- --------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934.
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934.
FOR THE TRANSITION PERIOD FROM TO
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COMMISSION FILE NUMBER: 0-26006
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TARRANT APPAREL GROUP
(Exact Name of Registrant as Specified in Its Charter)
CALIFORNIA 95-4181026
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification Number)
3151 EAST WASHINGTON BOULEVARD
LOS ANGELES, CALIFORNIA 90023
(Address of Principal Executive Offices) (Zip Code)
Registrant's Telephone Number, Including Area Code: (323) 780-8250
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes |X| No |_|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes |_| No |X|
Number of shares of Common Stock of the registrant outstanding as of November
12, 2004: 28,814,763.
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TARRANT APPAREL GROUP
FORM 10-Q
INDEX
PART I. FINANCIAL INFORMATION
PAGE
----
Item 1. Financial Statements (Unaudited)
Consolidated Balance Sheets at September 30, 2004
(Unaudited) and December 31, 2003 (Audited)................... 3
Consolidated Statements of Operations and Comprehensive
Loss for the Three Months and Nine Months Ended
September 30, 2004 and September 30, 2003..................... 4
Consolidated Statements of Cash Flows for the Nine
Months Ended September 30, 2004 and September 30, 2003........ 5
Notes to Consolidated Financial Statements.................... 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations .......................... 16
Item 3. Quantitative and Qualitative Disclosures About Market Risk ... 33
Item 4. Controls and Procedures....................................... 34
PART II. OTHER INFORMATION
Item 1. Legal Proceedings............................................. 35
Item 6. Exhibits and Reports on Form 8-K.............................. 35
SIGNATURES.................................................... 36
CAUTIONARY LEGEND REGARDING FORWARD-LOOKING STATEMENTS
Some of the information in this Quarterly Report on Form 10-Q may
constitute forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934,
both as amended. These forward-looking statements are subject to various risks
and uncertainties. The forward-looking statements include, without limitation,
statements regarding our future business plans and strategies and our future
financial position or results of operations, as well as other statements that
are not historical. You can find many of these statements by looking for words
like "will", "may", "believes", "expects", "anticipates", "plans" and
"estimates" and for similar expressions. Because forward-looking statements
involve risks and uncertainties, there are many factors that could cause the
actual results to differ materially from those expressed or implied. These
include, but are not limited to, economic conditions. This Quarterly Report on
Form 10-Q contains important cautionary statements and a discussion of many of
the factors that could materially affect the accuracy of Tarrant's
forward-looking statements and such statements and discussions are incorporated
herein by reference. Any subsequent written or oral forward-looking statements
made by us or any person acting on our behalf are qualified in their entirety by
the cautionary statements and factors contained or referred to in this section.
We do not intend or undertake any obligation to update any forward-looking
statements to reflect events or circumstances after the date of this document or
the date on which any subsequent forward-looking statement is made or to reflect
the occurrence of unanticipated events.
2
PART I -- FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
TARRANT APPAREL GROUP
CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, DECEMBER 31,
2004 2003
------------- -------------
(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents ................. $ 1,769,079 $ 3,319,964
Restricted cash ........................... -- 2,759,742
Accounts receivable, net .................. 40,007,470 57,165,926
Due from related parties .................. 10,493,983 18,056,488
Inventory ................................. 13,546,014 23,251,591
Temporary quota rights .................... 1,306,543 --
Prepaid expenses and other receivables .... 1,606,971 1,776,142
Income taxes receivable ................... 276,514 277,695
------------- -------------
Total current assets ........................ 69,006,574 106,607,548
Property and equipment, net ............... 2,060,195 135,645,751
Assets held for sale ...................... 42,186,290 --
Other assets .............................. 2,761,418 2,269,011
Excess of cost over fair value of net
assets acquired, net ................... 8,582,845 8,582,845
------------- -------------
Total assets ................................ $ 124,597,322 $ 253,105,155
============= =============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Short-term bank borrowings ................ $ 27,586,207 $ 29,293,323
Accounts payable .......................... 18,284,007 23,514,894
Accrued expenses .......................... 10,837,859 11,194,421
Income taxes .............................. 17,537,391 16,497,939
Due to related parties .................... 274,613 5,418,795
Due to shareholders ....................... -- 496
Current portion of long-term obligations .. 16,561,177 38,705,240
------------- -------------
Total current liabilities ................... 91,081,254 124,625,108
Long-term obligations ........................ 43,971 588,272
Deferred tax liabilities ..................... 243,136 275,129
Minority interest in UAV & PBG7 .............. 138,175 5,141,620
Minority interest in Tarrant Mexico .......... -- 14,766,215
Commitments and contingencies
Shareholders' equity:
Preferred stock, 2,000,000 shares
authorized; no shares issued and
outstanding ............................ -- --
Common stock, no par value, 100,000,000
shares authorized; 28,814,763 shares
(2004) and 27,614,763 shares (2003)
issued and outstanding .................. 111,515,091 107,891,426
Warrant to purchase common stock .......... 1,842,833 1,798,733
Contributed capital ....................... 1,666,868 1,505,831
Retained earnings (accumulative loss) ..... (54,570,963) 20,988,434
Notes receivable from officer/shareholder . (4,775,651) (4,796,428)
Accumulated other comprehensive loss ...... (22,587,392) (19,679,185)
------------- -------------
Total shareholders' equity .................. 33,090,786 107,708,811
------------- -------------
Total liabilities and shareholders' equity .. $ 124,597,322 $ 253,105,155
============= =============
The accompanying notes are an integral part of these consolidated
financial statements
3
TARRANT APPAREL GROUP
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(Unaudited)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMER 30,
------------------------------ ------------------------------
2004 2003 2004 2003
------------- ------------- ------------- -------------
Net sales ............................... $ 38,102,733 $ 96,457,780 $ 118,746,577 $ 253,388,065
Cost of sales ........................... 33,968,166 84,943,929 101,846,372 233,504,642
------------- ------------- ------------- -------------
Gross profit ............................ 4,134,567 11,513,851 16,900,205 19,883,423
Selling and distribution expenses ....... 2,081,389 2,878,886 7,110,002 8,723,246
General and administrative expenses ..... 5,494,741 7,186,640 25,564,599 23,112,501
Impairment of assets .................... -- -- 77,982,034 22,276,510
------------- ------------- ------------- -------------
Income (loss) from operations ........... (3,441,563) 1,448,325 (93,756,430) (34,228,834)
Interest expense ........................ (700,451) (1,591,130) (2,194,080) (4,510,190)
Interest income ......................... 94,067 88,122 281,292 263,448
Other income ............................ 383,899 1,106,649 6,994,834 1,579,168
Other expense ........................... (319,391) (706,535) (1,041,592) (1,226,041)
Minority interest ....................... 180,264 283,227 15,196,733 3,776,518
------------- ------------- ------------- -------------
Income (loss) before provision for income
taxes ................................ (3,803,175) 628,658 (74,519,243) (34,345,931)
Provision for income taxes .............. 215,511 489,811 1,040,154 1,965,345
------------- ------------- ------------- -------------
Net Income (loss) ....................... $ (4,018,686) $ 138,847 $ (75,559,397) $ (36,311,276)
============= ============= ============= =============
Net Income (loss) per share - Basic and
Diluted ................................. $ (0.14) $ 0.01 $ (2.63) $ (2.12)
============= ============= ============= =============
Weighted average common and common
equivalent shares:
Basic ................................ 28,814,763 18,765,425 28,705,274 17,144,611
============= ============= ============= =============
Diluted .............................. 28,814,763 18,767,701 28,705,274 17,144,611
============= ============= ============= =============
Net Income (loss) ....................... $ (4,018,686) $ 138,847 $ (75,559,397) $ (36,311,276)
Foreign currency translation adjustment . 56,998 (9,151,513) (2,908,207) (6,964,645)
------------- ------------- ------------- -------------
Total comprehensive loss ................ $ (3,961,688) $ (9,012,666) $ (78,467,604) $ (43,275,921)
============= ============= ============= =============
The accompanying notes are an integral part of these consolidated
financial statements
4
TARRANT APPAREL GROUP
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
NINE MONTHS ENDED SEPTEMBER 30,
------------- -------------
2004 2003
------------- -------------
Operating activities:
Net loss .................................................. $ (75,559,397) $ (36,311,276)
Adjustments to reconcile net loss to net cash provided by
operating activities:
Deferred taxes ......................................... (31,992) 11,833
Depreciation and amortization .......................... 7,940,452 11,919,289
Loss on sale of fixed assets ........................... 8,811 732,365
Asset impairment ....................................... 77,982,034 22,276,510
Inventory write-down ................................... -- 10,986,153
Unrealized (gain) loss on foreign currency ............. (362,159) 173,287
Compensation expense related to stock option ........... 161,037 --
Provision for returns and discounts .................... (323,925) 1,042,856
Income from investments ................................ (723,450) --
Minority interest ...................................... (15,196,731) (3,776,518)
Changes in operating assets and liabilities:
Restricted cash ...................................... 2,759,742 (2,000,000)
Accounts receivable .................................. 17,296,369 (6,203,135)
Due to/from related parties .......................... (1,792,814) (2,104,209)
Inventory ............................................ 9,561,962 (11,114,629)
Temporary quota rights ............................... (1,306,543) (1,746,983)
Prepaid expenses and other receivables ............... (127,714) 825,594
Accounts payable ..................................... (5,152,284) 17,510,673
Accrued expenses and income tax payable .............. 795,242 3,000,035
------------- -------------
Net cash provided by operating activities ............ 15,928,640 5,221,845
Investing activities:
Purchase of fixed assets ............................... 194,357 (442,277)
Proceeds from sale of fixed assets ..................... 3,086,350 209,788
(Increase) decrease in other assets .................... (300,899) (1,800,137)
Collection of advances from shareholders/officers ...... 20,778 759,242
------------- -------------
Net cash provided by (used in) investing activities .. 3,000,586 (1,273,384)
Financing activities:
Short-term bank borrowings, net ........................ (1,707,608) 11,755,693
Proceeds from long-term obligations .................... 89,259,375 193,782,799
Payment of long-term obligations and bank borrowings ... (111,585,581) (209,397,923)
Repayments to shareholders/officers .................... -- (121,328)
Proceeds from issuance of common stock and warrant ..... 3,667,765 --
Repurchase of stock .................................... -- (393,178)
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Net cash (used in) financing activities .............. (20,366,049) (4,373,937)
Effect of exchange rate on cash ........................... (114,062) (272,254)
------------- -------------
Decrease in cash and cash equivalents ..................... (1,550,885) (697,730)
Cash and cash equivalents at beginning of period .......... 3,319,964 1,388,482
------------- -------------
Cash and cash equivalents at end of period ................ $ 1,769,079 $ 690,752
============= =============
The accompanying notes are an integral part of these consolidated
financial statements
5
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. ORGANIZATION AND BASIS OF CONSOLIDATION
The accompanying financial statements consist of the consolidation of
Tarrant Apparel Group, a California corporation, and its majority owned
subsidiaries located primarily in the U.S., Mexico, and Asia. At September 30,
2004, we owned 75% of our subsidiaries in Mexico, 50.1% of United Apparel
Ventures, LLC ("UAV") and 75% of PBG7, LLC ("PBG7"). We consolidate these
entities and reflect the minority interests in earnings (losses) of the ventures
in the accompanying financial statements. All inter-company amounts are
eliminated in consolidation. The 25% minority interest in our subsidiaries in
Mexico is owned by affiliates of Mr. Kamel Nacif, one of our shareholders. The
49.9% minority interest in UAV is owned by Azteca Production International, a
corporation owned by the brothers of our Chairman, Gerard Guez. The 25% minority
interest in PBG7 is owned by BH7, LLC.
We serve specialty retail, mass merchandise and department store chains
and major international brands by designing, merchandising, contracting for the
manufacture of, and selling casual apparel for women, men and children under
private label. Commencing in 1999, we expanded our operations from sourcing
apparel to sourcing and operating our own vertically integrated manufacturing
facilities. In August 2003, we determined to abandon our strategy of being both
a trading and vertically integrated manufacturing company, and effective
September 1, 2003, we leased and outsourced operation of our manufacturing
facilities in Mexico to affiliates of Mr. Kamel Nacif, one of our shareholders.
See Note 11 of the "Notes to Consolidated Financial Statements". In August 2004,
we entered into a purchase and sale agreement to sell these facilities to
affiliates of Mr. Nacif, which transaction we expect to be consummated in the
fourth quarter of 2004. See Note 6 of the "Notes to Consolidated Financial
Statements".
Historically, our operating results have been subject to seasonal
trends when measured on a quarterly basis. This trend is dependent on numerous
factors, including the markets in which we operate, holiday seasons, consumer
demand, climate, economic conditions and numerous other factors beyond our
control. Generally, the second and third quarters are stronger than the first
and fourth quarters. There can be no assurance that the historic operating
patterns will continue in future periods.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accompanying unaudited financial statements have been prepared in
accordance with accounting principles generally accepted in the United States
for interim financial information and with the instructions to Form 10-Q and
Article 10 of Regulation S-X. Accordingly, they do not include all of the
information and footnotes required by accounting principles generally accepted
in the United States for complete financial statements. In the opinion of
management, all adjustments (consisting of normal recurring accruals) considered
necessary for a fair presentation of the results of operations for the periods
presented have been included.
The consolidated financial data at December 31, 2003 is derived from
audited financial statements which are included in the our Annual Report on Form
10-K for the year ended December 31, 2003, and should be read in conjunction
with the audited financial statements and notes thereto. Interim results are not
necessarily indicative of results for the full year.
The accompanying unaudited Consolidated Financial Statements include
all majority-owned subsidiaries in which we exercise control. Investments in
which we exercise significant influence, but which we do not control, are
accounted for under the equity method of accounting. The equity method of
accounting is used when we have a 20% to 50% interest in other entities, except
for variable interest entities for which we are considered the primary
beneficiary under Financial Accounting Standards Board ("FASB") Interpretation
No. 46, "Consolidation of Variable Interest Entities," an interpretation of ARB
No. 51. Under the equity method, original investments are recorded at cost and
adjusted by our share of undistributed earnings or losses of these entities. All
significant intercompany transactions and balances have been eliminated from the
Consolidated Financial Statements.
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Significant estimates used by us in
preparation of the Consolidated Financial Statements include: (i) allowance for
returns, discounts and bad debts, (ii) inventory, (iii) valuation of long lived
and intangible assets and goodwill, and (iv) income taxes. Actual results could
differ from those estimates.
6
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Assets and liabilities of our Mexico and Hong Kong subsidiaries are
translated at the rate of exchange in effect on the balance sheet date; income
and expenses are translated at the average rates of exchange prevailing during
the respective periods. The functional currency in which we transact business in
Hong Kong is the Hong Kong dollar and in Mexico is the peso.
Foreign currency gains and losses resulting from translation of assets
and liabilities are included in other comprehensive income (loss). Transaction
gains or losses, other than inter-company debt deemed to be of a long-term
nature, are included in net income (loss) in the period in which they occur.
Upon the substantial liquidation of the Mexico subsidiaries following the sale
of the fixed assets in Mexico, the foreign currency translation adjustment
related to our Mexico subsidiaries of approximately $22 million of loss will be
reclassified and charged to income. The adjustment is expected to occur during
the fourth quarter of 2004. See Note 6 of the "Notes to Consolidated Financial
Statements".
Certain 2003 amounts have been reclassified to conform to the 2004
presentation.
3. STOCK BASED COMPENSATION
We have adopted the disclosure provisions of Statement of Financial
Accounting Standards ("SFAS") No. 148, "Accounting for Stock-Based Compensation
- - Transition and Disclosure," an amendment of FASB Statement No. 123. This
pronouncement requires prominent disclosures in both annual and interim
financial statements regarding the method of accounting for stock-based employee
compensation and the effect of the method used on reported results. We account
for stock compensation awards under the intrinsic value method of Accounting
Principles Board ("APB") Opinion No. 25, rather than the alternative fair-value
accounting method. Under the intrinsic-value method, if the exercise price of
the employee's stock options equals the market price of the underlying stock on
the date of the grant, no compensation expense is recognized. For the three
months ended September 30, 2004 and 2003, $54,000 and $0 was recorded,
respectively, as an expense related to our stock options.
For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period. Our pro forma
information follows:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------------- ----------------------------
2004 2003 2004 2003
------------ ------------ ------------ ------------
Net income (loss) as reported ....... $ (4,018,686) $ 138,847 $(75,559,397) $(36,311,276)
Add stock-based employee compensation
charges reported in net loss ...... 53,679 -- 161,037 --
Less total stock-based employee
compensation expense, determined
under the fair value method ....... (970,416) (951,152) (3,596,972) (3,216,310)
------------ ------------ ------------ ------------
Pro forma net loss .................. $ (4,935,423) $ (812,305) $(78,995,332) $(39,527,586)
============ ============ ============ ============
Pro forma loss per share - Basic and
Diluted ........................... $ (0.17) $ (0.04) $ (2.75) $ (2.31)
Net income (loss) per share as
reported - Basic and Diluted ...... $ (0.14) $ 0.01 $ (2.63) $ (2.12)
The fair value of each option grant is estimated on the date of grant
using the Black-Scholes option-pricing model with the following weighted average
assumptions used for grants in 2004 and 2003: weighted-average volatility
factors of the expected market price of our common stock of 0.51 and 0.65 for
the three months and nine months ended September 30, 2004 and 2003,
respectively, weighted-average risk-free interest rates of 3% and 4% for the
three months and nine months ended September 30, 2004 and 2003, respectively,
dividend yield of 0% and weighted-average expected life of the options of 4
years. These pro forma results may not be indicative of the future results for
the full fiscal year due to potential grants, vesting and other factors.
7
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
4. ACCOUNTS RECEIVABLE
Accounts receivable consists of the following:
SEPTEMBER 30, DECEMBER 31,
2004 2003
------------ ------------
United States trade accounts receivable .... 22,974,095 $ 30,729,774
Foreign trade accounts receivable .......... 18,299,734 24,528,500
Due from factor ............................ -- 955,534
Other receivables .......................... 2,375,329 5,178,501
Allowance for returns, discounts and
bad debts ............................... (3,641,688) (4,226,383)
------------ ------------
$ 40,007,470 $ 57,165,926
============ ============
5. INVENTORY
Inventory consists of the following:
SEPTEMBER 30, DECEMBER 31,
2004 2003
----------- -----------
Raw materials - fabric and trim accessories ...... $ 1,566,859 $ 5,859,558
Work-in-process .................................. 32,101 1,094,786
Finished goods shipments-in-transit .............. 3,672,999 7,522,464
Finished goods ................................... 8,274,055 8,774,783
----------- -----------
$13,546,014 $23,251,591
=========== ===========
6. IMPAIRMENT OF LONG-LIVED ASSETS
Following our restructuring of our Mexican operations in 2003, and the
resulting reduction in our Mexican work force, we became the target of workers'
rights activists who have picketed our customers, stuffed electronic mailboxes
with inaccurate, protest e-mails, and threatened customers with retaliation for
continuing business with us. While we have defended our position to our
customers, some of our larger customers for Mexico-produced jeans wear have been
reluctant to place orders with us in response to actions taken and contemplated
by these activist groups. As a consequence, we experienced a significant decline
in revenue from sales of Mexico-produced merchandise during the three and nine
months ended September 30, 2004. As a result of this reduction in revenue from
the sale of Mexico-produced merchandise, the Board of Directors approved a
resolution in July 2004 authorizing management to sell the manufacturing
operations in Mexico.
In August 2004, through Tarrant Mexico, S. de R.L. de C.V., our
majority owned and controlled subsidiary in Mexico, we entered into an Agreement
for Purchase of Assets with affiliates of Mr. Kamel Nacif, one of our
shareholders, which agreement was amended in October 2004. Pursuant to the
agreement, as amended, we agreed to sell to Mr. Nacif's affiliates,
substantially all of our assets and real property in Mexico which include
equipment and facilities previously leased to Mr. Nacif's affiliates in October
2003, for an aggregate purchase price consisting of the following:
o $105,400 in cash and $3,910,000 by delivery of unsecured
promissory notes bearing interest at 5.5% per annum, which is
being delivered in lieu of 4,724,000 shares of our common
stock as previously reported; and
o $40,204,000, by delivery of secured promissory notes bearing
interest at 4.5% per annum, maturing on December 31, 2014, and
payable in equal monthly installments of principal and
interest over the term of the notes.
Upon consummation of this purchase and sale transaction, we will enter
into a purchase commitment agreement with Mr. Nacif's affiliates, pursuant to
which we will agree to purchase annually over the ten year term of the
agreement, $5 million of fabric manufactured at the facilities acquired by Mr.
Nacif's affiliates at negotiated market prices. This agreement will replace our
existing purchase commitment agreement whereby we are obligated to purchase
annually from
8
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Mr. Nacif's affiliates, 6 million yards of fabric (or approximately $19.2
million of fabric at today's market prices) manufactured at these same
facilities through October 2009. Pending consummation of the transaction, Mr.
Nacif's affiliates have agreed to suspend our fabric purchase obligations under
the existing purchase commitment, and we have agreed to suspend the affiliates
of Mr. Nacif's lease payment obligations under the lease agreements pursuant to
which Mr. Nacif's affiliates presently operate our manufacturing facilities in
Mexico.
Consummation of the purchase and sale transaction is subject to
customary closing conditions, including, without limitation, approval of the
transaction by the Mexican antitrust authorities. While we anticipate that the
transaction will be consummated in the fourth quarter of 2004, there can be no
assurance that the transaction will be consummated in 2004.
In accordance with SFAS No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets," we evaluated the long-lived assets in Mexico for
recoverability and concluded that the book value of the asset group was
significantly higher than the expected future cash flows and that impairment had
occurred. Accordingly, we recognized a non-cash impairment loss of approximately
$78 million in the second quarter of 2004. The impairment charge was the
difference between the carrying value and fair value of the impaired assets.
Fair value was determined based on independent appraisals of the property and
equipment obtained in June 2004. There was no tax benefit recorded with the
impairment loss due to a full valuation allowance recorded against the future
tax benefit as of June 30, 2004. Following the Board resolution authorizing the
sale of the assets in the third quarter of fiscal 2004, the assets were
reclassified to held for sale.
7. DEBT
Short-term bank borrowings consist of the following:
SEPTEMBER 30, DECEMBER 31,
2004 2003
----------- -----------
Import trade bills payable ................. $ 3,046,945 $ 3,113,030
Bank direct acceptances .................... 19,876,198 12,660,945
Other Hong Kong credit facilities .......... 4,663,064 11,375,363
Other Mexican credit facilities ............ -- 2,143,985
----------- -----------
$27,586,207 $29,293,323
=========== ===========
Long-term obligations consist of the following:
SEPTEMBER 30, DECEMBER 31,
2004 2003
------------ ------------
Vendor financing ................... $ 197,773 $ 3,971,490
Equipment financing ................ 59,583 3,710,355
Debt facility ...................... 16,347,792 31,611,667
------------ ------------
16,605,148 39,293,512
Less current portion ............... (16,561,177) (38,705,240)
------------ ------------
$ 43,971 $ 588,272
============ ============
IMPORT TRADE BILLS PAYABLE AND BANK DIRECT ACCEPTANCES
On June 13, 2002, we entered into a letter of credit facility of $25
million with UPS Capital Global Trade Finance Corporation ("UPS"). Under this
facility, we may arrange for the issuance of letters of credit and acceptances.
The facility is a one-year facility subject to renewal on its anniversary, and
currently expires on December 31, 2004. The facility is collateralized by the
shares and debentures of all of our subsidiaries in Hong Kong, as well as our
permanent quota holdings in Hong Kong. In addition to the guarantees provided by
Tarrant Apparel Group and our subsidiaries, Fashion Resource (TCL) Inc. and
Tarrant Luxembourg Sarl, Gerard Guez, our Chairman, also signed a guarantee of
$5 million in favor of UPS to secure this facility. This facility bears interest
at 5.75% per annum at September 30, 2004. Under this facility, we are subject to
certain restrictive covenants, including that we maintain a specified tangible
net worth, fixed charge ratio, and leverage ratio. In October 2004, we
established new financial covenants with UPS for the fiscal year of 2004, which
were effective retroactively to September 30, 2004. Tangible net worth for the
third and fourth quarters of 2004 were fixed at $20 million and $22 million,
respectively. Capital expenditures are capped at $700,000 per quarter. We
9
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
also agreed to reduce the outstanding balance under this facility to $22 million
before the end of October 2004 and $20 million before the end of December 2004.
As of September 30, 2004, we were in compliance with the new tangible net worth
and capital expense covenants. As of September 30, 2004, $24.6 million was
outstanding under this facility, and an additional $115,000 was available for
future borrowings. In addition, $303,000 of open letters of credit was
outstanding as of September 30, 2004.
Since March 2003, DBS Bank (Hong Kong) Limited (formerly known as Dao
Heng Bank) has made available a letter of credit facility of up to HKD 20
million (equivalent to US $2.6 million) to our subsidiaries in Hong Kong. This
is a demand facility and is secured by the pledge of our office property owned
by Gerard Guez, our Chairman, and Todd Kay, our Vice Chairman, and by our
guarantee. The letter of credit facility was increased to HKD 30 million
(equivalent to US $3.9 million) in June 2004. As of September 30, 2004, $2.7
million was outstanding under this facility. In addition, $1.2 million of open
letters of credit was outstanding as of September 30, 2004. In December 2003, a
tax loan for HKD 2 million (equivalent to US $256,000) was also made available
to our Hong Kong subsidiaries. As of September 30, 2004, $66,000 was outstanding
under this loan.
OTHER MEXICAN CREDIT FACILITIES
Tarrant Mexico S. de R.L. de C.V., Famian division was indebted
to Banco Nacional de Comercio Exterior SNC pursuant to a credit facility
assumed by Tarrant Mexico following its merger with Grupo Famian. We
paid off this loan in the third quarter of 2004.
VENDOR FINANCING
During 2000, we financed equipment purchases for a manufacturing
facility with certain vendors. A total of $16.9 million was financed with
five-year promissory notes, which bear interest ranging from 7.0% to 7.5%, and
are payable in semi-annual payments, which commenced in February 2000. Of this
amount, $198,000 was outstanding as of September 30, 2004. All of the $198,000
was payable in U.S. dollars. We are subject to foreign exchange risk resulting
from the fluctuation of the Euro. An unrealized gain of $178,000 and $228,000
were recorded for the three months ended September 30, 2004 and 2003,
respectively, related to this fluctuation and were recorded in other income in
the accompanying financial statements.
From time to time, we open letters of credit under an uncommitted
credit arrangement with Aurora Capital Associates, which issues these credits
through Israeli Discount Bank. As of September 30, 2004, $294,000 was
outstanding under this facility and $1.4 million of letters of credit was open
under this arrangement.
EQUIPMENT FINANCING
We had an equipment loan with an initial borrowing of $16.25 million
from GE Capital Leasing ("GE Capital"), which was scheduled to mature in
November 2005. The loan was secured by equipment located in Puebla and Tlaxcala,
Mexico. We paid off this loan in the third quarter of 2004.
DEBT FACILITY
We were party to a revolving credit, factoring and security agreement
(the "Debt Facility") with GMAC Commercial Credit, LLC. The Debt Facility
provided a revolving facility of $90 million, including a letter of credit
facility not to exceed $20 million, and was scheduled to mature on January 31,
2005. The Debt Facility also provided a term loan of $25 million, which is being
repaid in monthly installments of $687,500. The amount we could borrow under the
Debt Facility was determined based on a defined borrowing base formula related
to eligible accounts receivable and inventories. The Debt Facility provided for
interest at LIBOR plus the LIBOR rate margin determined by the Total Leverage
Ratio (as defined in the Debt Facility agreements), and is collateralized by our
receivables, intangibles, inventory and various other specified non-equipment
assets. Under the facility, we were subject to various financial covenants on
tangible net worth, interest coverage, fixed charge ratio and leverage ratio,
and were prohibited from paying dividends. In May 2004, the maximum facility
amount was reduced to $45 million in total and we established new financial
covenants with GMAC for
10
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
the fiscal year of 2004. As of September 30, 2004, we were in violation of
tangible net worth, fixed charge ratio and leverage ratio covenants and a waiver
was obtained. Based on the borrowing base formula, no additional amounts were
available for borrowing under the Debt Facility at September 30, 2004.
Effective as of September 29, 2004, we entered into a new three-year
factoring facility with GMAC to replace our existing Debt Facility. The revised
facility, with maximum borrowing of $45 million, is a factoring facility of all
eligible account receivables covering all U.S. operating subsidiaries and
without any inventory advances. This facility bears interest at 6% per annum at
September 30, 2004. Restrictive covenants under the revised facility include a
limit on quarterly capital expenses of $800,000 and tangible net worth of $20
million at September 30, 2004, $22 million at December 31, 2004 and March 31,
2005 and $25 million at the end of each fiscal quarter thereafter beginning on
June 30, 2005. A total of $16.3 million was outstanding under the GMAC facility
at September 30, 2004.
The credit facility with GMAC and the credit facility with UPS carry
cross-default clauses. A breach of a financial covenant set by GMAC or UPS
constitutes an event of default under the other credit facility, entitling both
financial institutions to demand payment in full of all outstanding amounts
under their respective debt and credit facilities.
GUARANTEES
Guarantees have been issued since 2001 in favor of YKK, Universal
Fasteners, and RVL Inc. for $750,000, $500,000 and an unspecified amount,
respectively, to cover trim purchased by Tag-It Pacific Inc. on our behalf. We
have not reported a liability for these guarantees. We issued the guarantees to
cover trim purchased by Tag-It in order to ensure our production in a timely
manner. If Tag-It ever defaults, we would have to pay the outstanding liability
due to these vendors by Tag-It for purchases made on our behalf. We have not had
to perform under these guarantees since inception. It is not predictable to
estimate the fair value of the guarantee; however, we do not anticipate that we
will incur losses as a result of these guarantees. As of September 30, 2004,
Tag-It Pacific Inc. had approximately $270,000 due to RVL Inc.
8. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In January 2003, the FASB issued Interpretation No. 46 ("FIN 46"),
"Consolidation of Variable Interest Entities." FIN 46 addresses when a company
should consolidate in its financial statements the assets, liabilities and
activities of a variable interest entity ("VIE"). It defines VIEs as entities
that either do not have any equity investors with a controlling financial
interest, or have equity investors that do not provide sufficient financial
resources for the entity to support its activities without additional
subordinated financial support. FIN 46 also requires disclosures about VIE's
that a company is not required to consolidate, but in which it has a significant
variable interest. The consolidation requirements of FIN 46 applied immediately
to variable interest entities created after January 31, 2003. We have not
obtained an interest in a VIE subsequent to that date. A modification to FIN 46
(FIN 46(R)) was released in December 2003. FIN 46(R) delayed the effective date
for VIEs created before February 1, 2003, with the exception of special-purpose
entities ("SPE"), until the first fiscal year or interim period ending after
March 15, 2004. FIN 46(R) delayed the effective date for SPEs until the first
fiscal year or interim period after December 15, 2003. We are not the primary
beneficiaries of any SPEs at December 31, 2003. We adopted FIN 46(R) for non-SPE
entities as of March 31, 2004. The adoption of FIN 46 did not result in the
consolidation of any VIEs, nor is the adoption of FIN 46(R) expected to result
in the consolidation of any VIEs. We are continuing to evaluate the impact of
FIN 46(R) will have on our financial statements.
9. INCOME TAXES
Our effective tax rate differs from the statutory rate principally due
to the following reasons: (1) A full valuation allowance has been provided for
deferred tax assets as a result of the operating losses in the United States and
Mexico, since recoverability of those assets has not been assessed as more
likely than not; (2) Although we have taxable losses in Mexico, we are subject
to a minimum tax; and (3) The earnings of our Hong Kong subsidiary are taxed at
a rate of 17.5% versus the 35% U.S. federal rate. The impairment charge in
Mexico did not result in a tax benefit due to an increase in the valuation
allowance against the future tax benefit. We believe it is more likely than not
that the tax benefit will not be realized based on our future business plans in
Mexico.
11
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
In January 2004, the Internal Revenue Service completed its examination
of our Federal income tax returns for the years ended December 31, 1996 through
2001. The IRS has proposed adjustments to increase our income tax payable for
the six years under examination by an aggregate of approximately $14.5 million.
This adjustment would also result in additional state taxes and interest of
approximately $12.6 million. We believe that we have meritorious defenses to and
intend to vigorously contest the proposed adjustments. If the proposed
adjustments are upheld through the administrative and legal process, they could
have a material impact on our earnings and cash flow. We believe we have
provided adequate reserves for any reasonably foreseeable outcome related to
these matters on the balance sheet included in the Consolidated Financial
Statements under the caption "Income Taxes". We do not believe that the
adjustments, if any, arising from the IRS examination, will result in an
additional income tax liability beyond what is recorded in the accompanying
balance sheet. In July 2004, the IRS initiated its examination of our Federal
income tax return for the year ended December 31, 2002.
10. EARNINGS (LOSS) PER SHARE AND EQUITY
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
SEPTEMBER 30, SEPTEMBER 30,
---------------------------- ----------------------------
2004 2003 2004 2003
------------ ------------ ------------ ------------
Basic EPS Computation:
Numerator ..................... $ (4,018,686) $ 138,847 $(75,559,397) $(36,311,276)
Denominator:
Weighted average common shares
outstanding ................... 28,814,763 18,765,425 28,705,274 17,144,611
------------ ------------ ------------ ------------
Total shares .................. 28,814,763 18,765,425 28,705,274 17,144,611
------------ ------------ ------------ ------------
Basic EPS ..................... $ (0.14) $ 0.01 $ (2.63) $ (2.12)
============ ============ ============ ============
Diluted EPS Computation:
Numerator ..................... $ (4,018,686) $ 138,847 $(75,559,397) $(36,311,276)
Denominator:
Weighted average common share
outstanding ................... 28,814,763 18,765,425 28,705,274 17,144,611
Incremental shares from assumed
exercise of options ........... -- 2,276 -- --
------------ ------------ ------------ ------------
Total shares .................. 28,814,763 18,767,701 28,705,274 17,144,611
------------ ------------ ------------ ------------
Diluted EPS ................... $ (0.14) $ 0.01 $ (2.63) $ (2.12)
============ ============ ============ ============
Basic and diluted loss per share has been computed in accordance with
SFAS No. 128, "Earnings Per Share." Options and warrants to purchase a total of
9,671,594 shares and 8,348,487 shares have been excluded from the computation in
the nine months ended September 30, 2004 and 2003, respectively, as the impact
would be anti-dilutive.
In January 2004, we sold an aggregate of 1,200,000 shares of our common
stock at a price of $3.35 per share, for aggregate proceeds to us of
approximately $3.7 million after payment of placement agent fees and other
offering expenses.
12
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
We used the proceeds of this offering for working capital purposes. The
securities sold in the offering were registered under the Securities Act of
1933, as amended, pursuant to our effective shelf registration statement. In
conjunction with this public offering, we issued a warrant to purchase 30,000
shares of our common stock to the placement agent. This warrant has an exercise
price of $3.35 per share, is fully vested and exercisable and has a term of five
years. The warrant was valued using the Black-Scholes option valuation model
with the following assumptions: risk-free interest rate of 3%; dividend yields
of 0%; volatility factors of the expected market price of warrants of 0.51; and
an expected life of 4 years.
11. RELATED PARTY TRANSACTIONS
As of September 30, 2004, related party affiliates were indebted to us
in the amount of $10.5 million. This amount included various employee
receivables totaling $450,000 at September 30, 2004. Amount due from our
shareholder and officer was $4.8 million at September 30, 2004, which has been
shown as a reduction to shareholders' equity in the accompanying financial
statements. Total interest paid by related party affiliates, the Chairman and
the Vice Chairman were $92,000 and $86,000 for the three months ended September
30, 2004 and 2003, respectively.
From time to time, we have borrowed funds from, and advanced funds to,
certain officers and principal shareholders, including Gerard Guez, our
Chairman. The maximum amount of such advances to Mr. Guez in the third quarter
of 2004 was approximately $4,782,000. Mr. Guez had an outstanding advance from
us in the amount of $4,776,000 as of September 30, 2004. All advances to, and
borrowings from, Mr. Guez in 2004 bore interest at the rate of 7.75%. All
existing loans to officers and directors before July 30, 2002 are grandfathered
under the Sarbanes-Oxley Act of 2002. No further personal loans will be made to
officers and directors in compliance with the Sarbanes-Oxley Act.
In February 2004, our Hong Kong subsidiary entered into a 50/50 joint
venture with Auto Enterprises Limited, an unrelated third party, to source
products for Seven Licensing Company, LLC in mainland China. On May 31, 2004,
after realizing an accumulated loss from the venture of approximately $200,000
(our share being half), we sold our interest for $1 to Asia Trading Limited, a
company owned by Jacqueline Rose, wife of Gerard Guez.
Since June 2003, United Apparel Ventures, LLC has been selling to Seven
Licensing Company, LLC ("Seven Licensing"), jeans wear bearing the brand
"Seven7", which is ultimately purchased by Express. Seven Licensing is
beneficially owned by our Chairman. Total sales to Seven Licensing in the three
months ended September 30, 2004 and 2003 was $42,000 and $5.7 million,
respectively. In 1998, a California limited liability company owned by our
Chairman and Vice Chairman purchased 2,300,000 shares of the common stock of
Tag-It Pacific, Inc. ("Tag-It") (or approximately 37% of such common stock then
outstanding). Tag-It is a provider of brand identity programs to manufacturers
and retailers of apparel and accessories. Starting from 1998, Tag-It assumed the
responsibility for managing and sourcing all trim and packaging used in
connection with products manufactured by or on behalf of us in Mexico. This
arrangement is terminable by Tag-It or us at any time. We believe that the terms
of this arrangement, which is subject to the acceptance of our customers, are no
less favorable to us than could be obtained from unaffiliated third parties. We
purchased $465,000 and $4.3 million of trim inventory from Tag-It in the three
months ended September 30, 2004 and 2003, respectively. We purchased $2.0
million and $9.5 million of finished goods and services from Azteca Production
International and its affiliates in the three months ended September 30, 2004
and 2003, respectively. Azteca is owned by the brothers of our Chairman, Gerard
Guez, and is the minority member of our subsidiary, United Apparel Ventures,
LLC. Our total sales of fabric and services to Azteca in the three months ended
September 30, 2004 and 2003 were $0 and $2.5 million, respectively.
Additionally, UAV paid two and one half percent of its gross sales as management
fees to each of the members of UAV. The amount paid by UAV to Azteca totaled $0
and $434,000 in the three months ended September 30, 2004 and 2003,
respectively. Net amount due from these related parties as of September 30, 2004
was $9.4 million.
On October 16, 2003, we entered into a lease with affiliates of Mr.
Kamel Nacif, one of our shareholders, for a substantial portion of our
manufacturing facilities and operations in Mexico including real estate and
equipment. The lease was effective as of September 1, 2003. We leased our twill
mill in Tlaxcala, Mexico, and our sewing plant in Ajalpan, Mexico, for a period
of 6 years and for an annual rental fee of $11 million. In connection with this
lease transaction, we also entered into a management services agreement pursuant
to which Mr. Nacif's affiliates will manage the operation of our remaining
facilities in Mexico in exchange for the use of such facilities. The term of the
management services agreement is also for a period of 6 years. Additionally, we
entered into a purchase commitment agreement with Mr. Nacif's
13
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
affiliates to purchase annually, six million yards of fabric manufactured at the
facilities leased and/or operated by Mr. Nacif's affiliates at market prices to
be negotiated. Using current market prices, the purchase commitment would be
approximately $19 million per year. We must pay $1 for each yard of fabric that
we fail to purchase under the agreement. We purchased $1.1 million of fabric
under this agreement in the three months ended September 30, 2004. Net amount
due from these related parties as of September 30, 2004 was $410,000.
In August 2004, we entered into a purchase and sale agreement to sell
to Mr. Nacif's affiliates, substantially all of our assets and real property in
Mexico, including the equipment and facilities we currently lease to Mr. Nacif's
affiliates. Upon consummation of this purchase and sale transaction, we will
enter into a purchase commitment agreement with Mr. Nacif's affiliates, pursuant
to which we will agree to purchase annually over the ten year term of the
agreement, $5 million of fabric manufactured at the facilities acquired by Mr.
Nacif's affiliates at negotiated market prices. This agreement will replace our
existing purchase commitment agreement with Mr. Nacif's affiliates. Pending
consummation of the transaction, Mr. Nacif's affiliates have agreed to suspend
our fabric purchase obligations under the existing purchase commitment, and we
have agreed to suspend the affiliates of Mr. Nacif's lease payment obligations
under the lease agreements pursuant to which Mr. Nacif's affiliates presently
operate our manufacturing facilities in Mexico. In the three months ended
September 30, 2004, no lease income was recorded in other income. Consummation
of the purchase and sale transaction is subject to customary closing conditions,
including, without limitation, approval of the transaction by the Mexican
antitrust authorities. While we anticipate that the transaction will be
consummated in the second half of 2004, there can be no assurance that the
transaction will be consummated in 2004. See Note 6 of the "Notes to
Consolidated Financial Statements".
In the three months ended September 30, 2004 and 2003, we paid $332,000
in rent for office and warehouse facilities we lease from two entities owned by
Mr. Guez, our Chairman, Mr. Kay, our Vice Chairman. We currently lease both
facilities on a month-to-month basis.
We reimburse our Chairman for fuel and related expenses whenever our
executives use our Chairman's aircraft for company business.
In the second quarter of 2003, we acquired a 45% equity interest in the
owner of the trademark "American Rag CIE" and the operator of American Rag
retail stores for $1.4 million, and our subsidiary, Private Brands, Inc.,
acquired a license to certain exclusive rights to this trademark. The investment
in American Rag Cie, LLC totaling $2.2 million at September 30, 2004 was
accounted for under the equity method and included in other assets.
12. COMMITMENTS AND CONTINGENCIES
In connection with the restructuring of our Mexican operations, and the
resulting reduction in our Mexican work force, we became the target of workers'
rights activists who have picketed our customers, stuffed electronic mailboxes
with inaccurate, protest e-mails, and threatened customers with retaliation for
continuing business with us. While we have defended our position to our
customers, some of our larger customers for Mexico-produced jeans wear have been
reluctant to place orders with us in response to actions taken and contemplated
by these activist groups. As a consequence, we project a loss of approximately
$75 million in revenue from sales of Mexico-produced merchandise in 2004.
14
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
13. OPERATIONS BY GEOGRAPHIC AREAS
Our predominant business is the design, distribution and importation of
private label and private brand casual apparel. Substantially all of our
revenues are from the sales of apparel. We are organized into three geographic
regions: the United States, Asia and Mexico. We evaluate performance of each
region based on profit or loss from operations before income taxes not including
the cumulative effect of change in accounting principles. Information about our
operations in the United States, Asia, and Mexico is presented below.
Inter-company revenues and assets have been eliminated to arrive at the
consolidated amounts.
ADJUSTMENTS
AND
UNITED STATES ASIA MEXICO ELIMINATIONS TOTAL
------------- ------------- ------------- ------------- -------------
THREE MONTHS ENDED
SEPTEMBER 30, 2004
Sales ............. $ 37,263,000 $ 696,000 $ 144,000 $ -- $ 38,103,000
Inter-company sales -- 17,644,000 780,000 (18,424,000) --
------------- ------------- ------------- ------------- -------------
Total revenue ..... $ 37,263,000 $ 18,340,000 $ 924,000 $ (18,424,000) $ 38,103,000
============= ============= ============= ============= =============
Income (loss) from
operations ..... $ (3,109,000) $ 554,000 $ (887,000) $ -- $ (3,442,000)
============= ============= ============= ============= =============
THREE MONTHS ENDED
SEPTEMBER 30, 2003
Sales ............. $ 86,800,000 $ 1,988,000 $ 7,670,000 $ -- $ 96,458,000
Inter-company sales 11,865,000 30,622,000 27,739,000 (70,226,000) --
------------- ------------- ------------- ------------- -------------
Total revenue ..... $ 98,665,000 $ 32,610,000 $ 35,409,000 $ (70,226,000) $ 96,458,000
============= ============= ============= ============= =============
Income (loss) from
operations ..... $ 2,961,000 $ 1,768,000 $ (3,281,000) $ -- $ 1,448,000
============= ============= ============= ============= =============
NINE MONTHS ENDED
SEPTEMBER 30, 2004
Sales ............. $ 113,042,000 $ 1,713,000 $ 3,992,000 $ -- $ 118,747,000
Inter-company sales -- 56,243,000 7,440,000 (63,683,000) --
------------- ------------- ------------- ------------- -------------
Total revenue ..... $ 113,042,000 $ 57,956,000 $ 11,432,000 $ (63,683,000) $ 118,747,000
============= ============= ============= ============= =============
Income (loss) from
operations (1) . $ (8,308,000) $ 3,116,000 $ (88,565,000) $ -- $ (93,757,000)
============= ============= ============= ============= =============
NINE MONTHS ENDED
SEPTEMBER 30, 2003
Sales ............. $ 229,121,000 $ 5,156,000 $ 19,111,000 $ -- $ 253,388,000
Inter-company sales 25,301,000 90,795,000 57,375,000 (173,471,000) --
------------- ------------- ------------- ------------- -------------
Total revenue ..... $ 254,422,000 $ 95,951,000 $ 76,486,000 $(173,471,000) $ 253,388,000
============= ============= ============= ============= =============
Income (loss) from
operations (2) . $ (16,341,000) $ 7,437,000 $ (25,325,000) $ -- $ (34,229,000)
============= ============= ============= ============= =============
(1) Included in Income (loss) from operations was an impairment charge of
$78.0 million in the Mexico region.
(2) Included in Income (loss) from operations was an impairment charge of
$10.5 million in the United States region and $11.8 million in the
Mexico region.
15
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
BUSINESS OVERVIEW AND RECENT DEVELOPMENTS
We are a leading provider of casual apparel, serving specialty retail,
mass merchandise and department stores, branded wholesalers and specialty chains
located primarily in the United States by designing, merchandising, contracting
for the manufacture of, and selling casual apparel for women, men and children.
Our major customers include Federated Department Stores, Lerner New York, J.C.
Penney, K-Mart, Kohl's, Mervyns, and Wal-Mart. Our products are manufactured in
a variety of woven and knit fabrications and include jeans wear, casual pants,
t-shirts, shorts, blouses, shirts and other tops, dresses and jackets.
During 2003, we launched our private brands initiative, where we
acquire ownership of or exclusively license rights to a brand name and sell
apparel products under this brand to a single retail company within a geographic
region. In the second quarter of 2003, we acquired an equity interest in the
owner of the trademark "American Rag CIE," and the operator of American Rag
retail stores, and our subsidiary, Private Brands, Inc., acquired a license to
certain exclusive rights to this trademark. Private Brands then entered into a
multi-year exclusive distribution agreement with Federated Merchandising Group
("FMG"), the sourcing arm of Federated Department Stores, to supply FMG with
American Rag CIE, a new casual sportswear collection for juniors and young men.
Private Brands designs and manufactures a full collection of American Rag
apparel exclusively for sale in Federated stores across the country. Currently,
the American Rag collection is available in approximately 170 select Macy's, the
Bon Marche, Burdines, Goldsmith's, Lazarus and Rich's-Macy's locations. During
2003, we also began selling products under our own brand "No Jeans" exclusively
to Wet Seal, and we acquired the distribution rights for Alain Weiz, which will
be sold at selected Dillard's stores. On April 1, 2004, we entered into a
license agreement with Cynthia Rowley to manufacture, market and distribute
Cynthia Rowley branded jeans wear for women, and in July 2004, we formed PBG7,
LLC to acquire an ownership interest in, and manufacture, market and distribute
apparel under the brand "Gear 7," which presently is sold at Kmart stores.
Orders for production of Alain Weiz and Gear 7 will impact our sales beginning
first quarter of 2005.
In connection with the restructuring of our Mexican operations, and the
resulting reduction in our Mexican work force, we became the target of workers'
rights activists who have picketed our customers, stuffed electronic mailboxes
with inaccurate, protest e-mails, and threatened customers with retaliation for
continuing business with us. While we have defended our position to our
customers, some of our larger customers for Mexico-produced jeans wear have been
reluctant to place orders with us in response to actions taken and contemplated
by these activist groups. As a consequence, we experienced a significant decline
in revenue from sales of Mexico-produced merchandise during the three and nine
months ended September 30, 2004. We anticipate that this decline in revenue will
continue during the remainder of fiscal 2004, resulting in a projected loss of
approximately $75 million in revenue from sales of Mexico-produced merchandise
in 2004. As a result of this reduction in revenue from the sale of
Mexico-produced merchandise, the Board of Directors approved a resolution in
July 2004 authorizing management to sell the manufacturing operations in Mexico.
In August 2004, through Tarrant Mexico, S. de R.L. de C.V., our
majority owned and controlled subsidiary in Mexico, we entered into an Agreement
for Purchase of Assets with affiliates of Mr. Kamel Nacif, one of our
shareholders, which agreement was amended in October 2004. Pursuant to the
agreement, as amended, we agreed to sell to Mr. Nacif's affiliates,
substantially all of our assets and real property in Mexico which include
equipment and facilities previously leased to Mr. Nacif's affiliates in October
2003, for an aggregate purchase price consisting of the following:
o $105,400 in cash and $3,910,000 by delivery of unsecured
promissory notes bearing interest at 5.5% per annum, which is
being delivered in lieu of 4,724,000 shares of our common
stock as previously reported; and
o $40,204,000, by delivery of secured promissory notes bearing
interest at 4.5% per annum, maturing on December 31, 2014, and
payable in equal monthly installments of principal and
interest over the term of the notes.
16
Upon consummation of this purchase and sale transaction, we will enter
into a purchase commitment agreement with Mr. Nacif's affiliates, pursuant to
which we will agree to purchase annually over the ten year term of the
agreement, $5 million of fabric manufactured at the facilities acquired by Mr.
Nacif's affiliates at negotiated market prices. This agreement will replace our
existing purchase commitment agreement whereby we are obligated to purchase
annually from Mr. Nacif's affiliates, 6 million yards of fabric (or
approximately $19.2 million of fabric at today's market prices) manufactured at
these same facilities through October 2009. Pending consummation of the
transaction, Mr. Nacif's affiliates have agreed to suspend our fabric purchase
obligations under the existing purchase commitment, and we have agreed to
suspend the affiliates of Mr. Nacif's lease payment obligations under the lease
agreements pursuant to which Mr. Nacif's affiliates presently operate our
manufacturing facilities in Mexico.
Consummation of the purchase and sale transaction is subject to
customary closing conditions, including, without limitation, approval of the
transaction by the Mexican antitrust authorities. While we anticipate that the
transaction will be consummated in the fourth quarter of 2004, there can be no
assurance that the transaction will be consummated in 2004.
In accordance with SFAS 144, we evaluated the long-lived assets in
Mexico for recoverability and concluded that the book value of the asset group
was significantly higher than the expected future cash flows and that impairment
had occurred. Accordingly, we recognized a non-cash impairment loss of
approximately $78 million in the second quarter of 2004. The impairment charge
was the difference between the carrying value and fair value of the impaired
assets. Fair value was determined based on independent appraisals of the
property and equipment obtained in June 2004. There was no tax benefit recorded
with the impairment loss due to a full valuation allowance recorded against the
future tax benefit as of June 30, 2004. Following the Board resolution
authorizing the sale of the assets in the third quarter of fiscal 2004, the
assets were reclassified to held for sale.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Management's discussion and analysis of our financial condition and
results of operations are based upon our Consolidated Financial Statements,
which have been prepared in accordance with accounting principles generally
accepted in the United States of America. The preparation of these financial
statements requires us to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenues and expenses, and related disclosures
of contingent assets and liabilities. On an ongoing basis, we evaluate
estimates, including those related to returns, discounts, bad debts,
inventories, intangible assets, income taxes, and contingencies and litigation.
We base our estimates on historical experience and on various other assumptions
that are believed to be reasonable under the circumstances, the results of which
form the basis for making judgments about the carrying values of assets and
liabilities that are not readily apparent from other sources. Actual results may
differ from these estimates under different assumptions or conditions.
We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our Consolidated
Financial Statements. For a further discussion on the application of these and
other accounting policies, see Note 1 to our audited Consolidated Financial
Statements included in our Annual Report on Form 10-K for the year ended
December 31, 2003.
ACCOUNTS RECEIVABLE--ALLOWANCE FOR RETURNS, DISCOUNTS AND BAD DEBTS
We evaluate the collectibility of accounts receivable and charge backs
(disputes from the customer) based upon a combination of factors. In
circumstances where we are aware of a specific customer's inability to meet its
financial obligations (such as in the case of bankruptcy filings or substantial
downgrading of credit sources), a specific reserve for bad debts is taken
against amounts due to reduce the net recognized receivable to the amount
reasonably expected to be collected. For all other customers, we recognize
reserves for bad debts and charge backs based on our historical collection
experience. If collection experience deteriorates (for example, due to an
unexpected material adverse change in a major customer's ability to meet its
financial obligations to us), the estimates of the recoverability of amounts due
us could be reduced by a material amount.
As of September 30, 2004, the balance in the allowance for returns,
discounts and bad debts reserves was $3.6 million.
17
INVENTORY
Our inventories are valued at the lower of cost or market. Under
certain market conditions, we use estimates and judgments regarding the
valuation of inventory to properly value inventory. Inventory adjustments are
made for the difference between the cost of the inventory and the estimated
market value and charged to operations in the period in which the facts that
give rise to the adjustments become known.
VALUATION OF LONG-LIVED AND INTANGIBLE ASSETS AND GOODWILL
We assess the impairment of identifiable intangibles, long-lived assets
and goodwill whenever events or changes in circumstances indicate that the
carrying value may not be recoverable. Factors considered important that could
trigger an impairment review include, but are not limited to, the following:
o a significant underperformance relative to expected historical
or projected future operating results;
o a significant change in the manner of the use of the acquired
asset or the strategy for the overall business; or
o a significant negative industry or economic trend.
Effective January 1, 2002, we adopted Statement of Financial Accounting
Standards No. 142, "Goodwill and Other Intangible Assets." According to this
statement, goodwill and other intangible assets with indefinite lives are no
longer subject to amortization, but rather an annual assessment of impairment
applied on a fair-value-based test.
We utilized the discounted cash flow methodology to estimate fair
value. As of September 30, 2004, we have a goodwill balance of $8.6 million, and
a net property and equipment balance of $2.1 million. Our goodwill balance
reflects the write off of $19.5 million of goodwill in the second quarter of
2003. Our net property and equipment balance reflects the write off of $78.0
million of net property and equipment in the second quarter of 2004 and a
reclassification of $42.2 million to assets held for sale in the third quarter
of 2004. See Note 6 of the "Notes to Consolidated Financial Statements".
FOREIGN CURRENCYTRANSLATION
Assets and liabilities of our Mexico and Hong Kong subsidiaries are
translated at the rate of exchange in effect on the balance sheet date; income
and expenses are translated at the average rates of exchange prevailing during
the respective periods. The functional currency in which we transact business in
Hong Kong is the Hong Kong dollar and in Mexico is the peso.
Foreign currency gains and losses resulting from translation of assets
and liabilities are included in other comprehensive income (loss). Transaction
gains or losses, other than inter-company debt deemed to be of a long-term
nature, are included in net income (loss) in the period in which they occur.
Upon the substantial liquidation of the Mexico subsidiaries following the sale
of the fixed assets in Mexico, the foreign currency translation adjustment
related to the Mexico subsidiaries of approximately $22 million of loss will be
reclassified and charged to income. The adjustment is expected to occur during
the fourth quarter of 2004. See Note 6 of the "Notes to Consolidated Financial
Statements".
INCOME TAXES
As part of the process of preparing our Consolidated Financial
Statements, management is required to estimate income taxes in each of the
jurisdictions in which we operate. The process involves estimating actual
current tax expense along with assessing temporary differences resulting from
differing treatment of items for book and tax purposes. These timing differences
result in deferred tax assets and liabilities, which are included in our
consolidated balance sheet. Management records a valuation allowance to reduce
our net deferred tax assets to the amount that is more likely than not to be
realized. Management has considered future taxable income and ongoing
18
tax planning strategies in assessing the need for the valuation allowance.
Increases in the valuation allowance result in additional expense to be
reflected within the tax provision in the consolidated statement of operations.
In addition, accruals are also estimated for ongoing audits regarding
U.S. Federal tax issues that are currently unresolved, based on our estimate of
whether, and the extent to which, additional taxes will be due. We routinely
monitor the potential impact of these situations and believe that amounts are
properly accrued for. If we ultimately determine that payment of these amounts
is unnecessary, we will reverse the liability and recognize a tax benefit during
the period in which we determine that the liability is no longer necessary. We
will record an additional charge in our provision for taxes in any period we
determine that the original estimate of a tax liability is less than we expect
the ultimate assessment to be. See Note 9 of the "Notes to Consolidated
Financial Statements" for a discussion of current tax matters.
DEBT COVENANTS
Our debt agreements require the maintenance of certain financial ratios
and a minimum level of net worth as discussed in Note 7 to our Consolidated
Financial Statements. If our results of operations erode and we are not able to
obtain waivers from the lenders, the debt would be in default and callable by
our lenders. In addition, due to cross-default provisions in a majority of the
debt agreements, approximately 99% of our long-term debt would become due in
full if any of the debt is in default. In anticipation of us not being able to
meet the required covenants due to various reasons, we either negotiate for
changes in the relative covenants or obtain an advance waiver or reclassify the
relevant debt as current. We also believe that our lenders would provide waivers
if necessary. However, our expectations of future operating results and
continued compliance with other debt covenants cannot be assured and our
lenders' actions are not controllable by us. If projections of future operating
results are not achieved and the debt is placed in default, we would be required
to reduce our expenses, by curtailing operations, and to raise capital through
the sale of assets, issuance of equity or otherwise, any of which could have a
material adverse effect on our financial condition and results of operations.
RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, certain
items in our consolidated statements of operations as a percentage of net sales:
THREE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
----------------- -----------------
2004 2003 2004 2003
------- ------- ------- -------
Net sales ............................ 100.0% 100.0% 100.0% 100.0%
Cost of sales ........................ 89.1 88.1 85.8 92.2
------- ------- ------- -------
Gross profit ......................... 10.9 11.9 14.2 7.8
Selling and distribution expenses .... 5.5 3.0 6.0 3.4
General and administration
expenses .......................... 14.4 7.4 21.5 9.1
Impairment of assets ................. -- -- 65.6 8.8
------- ------- ------- -------
Income (loss) from operations ........ (9.0) 1.5) (78.9) (13.5)
Interest expense ..................... (1.8) (1.6) (1.8) (1.7)
Interest Income ...................... 0.2 0.0 0.2 0.1
Other income ......................... 1.0 1.1 5.9 0.6
Other expense ........................ (0.8) (0.7) (0.9) (0.5)
Minority interest .................... 0.5 0.3 12.8 1.5
------- ------- ------- -------
Income (loss) before taxes ........... (9.9) 0.6 (62.7) (13.5)
Income taxes ......................... 0.6 0.5 0.9 0.8
------- ------- ------- -------
Net income (loss) .................... (10.5)% 0.1% (63.6)% (14.3)%
======= ======= ======= =======
THIRD QUARTER 2004 COMPARED TO THIRD QUARTER 2003
Net sales decreased by $58.4 million, or 60.5%, to $38.1 million in
third quarter of 2004 from $96.5 million in the third quarter of 2003. The
decrease in net sales was caused primarily by a decline in Mexico based sales
resulting from the cessation of our manufacturing operations in Mexico in
September 2003 and the resulting
19
labor difficulties we experienced following the reduction in our Mexico work
force. Some of our larger customers for Mexico-produced jeans wear did not place
orders with us during the third quarter of 2004 in response to actions taken and
contemplated by workers' rights activists. Additionally, some of our customers
reduced the level of order activity for the third quarter of 2004 in response to
poor back to school sales results.
Gross profit consists of net sales less product costs, direct labor,
manufacturing overhead, duty, quota, freight in, brokerage, and warehousing.
Gross profit decreased by $7.4 million to $4.1 million in the third quarter of
2004 from $11.5 million in the third quarter of 2003. The decrease in gross
profit occurred primarily because of a decline in sales. As a percentage of net
sales, gross profit decreased from 11.9% in the third quarter of 2003 to 10.9%
in the third quarter of 2004.
Selling and distribution expenses decreased by $797,000, or 27.7%, to
$2.1 million in the third quarter of 2004 from $2.9 million in the third quarter
of 2003. The decrease in such expense is partially due to a decrease of freight
expense to $146,000 in the third quarter of 2004 compared to $422,000 in the
third quarter of 2003. As a percentage of net sales, these expenses increased to
5.5% in the third quarter of 2004 from 3.0% in the third quarter of 2003 due to
the significant decline in sales during the third quarter of 2004.
General and administrative expenses decreased by $1.7 million, or
23.5%, to $5.5 million in the third quarter of 2004 from $7.2 million in the
third quarter of 2003. The decrease was the result of our efforts to reduce
overhead. As a percentage of net sales, these expenses increased to 14.4% in the
third quarter of 2004 from 7.4% in the third quarter of 2003 due to the
significant decline in sales during the third quarter of 2004.
Operating loss in the third quarter of 2004 was $3.4 million, or 9.0%
of net sales, compared to operating profit of $1.4 million, or 1.5% of net
sales, in the comparable period of 2003, because of the factors discussed above.
Interest expense decreased by $891,000, or 56%, to $700,000 in the
third quarter of 2004 from $1.6 million in the third quarter of 2003 due to a
reduction in the average debt balance outstanding resulting from debt repayment
following our equity financing transactions in late 2003 and January 2004. As a
percentage of net sales, this expense increased to 1.8% in the third quarter of
2004 from 1.6% in the third quarter of 2003. Interest income was $94,000 in the
third quarter of 2004, compared to $88,000 in the third quarter of 2003. Other
income was $384,000 in the third quarter of 2004, compared to $1.1 million in
the third quarter of 2003. This reduction in other income was due primarily to
$917,000 of lease income received for the lease of our facilities and equipment
in the third quarter of 2003, while no such income was received in the third
quarter of 2004 as we agreed to suspend the lessee's lease payment obligations
pending completion of the sale of our Mexico assets. See Note 6 of the "Notes to
Consolidated Financial Statements". Other expense was $319,000 in the third
quarter of 2004, compared to $707,000 in the third quarter of 2003.
Losses allocated to minority interest in the third quarter of 2004 was
$180,000, representing the minority shareholder's share of losses in each of UAV
and PBG7. Losses allocated to minority interest in the third quarter of 2003 was
$283,000, representing the minority partner's share of profit in UAV totaling
$518,000, and the minority shareholder's share of losses in Tarrant Mexico
totaling $801,000.
FIRST NINE MONTHS OF 2004 COMPARED TO FIRST NINE MONTHS OF 2003
Net sales decreased by $134.6 million, or 53.1%, to $118.7 million in
the first nine months of 2004 from $253.4 million in the first nine months of
2003. The decrease in net sales was caused primarily by a decline in Mexico
based sales resulting from the cessation of our manufacturing operations in
Mexico in September 2003 and the resulting labor difficulties we experienced
following the reduction in our Mexico work force. Some of our larger customers
for Mexico-produced jeans wear did not place orders with us during the first
nine months of 2004 in response to actions taken and contemplated by workers'
rights activists. Additionally, some of our customers reduced the level of order
activity for third quarter of 2004 in response to poor back to school sales
results.
Gross profit decreased by $3.0 million, or 15.0%, to $16.9 million, or
14.2% of net sales in the first nine months of 2004 from $19.9 million, or 7.8%
of net sales in the first nine months of 2003. The decrease in gross profit
occurred primarily because of a significant decline in sales. The effect was
partially offset by a reclassification of depreciation and amortization of our
Mexico assets of $6.7 million in the first nine months of
20
2004 from cost of goods sold to general and administrative expenses. The
reclassification was due to our cessation of direct manufacturing in Mexico and
the lease of our Mexico assets. Additionally, in the first nine months of 2003,
there was an inventory write-down of $11.0 million, which did not occur in the
2004 period.
Selling and distribution expenses decreased by $1.6 million, or 18.5%,
to $7.1 million in the first nine months of 2004 from $8.7 million in the first
nine months of 2003. The decrease in such expense is primarily due to a decrease
of freight expense to $592,000 in the first nine months of 2004 compared to $1.6
million in the first nine months of 2003. As a percentage of net sales, these
expenses increased from 3.4% for the first nine months of 2003 to 6.0% for the
first nine months of 2004 due to the significant decline in sales during the
nine months of 2004.
General and administrative expenses increased by $2.5 million, or
10.6%, to $25.6 million in the first nine months of 2004 from $23.1 million in
the first nine months of 2003. The increase was caused by the reclassification
of depreciation and amortization of our Mexico assets of $6.7 million from cost
of goods sold, partially offset by the results of our efforts to reduce
overhead. As a percentage of net sales, these expenses increased to 21.5% in the
first nine months of 2004 from 9.1% in the first nine months of 2003 due to the
significant decline in sales and the reclassification of depreciation and
amortization of our Mexico assets in the first nine months of 2004.
Impairment of assets expense was $78.0 million in the first nine months
of 2004, compared to $22.3 million in the first nine months of 2003. This
expense in the first nine months of 2004 was a consequence of our write-down of
the book value of our fixed assets in Mexico. See Note 6 of the "Notes to
Consolidated Financial Statements." This expense in the first nine months of
2003 was primarily due to our decision to cease directly operating a substantial
majority of our equipment and fixed assets in Mexico commencing in the third
quarter of 2003.
Operating loss for the first nine months of 2004 was $93.8 million, or
78.9% of net sales, compared to operating loss of $34.2 million, or 13.5% of net
sales, in the comparable prior period of 2003 as a result of the factors
discussed above.
Interest expense decreased by $2.3 million, or 51.4%, to $2.2 million
in the first nine months of 2004 from $4.5 million in the first nine months of
2003. The decrease was due to a reduction in the average debt balance
outstanding resulting from debt repayment following our equity financing
transactions in late 2003 and January 2004. As a percentage of net sales, this
expense increased from 1.7% in the first nine months of 2003 to 1.8% in the
first nine months of 2004. Interest income was $281,000 in the first nine months
of 2004, compared to $263,000 in the first nine months of 2003. Other income was
$7.0 million in the first nine months of 2004, compared to $1.6 million in the
first nine months of 2003, due primarily to $5.5 million of lease income
received for the lease of our facilities and equipment in Mexico in the first
nine months of 2004 and $917,000 of such income in the first nine months of
2003. Other expense was $1.0 million in the first nine months of 2004 as
compared to $1.2 million in the first nine months of 2003.
Losses allocated to minority interest in the first nine months of 2004
was $15.2 million, representing the minority partner's share of losses in UAV
and PBG7 totaling $337,000, and the minority shareholder's shares of losses in
Tarrant Mexico totaling $14.9 million, of which $13.7 million is this
shareholder's 25% share of the charge we incurred for the write down of fixed
assets in Mexico. Losses allocated to minority interest in the first nine months
of 2003 was $3.8 million, representing the minority partner's share of profit in
UAV totaling $2.6 million, and the minority shareholder's shares of losses in
Tarrant Mexico totaling $6.4 million.
LIQUIDITY AND CAPITAL RESOURCES
Our liquidity requirements arise from the funding of our working
capital needs, principally inventory, finished goods shipments-in-transit,
work-in-process and accounts receivable, including receivables from our contract
manufacturers that relate primarily to fabric we purchase for use by those
manufacturers. Our primary sources for working capital and capital expenditures
are cash flow from operations, borrowings under our bank and other credit
facilities, borrowings from principal shareholders, issuance of long-term debt,
sales of equity securities, borrowing from affiliates and the proceeds from the
exercise of stock options.
21
Our liquidity is dependent, in part, on customers paying on time. Any
abnormal charge backs or returns may affect our source of short-term
funding. We are also subject to market price changes. Any changes in credit
terms given to major customers may have an impact on our cash flow. Suppliers'
credit is another major source of short-term financing and any adverse changes
in their terms will have negative impact on our cash flow.
During the first nine months of 2004, net cash provided by operating
activities was $15.9 million, as compared to net cash provided by operating
activities of $5.2 million for the same period in 2003. Net cash provided by
operating activities in the first nine months of 2004 primarily was the result
of the operating loss of $75.6 million, an increase of $1.3 million in temporary
quota rights and a decrease of $5.2 million in accounts payable, offset by
depreciation and amortization of $7.9 million, asset impairment charge of $78.0
million, decreases of $17.3 million in accounts receivable, $2.8 million of
restricted cash, and $9.6 million of inventory.
During the first nine months of 2004, net cash provided by investing
activities was $3.0 million, as compared to net cash used in investing
activities of $1.3 million for the same period in 2003. Cash provided by
investing activities in the first nine months of 2004 included approximately
$3.1 million from sale of fixed assets.
During the first nine months of 2004, net cash used in financing
activities was $20.4 million, as compared to $4.4 million of net cash used in
financing activities for the same period in 2003. Cash used in financing
activities in first nine months of 2004 included $3.7 million of proceeds from
issuance of common stock and $89.3 million of proceeds from long-term
obligations, offset by $111.6 million of payments of long-term obligations and
$1.7 million of payments of bank borrowings.
CONTRACTUAL OBLIGATIONS AND COMMITMENTS
Following is a summary of our contractual obligations and commercial
commitments available to us as of September 30, 2004 (in millions):
PAYMENTS DUE BY PERIOD
---------------------------------------------------------
CONTRACTUAL OBLIGATIONS Total Less than Between Between After
1 year 2-3 years 4-5 years 5 years
- ---------------------------------- -------- ------- ------- ------- -------
Long-term debt ................... $ 16.6 $ 16.6 $ 0 $ 0 $ 0
Operating leases ................. 0.6 0.3 0.3 0 0
Minimum royalties ................ 9.8 0.6 1.4 1.8 6.0
Purchase commitment (1) .......... 96.0 19.2 38.4 38.4 0
Employment contracts ............. 1.9 1.4 0.5 0 0
-------- ------- ------- ------- -------
Total Contractual Cash Obligations $ 124.9 $ 38.1 $ 40.6 $ 40.2 $ 6.0
(1) Pending consummation of the sale of assets, this purchase commitment is
being suspended. See Note 6 of the "Notes to Consolidated Financial
Statements".
AMOUNT OF COMMITMENT EXPIRATION
PER PERIOD
---------------------------------------
TOTAL
AMOUNTS LESS BETWEEN BETWEEN AFTER
COMMERCIAL COMMITMENTS COMMITTED THAN 2-3 4-5 5
AVAILABLE TO US TO US 1 YEAR YEARS YEARS YEARS
- ---------------------------- -------- -------- -------- -------- ------
Lines of credit............. $ 74.5 $ 74.5 $ -- $ -- $ --
Letters of credit (within
lines of credit)......... $ 30.0 $ 30.0 $ -- $ -- $ --
Total commercial commitments $ 74.5 $ 74.5 $ -- $ -- $ --
On June 13, 2002, we entered into a letter of credit facility of $25
million with UPS Capital Global Trade Finance Corporation ("UPS"). Under this
facility, we may arrange for the issuance of letters of credit and acceptances.
The facility is a one-year facility subject to renewal on its anniversary, and
currently expires on December 31, 2004. The facility is collateralized by the
shares and debentures of all of our subsidiaries in Hong Kong, as well as our
permanent quota holdings in Hong Kong. In addition to the guarantees provided by
Tarrant Apparel Group and our subsidiaries, Fashion Resource (TCL) Inc. and
Tarrant Luxembourg Sarl, Gerard Guez, our Chairman, also signed a guarantee of
$5 million in favor of UPS to secure this facility. This facility bears interest
at 5.75% per annum at September 30, 2004. Under this facility, we are subject to
certain restrictive covenants,
22
including that we maintain a specified tangible net worth, fixed charge ratio,
and leverage ratio. In October, 2004, we established new financial covenants
with UPS for the fiscal year of 2004, which were effective retroactively to
September 30, 2004. Tangible net worth for the third and fourth quarters of 2004
were fixed at $20 million and $22 million, respectively. Capital expenditures
are capped at $700,000 per quarter. We also agreed to reduce the outstanding
balance under this facility to $22 million before the end of October 2004 and
$20 million before the end of December 2004. As of September 30, 2004 we were in
compliance with the new tangible net worth and capital expense covenants. As of
September 30, 2004, $24.6 million was outstanding under this facility with UPS,
and an additional $115,000 was available for future borrowings. In addition,
$303,000 of open letters of credit was outstanding as of September 30, 2004.
Since March 2003, DBS Bank (Hong Kong) Limited (formerly known as Dao
Heng Bank) has made available a letter of credit facility of up to HKD 20
million (equivalent to US $2.6 million) to our subsidiaries in Hong Kong. This
is a demand facility and is secured by the pledge of our office property, which
is owned by Gerard Guez, our Chairman and Todd Kay, our Vice Chairman, and by
our guarantee. The letter of credit facility was increased to HKD 30 million
(equivalent to US$3.9 million) in June 2004. As of September 30, 2004, $2.7
million was outstanding under this facility. In addition,$1.2 million of open
letters of credit was outstanding as of September 30, 2004. In December 2003, a
tax loan for HKD 2 million (equivalent to US $256,000) was also made available
to our Hong Kong subsidiaries. As of September 30, 2004, $66,000 was outstanding
under this loan.
We were previously party to a revolving credit, factoring and security
agreement (the "Debt Facility") with GMAC Commercial Credit, LLC. The Debt
Facility provided a revolving facility of $90 million, including a letter of
credit facility not to exceed $20 million, and was scheduled to mature on
January 31, 2005. The Debt Facility also provided a term loan of $25 million,
which was being repaid in monthly installments of $687,500. The amount we could
borrow under the Debt Facility was determined based on a defined borrowing base
formula related to eligible accounts receivable and inventories. The Debt
Facility provided for interest at LIBOR plus the LIBOR rate margin determined by
the Total Leverage Ratio (as defined in the Debt Facility agreements), and was
collateralized by our receivables, intangibles, inventory and various other
specified non-equipment assets. Under the facility, we were subject to various
financial covenants on tangible net worth, interest coverage, fixed charge ratio
and leverage ratio, and were prohibited from paying dividends. In May 2004, the
maximum facility amount was reduced to $45 million in total and we established
new financial covenants with GMAC for the fiscal year of 2004. As of September
30, 2004, we were in violation of tangible net worth, fixed charge ratio, and
leverage ratio covenants and a waiver was obtained. A total of $16.3 million was
outstanding under the Debt Facility at September 30, 2004. Based on the
borrowing base formula, no additional amounts were available for borrowing under
the Debt Facility at September 30, 2004.
Effective as of September 29, 2004, we entered into a new three-year
factoring facility with GMAC to replace our existing Debt Facility. The revised
facility, with maximum borrowing of $45 million, is a factoring facility of all
eligible account receivables covering all U.S. operating subsidiaries and
without any inventory advances. This facility bears interest at 6% per annum at
September 30, 2004. Restrictive covenants under the revised facility include a
limit on quarterly capital expenses of $800,000 and tangible net worth of $20
million at September 30, 2004, $22 million at December 31, 2004 and March 31,
2005 and $25 million at the end of each fiscal quarter thereafter beginning on
June 30, 2005. A total of $16.3 million was outstanding under the GMAC facility
at September 30, 2004.
The credit facility with GMAC and the credit facility with UPS carry
cross-default clauses. A breach of a financial covenant set by GMAC or UPS
constitutes an event of default under the other credit facility, entitling both
financial institutions to demand payment in full of all outstanding amounts
under their respective debt and credit facilities.
The amount we can borrow under the new credit facility with GMAC is
determined based on a defined borrowing base formula related to eligible
accounts receivable. A significant decrease in eligible accounts receivable due
to the aging of receivables, can have an adverse effect on our borrowing
capabilities under our credit facility, which may adversely affect the adequacy
of our working capital. In addition, we have typically experienced seasonal
fluctuations in sales volume. These seasonal fluctuations result in sales volume
decreases in the first and fourth quarters of each year due to the seasonal
fluctuations experienced by the majority of our customers. During
23
these quarters, borrowing availability under our credit facility may decrease as
a result of decrease in eligible accounts receivables generated from our sales.
Tarrant Mexico S. de R.L. de C.V., Famian division was indebted to
Banco Nacional de Comercio Exterior SNC pursuant to a credit facility assumed by
Tarrant Mexico following its merger with Grupo Famian. We paid off this loan in
the third quarter of 2004.
We had an equipment loan with an initial borrowing of $16.25 million
from GE Capital Leasing ("GE Capital"), which was scheduled to mature in
November 2005. The loan was secured by equipment located in Puebla and Tlaxcala,
Mexico. Interest accrued at a rate of 2.5% over LIBOR. Under this facility, we
were subject to covenants on tangible net worth of $30 million, leverage ratio
of not more than two times at the end of each financial year, and no losses for
two consecutive quarters. We paid off this loan in the third quarter of 2004.
During 2000, we financed equipment purchases for a manufacturing
facility with certain vendors. A total of $16.9 million was financed with
five-year promissory notes, which bear interest ranging from 7.0% to 7.5%, and
are payable in semiannual payments commencing in February 2000. Of this amount,
$198,000 was outstanding as of September 30, 2004. All of the $198,000 was
payable in U.S. dollars.
From time to time, we open letters of credit under an uncommitted line
of credit from Aurora Capital Associates, which issues these letters of credit
out of Israeli Discount Bank. As of September 30, 2004, $294,000 was outstanding
under this facility and $1.4 million of letters of credit was open under this
arrangement.
We have financed our operations from our cash flow from operations,
borrowings under our bank and other credit facilities, issuance of long-term
debt (including debt to or arranged by vendors of equipment purchased for our
Mexican twill and production facility), the proceeds from the exercise of stock
options and from time to time shareholder advances. Our short-term funding
relies very heavily on our major customers, banks, suppliers and major
shareholders. From time to time, we have had temporary over-advances from our
banks. Any withdrawal of support from these parties will have serious
consequences on our liquidity.
From time to time in the past, we borrowed funds from, and advanced
funds to, certain officers and principal shareholders, including Gerard Guez,
our Chairman. The greatest outstanding balance of such advances to Mr. Guez in
the third quarter of 2004 was approximately $4,782,000. Mr. Guez had an
outstanding advance from us in the amount of $4,776,000 as of September 30,
2004. All advances to Mr. Guez bore interest at the rate of 7.75% during the
period. Since the enactment of the Sarbanes-Oxley Act in 2002, no further
personal loans (or amendments to existing loans) have been or will be made to
officers or directors of Tarrant.
We intend to accumulate a cash reserve to meet any payment obligations
we have to taxing authorities relating to the Internal Revenue Services'
examination of our Federal income tax returns for the years ended December 31,
1996 through 2001. We intend to fund this cash reserve from operations, which
will require us to set aside on a periodic basis a significant amount of our
cash, which cannot be used for other purposes. In January 2004, the Internal
Revenue Service completed its examination of our Federal income tax returns for
the years ended December 31, 1996 through 2001. The IRS has proposed adjustments
to increase our income tax payable for the six years under examination by an
aggregate of approximately $14.5 million. This adjustment would also result in
additional state taxes and interest of approximately $12.6 million. We believe
that we have meritorious defenses to and intend to vigorously contest the
proposed adjustments. If the proposed adjustments are upheld through the
administrative and legal process, they could have a material impact on our
earnings and cash flow. We believe we have provided adequate reserves for any
reasonably foreseeable outcome related to these matters on the balance sheet
included in the Consolidated Financial Statements under the caption "Income
Taxes". We do not believe that the adjustments, if any, arising from the IRS
examination, will result in an additional income tax liability beyond what is
recorded in the accompanying balance sheet.
We may seek to finance future capital investment programs through
various methods, including, but not limited to, borrowings under our bank credit
facilities, issuance of long-term debt, sales of equity securities, leases and
long-term financing provided by the sellers of facilities or the suppliers of
certain equipment used in such facilities. To date, there is no plan for any
major capital expenditure.
24
We do not believe that the moderate levels of inflation in the United
States in the last three years have had a significant effect on net sales or
profitability.
RELATED PARTY TRANSACTIONS
We lease our principal offices and warehouse located in Los Angeles,
California and office space in Hong Kong from corporations owned by Gerard Guez,
our Chairman, and Todd Kay, our Vice Chairman of the Board of Directors. We
believe, at the time the leases were entered into, the rents on these properties
were comparable to then prevailing market rents. During the nine months ended
September 30, 2004, we paid $997,000 in rent for these office and warehouse
facilities. We currently lease both facilities on a month-to-month basis.
In February 2004, our Hong Kong subsidiary entered into a 50/50 joint
venture with Auto Enterprises Limited, an unrelated third party, to source
products for Seven Licensing Company, LLC in mainland China. On May 31, 2004,
after realizing an accumulated loss from the venture of approximately $200,000
(our share being half), we sold our interest for $1 to Asia Trading Limited, a
company owned by Jacqueline Rose, wife of Gerard Guez.
On October 16, 2003, we leased to affiliates of Mr. Kamel Nacif, one of
our shareholders, for a substantial portion of our manufacturing facilities and
operations in Mexico including real estate and equipment. We leased our twill
mill in Tlaxcala, Mexico, and our sewing plant in Ajalpan, Mexico, for a period
of 6 years and for an annual rental fee of $11 million. In connection with this
lease transaction, we also entered into a management services agreement pursuant
to which Mr. Nacif's affiliates will manage the operation of our remaining
facilities in Mexico in exchange for the use of such facilities. The term of the
management services agreement is also for a period of 6 years. In the three
months and nine months ended September 30, 2004, $0 and $5.5 million, of lease
income was recorded in other income, respectively. We have agreed to purchase
annually, six million yards of fabric manufactured at the facilities leased
and/or operated by Mr. Nacif's affiliates at market prices to be negotiated.
Based on current market price, the purchase commitment would be approximately
$19 million annually. We must pay $1 for each yard of fabric that we fail to
purchase under the agreement. We purchased $1.1 million and $5.3 million of
fabric, respectively, under this agreement, in the three months and nine months
ended September 30, 2004. Net amount due from Mr. Kamel Nacif and his affiliates
was $410,000 as of September 30, 2004
In August 2004, we entered into a purchase and sale agreement to sell
to Mr. Nacif's affiliates, substantially all of our assets and real property in
Mexico, including the equipment and facilities we currently lease to Mr. Nacif's
affiliates. Upon consummation of this purchase and sale transaction, we will
enter into a purchase commitment agreement with Mr. Nacif's affiliates, pursuant
to which we will agree to purchase annually over the ten year term of the
agreement, $5 million of fabric manufactured at the facilities acquired by Mr.
Nacif's affiliates at negotiated market prices. This agreement will replace our
existing purchase commitment agreement with Mr. Nacif's affiliates. Pending
consummation of the transaction, Mr. Nacif's affiliates have agreed to suspend
our fabric purchase obligations under the existing purchase commitment, and we
have agreed to suspend the affiliates of Mr. Nacif's lease payment obligations
under the lease agreements pursuant to which Mr. Nacif's affiliates presently
operate our manufacturing facilities in Mexico. Consummation of the purchase and
sale transaction is subject to customary closing conditions, including, without
limitation, approval of the transaction by the Mexican antitrust authorities.
While we anticipate that the transaction will be consummated in the fourth
quarter of 2004, there can be no assurance that the transaction will be
consummated in 2004. See Note 6 of the "Notes to Consolidated Financial
Statements".
From time to time in the past, we borrowed funds from, and advanced
funds to, certain officers and principal shareholders, including Gerard Guez,
our Chairman. The greatest outstanding balance of such advances to Mr. Guez in
the third quarter of 2004 was approximately $4,782,000. Mr. Guez had an
outstanding advance from us in the amount of $4,776,000 as of September 30,
2004. All advances to, and borrowings from, Mr. Guez bore interest at the rate
of 7.75% during the period. Since the enactment of the Sarbanes-Oxley Act in
2002, no further personal loans (or amendments to existing loans) have been or
will be made to officers or directors of Tarrant.
Since June 2003, United Apparel Venture LLC, a majority owned,
controlled and consolidated subsidiary of Tarrant, has been selling to Seven
Licensing Company, LLC, jeans wear bearing the brand "Seven7", which is
ultimately purchased by Express. Seven Licensing is beneficially owned by our
Chairman. Total sales in the three months and nine months ended September 30,
2004 was $42,000 and $3.3 million, respectively.
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On July 1, 2001, we formed an entity to jointly market, share certain
risks and achieve economies of scale with Azteca Production International, Inc.
("Azteca"), called United Apparel Ventures, LLC ("UAV"). Azteca Production
International, Inc. is owned by Hubert Guez, the brother of Gerard Guez, our
Chairman and Chief Executive Officer. This entity was created to coordinate the
production of apparel for a single customer of our branded business. UAV is
owned 50.1% by Tag Mex, Inc., a wholly owned subsidiary of ours, and 49.9% by
Azteca. Results of the operation of UAV have been consolidated into our results
since July 2001 with the minority partner's share of all gains and loses
eliminated through the minority interest line in our financial statements. Since
October 2002 and March 2003, UAV has serviced both parties' business with
Express and Levi Strauss & Co., respectively. UAV makes purchases from two
related parties in Mexico, Azteca and Tag-It Pacific, Inc. Azteca is owned by
the brothers of our Chairman, Gerard Guez, and is the minority member of our
subsidiary, United Apparel Ventures, LLC. We purchased finished goods and
services from Azteca $2.0 million and $7.5 million, respectively, in the three
months and nine months ended September 30, 2004. Our total sales of fabric and
services to Azteca in the three months and nine months ended September 30, 2004
were $0 and $1.0 million, respectively. Additionally, UAV paid two and one half
percent of its gross sales as management fees to each of the members of UAV. The
amount paid by UAV to Azteca, totaled $0 and $175,000 in the three months and
nine months ended September 30, 2004, respectively.
At September 30, 2004, Messrs. Guez and Kay beneficially owned 967,000
and 1,005,000 shares, respectively, of common stock of Tag-It Pacific, Inc.
("Tag-It"), collectively representing 10.9% of Tag-It Pacific's common stock at
September 30, 2004. Tag-It is a provider of brand identity programs to
manufacturers and retailers of apparel and accessories. Tag-It assumed the
responsibility for managing and sourcing all trim and packaging used in
connection with products manufactured by or on our behalf in Mexico. This
arrangement is terminable by either Tag-It or us at any time. We believe that
the terms of this arrangement, which is subject to the acceptance of our
customers, are no less favorable to us than could be obtained from unaffiliated
third parties. We purchased $465,000 and $1.2 million of trim from Tag-It in the
three and nine months ended September 30, 2004, respectively. From time to time
we have guaranteed the indebtedness of Tag-It for the purchase of trim on our
behalf. See Note 7 of the "Notes to Consolidated Financial Statements."
We have adopted a policy that any future transactions between us and
any of our affiliates or related parties, including our executive officers,
directors, the family members of those individuals and any of their affiliates,
must (i) be approved by a majority of the members of the Board of Directors and
by a majority of the disinterested members of the Board of Directors and (ii) be
on terms no less favorable to us than could be obtained from unaffiliated third
parties.
FACTORS THAT MAY AFFECT FUTURE RESULTS
This Quarterly Report on Form 10-Q contains forward-looking statements,
which are subject to a variety of risks and uncertainties. Our actual results
could differ materially from those anticipated in these forward-looking
statements as a result of various factors, including those set forth below.
RISKS RELATED TO OUR BUSINESS
WE DEPEND ON A GROUP OF KEY CUSTOMERS FOR A SIGNIFICANT PORTION OF OUR SALES. A
SIGNIFICANT ADVERSE CHANGE IN A CUSTOMER RELATIONSHIP OR IN A CUSTOMER'S
FINANCIAL POSITION COULD HARM OUR BUSINESS AND FINANCIAL CONDITION.
Affiliated stores owned by The Limited (including Limited Stores and
Express) accounted for approximately 5.4% and 13.5% of our net sales for the
first nine months of 2004 and 2003, respectively. Lerner New York accounted for
13.0% and 7.2% of our net sales for the first nine months of 2004 and 2003,
respectively. Kohl's accounted for 16.6% and 6.1% of our net sales for the first
nine months of 2004 and 2003, respectively. Mervyn's accounted for 16.5% and
6.3% of our net sales for the first nine months of 2004 and 2003, respectively.
We believe that consolidation in the retail industry has centralized purchasing
decisions and given customers greater leverage over suppliers like us, and we
expect this trend to continue. If this consolidation continues, our net sales
and results of operations may be increasingly sensitive to deterioration in the
financial condition of, or other adverse developments with, one or more of our
customers.
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While we have long-standing customer relationships, we generally do not
have long-term contracts with any of them. Purchases generally occur on an
order-by-order basis, and relationships exist as long as there is a perceived
benefit to both parties. A decision by a major customer, whether motivated by
competitive considerations, financial difficulties, and economic conditions or
otherwise, to decrease its purchases from us or to change its manner of doing
business with us, could adversely affect our business and financial condition.
In addition, during recent years, various retailers, including some of our
customers, have experienced significant changes and difficulties, including
consolidation of ownership, increased centralization of purchasing decisions,
restructurings, bankruptcies and liquidations.
These and other financial problems of some of our retailers, as well as
general weakness in the retail environment, increase the risk of extending
credit to these retailers. A significant adverse change in a customer
relationship or in a customer's financial position could cause us to limit or
discontinue business with that customer, require us to assume more credit risk
relating to that customer's receivables, limit our ability to collect amounts
related to previous purchases by that customer, or result in required prepayment
of our receivables securitization arrangements, all of which could harm our
business and financial condition.
FAILURE OF THE TRANSPORTATION INFRASTRUCTURE TO MOVE SEA FREIGHT IN ACCEPTABLE
TIME FRAMES COULD ADVERSELY AFFECT OUR BUSINESS.
Because the bulk of our freight is designed to move through the West
Coast ports in predictable time frames, we are at risk of cancellations and
penalties when those ports operate inefficiently creating delays in delivery. We
have experienced such delays for the past few months, and we may continue to
experience delays. There can be no assurances of, and we have no control over, a
return to timely deliveries. Unpredictable timing for shipping may cause us to
utilize air freight or may result in customer penalties for late delivery, any
of which could reduce our operating margins and adversely effect our results of
operations.
FAILURE TO MANAGE OUR GROWTH AND EXPANSION COULD IMPAIR OUR BUSINESS.
Since our inception, we have experienced periods of rapid growth. No
assurance can be given that we will be successful in maintaining or increasing
our sales in the future. Any future growth in sales will require additional
working capital and may place a significant strain on our management, management
information systems, inventory management, sourcing capability, distribution
facilities and receivables management. Any disruption in our order processing,
sourcing or distribution systems could cause orders to be shipped late, and
under industry practices, retailers generally can cancel orders or refuse to
accept goods due to late shipment. Such cancellations and returns would result
in a reduction in revenue, increased administrative and shipping costs and a
further burden on our distribution facilities.
FAILURE TO MANAGE OUR RESTRUCTURING IN MEXICO COULD IMPAIR OUR BUSINESS.
We have determined to cease directly operating a substantial majority
of our equipment and fixed assets in Mexico, and to lease a large portion of our
facilities and operations in Mexico to a related third party, which we
consummated effective September 1, 2003. Subsequently, in August 2004, we
entered into a purchase and sale agreement to sell substantially all of our
assets and real property in Mexico, including the equipment and facilities
previously leased to Mr. Nacif's affiliates, which transaction we expect to be
consummated in the fourth quarter of 2004. As a consequence, we have become
primarily a trading company, relying on third party manufacturers to produce the
merchandise we sell to our customers. We face many challenges related to our
decision to cease directly operating a substantial majority of our equipment and
fixed assets in Mexico. Any failure on our part to successfully manage these
challenges, or other unanticipated consequences may result in loss of customers
and sales, which would have an adverse impact on operations. The challenges we
face include:
o We may lose customers who desire to purchase merchandise
directly from the manufacturer;
o We may experience unanticipated expenses in winding down
manufacturing operations in Mexico, including labor costs and
additional write down of inventory, which may adversely affect
our results of operations in the short term;
27
o The party to whom we lease or sell our manufacturing
operations in Mexico may default in its obligations to us, in
which case we may not be able to lease or sell the facilities
to another party, or recommence use of the facilities to
manufacture goods without significant cost; and
o We may not be able to transfer Mexico sales to our trading
model in time to replace direct to manufacturer orders we have
experienced in the past due, for instance, to difficulty in
finding third party manufacturers, and capital constraints.
OUR OPERATING RESULTS MAY FLUCTUATE SIGNIFICANTLY.
We have experienced, and expect to continue to experience, substantial
variations in our net sales and operating results from quarter to quarter. We
believe that the factors which influence this variability of quarterly results
include the timing of our introduction of new product lines, the level of
consumer acceptance of each new product line, general economic and industry
conditions that affect consumer spending and retailer purchasing, the
availability of manufacturing capacity, the seasonality of the markets in which
we participate, the timing of trade shows, the product mix of customer orders,
the timing of the placement or cancellation of customer orders, the weather,
transportation delays, quotas, the occurrence of charge backs in excess of
reserves and the timing of expenditures in anticipation of increased sales and
actions of competitors. Due to fluctuations in our revenue and operating
expenses, we believe that period-to-period comparisons of our results of
operations are not a good indication of our future performance. It is possible
that in some future quarter or quarters, our operating results will be below the
expectations of securities analysts or investors. In that case, our stock price
could fluctuate significantly or decline.
INCREASES IN THE PRICE OF RAW MATERIALS OR THEIR REDUCED AVAILABILITY COULD
INCREASE OUR COST OF SALES AND DECREASE OUR PROFITABILITY.
The principal raw material used in our apparel is cotton. The price and
availability of cotton may fluctuate significantly, depending on a variety of
factors, including crop yields, weather, supply conditions, government
regulation, economic climate and other unpredictable factors. Any raw material
price increases could increase our cost of sales and decrease our profitability
unless we are able to pass higher prices on to our customers. Moreover, any
decrease in the availability of cotton could impair our ability to meet our
production requirements in a timely manner.
THE SUCCESS OF OUR BUSINESS DEPENDS UPON OUR ABILITY TO OFFER INNOVATIVE AND
UPGRADED PRODUCTS.
The apparel industry is characterized by constant product innovation
due to changing consumer preferences and by the rapid replication of new
products by competitors. As a result, our success depends in large part on our
ability to continuously develop, market and deliver innovative products at a
pace and intensity competitive with other manufacturers in our segments. In
addition, we must create products that appeal to multiple consumer segments at a
range of price points. Any failure on our part to regularly develop innovative
products and update core products could:
o limit our ability to differentiate, segment and price our
products;
o adversely affect retail and consumer acceptance of our
products; and
o limit sales potential.
The increasing importance of product innovation in apparel requires us
to strengthen our internal research and commercialization capabilities, to rely
on successful commercial relationships with third parties such as fiber, fabric
and finishing providers and to compete and negotiate effectively for new
technologies and product components.
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THE FINANCIAL CONDITION OF OUR CUSTOMERS COULD AFFECT OUR RESULTS OF OPERATIONS.
Certain retailers, including some of our customers, have experienced in
the past, and may experience in the future, financial difficulties, which
increase the risk of extending credit to such retailers and the risk that
financial failure will eliminate a customer entirely. These retailers have
attempted to improve their own operating efficiencies by concentrating their
purchasing power among a narrowing group of vendors. There can be no assurance
that we will remain a preferred vendor for our existing customers. A decrease in
business from or loss of a major customer could have a material adverse effect
on our results of operations. There can be no assurance that our factor will
approve the extension of credit to certain retail customers in the future. If a
customer's credit is not approved by the factor, we could assume the collection
risk on sales to the customer itself, require that the customer provide a letter
of credit, or choose not to make sales to the customer.
THE SUCCESS OF OUR BUSINESS DEPENDS ON OUR ABILITY TO ATTRACT AND RETAIN
QUALIFIED EMPLOYEES.
We need talented and experienced personnel in a number of areas
including our core business activities. Our success is dependent upon
strengthening our management depth across our business at a rapid pace. An
inability to retain and attract qualified personnel or the loss of any of our
current key executives could harm our business. Our ability to attract and
retain qualified employees is adversely affected by the Los Angeles location of
our corporate headquarters due to the high cost of living in the Los Angeles
area.
WE DEPEND ON OUR COMPUTER AND COMMUNICATIONS SYSTEMS.
As a multi-national corporation, we rely on our computer and
communication network to operate efficiently. Any interruption of this service
from power loss, telecommunications failure, weather, natural disasters or any
similar event could have a material adverse affect on our business and
operations. Additionally, hackers and computer viruses have disrupted operations
at many major companies. We may be vulnerable to similar acts of sabotage, which
could have a material adverse effect on our business and operations.
WE MAY REQUIRE ADDITIONAL CAPITAL IN THE FUTURE.
We may not be able to fund our future growth or react to competitive
pressures if we lack sufficient funds. Currently, we believe we have sufficient
cash on hand and cash available through our bank credit facilities, issuance of
long-term debt, proceeds from loans from affiliates, and proceeds from the
exercise of stock options to fund existing operations for the foreseeable
future. However, in the future we may need to raise additional funds through
equity or debt financings or collaborative relationships. This additional
funding may not be available or, if available, it may not be available on
economically reasonable terms. In addition, any additional funding may result in
significant dilution to existing shareholders. If adequate funds are not
available, we may be required to curtail our operations or obtain funds through
collaborative partners that may require us to release material rights to our
products.
OUR BUSINESS IS SUBJECT TO RISKS ASSOCIATED WITH IMPORTING PRODUCTS.
Substantially all of our import operations are subject to tariffs
imposed on imported products and quotas imposed by trade agreements. In
addition, the countries in which our products are manufactured or imported may
from time to time impose additional new quotas, duties, tariffs or other
restrictions on our imports or adversely modify existing restrictions. Adverse
changes in these import costs and restrictions, or our suppliers' failure to
comply with customs or similar laws, could harm our business. We cannot assure
that future trade agreements will not provide our competitors with an advantage
over us, or increase our costs, either of which could have an adverse effect on
our business and financial condition.
Our operations are also subject to the effects of international trade
agreements and regulations such as the North American Free Trade Agreement, and
the activities and regulations of the World Trade Organization. Generally, these
trade agreements benefit our business by reducing or eliminating the duties
and/or quotas assessed on products manufactured in a particular country.
However, trade agreements can also impose requirements that adversely affect our
business, such as limiting the countries from which we can purchase raw
materials and setting
29
quotas on products that may be imported into the United States from a particular
country. In addition, the World Trade Organization may commence a new round of
trade negotiations that liberalize textile trade by further eliminating quotas
or reducing tariffs. The elimination of quotas on World Trade Organization
member countries by 2005 and other effects of these trade agreements could
result in increased competition from developing countries, which historically
have lower labor costs, including China and Taiwan, both of which recently
became members of the World Trade Organization. This potential increase in
competition from developing countries is one of the several reasons why we have
determined to lease our manufacturing operations in Mexico.
Our ability to import products in a timely and cost-effective manner
may also be affected by problems at ports or issues that otherwise affect
transportation and warehousing providers, such as labor disputes. These problems
could require us to locate alternative ports or warehousing providers to avoid
disruption to our customers. These alternatives may not be available on short
notice or could result in higher transit costs, which could have an adverse
impact on our business and financial condition.
OUR DEPENDENCE ON INDEPENDENT MANUFACTURERS REDUCES OUR ABILITY TO CONTROL THE
MANUFACTURING PROCESS, WHICH COULD HARM OUR SALES, REPUTATION AND OVERALL
PROFITABILITY.
We depend on independent contract manufacturers to secure a sufficient
supply of raw materials and maintain sufficient manufacturing and shipping
capacity in an environment characterized by declining prices, labor shortage,
continuing cost pressure and increased demands for product innovation and
speed-to-market. This dependence could subject us to difficulty in obtaining
timely delivery of products of acceptable quality. In addition, a contractor's
failure to ship products to us in a timely manner or to meet the required
quality standards could cause us to miss the delivery date requirements of our
customers. The failure to make timely deliveries may cause our customers to
cancel orders, refuse to accept deliveries, impose non-compliance charges
through invoice deductions or other charge-backs, demand reduced prices or
reduce future orders, any of which could harm our sales, reputation and overall
profitability. We do not have material long-term contracts with any of our
independent contractors and any of these contractors may unilaterally terminate
their relationship with us at any time. To the extent we are not able to secure
or maintain relationships with independent contractors that are able to fulfill
our requirements, our business would be harmed.
We have initiated a factory compliance agreement with our suppliers,
and monitor our independent contractors' compliance with applicable labor laws,
but we do not control our contractors or their labor practices. The violation of
federal, state or foreign labor laws by one of the our contractors could result
in our being subject to fines and our goods that are manufactured in violation
of such laws being seized or their sale in interstate commerce being prohibited.
From time to time, we have been notified by federal, state or foreign
authorities that certain of our contractors are the subject of investigations or
have been found to have violated applicable labor laws. To date, we have not
been subject to any sanctions that, individually or in the aggregate, have had a
material adverse effect on our business, and we are not aware of any facts on
which any such sanctions could be based. There can be no assurance, however,
that in the future we will not be subject to sanctions as a result of violations
of applicable labor laws by our contractors, or that such sanctions will not
have a material adverse effect on our business and results of operations. In
addition, certain of our customers, including The Limited, require strict
compliance by their apparel manufacturers, including us, with applicable labor
laws and visit our facilities often. There can be no assurance that the
violation of applicable labor laws by one of our contractors will not have a
material adverse effect on our relationship with our customers.
OUR BUSINESS IS SUBJECT TO RISKS OF OPERATING IN A FOREIGN COUNTRY AND TRADE
RESTRICTIONS.
Approximately 92% of our products were imported from outside the U.S.
in the third quarter of 2004, and most of our fixed assets are located in
Mexico. We are subject to the risks associated with doing business and owning
fixed assets in foreign countries, including, but not limited to, transportation
delays and interruptions, political instability, expropriation, currency
fluctuations and the imposition of tariffs, import and export controls, other
non-tariff barriers (including changes in the allocation of quotas) and cultural
issues. Any changes in those countries' labor laws and government regulations
may have a negative effect on our profitability.
30
WE CANNOT GUARANTEE THAT OUR FUTURE ACQUISITIONS WILL BE SUCCESSFUL.
In the future, we may seek to continue our growth through acquisition.
We compete for acquisition and expansion opportunities with companies which have
significantly greater financial and management resources than us. There can be
no assurance that suitable acquisition or investment opportunities will be
identified, that any of these transactions can be consummated, or that, if
acquired, these new businesses can be integrated successfully and profitably
into our operations. These acquisitions and investments may also require a
significant allocation of resources, which will reduce our ability to focus on
the other portions of our business, including many of the factors listed in the
prior risk factor.
RISK ASSOCIATED WITH OUR INDUSTRY
OUR SALES ARE HEAVILY INFLUENCED BY GENERAL ECONOMIC CYCLES.
Apparel is a cyclical industry that is heavily dependent upon the
overall level of consumer spending. Purchases of apparel and related goods tend
to be highly correlated with cycles in the disposable income of our consumers.
Our customers anticipate and respond to adverse changes in economic conditions
and uncertainty by reducing inventories and canceling orders. As a result, any
substantial deterioration in general economic conditions, increases in interest
rates, acts of war, terrorist or political events that diminish consumer
spending and confidence in any of the regions in which we compete, could reduce
our sales and adversely affect our business and financial condition. This has
been underscored by the events of September 11, 2001 and the war in the Middle
East.
OUR BUSINESS IS HIGHLY COMPETITIVE AND DEPENDS ON CONSUMER SPENDING PATTERNS.
The apparel industry is highly competitive. We face a variety of
competitive challenges including:
o anticipating and quickly responding to changing consumer
demands;
o developing innovative, high-quality products in sizes, colors
and styles that appeal to consumers of varying age groups and
tastes;
o competitively pricing our products and achieving customer
perception of value; and
o providing strong and effective marketing support.
WE MUST SUCCESSFULLY GAUGE FASHION TRENDS AND CHANGING CONSUMER PREFERENCES TO
SUCCEED.
Our success is largely dependent upon our ability to gauge the fashion
tastes of our customers and to provide merchandise that satisfies retail and
customer demand in a timely manner. The apparel business fluctuates according to
changes in consumer preferences dictated in part by fashion and season. To the
extent, we misjudge the market for our merchandise, our sales may be adversely
affected. Our ability to anticipate and effectively respond to changing fashion
trends depends in part on our ability to attract and retain key personnel in our
design, merchandising and marketing staff. Competition for these personnel is
intense, and we cannot be sure that we will be able to attract and retain a
sufficient number of qualified personnel in future periods.
OUR BUSINESS IS SUBJECT TO SEASONAL TRENDS.
Historically, our operating results have been subject to seasonal
trends when measured on a quarterly basis. This trend is dependent on numerous
factors, including the markets in which we operate, holiday seasons, consumer
demand, climate, economic conditions and numerous other factors beyond our
control. There can be no assurance that our historic operating patterns will
continue in future periods as we cannot influence or forecast many of these
factors.
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OTHER RISKS RELATED TO AN INVESTMENT IN OUR COMMON STOCK
THE ULTIMATE RESOLUTION OF THE INTERNAL REVENUE SERVICE'S EXAMINATION OF OUR TAX
RETURNS MAY REQUIRE US TO INCUR AN EXPENSE BEYOND WHAT HAS BEEN RESERVED FOR ON
OUR BALANCE SHEET OR MAKE CASH PAYMENTS BEYOND WHAT WE ARE THEN ABLE TO PAY.
In January 2004, the Internal Revenue Service proposed adjustments to
increase our federal income tax payable for the years ended December 31, 1996
through 2001 by an aggregate of approximately $14.5 million. This adjustment
would also result in additional state taxes, penalties and interest of
approximately $12.6 million. If the proposed adjustments are upheld through the
administrative and legal process, they could have a material impact on our
earnings and cash flow. We believe we have provided adequate reserves for any
reasonably foreseeable outcome related to these matters on the balance sheet
included in the Consolidated Financial Statements. If the amount of any actual
liability, however, exceeds our reserves, we would experience an immediate
adverse earnings impact in the amount of such additional liability, which could
be material. Additionally, we anticipate that the ultimate resolution of these
matters will require that we make significant cash payments to the taxing
authorities. Presently we do not have sufficient cash or borrowing ability to
make any future payments that may be required. While we intend to accumulate a
cash reserve to meet this cash outflow contingency from operations, no assurance
can be given that we will have sufficient surplus cash from operations to build
and maintain this reserve by the time such payments are required. Additionally,
cash used to build this reserve will not be available for other corporate
purposes, which could have a material adverse effect on our financial condition
and results of operations.
WE MAY NOT BE ABLE TO MAINTAIN OUR LISTING ON THE NASDAQ NATIONAL MARKET AND IF
WE FAIL TO DO SO, THE PRICE AND LIQUIDITY OF OUR COMMON STOCK MAY DECLINE.
The Nasdaq Stock Market has quantitative maintenance criteria for the
continued listing of common stock on the Nasdaq National Market. The
requirements currently affecting us include (i) maintaining a minimum closing
bid price per share of $1.00 and (ii) having a majority of our directors qualify
as "independent directors" under the Nasdaq rules. On October 19, 2004, the
Nasdaq Stock Market Inc. issued a letter to us stating that we were not in
compliance with the minimum closing bid price requirement and, therefore, faced
delisting proceedings. On October 21, 2004, the Nasdaq Stock Market notified us
that, as a result of the recent resignation of one of our directors, we were not
in compliance with the requirement that a majority of the directors be
independent. As of November 12, 2004, our closing bid price had remained above
$1.00 for ten consecutive trading days, meaning we have regained compliance with
the minimum bid price rule. We have until the we have until the earlier of our
next shareholder meeting or October 15, 2005 to regain compliance with the
independent director rule, and we are actively seeking a new independent
director to join our board of directors Nevertheless, there can be no assurance
that we will be able to comply with the maintenance criteria or any of the
Nasdaq National Market's listing requirements or other rules, or other markets
listing requirements to the extent our stock is listed elsewhere, in the future.
If we fail to maintain continued listing on the Nasdaq National Market and must
move to a market with less liquidity, our financial condition could be harmed
and our stock price would likely further decline. If we are delisted, it could
have a material adverse effect on the market price of, and the liquidity of the
trading market for, our common stock.
INSIDERS OWN A SIGNIFICANT PORTION OF OUR COMMON STOCK, WHICH COULD LIMIT OUR
SHAREHOLDERS' ABILITY TO INFLUENCE THE OUTCOME OF KEY TRANSACTIONS.
As of September 30, 2004, our executive officers and directors and
their affiliates owned approximately 29.1% of the outstanding shares of our
common stock. Gerard Guez, our Chairman, and Todd Kay, our Vice Chairman, alone
own approximately 19.6% and 8.9%, respectively, of the outstanding shares of our
common stock at September 30, 2004. Accordingly, our executive officers and
directors have the ability to affect the outcome of, or exert considerable
influence over, all matters requiring shareholder approval, including the
election and removal of directors and any change in control. This concentration
of ownership of our common stock could have the effect of delaying or preventing
a change of control of us or otherwise discouraging or preventing a potential
acquirer from attempting to obtain control of us. This, in turn, could have a
negative effect on the market price of our common stock. It could also prevent
our shareholders from realizing a premium over the market prices for their
shares of common stock.
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WE HAVE ADOPTED A NUMBER OF ANTI-TAKEOVER MEASURES THAT MAY DEPRESS THE PRICE OF
OUR COMMON STOCK.
Our shareholders rights plan, our ability to issue additional shares of
preferred stock and some provisions of our articles of incorporation and bylaws
could make it more difficult for a third party to make an unsolicited takeover
attempt of us. These anti-takeover measures may depress the price of our common
stock by making it more difficult for third parties to acquire us by offering to
purchase shares of our stock at a premium to its market price without approval
of our board of directors.
OUR STOCK PRICE HAS BEEN VOLATILE.
Our common stock is quoted on the NASDAQ National Market System, and
there can be substantial volatility in the market price of our common stock. The
market price of our common stock has been, and is likely to continue to be,
subject to significant fluctuations due to a variety of factors, including
quarterly variations in operating results, operating results which vary from the
expectations of securities analysts and investors, changes in financial
estimates, changes in market valuations of competitors, announcements by us or
our competitors of a material nature, loss of one or more customers, additions
or departures of key personnel, future sales of common stock and stock market
price and volume fluctuations. In addition, general political and economic
conditions such as a recession, or interest rate or currency rate fluctuations
may adversely affect the market price of our common stock.
In addition, the stock market in general has experienced extreme price
and volume fluctuations that have affected the market price of our common stock.
Often, price fluctuations are unrelated to operating performance of the specific
companies whose stock is affected. In the past, following periods of volatility
in the market price of a company's stock, securities class action litigation has
occurred against the issuing company. If we were subject to this type of
litigation in the future, we could incur substantial costs and a diversion of
our management's attention and resources, each of which could have a material
adverse effect on our revenue and earnings. Any adverse determination in this
type of litigation could also subject us to significant liabilities.
ABSENCE OF DIVIDENDS COULD REDUCE OUR ATTRACTIVENESS TO YOU.
Some investors favor companies that pay dividends, particularly in
general downturns in the stock market. We have not declared or paid any cash
dividends on our common stock. We currently intend to retain any future earnings
for funding growth, and we do not currently anticipate paying cash dividends on
our common stock in the foreseeable future. Additionally, we cannot pay
dividends on our common stock unless the terms of our bank credit facilities and
outstanding preferred stock, if any, permit the payment of dividends on our
common stock. Because we may not pay dividends, your return on this investment
likely depends on your selling our stock at a profit.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
FOREIGN CURRENCY RISK. Our earnings are affected by fluctuations in the
value of the U.S. dollar as compared to foreign currencies as a result of doing
business in Mexico as well as certain debt denominated in the Euro. As a result,
we bear the risk of exchange rate gains and losses that may result in the future
as a result of this financing. At times we use forward exchange contracts to
reduce the effect of fluctuations of foreign currencies on purchases and
commitments. These short-term assets and commitments are principally related to
trade payables positions and fixed asset purchase obligations. We do not utilize
derivative financial instruments for trading or other speculative purposes. We
actively evaluate the creditworthiness of the financial institutions that are
counter parties to derivative financial instruments, and we do not expect any
counter parties to fail to meet their obligations.
INTEREST RATE RISK. Because our obligations under our various credit
agreements bear interest at floating rates (primarily LIBOR rates), we are
sensitive to changes in prevailing interest rates. Any major increase or
decrease in market interest rates that affect our financial instruments would
have a material impact on earning or cash flows during the next fiscal year.
Our interest expense is sensitive to changes in the general level of
U.S. interest rates. In this regard, changes in U.S. interest rates affect
interest paid on our debt. A majority of our credit facilities is at variable
rates.
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ITEM 4. CONTROLS AND PROCEDURES.
EVALUATION OF CONTROLS AND PROCEDURES
As of September 30, 2004, our Chief Executive Officer and our Chief
Financial Officer, with the participation of our management, carried out an
evaluation of the effectiveness of our disclosure controls and procedures
pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the Chief
Executive Officer and the Chief Financial Officer believe that, as of the date
of the evaluation, our disclosure controls and procedures are effective in
making known to them material information relating to us (including our
consolidated subsidiaries) required to be included in this report.
Disclosure controls and procedures, no matter how well designed and
implemented, can provide only reasonable assurance of achieving an entity's
disclosure objectives. The likelihood of achieving such objectives is affected
by limitations inherent in disclosure controls and procedures. These include the
fact that human judgment in decision-making can be faulty and that breakdowns in
internal control can occur because of human failures such as simple errors or
mistakes or intentional circumvention of the established process.
CHANGES IN CONTROLS AND PROCEDURES
There were no significant changes in our internal controls or in other
factors that could significantly affect internal controls, known to the Chief
Executive Officer or the Chief Financial Officer, subsequent to the date of the
evaluation.
RECOMMENDATIONS OF OUR AUDITORS
During 2003, our prior independent public accountants, Ernst & Young,
LLP, advised us and discussed with the Audit Committee of our Board of Directors
that, due in part to certain acquisitions by our subsidiaries in Mexico and
modifications to our inventory costing methodology, certain improvements in the
internal controls of those subsidiaries were necessary to ensure reporting from
the subsidiaries would be sufficient for us to develop reliable financial
statements. We have and will continue to address the deficiencies identified by
Ernst & Young, LLP in consultation with Grant Thornton LLP, our new independent
certified public accountants.
In connection with its audit of our Consolidated Financial Statements
for the year ended December 31, 2003, Grant Thornton LLP, our independent
accountants, advised the Audit Committee and management of our need for
additional staff with expertise in preparing required disclosures in the notes
to the financial statements, and our need to develop greater internal resources
for researching and evaluating the appropriateness of complex accounting
principles and evaluating the effect of new accounting pronouncements on the
Company. Grant Thornton LLP considers these matters to be significant
deficiencies as that term is defined under standards established by the American
Institute of Certified Public Accountants. In response to the observations made
by Grant Thornton LLP, in 2004 we have implemented certain enhancements to our
financial reporting processes, including increased training of staff on SEC
financial reporting requirements and the acquisition of accounting research
tools. We believe these steps will address the matters raised by Grant Thornton
LLP.
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PART II -- OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
From time to time, we are involved in various routine legal proceedings
incidental to the conduct of our business. Our management does not believe that
any of these legal proceedings will have a material adverse impact on our
business, financial condition or results of operations, either due to the nature
of the claims, or because our management believes that such claims should not
exceed the limits of the our insurance coverage.
ITEM 6. EXHIBITS.
Exhibit
Number Description
-------- -------------------------------------------------------
10.7.3 Third Amendment to Employment Agreement, effective as
of April 1, 2004, between Tarrant Apparel Group and
Gerard Guez.
10.8.3 Third Amendment to Employment Agreement, effective as
of April 1, 2004, between Tarrant Apparel Group and
Todd Kay.
10.23.14 Letter Agreement dated August 12, 2004 by and among
GMAC Commercial Finance LLC and Tarrant Apparel Group,
Fashion Resource (TCL), Inc., TAG Mex, Inc., United
Apparel Ventures, LLC, Private Brands, Inc. and NO!
Jeans, Inc.
10.23.15 Factoring Agreement dated as of September 29, 2004 by
and among GMAC Commercial Finance LLC and Tarrant
Apparel Group, Fashion Resource (TCL), Inc., TAG Mex,
Inc., United Apparel Ventures, LLC, Private Brands,
Inc. and NO! Jeans, Inc.
10.31.9 Ninth Deed of Variation to Syndicated Letter of Credit
Facility effective as of September 30, 2004 among
Tarrant Company Limited, Marble Limited and Trade Link
Holdings Limited and UPS Capital Global Trade Finance
Corporation.
10.53 Agreement for Purchase of Assets dated August 13, 2004
among Tarrant Mexico S. de R.L. de C.V., Acabados Y
Cortes Textiles S.A. de C.V. and Construcciones
Solticio S.A. de C.V.
10.53.1 Amendment No. 1 to Agreement for Purchase of Assets
dated October 29, 2004 among Tarrant Mexico S. de R.L.
de C.V., Acabados Y Cortes Textiles S.A. de C.V. and
Construcciones Solticio S.A. de C.V.
10.54 Termination Agreement dated August 13, 2004 among
Tarrant Mexico, S. de R.L. de C.V., Inmobiliaria
Cuadros, S.A., de C.V. and Acabados y Cortes Textiles
S.A. de C.V.
31.1 Certificate of Chief Executive Officer pursuant to Rule
13a-14(a) under the Securities and Exchange Act of
1934, as amended.
31.2 Certificate of Chief Financial Officer pursuant to Rule
13a-14(a) under the Securities and Exchange Act of
1934, as amended.
32.1 Certificate of Chief Executive Officer pursuant to Rule
13a-14(b) under the Securities and Exchange Act of
1934, as amended.
32.2 Certificate of Chief Financial Officer pursuant to Rule
13a-14(b) under the Securities and Exchange Act of
1934, as amended.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
TARRANT APPAREL GROUP
Date: November 15, 2004 By: /s/ Corazon Reyes
----------------------------
Corazon Reyes,
Chief Financial Officer
Date: November 15, 2004 By: /s/ Barry Aved
----------------------------
Barry Aved,
Chief Executive Officer
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