of 2003 and the third quarter of 2004.

 

11

 

Loss from Discontinued Operations, Net of Tax

 

The Company completed the closing of its Geppeddo subsidiary during the first quarter of 2004. The loss from discontinued operations, net of tax was $0.5 million in 2003.

 

Comparison of Results of Operations for the 39 Weeks Ended October 2, 2004 to the 40 Weeks Ended October 4, 2003.

 

		39 WEEKS ENDED OCTOBER 2, 2004					40 WEEKS ENDED OCTOBER 4, 2003
(In millions)		Dollars			% of Net Sales		Dollars			% of Net Sales
Net sales		$	122.4		100	%	$	137.7		100	%
Gross profit		65.5			54		74.3			54
Selling, general, and administrative expenses		39.3			32		40.4			29
Operating income from continuing operations		26.2			21		33.9			25
Interest expense		0.4			—		1.4			1
Litigation settlement		(6.9		)	6		—			—
Other expense (income), net		(0.2		)	—		(0.6		)	—
Income from continuing operations before income taxes		32.9			27		33.1			24
Income tax provision		11.8			10		11.9			9
Income from continuing operations		21.0			17		21.2			15
Loss from discontinued operations, net of tax		(1.4		)	1		(1.7		)	1
Net income		19.7			16		19.6			14

 

12

 

Net Sales

 

Net sales decreased $15.3 million, or 11%, from $137.7 million in 2003 to $122.4 million in 2004. The decrease in sales was principally due to a decrease in wholesale sales to independent gift retailers (wholesale customers).

 

Wholesale sales decreased $17.1 million, or 13%, from $133.4 million in 2003 to $116.3 million in 2004. The decrease in wholesale sales was principally due to the lower wholesale order rate and the timing of receipt of product from overseas vendors at the Company’s distribution center. Wholesale sales of the Company’s Village Series products of $53.5 million decreased $15.4 million, or 22%, while sales of Giftware products of $62.9 million decreased $1.7 million, or 3% between the two periods. Village Series products represented 52% of the Company’s wholesale sales during 2003 versus 46% during 2004.

 

Retail sales increased $1.7 million, or 41%, from $4.3 million in 2003 to $6.0 million in 2004. The increase in retail sales was principally due to the opening of two new stores during the second half of 2003, a third new store opened during the second quarter of 2004 and increased Time to Celebrate operations. Comparable sales from the Company’s retail stores that were open more than a year increased 2%. The Company’s retail operations historically generate losses from operations 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 54.0% and 53.5% in the first nine months of 2003 and 2004, respectively. The decrease in the gross profit percentage was principally due to the shift in the mix of wholesale product shipments, partially offset by the increase in retail sales (which carry higher gross profit margins).

 

Selling, General and Administrative Expenses

 

Selling, general and administrative expenses decreased $1.1 million, or 3%, between 2003 and 2004. The decrease in selling, general and administrative expenses in 2004 compared to 2003 was principally due to lower commission expense as a result of lower wholesale sales and lower bad debt expense, partially offset by an increase in retail operations and the $0.7 million charge for severance costs related to staff reductions.

 

Interest Expense

 

Interest expense decreased $0.9 million, or 68%, between 2003 and 2004 principally due to a decrease in the amount of debt outstanding.

 

Provision for Income Taxes

 

The effective income tax rate was 36% during the first nine months of 2003 and the first nine months of 2004.

 

13

 

Loss from Discontinued Operations, Net of Tax

 

Loss from discontinued operations, net of tax decreased $0.3 million from $1.7 million in 2003 to $1.4 million in 2004. The Company completed the closing of its Geppeddo subsidiary during the first quarter of 2004.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Cash Flows from Operations

 

Net cash used in operating activities decreased $9.4 million from $48.1 million in 2003 to $38.7 million in 2004 principally due to the $6.9 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) and lower inventory purchases, partially offset by decreased cash collections during 2004 as a result of lower receivable balances at the end of 2003. Accounts receivable balances were lower at the end of 2003 compared to fiscal year end 2002 principally due to five additional days of cash collections in 2003 as a result of the 2003 fiscal year ending on January 3, 2004 compared to the 2002 fiscal year ending on December 28, 2002.

 

Accounts receivable, net of reserves, which principally consists of wholesale trade receivables, decreased from $91.2 million at October 4, 2003 to $83.0 million at October 2, 2004.  Accounts receivable decreased principally due to reduced wholesale sales.

 

Inventories decreased from $20.6 million at October 4, 2003 to $18.1 million at October 2, 2004. The decrease was principally due to reduced wholesale orders, partially offset by higher retail segment inventories resulting from the addition of two new retail stores during the second half of 2003, a new retail store in the second quarter of 2004, and an increase in Time to Celebrate operations.

 

Because the Company’s wholesale business is not capital intensive, the Company has historically not incurred significant capital expenditures. Capital expenditures for the third quarter and first nine months of 2004 were $0.7 million and $1.9 million, respectively, compared to $0.7 million and $1.6 million in the third quarter and first nine months of 2003. The Company opened its sixth retail store during the second quarter of 2004 at the Pier 39 shopping complex in San Francisco, California. Management anticipates 2004 capital expenditures will be less than $2.5 million.

 

Sources of Liquidity

 

The Company’s primary source of cash is the funds generated from operations. Additionally, the Company has a revolving credit facility available for working capital and investment needs as described below. Based on current levels of operations, the Company believes its funds generated from operations, its available cash, and its revolving credit facility will be sufficient to finance any capital expenditures, contractual obligations or strategic initiatives in the foreseeable future.

 

14

 

The Company’s strategy includes the pursuit of a significant acquisition that aligns with and complements its existing business. As a result, the Company intends to accumulate cash to help finance a potential acquisition. The Company also has the ability to use its revolving credit facility to finance an acquisition. However, depending on the size of the acquisition, the Company may have to find additional financing to complete an acquisition. In the event the Company is not able to identify an acceptable acquisition by mid-2005, the Company intends to return cash to its shareholders at that time.

 

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 that the Company has generally financed with seasonal borrowings under its revolving credit facility. The Company’s cash and cash equivalents balances peak early in the first quarter of the subsequent year, following the collection of wholesale customer accounts receivable with extended payment terms and cash receipts from the Company’s retail operations.

 

The Company’s revolving credit facility provides for borrowings of up to $75 million, which may be in the form of letters of credit and revolving credit loans. The letters of credit are issued primarily in connection with inventory purchases. Borrowings under the credit agreement are subject to certain borrowing base limitations (as defined in the agreement). The Company’s borrowing capacity under the revolving credit facility as of October 2, 2004 was $75 million and will fluctuate during 2004 based on accounts receivable and inventory levels. The credit agreement includes restrictions as to, among other things, the amount of additional indebtedness, liens, contingent obligations, investments and dividends. Under the most restrictive of these covenants, approximately $246 million of retained earnings were restricted at October 2, 2004. The credit agreement also requires maintenance of minimum levels of interest coverage, net worth and maximum levels of leverage, 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.

 

OFF-BALANCE SHEET ARRANGEMENTS

 

The Company does not have off-balance sheet arrangements.

 

CONTRACTUAL OBLIGATIONS

 

The Company had open purchase orders to suppliers of $9.5 million at the end of the third quarter of 2004 compared to $9.6 million at January 3, 2004. There were no other material changes in contractual obligations from those disclosed in the Company’s 2003 Annual Report on Form 10-K.

 

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WHOLESALE CREDIT AND RETURN POLICIES

 

The Company has credit policies that establish specific criteria related to creditworthiness 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 and willingness 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.

 

CRITICAL ACCOUNTING POLICIES

 

Our consolidated financial statements are prepared in accordance with generally accepted accounting principles of the United States. In connection with the preparation of the financial statements, we are required to make assumptions, estimates and apply judgment that affect the reported amounts of assets, liabilities, revenue, expenses and related disclosures. The Company bases its assumptions, estimates and judgments on historical experience, current trends and other factors that management believes to be relevant at the time the consolidated financial statements are prepared. On a regular basis, management reviews the accounting policies, assumptions, estimates and judgments to ensure that our financial statements are presented fairly and in accordance with generally accepted accounting principles. However, because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates, and such differences could be material.

 

The following accounting policies are the accounting policies that management believes require the most difficult, subjective or complex judgments about matters that are inherently uncertain:

 

Sales Returns and Credits – An allowance is established for credits related to possible returned or damaged product, pricing and shipping discrepancies. The amount of the allowance is based on historical ratios of credits to sales, the historical average length of time between the sale and the credit, and other factors. Changes in customers’ behavior versus historical experience, changes in product damage or defect rates, or changes in the Company’s return policies are among the factors that would result in materially different amounts for this item.

 

Inventory Valuation – Inventory is valued at the lower of cost or net realizable value. The amount is determined by analyzing historical and projected sales information, plans for discontinued products and other factors. The Company procures product based on forecasted sales volume. If actual sales were significantly lower than forecasted sales due to unexpected economic or competitive conditions, it could result in materially higher surplus and discontinued inventories.

 

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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. Additionally, since the majority of the Company’s wholesale sales have dating terms which come due in November and December, the Company does not have visibility into overdue balances for most of its wholesale customers until the fourth quarter of its fiscal year. Due to the seasonality of the Company’s business, the extended dating terms provided to customers and the relative size of accounts receivable balances at year end, it is not uncommon for the Company to experience fluctuations in the provision for bad debt expense from quarter to quarter as the Company refines its estimate. Unexpected changes in the aforementioned factors would result in materially different amounts for this item. In addition, results could be materially different if economic conditions worsened for the Company’s customers.

 

Tax Contingencies – The Company is periodically contacted or audited by federal and state tax authorities. These contacts or audits include questions regarding the timing and amount of deductions and the allocation of income among various tax jurisdictions. In evaluating the exposure associated with various filing positions, the Company records a reserve for estimated probable exposures. The estimate of this reserve contains uncertainty because management must use judgment to estimate the exposure associated with its various filing positions. To the extent the Company does not have to pay taxes for which reserves have been established or is required to pay amounts in excess of its reserves, the Company’s tax rate in a given financial period could be materially impacted.

 

FOREIGN EXCHANGE

 

Approximately 97% of the Company’s sales in 2003 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 were denominated in foreign currencies that were subject to changes in exchange rates, and the Company anticipates that such percentage will remain approximately the same during 2004. At this time, the Company does not use derivative instruments to manage the exchange rate risk.

 

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 (“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; this could result from decision by China to allow its currency to float instead of being pegged to the U.S. dollar at a fixed rate. Conversely, its costs would be favorably affected if the Chinese currency depreciates significantly relative to the United States dollar. In addition, less than 1% of the Company’s product purchases in 2003 were denominated in foreign currencies that were subject to changes in exchange rates, and

 

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the Company anticipates that such percentage will remain approximately the same during 2004. The Company currently does not use derivative instruments to manage the exchange rate risk.

 

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.

 

IMPORTS

 

The Company does not own or operate any manufacturing facilities and imports most of its products from manufacturers in the Pacific Rim, primarily China. The Company also imports a small percentage of its products from sources in the Philippines, India and Europe.

 

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 that can produce detailed, high quality products at affordable prices. Foreign manufacturing and procurement of imports is subject to the following inherent risks: labor, economic and political instability; cost and capacity fluctuations and delays in transportation, dockage and materials handling; restrictive actions by governments; nationalizations; the laws and policies of the U.S. affecting importation of goods (including duties, quota and taxes); international political/military/terrorist developments; and foreign trade and tax laws. 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.

 

Fluctuations in currency exchange also present risk inherent in the Company’s method for inventory procurement. 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; this could result, for example, from a decision by China to allow its currency to float instead of being pegged to the U.S. dollar at a fixed rate.

 

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. Bureau of Customs and Border Protection (“U.S. Customs”) regarding the amount of duty to be paid, the value of merchandise to be reported or other customs regulations relating 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. Since the terrorist attacks of September 11, 2001, U.S. Customs has enacted various security protocols affecting the importation of goods. Such protocols could adversely affect the speed or cost involved in the Company’s receipt of inventory from its overseas vendors.

 

In fiscal 2003, approximately 88% of the Company’s imports were manufactured in China, and the Company anticipates that such percentage will hold constant or increase for the

 

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foreseeable future. China has joined the World Trade Organization and been accorded permanent “Normal Trade Relations” status by the U.S. government. However, various commercial and legal practices widespread in China, including the handling of intellectual properties and certain labor practices, 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 that may be taken by the U.S. government, none of which the Company believes would have a material impact on its 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 take in the future.

 

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.

 

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SEASONALITY AND WHOLESALE CUSTOMER ORDERS

 

Wholesale Customer Orders Entered (1)

(In millions)

 

		1st Qtr			2nd Qtr			3rd Qtr			4th Qtr			Total
2002		$	114		$	42		$	20		$	2		$	178
2003		104			34			22			3			163
2004		101			30			18			—			—

 

(1)  Customer orders entered are orders received and approved by the Company, net of any cancellation for various reasons including credit considerations, inventory stock-outs, and customer requests. Customer orders entered do not include freight and other revenue adjustments, which are included in net sales. Additionally, wholesale customer orders entered exclude orders from company-operated retail stores.

 

Wholesale customer orders decreased $11.1 million, or 6.9%, from $160.5 million to $149.4 million through the third quarter of 2003 and 2004, respectively. Orders for the Company’s Giftware products were up 5% while Village product orders were down 17%. Village product orders continued to be negatively impacted by cautious buying patterns of the Village dealers and the continued attrition of these dealers.

 

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. During the first quarter of each of the past three years, the Company has received approximately 62% to 64% of its annual wholesale orders for such year. Approximately 7% to 8% of the Company’s total annual wholesale customer orders have been cancelled in each of the last three years for a number of reasons, primarily customer credit considerations and inventory stock-outs. Orders not shipped in a particular year, net of cancellations, are carried into backlog for the following year and have historically been orders for Spring and Easter products. The Company’s backlog of wholesale customer orders was $34.2 million and $36.6 million at October 4, 2003 and October 2, 2004, 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 winter 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

 

As of the end of the period covered by this report, an evaluation was carried out under the supervision and with the participation of the Company’s management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934). Any control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. The design of a control system inherently has limitations, including that the benefits of controls must be considered relative to their costs. Additionally, controls can be circumvented by the individual acts of some persons, or by collusion of two or more people. Therefore, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objective. Based upon and as of the date of that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that those disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms.

 

There have been no changes in the Company’s internal control over financial reporting (as defined in Rules 13a-15 and 15d-15 of the Exchange Act) during the Company’s most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

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PART II  - -  OTHER INFORMATION

 

Item 1.           Legal Proceedings

 

On May 5, 2004, the Company agreed to settle tort and warranty claims it brought against a third party. Under the settlement, the Company received net cash proceeds (before income taxes) of $6,871.

 

Reference is made to Item 3, “Legal Proceedings,” of the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2004, which Item is incorporated herein in its entirety. In the ordinary course of its business, the Company is involved in various legal proceedings, claims and governmental audits. In the opinion of management, the ultimate disposition of these proceedings, claims and audits will not have a material adverse effect on the results of operations, financial position or cash flows of the Company.

 

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 2003 dated March 17, 2004 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

 

The following documents are exhibits to this Report:

 

11.1		Computation of net income per share
31.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2		Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1		Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350
32.2		Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350

 

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