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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2004
or
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from ______ to _______
Commission File Number: 0-26006
TARRANT APPAREL GROUP
(Exact name of registrant as specified in its charter)
CALIFORNIA 95-4181026
(State or other jurisdiction (I.R.S. Employer
of 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
Securities registered pursuant
to Section 12(b) of the Act:
NONE
Securities registered pursuant
to Section 12(g) of the Act:
COMMON STOCK
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 if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Act). Yes [ ] No [X]
The aggregate market value of the Common Stock held by non-affiliates
of the Registrant is approximately $23,495,688 based upon the closing price of
the Common Stock on June 30, 2004.
Number of shares of Common Stock of the Registrant outstanding as of
March 31, 2005: 28,814,763.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's definitive Proxy Statement to be filed
with the Securities and Exchange Commission pursuant to Regulation 14A in
connection with the 2005 Annual Meeting of Shareholders are incorporated by
reference into Part III of this Report.
TARRANT APPAREL GROUP
INDEX TO FORM 10-K
PART I PAGE
----
Item 1. Business.................................................... 1
Item 2. Properties.................................................. 12
Item 3. Legal Proceedings........................................... 13
Item 4. Submission of Matters to a Vote of Security Holders......... 13
PART II
Item 5. Market for Registrant's Common Equity, Related
Stockholder Matters and Issuer Purchases
of Equity Securities..................................... 14
Item 6. Selected Financial Data..................................... 15
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations...................... 17
Item 7A. Quantitative and Qualitative Disclosures about Market Risk . 41
Item 8. Financial Statements and Supplementary Data................. 42
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure...................... 42
Item 9A. Controls and Procedures..................................... 42
PART III
Item 10. Directors and Executive Officers of the Registrant.......... 43
Item 11. Executive Compensation...................................... 43
Item 12. Security Ownership of Certain Beneficial Owners and
Management and Related Stockholder Matters............... 43
Item 13. Certain Relationships and Related Transactions.............. 43
Item 14. Principal Accounting Fees and Services...................... 43
PART IV
Item 15. Exhibits and Financial Statement Schedules.................. 43
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PART I
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
This 2004 Annual Report on Form 10-K contains statements which
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. Those statements include statements regarding our intent,
belief or current expectations. Prospective investors are cautioned that any
such forward-looking statements are not guarantees of future performance and
involve risks and uncertainties, and that actual results may differ materially
from those projected in the forward-looking statements. Such risks and
uncertainties include, among other things, our ability to face stiff
competition, profitably manage a sourcing and distribution business, the
financial strength of our major customers, the continued acceptance of our
existing and new products by our existing and new customers, dependence on key
customers, the risks of foreign manufacturing, competitive and economic factors
in the textile and apparel markets, the availability of raw materials, the
ability to manage growth, weather-related delays, dependence on key personnel,
general economic conditions, China's entry into World Trade Organization, or
"WTO", global manufacturing costs and restrictions, and other risks and
uncertainties that may be detailed herein. See "Item 7. Management's Discussion
and Analysis of Financial Condition and Results of Operations--Factors That May
Affect Future Results."
ITEM 1. BUSINESS
OVERVIEW
Tarrant Apparel Group is a design and sourcing company for private
label and private brand casual apparel serving mass merchandisers, department
stores, branded wholesalers and specialty chains located primarily in the United
States. Our major customers include specialty retailers, such as Chico's, Macy's
Merchandising Group, the Avenue, Lane Bryant, Lerner New York, J.C. Penney,
K-Mart, Kohl's, Mervyn's and Wal-Mart. Our products are manufactured in a
variety of woven and knit fabrications and include jeans wear, casual pants,
t-shirts, shorts, blouses, shirts and other tops, dresses and jackets.
In 2002, our net sales increased by 5.2% to $347 million. In 2003, our
net sales decreased by 7.8% to $320 million. In 2004, our net sales decreased by
51.5% to $155 million. In 2002, we experienced a net loss of $1.2 million before
cumulative effect of accounting change due to our adoption of SFAS No. 142, and
$6.1 million after the cumulative effect of accounting change. In 2003, we
experienced a net loss of $35.9 million, which included non-cash charges of
inventory write-down of $11 million and an impairment of asset charge of $22.3
million. In 2004, we experienced a net loss of $104.7 million, which included
non-cash charges of $22.8 million of foreign currency translation loss and $78.0
million of asset impairments. See "Item 7. Management's Discussion and Analysis
of Financial Condition and Results of Operations."
During 2003, we launched our private brands initiative, where we
acquire ownership of or license rights to a brand name and sell apparel products
under the brand to a single retail company within a geographic region. At March
31, 2005, we owned or licensed rights to the following brands for apparel
products sold at the following retailers:
BRAND STORES
-------------------------- --------------------------
American Rag CIE Macy's Merchandising Group
Alan Weiz Dillard's
Gear 7 K-Mart, Sears
Jessica Simpson collection Charming Shoppes
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BRAND STORES
-------------------------- --------------------------
Princy, JS by Jessica, Department stores and better
Sweet Kisses specialty stores
Beyonce - House of Dereon Better specialty stores
NO! Jeans Sears
Commencing September 1, 2003, we ceased directly operating nearly all
of our equipment and fixed assets in Mexico by leasing and outsourcing the
management of a substantial majority of our Mexican operations to affiliates of
Mr. Kamel Nacif, a shareholder at the time of the transaction. In November 2004,
we sold substantially all our fixed assets and real property in Mexico to Mr.
Nacif's affiliates. See "--Restructuring and Sale of Mexico Operations."
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 of these actions, we experienced a
significant decline in revenue of approximately $75 million from sales of
Mexico-produced merchandise during 2004 as compared to 2003.
RESTRUCTURING AND SALE OF MEXICO OPERATIONS
At inception, we relied on independent contract manufacturers located
primarily in the Far East to produce the merchandise we sold to our customers.
Commencing in the third quarter of 1997, and taking advantage of the North
American Free Trade Agreement, or "NAFTA", we substantially expanded our use of
independent cutting, sewing and finishing contractors in Mexico, primarily for
basic garments. Commencing in 1999, and concluding in December 2002 with the
purchase of a denim and twill manufacturing plant in Tlaxacala, Mexico, we
engaged in an ambitious program to develop a vertically integrated manufacturing
operation in Mexico while maintaining our sourcing operation in the Far East. We
believed that the dual strategy of maintaining independent contract
manufacturers in the Far East and operating manufacturing facilities in Mexico
controlled by us could best serve the different needs of our customers and
enable us to capitalize on advantages offered by both markets. We believed this
diversified approach would help to mitigate the risks of doing business outside
of North America, such as transportation delays, economic and political
instability, currency fluctuations, restrictions on the transfer of funds and
the imposition of tariffs, export duties, quota, and other trade restrictions.
In August 2003, we determined to abandon our strategy of being both a
trading and vertically integrated manufacturing company, and commencing
September 1, 2003, we ceased directly operating nearly all of our equipment and
fixed assets in Mexico by leasing and outsourcing the management of a
substantial majority of our Mexican operations to affiliates of Mr. Kamel Nacif,
a shareholder at the time of the transaction. We made our determination based on
many factors, including the following:
o Our vertical integration strategy in Mexico required
significant working capital, which required us to
significantly increase debt to finance our Mexico operations.
Such financing was not available to us on commercially
reasonable terms.
o We faced the challenges of rising overhead costs and the need
to take low and sometimes negative margin orders in slow
seasons to fill capacity at our facilities, which reduced our
overall average gross margin.
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o The elimination of quotas on WTO member countries by 2005, and
the other effects of trade agreements among WTO countries,
would soon 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 WTO.
Our Mexican operations did not represent an independent cash flow
generating entity. It was a component of our vertical integration business
strategy and its sales were primarily to the United States reportable segment.
In connection with our restructuring of our Mexico operations, we
incurred $2.5 million and $1.1 million of severance costs in 2003 and 2004,
respectively, in the Mexico reportable segment. We did not relocate any
employees in connection with this restructuring and therefore did not incur any
relocation costs. In addition, we did not incur any contract termination costs.
There was no ending liability balance for the severance costs incurred in 2003
and 2004 since such amounts were all paid in 2003 and 2004. Severance costs
incurred in 2003 were included in costs of goods sold and such costs incurred in
2004 were included in general and administrative expenses in the accompanying
consolidated statements of operations.
Due to our change of strategy in Mexico, at June 30, 2003, we wrote off
approximately $19.5 million in goodwill associated with certain assets we
acquired in Mexico, and wrote down $11 million of inventory in Mexico in
anticipation of its liquidation at reduced prices. See Note 7 of the "Notes to
Consolidated Financial Statements."
In August 2004, through Tarrant Mexico, S. de R.L. de C.V., our
majority owned and controlled subsidiary in Mexico, we entered into an Agreement
for Purchase of Assets with affiliates of Mr. Kamel Nacif, a shareholder at the
time of the transaction, which agreement was amended in October 2004. Pursuant
to the agreement, as amended, on November 30, 2004, we sold to the purchasers
substantially all of our assets and real property in Mexico which include
equipment and facilities previously leased to Mr. Nacif's affiliates in 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; and
o $40,204,000, by delivery of secured promissory notes bearing
interest at 4.5% per annum, maturing on December 31, 2014
payable in equal installments of principal and interest over
the term of the notes.
Upon consummation of the sale, we entered into a purchase commitment
agreement with the purchasers, pursuant to which we have agreed to purchase
annually over the ten-year term of the agreement, $5 million of fabric
manufactured at our former facilities acquired by the purchasers at negotiated
market prices. This agreement replaced an existing purchase commitment agreement
whereby we were 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.
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
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recorded with the impairment loss due to a full valuation allowance recorded
against the future tax benefit as of June 30, 2004.
Our disposition of our facilities in Mexico has reduced our working
capital requirements, eliminated the need to accept low or negative margin
orders to fill production capacity, and permitted us to source production in the
best locations worldwide. We believe that our strong design, merchandising and
sourcing capabilities are competitive advantages that will enable us to overcome
the desire by some retailers to purchase merchandise directly from the
manufacturer.
BUSINESS STRATEGY
We believe that the following trends are currently affecting apparel
retailing and manufacturing:
o There is a need for a marketing catalyst such as celebrity
endorsed, or celebrity branded apparel, which brings attention
and credibility to clothing collections through the
association of entertainment and fashion.
o Consolidation among apparel retailers has increased their
ability to demand value-added services from apparel
manufacturers, including fashion expertise, rapid response,
just-in-time delivery, Electronic Data Interchange and
favorable pricing.
o Increased competition among retailers due to consolidation has
resulted in an increased demand for private label and private
brand apparel, which generally offers retailers higher margins
and permits them to differentiate their products.
o The current fashion cycle requires more design and product
development, in addition to quickly responding to emerging
trends. Apparel manufacturers that offer these capabilities
are in demand.
We believe that we have the capabilities to take advantage of these
trends and remain a principal value-added supplier of casual, moderately priced
apparel as well as increase our share of the more upscaled market segment due to
the following:
DESIGN EXPERTISE. As one of the very few sourcing companies with our
own design team, we believe that we have established a reputation with our
customers as a fashion resource and manufacturer that is capable of providing
design assistance to customers in the face of rapidly changing fashion trends.
RESEARCH AND DEVELOPMENT CAPABILITIES. We believe our design team and
our two sample rooms in Los Angeles and China have made significant
contributions to customers in developing new fabrics, washes and finishes.
SAMPLE-MAKING AND MARKET-TESTING CAPABILITIES. We seek to support
customers with our design expertise, sample-making capability and ability to
rapidly produce small test orders of products.
ON-TIME DELIVERY. We have developed a diversified network of
international contract manufacturers and fabric suppliers, which enable us to
accept orders of varying sizes and delivery schedules and to produce a broad
range of garments at varying prices depending upon lead time and other
requirements of the customer.
QUALITY AND COMPETITIVELY PRICED PRODUCTS. We believe that our long
time presence in the Far East and our experienced product management teams
provide a superior supply chain that enables us to meet the individual needs of
our customers in terms of quality and lead time.
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PRODUCT DIVERSIFICATION. Our experiencing in designing and delivering
complete apparel collections for some of our customers has improved our overall
ability to deliver product classifications beyond our core casual bottoms
offerings, which has further diversified the merchandise we offer to other
customers.
PRIVATE BRANDS. With a private brand relationship, we own and control
the brand and thus build equity in the brand as the product gains acceptance by
consumers. In a private label relationship, we source products for our customers
who own and control the brand and thus benefit from any increase in value of the
brand. We also control the production of private brand merchandise, unlike
private label merchandise where the brand owner controls sourcing. For instance,
we experienced a significant loss of business from Lane Bryant due to a change
in their management and the subsequent shift in their sourcing strategy.
We believe that forming private brand alliances with premier retailers
allows us greater penetration of apparel categories in addition to our core
casual bottoms business. In addition to the increased breadth of
classifications, we have improved our ability to compete for private label
business from our private brand customers. We also receive higher margins for
private branded merchandise, which allows us to be more profitable on the same
level of unit sales.
PRODUCTS
Women's jeans historically have been, and continue to be, our principal
product. In recent years, we have expanded our sales of moderately priced
women's apparel to include casual, denim and non-denim, including twill, woven
tops and bottoms, and in 1998, we commenced the sales of men's and children's
apparel. Our women's apparel products currently include jeans wear, casual
pants, t-shirts, shorts, blouses, shirts, knits and sweaters, dresses and
jackets. These products are manufactured in petite, standard and large sizes and
are sold at a variety of wholesale prices generally ranging from less than $3.00
to over $50.00 per garment.
Over the past three years, approximately 71% of net sales were derived
from the sales of pants and jeans, approximately 5% from the sale of shorts,
approximately 9% from the sale of shirts, blouses and tops and approximately 7%
from the sale of skirts and skort-alls. The balance of net sales consisted of
sales of dresses, jackets and other products.
CUSTOMERS
We generally market our products to high-volume retailers that we
believe can grow into major accounts. By limiting our customer base to a select
group of larger accounts, we seek to build stronger long-term relationships and
leverage our operating costs against large bulk orders. Although we continue to
diversify our customer base, the majority of any growth in sales is expected to
come from existing customers.
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The following table shows the percentage of our net sales in fiscal
years 2002, 2003 and 2004 attributable to each customer that accounted for more
than 5% of net sales.
PERCENTAGE OF NET SALES
-----------------------------------
CUSTOMER 2002 2003 2004
- ------------------------------------ ------- ------- -------
Kohl's.............................. 5.1 6.6 16.4
Mervyn's............................ 7.3 5.9 15.4
Lerner New York (2)................. 9.9 8.3 15.0
Federated........................... 0.5 5.2 10.3
Wet Seal............................ 0.8 3.3 7.9
Wal-Mart............................ 9.7 8.7 5.9
The Limited (1)..................... 12.7 15.3 4.6
Lane Bryant......................... 17.6 12.1 2.0
Tommy Hilfiger...................... 17.4 6.7 0.0
- ----------
(1) Includes Express and Limited stores.
(2) Sold by Limited Brands Inc. in November 2002.
In 2002, virtually all of our sales were of private label apparel. In
2003 and 2004, we experienced Private Brand sales of approximately 6% and 14%,
respectively. We currently serve over 25 customers, which in addition to those
identified above, include, Chico's, Dillard's, J.C. Penney, Mothers Work,
K-Mart, and the Avenue. During 2003, we launched our private brands initiative,
where we acquire ownership of or license rights to a brand name and sell apparel
products under this brand to a single retail company within a geographic region.
We sell products under our company-owned brand "NO! Jeans" exclusively to Sears,
our licensed brand "American Rag Cie" to Macy's Merchandising Group, and "Gear
7" to K-Mart.
We do not have long-term contracts with any of our customers except for
Macy's Merchandising Group for American Rag Cie and, therefore, there can be no
assurance that other customers will continue to place orders with us of the same
magnitude as it has in the past, or at all. In addition, the apparel industry
historically has been subject to substantial cyclical variation, with consumer
spending for purchases of apparel and related goods tending to decline during
recessionary periods. To the extent that these financial difficulties occur,
there can be no assurance that our financial condition and results of operations
would not be adversely affected. See "Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations--Factors That May
Affect Future Results."
DESIGN, MERCHANDISING AND SALES
While many private label producers only arrange for the bulk production
of styles specified by their customers, we not only design garments, but also
assist some of our customers in market testing new designs. We believe that our
design, sample-production and test-run capabilities give us a competitive
advantage in obtaining bulk orders from our customers. We also often receive
bulk orders for garments we have not designed because many of our customers
allocate bulk orders among more than one producer.
We have developed integrated teams of design, merchandising and support
personnel, some of whom serve on more than one team, that focus on designing and
producing merchandise that reflects the style and image of their customers.
Teams are divided between private label and private brands for sourcing
operations.
Each team is responsible for all aspects of its customer's needs,
including designing products, developing product samples and test items,
obtaining orders, coordinating fabric choices and
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procurement, monitoring production and delivering finished products. The team
seeks to identify prevailing fashion trends that meet its customer's retail
strategies and design garments incorporating those trends. The team also works
with the buyers of its customer to revise designs as necessary to better reflect
the style and image that the customer desires to project to consumers. During
the production process, the team is responsible for informing the customer about
the progress of the order, including any difficulties that might affect the
timetable for delivery. In this way, our customer and we can make appropriate
arrangements regarding any delay or other change in the order. We believe that
this team approach enables our employees to develop an understanding of the
customer's distinctive styles and production requirements in order to respond
effectively to the customer's needs. During 2000, we opened an office in
Bentonville, Arkansas to support this approach and better service the needs of
Wal-Mart.
As part of our merchandising strategy, we produce, at our own expense,
four collections a year in order to offer new designs and fabrics for customers
that rely on us for fashion direction. We produce samples at our facility in Los
Angeles, California and subcontract with a third party for the production of
samples in China.
From time to time and at scheduled seasonal meetings, we present these
samples to the customer's buyers who determine which, if any, of the samples
will be produced on a test run or a bulk order. Samples are often presented in
coordinated groupings or as part of a product line. Some customers, particularly
specialty retail stores, may require that a product be tested before placing a
bulk order. Testing involves the production of as few as several hundred copies
of a given sample in different size, fabric and color combinations. The customer
pays for these test items, which are placed in selected stores to gauge consumer
response. The production of test items enables our customers to identify
garments that may appeal to consumers and also provides us with important
information regarding the cost and feasibility of the bulk production of the
tested garment. If the test is determined to be successful, we generally receive
a significant percentage of the customer's total bulk order of the tested item.
In addition, as is typical in the private label business, we receive bulk
production orders to produce merchandise designed by our competitors or other
designers, since most customers allocate bulk orders among a number of
suppliers.
SOURCING
GENERAL
When bidding for or filling an order, our international sourcing
network enables us to choose from among a number of suppliers and manufacturers
based on the customer's price requirements, product specifications and delivery
schedules. Historically, we manufactured our products through independent
cutting; sewing and finishing contractors located primarily in Hong Kong and
China, and have purchased our fabric from independent fabric manufacturers with
weaving mills located primarily in Hong Kong and China. In recent years, we have
expanded our network to include suppliers and manufacturers located in a number
of additional countries, including India, Nepal, Cambodia, Peru, Thailand, Egypt
and Mexico. Before we ceased manufacturing in Mexico on September 1, 2003, we
sourced more than 50% of our merchandise annually from our factories in Mexico.
Our sourcing strategy is based on a strong presence in Hong Kong and China, and
a continued presence in Southeast Asia. We also continue to source production in
Mexico. The following table sets forth the percentage of our merchandise, on the
basis of the free on board cost at the supplier's plant, or FOB Basis, by
country for the periods indicated:
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2002 2003 2004
------ ------ ------
INTERNATIONAL SOURCING:
Hong Kong and China.................... 25.3 % 28.6 % 46.6 %
Other (1).............................. 13.3 % 24.4 % 33.7 %
DOMESTIC SOURCING:
United States.......................... 6.1 % 4.4 % 7.1 %
Mexico and Central America............. 55.3 % 42.6 % 12.6 %
- ----------
(1) In 2004, such countries consisted mainly of Egypt, Mongolia, Thailand,
Nepal, Vietnam and India.
DEPENDENCE ON CONTRACT MANUFACTURERS
The use of contract manufacturers and the resulting lack of direct
control over the production of our products could result in our failure to
receive timely delivery of products of acceptable quality. Although we believe
that alternative sources of cutting, sewing and finishing services are readily
available, the loss of one or more contract manufacturers could have a
materially adverse effect on our results of operations until an alternative
source can be located and commence producing our products.
Although we have adopted a code of vendor conduct and monitor the
compliance of our independent contractors with our code of conduct and
applicable labor laws, we do not control our contractors or their labor
practices. The violation of federal, state or foreign labor laws by one of our
contractors can result in us being subject to fines and our goods, which are
manufactured in violation of such laws, being seized or their sale in interstate
commerce being prohibited. Additionally, certain of our customers may refuse to
do business with us based on our contractors' labor practices. 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 or could have a
material adverse effect upon us, 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 or lose business from our customers
as a result of violations of applicable labor laws by our contractors, or that
such sanctions or loss of business will not have a material adverse effect on
us. In addition, our customers require strict compliance by their apparel
manufacturers, including us, with applicable labor laws. To that end, we are
regularly inspected by some of our major customers. 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.
Except for a commitment to purchase $5 million of fabric annually
manufactured at facilities in Mexico that we previously owned and sold to
affiliates of Mr. Nacif, a shareholder at the time of transaction, in 2004, we
do not have any long-term contracts with independent fabric suppliers. The loss
of any of our major fabric suppliers could have a material adverse effect on our
financial condition and results of operations until alternative arrangements are
secured.
DIVERSIFIED PRODUCTION NETWORK
We believe that we have a production network that is capable of
servicing a wide range of customer needs. Some customers place a priority on
"speed to market," and are willing to pre-approve several different fabric
styles, and pay air freight in order to quickly get the most current styling
into their stores. Other customers seek lower costs, and are willing to source
production from more remote areas with long lead-times. Although mass
merchandisers, such as Wal-Mart, are beginning to operate on shorter lead times,
they are occasionally able to estimate their needs as much as six months to nine
months in advance for "program" business--basic products that do not change in
style significantly from
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season to season. Our ability to operate on different production schedules helps
us to meet our customers' varying needs.
By allocating an order among different manufacturers, we seek to fill
the high-volume orders of our customers, while meeting their delivery
requirements. Upon receiving an order, we determine which of our suppliers and
manufacturers (both owned and third party contractors) can best fill the order
and meet the customer's price, quality and delivery requirements. We consider,
among other things, the price charged by each manufacturer and the
manufacturer's available production capacity to complete the order, as well as
the availability of quota for the product from various countries and the
manufacturer's ability to produce goods on a timely basis subject to the
customer's quality specifications. Our personnel also consider the
transportation lead times required to deliver an order from a given manufacturer
to the customer. In addition, some customers prefer not to carry excess
inventory and therefore require that we stagger the delivery of products over
several weeks.
INTERNATIONAL SOURCING
We conduct and monitor our sourcing operations from our international
offices. At December 31, 2004, we had offices in Hong Kong, Mexico and Thailand.
The staffs at these locations have extensive knowledge about, and experience
with, sourcing and production in their respective regions, including purchasing,
manufacturing and quality control. Several times each year, members of our
senior management, including local staff, visit and inspect the facilities and
operations of our international suppliers and manufacturers.
Foreign manufacturing is subject to a number of risk factors,
including, among other things, 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), natural disasters and cultural issues.
Each of these factors could have a material adverse effect on us.
While we are in the process of establishing business relationships with
manufacturers and suppliers located in countries other than Hong Kong or China,
such as in India, Nepal, Cambodia, Peru, Thailand and Egypt, we still primarily
contract with manufacturers and suppliers located in Hong Kong and China for our
international sourcing needs, and currently expect that we will continue to do
so for the foreseeable future. Any significant disruption in our operations or
our relationships with our manufacturers and suppliers located in Hong Kong or
China could have a material adverse effect on us.
THE IMPORT SOURCING PROCESS
As is customary in the apparel industry, we do not have any long-term
contracts with our manufacturers. During the manufacturing process, our quality
control personnel visit each factory to inspect garments when the fabric is cut,
as it is being sewn and as the garment is being finished. Daily information on
the status of each order is transmitted from the various manufacturing
facilities to our offices in Hong Kong and Los Angeles. We, in turn, keep our
customers apprised, often through daily telephone calls and frequent written
reports. These calls and reports include candid assessments of the progress of a
customer's order, including a discussion of the difficulties, if any, that have
been encountered and our plans to rectify them.
We often arrange, on behalf of manufacturers, for the purchase of
fabric from a single supplier. We have the fabric shipped directly to the
cutting factory and invoice the factory for the fabric. Generally, the factories
pay us for the fabric with offsets against the price of the finished goods. For
our longstanding program business, we may purchase or produce fabric in advance
of receiving the order, but
9
in accordance with the customer's specifications. By procuring fabric for an
entire order from one source, we believe that production costs per garment are
reduced and customer specifications as to fabric quality and color can be better
controlled.
The anti-terrorist measures adopted by the U.S. government and in
particular, by the U.S. Customs, have meant more stringent inspection processes
before imported goods are cleared for delivery into the U.S. In some instances,
these measures have caused delays in the pre-planned delivery of products to
customers.
DISTRIBUTION
Based on our world wide sourcing capability and in order to properly
fulfill orders, we have tailored our distribution system to meet the needs of
the customer. Some customers, like Wal-Mart and Kohl's, use Electronic Data
Interchange, or "EDI", to send orders and receive merchandise and invoices. The
EDI distribution function has been centralized in our Los Angeles corporate
headquarters in order to expedite and control the flow of merchandise and
electronic information, and to insure that the special requirements of our EDI
customers are met.
For orders sourced outside the United States and Mexico, the
merchandise is shipped from the production facility by truck to a port where it
is consolidated and loaded on containerized vessels for ocean transport to the
United States. For customers with West Coast and Mid West distribution centers,
the merchandise is brought into the port of Los Angeles. After Customs
clearance, the merchandise is shipped by truck to either our Los Angeles
warehouse facility or an independent bonded warehouse in Ohio. Proximity to the
customer's distribution center is important for customer support. For
merchandise produced in the Middle East and destined for an East Coast customer
distribution center, the port of entry is New York. After Customs clearance, the
merchandise is trucked to an independent public warehouse in New Jersey. The
independent warehouses are instructed in writing by the Los Angeles office when
to ship the merchandise to the customer.
BACKLOG
As of March 22, 2005, we had unfilled customer orders of approximately
$73 million as compared to approximately $67 million as of March 22, 2004. We
believe that all of our backlog of orders as of March 22, 2005 will be filled
before the end of the third quarter of fiscal 2005. Backlog is based on our
estimates derived from internal management reports. The amount of unfilled
orders at a particular time is affected by a number of factors, including the
scheduling of manufacturing and shipping of the product, which in some
instances, depends on the customer's requirements. Accordingly, a comparison of
unfilled orders from period to period is not necessarily meaningful and may not
be indicative of eventual annual bookings or actual shipments. Our experience
has been that the cancellations, rejections or returns of orders have not
materially reduced the amount of sales realized from our backlog.
SEGMENT INFORMATION
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. For information
regarding the revenues and assets associated with our geographic regions, see
Note 16 of the "Notes to Consolidated Financial Statements."
10
IMPORT RESTRICTIONS
QUOTAS
We imported approximately 91% of our products sold in 2004.
Approximately 10% of this merchandise was imported from Mexico, which is subject
to special rules under NAFTA. NAFTA allows for the duty and quota free entry
into the United States of certain qualifying merchandise.
A majority of the balance of the merchandise imported by us in 2004 was
manufactured in various countries (e.g., China) with which the U.S. had entered
into bilateral trade agreements.
As of January 1, 2005, quota on apparel from all WTO countries,
including China, was eliminated. As China is now a member of the WTO, its
exports of textiles and apparel to the U.S. are covered by the WTO Agreement on
Textiles and Clothing. Various statutory mechanisms remain, which could be
invoked by the United States in order to impose "safeguard" measures (i.e.,
additional duties or quotas) upon imports of products from China. These measures
arise out of the accession agreement that allowed China to join the WTO. For
example, the China textile "safeguard" authorizes the imposition of quotas in
response to a textile or apparel product of China being imported into the United
States in such increased quantities or under such conditions as to cause or
threaten to cause market disruption.
In 2004, approximately 40% of the product imported by us was of Hong
Kong origin, for which Hong Kong quota was utilized upon import. Certain
non-origin conferring production operations were performed in China in
connection with a large portion of our imported products of Hong Kong origin,
under the so-called Outward Processing Arrangement ("OPA").
DUTIES AND TARIFFS
As with all goods imported into the U.S., our imported merchandise is
subject to duty (unless statutorily exempt from duty) at rates established by
U.S. law. These rates range, depending on the type of product, from
approximately 2% to 33% of the appraised value of the product. In addition to
duties, in the ordinary course of our business, we are occasionally subject to
claims by the U.S. Bureau of Customs and Border Protection for penalties,
liquidated damages and other charges relating to import activities. Similarly,
we are at times entitled to refunds from Customs, resulting from the overpayment
of duties.
Products imported from China into the United States receive the same
preferential tariff treatment accorded goods from other countries granted Normal
Trade Relations ("NTR") status. This status has been in place conditionally for
a number of years and is now guaranteed on a more permanent basis by China's
accession to WTO membership in December 2001.
Our continued ability to source products from foreign countries may be
adversely affected or improved by future trade agreements and restrictions,
changes in U.S. trade policy, embargoes, the disruption of trade from exporting
countries as a result of political instability or the imposition of additional
duties, taxes and other charges or restrictions on all imports or specified
classes of imports.
COMPETITION
There is intense competition in the sectors of the apparel industry in
which we participate. We compete with many other manufacturers, many of which
are larger and have greater resources than us. We also face competition from our
own customers and potential customers, many of which have established, or may
establish, their own internal product development and sourcing capabilities. We
11
believe that we compete favorably on the basis of design and sample
capabilities, the quality and value of our products, price, and the production
flexibility that we enjoy as a result of our sourcing network.
TRADEMARKS
As part of Private Brands strategy, we acquire ownership of or rights
to a brand name and sell apparel products under this brand. We have ownership
rights to the registered trademarks "American Rag Cie," "Gear7" and "NO! Jeans."
In addition, we have acquired license rights to design, market and distribute
certain apparel products under the Cynthia Rowley, Alan Weiz, Jessica Simpson
and Beyonce's House of Dereon brands.
SEASONALITY
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.
EMPLOYEES
At December 31, 2004, we had approximately 128 full-time employees in
the United States, 26 in Mexico, 118 in Hong Kong, 83 in China and 9 in
Thailand. None of our employees are unionized. We consider our relations with
our employees to be satisfactory in all areas of our operations with the
exception of our prior Mexico operations, where we experienced labor
difficulties in 2003 and early 2004 following our decision to restructure our
Mexican operations.
ITEM 2. PROPERTIES
At March 31, 2005, we conducted our operations from 9 facilities, 7 of
which were leased. Our leased facilities included:
Annual
Location Purpose Rental Amount Expiration
- ------------------ -------------------- ------------- --------------
Los Angeles, CA Executive offices $656,000 Monthly
(Washington Blvd.)
New York, NY Showroom $150,000 August 2007
Bentonville, AK Office -- $35,000 September 2005
Wal-Mart Business
Ruleville, MS Office and warehouse Own
Hong Kong Office and warehouse $674,000 Monthly
Hong Kong Warehouse $12,000 September 2005
Bangkok Office $6,000 March 2005
Tehuacan, Mexico Storage $18,000 Monthly
We lease our executive offices in Los Angeles, California from GET, a
corporation which is owned by Gerard Guez and Todd Kay, our Chairman and Vice
Chairman, respectively. Additionally, we lease our warehouse and office space in
Hong Kong from Lynx International Limited, a Hong Kong corporation that is owned
by Messrs. Guez and Kay.
12
On April 18, 1999, we acquired a 250,000 square foot denim mill in
Puebla, Mexico with an annual capacity of approximately 18 million meters of
denim. On March 29, 2001, we completed the acquisition of a sewing facility in
Ajalpan, Mexico. This facility contains 98,702 square feet. On December 31,
2002, we completed the acquisition of a twill mill facility, which has 1,700,000
square feet, and a capacity of 18 million meters of denim or twill. Commencing
on September 1, 2003, we leased a substantial majority of these premises to an
affiliate of Mr. Kamel Nacif, for an annual rental of $11 million. In November
2004, we sold our Mexican assets, including these facilities, to affiliates of
Mr. Kamel Nacif.
We own two facilities in Ruleville, Mississippi with an aggregate of
70,000 square feet.
We believe that all of our existing facilities are well maintained, in
good operating condition and adequate to meet our current and foreseeable needs.
ITEM 3. LEGAL PROCEEDINGS
On December 10, 2004 and December 14, 2004, Mr. Benjamin Dominguez
Gonzalez brought suits against our Mexico Subsidiary, Tarrant Mexico, S. de R.L.
de C.V., in Puebla, Puebla, Mexico: (a) "Juicio Ejecutivo Mercantil 887/2004,
Juzgado Dicimo de lo Civil del Estado de Puebla, Puebla, Mexico, Dominguez
Gonzalez Benjamin vs. Tarrant Mexico S. de R.L. de C.V. e Inmobiliaria Cuadros
S.A. de C.V."; (b) "Juicio Ejecutivo Mercantil 889/2004, Juzgado Noveno de lo
Civil del Estado de Puebla, Puebla, Mexico, Dominguez Gonzalez Benjamin vs.
Tarrant Mexico S. de R.L. de C.V. e Inmobiliaria Cuadros S.A. de C.V.", for the
non-payment of approximately $14 million in principal amount and accrued
interest on two promissory notes, which Mr. Gonzalez asserts were issued by
Tarrant Mexico. The amounts Mr. Gonzalez claimed were due and owing under the
notes previously had been paid in full. In April 2005, Mr. Gonzalez agreed to
dismiss his claims, which agreement has been submitted to and is pending final
approval of the court.
Other than the above lawsuits, 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 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of our shareholders during
the fourth quarter of 2004.
13
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS
AND ISSUER PURCHASES OF EQUITY
NASDAQ NATIONAL MARKET
Our common stock began trading on The NASDAQ Stock Market's National
Market under the symbol "TAGS" on July 24, 1995.
The following table sets forth, for the periods indicated, the range of
high and low sale prices for our common stock as reported by NASDAQ.
Low High
-------- --------
2003
- ----
First Quarter...................................... 3.61 4.29
Second Quarter..................................... 2.83 4.03
Third Quarter...................................... 2.72 4.10
Fourth Quarter..................................... 3.40 4.70
2004
- ----
First Quarter...................................... 1.68 3.73
Second Quarter..................................... 1.45 2.53
Third Quarter...................................... 0.79 1.57
Fourth Quarter..................................... 0.78 2.44
On March 24, 2005, the last reported sale price of our common stock as
reported by NASDAQ was $1.91. As of March 24, 2005, we had 28 shareholders of
record.
DIVIDEND POLICY
We have not declared dividends on our common stock during either of the
last two fiscal years. We intend to retain any future earnings for use in our
business and, therefore, do not anticipate declaring or paying any cash
dividends in the foreseeable future. The declaration and payment of any cash
dividends in the future will depend upon our earnings, financial condition,
capital needs and other factors deemed relevant by the Board of Directors. In
addition, our credit agreements prohibit the payment of dividends during the
term of the agreements.
14
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data is qualified in its entirety by,
and should be read in conjunction with, the other information and financial
statements, including the notes thereto, appearing elsewhere herein.
YEAR ENDED DECEMBER 31,
-------------------------------------------------------------
2000 2001 2002 2003 2004
--------- --------- --------- --------- ---------
(in thousands, except per share data)
INCOME STATEMENT DATA:
Net sales ....................... $ 395,169 $ 330,253 $ 347,391 $ 320,423 $ 155,453
Cost of sales ................... 332,333 277,525 302,082 288,445 134,492
--------- --------- --------- --------- ---------
Gross profit ................. 62,836 52,728 45,309 31,978 20,961
Selling and distribution expenses 17,580 14,345 10,757 11,329 9,291
General and administrative
expenses ..................... 40,327 33,136 30,082 31,767 32,084
Amortization of intangibles(1)(3) 2,840 3,317 -- -- --
Impairment charges (4) .......... -- -- -- 22,277 77,982
Cumulative translation loss (5) . -- -- -- -- 22,786
--------- --------- --------- --------- ---------
Income (loss) from operations $ 2,089 1,930 4,470 (33,395) (121,182)
Interest expense ................ (9,850) (7,808) (5,444) (5,603) (2,857)
Interest income ................. 1,295 3,256 4,748 425 377
Minority interest ............... 1,313 (412) (4,581) 3,461 15,331
Other income(2) ................. 1,350 1,853 2,648 4,784 7,136
Other expense(2) ................ (193) (856) (2,004) (1,425) (1,134)
--------- --------- --------- --------- ---------
Loss before provision for
income taxes and cumulative
effect of accounting change .. (3,996) (2,037) (163) (31,753) (102,329)
Provision for income taxes ...... 1,478 (852) (1,051) (4,132) (2,348)
--------- --------- --------- --------- ---------
Loss before cumulative
effect of accounting change $ (2,518) $ (2,889) $ (1,214) $ (35,885) $(104,677)
Cumulative effect of
accounting change(3) ......... -- -- (4,871) -- --
--------- --------- --------- --------- ---------
Net loss ........................ $ (2,518) $ (2,889) $ (6,085) $ (35,885) $(104,677)
========= ========= ========= ========= =========
Net loss per share -
Basic:
Before cumulative effect of
accounting change .......... $ (0.16) $ (0.18) $ (0.08) $ (1.97) $ (3.64)
Cumulative effect of
accounting change .......... -- -- (0.30) -- --
After cumulative effect of
accounting change .......... $ (0.16) $ (0.18) $ (0.38) $ (1.97) $ (3.64)
Net loss per share -
Diluted:
Before cumulative effect of
accounting change .......... $ (0.16) $ (0.18) $ (0.08) $ (1.97) $ (3.64)
Cumulative effect of
accounting change .......... -- -- (0.30) -- --
After cumulative effect of
accounting change .......... $ (0.16) $ (0.18) $ (0.38) $ (1.97) $ (3.64)
Weighted average shares
outstanding (000)
Basic ........................ 15,815 15,825 15,834 18,215 28,733
Diluted ...................... 15,815 15,825 15,834 18,215 28,733
15
AS OF DECEMBER 31,
----------------------------------------------------------
2000 2001 2002 2003 2004
- ---------------------------- --------- --------- --------- --------- ---------
(in thousands)
BALANCE SHEET DATA:
Working capital ............ $ 27,957 $ 25,109 $ 11,731 $ (18,018) $ (12,295)
Total assets ............... 308,092 288,467 316,444 253,105 131,811
Bank borrowings, convertible
debenture and long-term
obligations ............. 114,439 111,336 106,937 68,587 48,455
Shareholders' equity ....... 130,489 125,164 121,161 107,709 30,678
- ----------
(1) See "Item 1. Business--Acquisitions."
(2) Major components of other income (expense) (as presented above) include
rental and lease income, and foreign currency gains or losses. See
"Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations."
(3) 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 adopted
SFAS No. 142 in fiscal 2002 and performed our first annual assessment
of impairment, which resulted in an impairment loss of $4.9 million.
(4) The expense in 2004 was the impairment of long-lived assets of our
Mexico operations due to our decision to sell the manufacturing
operations in Mexico. The expense in 2003 was the impairment of our
goodwill and intangible assets and write-off of prepaid expenses 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. See Note 5 and Note 7 of the "Notes to Consolidated Financial
Statements."
(5) Cumulative translation loss attributable to liquidated Mexico
operations in 2004 was due to our decision to cease our Mexico
operations.
16
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion and analysis should be read together with the
Consolidated Financial Statements of Tarrant Apparel Group and the "Notes to
Consolidated Financial Statements" included elsewhere in this Form 10-K. This
discussion summarizes the significant factors affecting the consolidated
operating results, financial condition and liquidity and cash flows of Tarrant
Apparel Group for the fiscal years ended December 31, 2002, 2003 and 2004.
Except for historical information, the matters discussed in this Management's
Discussion and Analysis of Financial Condition and Results of Operations are
forward looking statements that involve risks and uncertainties and are based
upon judgments concerning various factors that are beyond our control. See
"Cautionary Statement Regarding Forward-Looking Statements."
OVERVIEW
Tarrant Apparel Group is a design and sourcing provider of private
label and private brand casual apparel for women, men and children, serving mass
merchandisers, department stores, branded wholesalers and specialty chains
located primarily in the United States.
We generate revenues from the sale of apparel merchandise to our
customers that we have manufactured by third party contract manufacturers
located outside of the United States. Revenues and net loss for the years ended
December 31, 2002, 2003 and 2004 were as follows (dollars in thousands):
REVENUES AND NET LOSS: 2002 2003 2004
- ----------------------------------------- --------- --------- ----------
Net sales................................ $ 347,391 $ 320,423 $ 155,453
Net loss before cumulative
effect of accounting change........... $ (1,214) $ (35,885) $ (104,677)
Net loss after cumulative
effect of accounting change........... $ (6,085) $ (35,885) $ (104,677)
Cash flows for the years ended December 31, 2002, 2003 and 2004 were as
follows (dollars in thousands):
CASH FLOWS: 2002 2003 2004
- ----------------------------------------- --------- --------- ----------
Net cash provided by operating
activities............................ $ 15,493 $ 9,484 $ 12,168
Net cash provided by (used in)
investing activities.................. $ (5,670) $ (1,053) $ 1,250
Net cash used in financing
activities............................ $ (8,435) $ (6,295) $ (15,552)
SIGNIFICANT DEVELOPMENTS IN 2004
RESTRUCTURING AND SALE OF MEXICO OPERATIONS
In August 2003, we determined to abandon our strategy of being both a
trading and vertically integrated manufacturing company, and commencing
September 1, 2003, we ceased directly operating nearly all of our equipment and
fixed assets in Mexico by leasing and outsourcing the management of a
substantial majority of our Mexican operations to affiliates of Mr. Kamel Nacif,
a shareholder at the time of the transaction. We made our determination based on
many factors, including the following:
o Our vertical integration strategy in Mexico required
significant working capital, which required us to
significantly increase debt to finance our Mexico operations.
Such financing was not available to us on commercially
reasonable terms.
17
o We faced the challenges of rising overhead costs and the need
to take low and sometimes negative margin orders in slow
seasons to fill capacity at our facilities, which reduced our
overall average gross margin.
o The elimination of quotas on WTO, member countries by 2005,
and the other effects of trade agreements among WTO countries,
would soon 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 WTO.
Our Mexican operations did not represent an independent cash flow
generating entity. It was a component of our vertical integration business
strategy and its sales were primarily to the United States reportable segment.
In connection with our restructuring of our Mexico operations, we
incurred $2.5 million and $1.1 million of severance costs in 2003 and 2004,
respectively, in the Mexico reportable segment. We did not relocate any
employees in connection with this restructuring and therefore did not incur any
relocation costs. In addition, we did not incur any contract termination costs.
There was no ending liability balance for the severance costs incurred in 2003
and 2004 since such amounts were all paid in 2003 and 2004. Severance costs
incurred in 2003 were included in costs of goods sold and such costs incurred in
2004 were included in general and administrative expenses in the accompanying
consolidated statements of operations.
Due to our change of strategy in Mexico, at June 30, 2003, we wrote off
approximately $19.5 million in goodwill associated with certain assets we
acquired in Mexico, and wrote down $11 million of inventory in Mexico in
anticipation of its liquidation at reduced prices. See Note 7 of the "Notes to
Consolidated Financial Statements."
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 Mr. Nacif's affiliates, which agreement was amended
in October 2004. Pursuant to the agreement, as amended, on November 30, 2004, we
sold to the purchasers substantially all of our assets and real property in
Mexico which include equipment and facilities previously leased to Mr. Nacif's
affiliates in 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; and
o $40,204,000, by delivery of secured promissory notes bearing
interest at 4.5% per annum, maturing on December 31, 2014
payable in equal installments of principal and interest over
the term of the notes.
Upon consummation of the sale, we entered into a purchase commitment
agreement with the purchasers, pursuant to which we have agreed to purchase
annually over the ten-year term of the agreement, $5 million of fabric
manufactured at our former facilities acquired by the purchasers at negotiated
market prices. This agreement replaced an existing purchase commitment agreement
whereby we were 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.
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
18
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.
Our disposition of our facilities in Mexico has reduced our working
capital requirements, eliminated the need to accept low or negative margin
orders to fill production capacity, and permitted us to source production in the
best locations worldwide. We believe that our strong design, merchandising and
sourcing capabilities are competitive advantages that will enable us to overcome
the desire by some retailers to purchase merchandise directly from the
manufacturer.
PRIVATE BRANDS INITIATIVE
During 2003, we launched our private brands initiative, where we
acquire ownership of or license rights to a brand name and sell apparel products
under this brand to a single retail company within a geographic region. During
2004, we made significant progress in our private brands initiative, as follows:
o Amended our agreement with Macy's Merchandising Group
(formerly Federated Merchandising Group) to exclusively
distribute American Rag Cie;
o Established an exclusive distribution with Dillard's
Department Stores for Alain Weiz;
o Added Gear 7 for distribution at K-Mart;
o Began discussions with, and subsequently entered into apparel
license agreement for House of Dereon by Beyonce; and
o Entered into apparel license agreement for Jessica Simpson.
INTERNAL REVENUE SERVICE AUDIT
In January 2004, the Internal Revenue Service completed its examination
of our Federal income tax returns for the years ended December 31, 1996 through
2001. The IRS has proposed adjustments to increase our income tax payable for
the six years under examination. This adjustment would also result in additional
state taxes and interest. In addition, in July 2004, the IRS initiated an
examination of our Federal income tax return for the year ended December 31,
2002. In March 2005, the IRS proposed an adjustment to our taxable income of
approximately $6 million related to similar issues identified in their audit of
the 1996 through 2001 federal income tax returns. The proposed adjustments to
our 2002 federal income tax return would not result in additional tax due for
that year due to the tax loss reported in the 2002 federal return. However, it
could reduce the amount of net operating losses available to offset taxes due
from the preceding tax years. We believe that we have meritorious defenses to
and intend to vigorously contest the proposed adjustments made to our federal
income tax returns for the years ended 1996 through 2002. If the proposed
adjustments are upheld through the administrative and legal process, they could
have a material impact on our earnings and cash flow. We believe we have
provided adequate reserves for any reasonably foreseeable outcome related to
these matters on the consolidated balance sheets included in the Consolidated
Financial Statements under the caption "Income Taxes". The maximum amount of
loss in excess of the amount accrued in the financial statements is $12.6
million. We do not believe that the adjustments, if any, arising from the IRS
examination, will result in an additional income tax liability beyond what is
recorded in the accompanying consolidated balance sheets.
19
LABOR DIFFICULTIES IN MEXICO
In connection with the restructuring of our Mexican operations, and the
resulting reduction in our Mexican work force, a group of laid off workers
attempted to form a new labor union and organized walkouts and demonstrations at
one of our sewing plants in Ajalpan, Mexico. These demonstrations took place in
August 2003 and were short-lived, but very well publicized. Workers rights
groups picked up the story and began an Internet campaign to publicize the
workers' grievances. In October 2003, a local labor board denied the group's
application to organize a new union. Nevertheless, we have remained 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 of these actions, we
experienced a significant decline in revenue of approximately $75 million from
sales of Mexico-produced merchandise in 2004 as compared to 2003.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Management's discussion and analysis of our financial condition and
results of operations are based upon our consolidated financial statements,
which have been prepared in accordance with accounting principles generally
accepted in the United States of America. The preparation of these financial
statements requires us to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenues and expenses, and related disclosures
of contingent assets and liabilities. We are required to make assumptions about
matters, which are highly uncertain at the time of the estimate. Different
estimates we could reasonably have used or changes in the estimates that are
reasonably likely to occur could have a material effect on our financial
condition or result of operations. Estimates and assumptions about future events
and their effects cannot be determined with certainty. On an ongoing basis, we
evaluate estimates, including those related to returns, discounts, bad debts,
inventories, intangible assets, income taxes, and contingencies and litigation.
We base our estimates on historical experience and on various assumptions
believed to be applicable and reasonable under the circumstances. These
estimates may change as new events occur, as additional information is obtained
and as our operating environment changes. In addition, management is
periodically faced with uncertainties, the outcomes of which are not within its
control and will not be known for prolonged period of time.
Management believes our financial statements are fairly stated in
accordance with accounting principles generally accepted in the United States of
America and provide a meaningful presentation of our financial condition and
results of operations.
We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our consolidated
financial statements. For a further discussion on the application of these and
other accounting policies, see Note 1 of the "Notes to Consolidated Financial
Statements."
ACCOUNTS RECEIVABLE--ALLOWANCE FOR RETURNS, DISCOUNTS AND BAD DEBTS
We evaluate the collectibility of accounts receivable and chargebacks
(disputes from the customer) based upon a combination of factors. In
circumstances where we are aware of a specific customer's inability to meet its
financial obligations (such as in the case of bankruptcy filings or substantial
downgrading of credit sources), a specific reserve for bad debts is taken
against amounts due to reduce the net recognized receivable to the amount
reasonably expected to be collected. For all other customers, we recognize
reserves for bad debts and chargebacks based on our historical collection
experience. If collection experience deteriorates (for example, due to an
unexpected material adverse
20
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 December 31, 2004, the balance in the allowance for returns,
discounts and bad debts reserves was $2.4 million, compared to $4.2 million at
December 31, 2003.
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 adopted SFAS No. 142 in fiscal 2002 and
performed our first annual assessment of impairment, which resulted in an
impairment loss of $4.9 million.
We utilized the discounted cash flow methodology to estimate fair
value. At December 31, 2004, we have a goodwill balance of $8.6 million, and a
net property and equipment balance of $1.9 million, as compared to a goodwill
balance of $8.6 million and a net property and equipment balance of $135.6
million at December 31, 2003. Our goodwill balance reflects the write off of
$19.5 million of goodwill in 2003 as discussed in "-- Significant Developments
in 2004 - Restructuring and Sale of Mexico Operations" and Note 5 and Note 7 of
the "Notes to Consolidated Financial Statements." Our net property and equipment
balance at December 31, 2004 reflects the disposal of our Mexico fixed assets of
$123.3 million in the fourth quarter of 2004.
We assess the carrying value of long-lived assets In accordance with
SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets."
In 2004, 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. Our determination of fair value was
determined based on independent appraisals of the property and equipment
obtained in June 2004.
21
FOREIGN CURRENCY TRANSLATION
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 sale in November 2004 of our fixed assets in Mexico, the foreign
currency translation adjustment related to our Mexico subsidiaries of
approximately $22.8 million of loss was reclassified and charged to income in
the fourth quarter of 2004.
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 sheets. Management records a valuation allowance to reduce
its deferred tax assets to the amount that is more likely than not to be
realized. Management has considered future taxable income and ongoing tax
planning strategies in assessing the need for the valuation allowance. Increases
in the valuation allowance result in additional expense to be reflected within
the tax provision in the consolidated statement of operations.
In addition, accruals are also estimated for ongoing audits regarding
U.S. Federal tax issues that are currently unresolved, based on our estimate of
whether, and the extent to which, additional taxes will be due. We routinely
monitor the potential impact of these situations and believe that amounts are
properly accrued for. If we ultimately determine that payment of these amounts
is unnecessary, we will reverse the liability and recognize a tax benefit during
the period in which we determine that the liability is no longer necessary. We
will record an additional charge in our provision for taxes in any period we
determine that the original estimate of a tax liability is less than we expect
the ultimate assessment to be. See Note 10 of the "Notes to Consolidated
Financial Statements" for a discussion of current tax matters.
DEBT COVENANTS
Our debt agreements require certain covenants including a minimum level
of net worth as discussed in Note 8 of the "Notes to Consolidated Financial
Statements." If our results of operations erode and we are not able to obtain
waivers from the lenders, the debt would be in default and callable by our
lenders. In addition, due to cross-default provisions in our debt agreements,
substantially all of our long-term debt would become due in full if any of the
debt is in default. In anticipation of us not being able to meet the required
covenants due to various reasons, we either negotiate for changes in the
relative covenants or 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,
including 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.
22
NEW ACCOUNTING PRONOUNCEMENTS
For a description of recent accounting pronouncements including the
respective expected dates of adoption and effects on results of operations and
financial condition, see Note 1 of the "Notes to Consolidated Financial
Statements."
RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, certain
items in our consolidated statements of income as a percentage of net sales:
YEARS ENDED DECEMBER 31,
-----------------------------
2002 2003 2004
------- ------- -------
Net sales ................................... 100.0 % 100.0 % 100.0 %
Cost of sales ............................... 87.0 90.0 86.5
------- ------- -------
Gross profit ................................ 13.0 10.0 13.5
Selling and distribution expenses ........... 3.1 3.5 6.0
General and administration expenses ......... 8.6 9.9 20.6
Impairment charges .......................... -- 7.0 50.2
Cumulative translation loss ................. -- -- 14.7
------- ------- -------
Income (loss) from operations ............... 1.3 (10.4) (78.0)
Interest expense ............................ (1.6) (1.7) (1.8)
Interest income ............................. 1.4 0.1 0.2
Minority interest ........................... (1.3) 1.0 9.9
Other income ................................ 0.8 1.5 4.6
Other expense ............................... (0.6) (0.4) (0.7)
------- ------- -------
Loss before provision for income taxes
and cumulative effect of accounting
change ................................... 0.0 (9.9) (65.8)
Income taxes ................................ (0.3) (1.3) (1.5)
------- ------- -------
Loss before cumulative effect of
accounting change ........................ (0.3) (11.2) (67.3)
Cumulative effect of accounting change(1) ... (1.4) -- --
------- ------- -------
Net loss .................................... (1.7)% (11.2)% (67.3)%
======= ======= =======
- ----------
(1) Reflects the adoption of SFAS No. 142
COMPARISON OF 2004 TO 2003
Net sales decreased by $165.0 million, or 51.5%, from $320.4 million in
2003 to $155.5 million in 2004. The decrease in net sales was largely
attributable to a decrease in Mexican sourced sales from $139.1 million in 2003
to $19.5 million. Several of our larger customers for Mexico produced jeans wear
refused to place orders with us following the restructuring of our Mexico
operations and resulting labor unrest in Mexico, which resulted in a decline in
revenue of approximately $75 million from sales of Mexico-produced merchandise
during 2004 as compared to 2003. Additionally, in 2004 we experienced a decline
in sales to certain customers of Mexico-sourced merchandise that was unrelated
to the labor unrest. In 2004, we also experienced a reduction of sales of fabric
to Mexican manufacturers of
23
approximately $17 million. We also experienced a reduction of sales from our
import operations in the Far East of approximately $40 million, due in part to
several of our larger customers reducing their back-to-school and holiday order
placements.
Gross profit consists of net sales less product costs, direct labor,
manufacturing overhead, duty, quota, freight in, brokerage, and warehousing
expense. Gross profit for 2004 was $21.0 million, or 13.5% of net sales,
compared to $32.0 million, or 10.0 % of net sales, for 2003, representing a
decrease of $11.0 million or 34.5%. The decrease in gross profit for 2004 was
primarily due to the substantial decrease in sales volume. The lower gross
profit, especially in the fourth quarter, was primarily due to unplanned air
freight costs and higher quota costs in some categories coupled with additional
inventory markdowns. The increase in gross profit as a percentage of net sales
for 2004 when compared to 2003 was primarily because of an inventory write-down
of $11 million and severance payments to Mexican workers of approximately $2.5
million included in cost of goods sold in 2003. Excluding the inventory
write-down and severance payments in 2003, gross profit as a percentage of net
sales for 2003 was 14.2% compared to 13.5% for 2004.
Selling and distribution expenses decreased by $2.0 million, or 18%,
from $11.3 million in 2003 to $9.3 million in 2004. As a percentage of net
sales, these variable expenses increased from 3.5% in 2003 to 6.0% in 2004 due
to the significant decline in sales during 2004.
General and administrative expenses increased by $317,000, or 1.0%,
from $31.8 million in 2003 to $32.1 million in 2004. As a percentage of net
sales, these expenses increased from 9.9% in 2003 to 20.6% in 2004 due to
significant decline in sales during 2004. This increase was partly caused by the
reclassification of $3.2 million of depreciation of our Mexican facilities from
cost of goods sold in the fourth quarter of 2003, compared to $6.8 million of
depreciation and $1.1 million of severance payments to Mexican workers in 2004.
Impairment charges were $78.0 million in 2004, compared to $22.3
million in 2003. The expense in 2004 was the impairment of long-lived assets of
our Mexico operations due to our decision to sell the manufacturing operations
in Mexico. The expense in 2003 included $19.5 million of the impairment of our
goodwill and intangible assets and $2.8 million of write-off of prepaid expenses
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.
See Note 5 and Note 7 of the "Notes to Consolidated Financial Statements."
Cumulative translation loss attributable to liquidated Mexico
operations was $22.8 million in 2004, or (14.7)% of net sales, compared to no
such expense in 2003. As discussed above, we incurred this charge upon the sale
of our fixed assets in Mexico in the fourth quarter of 2004.
Loss from operations was $121.2 million in 2004, or (78.0)% of net
sales, compared to $33.4 million in 2003, or (10.4)% of net sales, due to the
factors described above.
Interest expense decreased by $2.7 million, or 49.0%, from $5.6 million
in 2003 to $2.9 million in 2004. This decrease in interest expense was a result
of a decrease of the amount we financed under our main credit facility in 2004.
Interest income was $378,000 in 2004 compared to $425,000 in 2003. Other income
increased by $2.4 million, or 49.2%, from $4.8 million in 2003 to $7.1 million
in 2004, due to $3.7 million of lease income received for our facilities and
equipment in Mexico in 2003, compared to $5.5 million in 2004. Other expenses
decreased from $1.4 million in 2003 to $1.1 million in 2004.
Losses allocated to minority interests in 2004 was $15.3 million,
representing $471,000 attributed to the minority shareholder in United Apparel
Ventures, LLC, for its 49.9% share in the loss and $14.8 million attributed to
the minority shareholder in Tarrant Mexico for its 25% share in the loss. Losses
24
allocated to minority interests in 2003 was $3.5 million, representing the
minority partner's share of profit in UAV of $3.5 million, offset by $7.0
million attributed to the minority shareholder in Tarrant Mexico for its 25%
share in the loss including $4.4 million for its share in the special write-down
on goodwill and inventory of Tarrant Mexico.
Loss before provision for income taxes was $102.3 million in 2004 and
$31.8 million in 2003, representing (65.8)% and (9.9)% of net sales,
respectively. The increase in loss before provision for income was due to the
factors discussed above.
Provision for income taxes was $2.3 million in 2004 versus $4.1 million
in 2003, representing (1.5)% and (1.3)% of net sales, respectively.
Loss after taxes and cumulative effect of accounting change was $104.7
million in 2004 and $35.9 million in 2003, representing (67.3)% and (11.2)% of
net sales, respectively. Included in the $104.7 million loss in 2004 were
charges of $78.0 million for the impairment of long-lived assets and $22.8
million of cumulative translation loss attributable to liquidated Mexico
operations. Included in the $35.9 million loss in 2003 were non-cash charges of
$22.3 million for the impairment of assets and an inventory write-down of $11
million.
COMPARISON OF 2003 TO 2002
Net sales decreased by $27.0 million, or 7.8% from $347.4 million in
2002 to $320.4 million in 2003. The decrease in net sales was largely
attributable to a decrease in Mexican sourced sales from $186.9 million in 2002
to $139.1 million in 2003. This decrease in net sales was primarily a result of
the cessation of our manufacturing operations in Mexico in September 2003 and
the labor difficulties and workers' rights activities we experienced following
the reduction of our Mexico work force. The decrease in net sales was partially
offset by additional revenue of $20.5 million from sales of private brands,
which we started to develop during 2003. However, the private brand revenue was
not sufficient to cover the loss of sales volume from Mexican-sourced products.
Gross profit for 2003 was $32.0 million, or 10.0% of net sales,
compared to $45.3 million, or 13.0% of net sales, for 2002, representing a
decrease of $13.3 million or 29.4%. The decrease in gross profit as a percentage
of net sales occurred primarily because of an inventory write-down of $11
million in the second quarter of 2003 and severance payments to Mexican workers
of approximately $2.5 million included in cost of goods sold in 2003. This
increase in cost of goods sold was partially offset by a reclassification of
depreciation and amortization in fourth quarter of 2003 of $3.2 million to
general and administration expense. Excluding the inventory write-down,
severance payments and reclassification of depreciation and amortization in
2003, gross profit would have decreased by $3.0 million or 6.6% to $42.3 million
or 13.2%.
Selling and distribution expenses increased by $572,000, or 5.3%, from
$10.8 million in 2002 to $11.3 million in 2003. As a percentage of net sales,
these variable expenses increased from 3.1% in 2002 to 3.5% in 2003. The
increase was primarily caused by an overall increase in warehousing and
distribution cost due to the sale of private brands apparel in smaller size
shipments.
General and administrative expenses increased by $1.7 million, or 5.6%,
from $30.1 million in 2002 to $31.8 million in 2003. As a percentage of net
sales, these expenses increased from 8.6% in 2002 to 9.9% in 2003. This increase
was primarily caused by the reclassification of $3.2 million of depreciation
from cost of goods sold in the fourth quarter of 2003. The charge for the change
in the allowances for returns and discounts for 2003 was $183,000, or 0.1% of
sales, compared to such charge of $867,000, or 0.2% of sales, during 2002.
25
Impairment charge was $22.3 million in 2003, compared to $4.9 million
in 2002 being classified as a cumulative effect of accounting change in
accordance with SFAS 142. This expense in 2003 is 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. See Note 7 of the
"Notes to Consolidated Financial Statements."
Loss from operations was $33.4 million in 2003, or (10.4)% of net
sales, compared to income from operations of $4.5 million in 2002, or 1.3% of
net sales, due to the factors described above.
Interest expense increased by $159,000, or 2.9%, from $5.4 million in
2002 to $5.6 million in 2003. This increase in interest expense was a result of
an increase in interest rate applicable to our main credit facility. Interest
income was $425,000 in 2003 compared to $4.7 million in 2002. Included in
interest income for 2002 was approximately $4.5 million from a related party
note receivable related to the sale of certain equipment pertaining to the twill
mill, which we re-acquired in December 2002. Other income increased by $2.1
million, or 80.7%, from $2.6 million in 2002 to $4.8 million in 2003, due to
$3.7 million of lease income received for our facilities and equipment in Mexico
starting September 1, 2003, offset by a reduction of realized gain on foreign
currency of $819,000. Other expenses decreased from $2.0 million in 2002 to $1.4
million in 2003 due to a reduction of unrealized loss on foreign currency of
$454,000.
Losses allocated to minority interests in 2003 was $3.5 million,
representing the minority partner's share of profit in United Apparel Ventures,
LLC of $3.5 million, offset by $7.0 million attributed to the minority
shareholder in Tarrant Mexico for its 25% share in the loss including $4.4
million for its share in the special write-down on goodwill and inventory of
Tarrant Mexico. In 2002, we allocated $4.6 million of profit to minority
interest, which consisted of profit shared by the minority partner in the UAV
joint venture.
Loss before taxes and cumulative effect of accounting change was
$163,000 in 2002 and $31.8 million in 2003, representing 0.0% and (9.9)% of net
sales, respectively. The increase in loss before taxes and cumulative effect of
accounting change was due to the factors discussed above.
Provision for income taxes was $1.1 million in 2002 versus $4.1 million
in 2003. The increase in income tax expense is due to adjustments to the accrual
for potential IRS audits and increases in the valuation allowance.
Loss after taxes and cumulative effect of accounting change was $6.1
million in 2002 and $35.9 million in 2003, representing (1.7)% and (11.2)% of
net sales, respectively. Included in the $6.1 million loss in 2002 was a
non-cash charge of $4.9 million to reduce the carrying value of goodwill to the
estimated fair value, resulting from adoption of SFAS No. 142, "Goodwill and
Other Intangible Assets." Included in the $35.9 million loss in 2003 were
non-cash charges of $22.3 million for the impairment of assets and an inventory
write-down of $11 million.
26
QUARTERLY RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, certain
items in our consolidated statements of income in millions of dollars and as a
percentage of net sales:
QUARTER ENDED
----------------------------------------------------------------------
MAR.31 JUN.30 SEP.30 DEC.31 MAR.31 JUN.30 SEP.30 DEC.31
2003 2003 2003 2003 2004 2004 2004 2004
------- ------- ------- ------- ------- ------- ------- -------
Net Sales ....... $ 78.7 $ 78.2 $ 96.5 $ 67.0 $ 42.2 $ 38.5 $ 38.1 $ 36.7
Gross profit .... 8.8 (0.4) 11.5 12.1 7.5 5.3 4.1 4.1
Operating income
(loss) ......... (1.3) (34.4) 1.4 0.8 (5.9) (84.4) (3.4) (27.5)
Net income (loss) (3.9) (32.6) 0.1 0.4 (3.0) (68.6) (4.0) (29.1)
QUARTER ENDED
--------------------------------------------------------------------------
MAR.31 JUN.30 SEP.30 DEC.31 MAR.31 JUN.30 SEP.30 DEC.31
2003 2003 2003 2003 2004 2004 2004 2004
- ----------------- ------ ------ ------ ------ ------ ------ ------ ------
Net sales ....... 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Gross profit .... 11.2 (0.6) 11.9 18.0 17.8 13.7 10.9 11.1
Operating income
(loss) ......... (1.7) (44.0) 1.5 1.2 (14.0) (219.2) (9.0) (74.7)
Net income (loss) (4.9) (41.7) 0.1 0.6 (7.1) (178.1) (10.5) (79.3)
As is typical for us, quarterly net sales fluctuated significantly
because our customers typically place bulk orders with us, and a change in the
number of orders shipped in any one period may have a material effect on the net
sales for that period.
27
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, issuance of long-term debt, sales of equity and debt securities, and
vendor financing. In the near term, we expect that our operations and borrowings
under bank and other credit facilities will provide sufficient cash to fund our
operating expenses, capital expenditures and interest payments on our debt. In
the long-term, we expect to use internally generated funds and external sources
to satisfy our debt and other long-term liabilities.
Our liquidity is dependent, in part, on customers paying on time. Any
abnormal chargebacks or returns may affect our source of short-term funding. Any
changes in credit terms given to major customers may have an impact on our cash
flow. Suppliers' credit is another major source of short-term financing and any
adverse changes in their terms will have negative impact on our cash flow.
Other principal factors that could affect the availability of our
internally generated funds include:
o deterioration of sales due to weakness in the markets in which
we sell our products;
o decreases in market prices for our products;
o increases in costs of raw materials; and
o changes in our working capital requirements.
Principal factors that could affect our ability to obtain cash from
external sources include:
o financial covenants contained in our current or future bank
and debt facilities; and
o volatility in the market price of our common stock or in the
stock markets in general.
The disposition of our Mexico operations has enabled us to return to
the business model that was profitable prior to implementation of our vertically
integrated manufacturing operations that required major capital expenditures and
substantial working capital. The lease and subsequent sale of our Mexican
facilities significantly reduced our working capital requirements due to fewer
employees and the elimination of fixed overhead. Investment in inventory also
was substantially reduced as we no longer need to purchase raw materials, such
as cotton, at commencement of the manufacturing process and carry the costs of
such materials until finished goods are shipped to our customers. Reduced
working capital and capital expenditures in Mexico has resulted in a
corresponding reduction of outstanding indebtedness and interest payments.
Furthermore, we no longer need to accept orders with low or negative margins to
fill production capacity in slow seasons, which should improve margins and allow
us to source production in the best locations worldwide.
28
Cash flows for the years ended December 31, 2002, 2003 and 2004 were as
follows (dollars in thousands):
CASH FLOWS: 2002 2003 2004
- -------------------------------------------- -------- -------- --------
Net cash provided by operating activities .. $ 15,493 $ 9,484 $ 12,168
Net cash provided by (used in) investing
activities .............................. $ (5,670) $ (1,053) $ 1,250
Net cash used in financing activities ...... $ (8,435) $ (6,295) $(15,552)
Net cash provided by operating activities was $12.2 million in 2004, as
compared to net cash provided by operations in 2003 of $9.5 million and $15.5
million in 2002. Net cash provided by operations in 2004 resulted primarily from
a net loss of $104.7 million offset by depreciation and amortization of $8.3
million, asset impairment of $78.0 million and cumulative translation of $22.8
million. In addition to these items, the components of working capital impacting
cash from operations included a decrease of $21.2 million in accounts receivable
and a decrease of $4.2 million in inventory.
During 2004, cash flow provided by investing activities was $1.3
million, as compared to net cash used in investing activities of $1.1 million in
2003 and $5.7 million in 2002. Cash provided by investing activities in 2004
included approximately $1.2 million of proceeds from the sale of fixed assets.
During 2004, net cash used in financing activities was $15.6 million as
compared to $6.3 million in 2003 and $8.4 million in 2002. Net cash used in
financing activities in 2004 included $11.3 million net repayment of our
short-term bank borrowings and $17.2 million net repayment of indebtedness under
our credit facilities, partially offset by $9.4 million of net proceeds from the
issuance of convertible debentures and $3.6 million of net proceeds from the
issuance of preferred stock and warrant.
CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
Following is a summary of our contractual obligations and commercial
commitments available to us as of December 31, 2004 (in millions):
PAYMENTS DUE BY PERIOD
------------------------------------------------
Between Between
Less than 2-3 4-5 After
CONTRACTUAL OBLIGATION Total 1 year years years 5 years
-------- ------- ------- ------- -------
Long-term debt(1) ................ $ 22.2 $ 19.6 $ 2.6 $ -- $ --
Convertible debentures, net ...... $ 10.0 $ -- $ 10.0 $ -- $ --
Operating leases ................. $ 0.6 $ 0.3 $ 0.3 $ -- $ --
Minimum royalties ................ $ 17.9 $ 2.8 $ 7.5 $ 1.9 $ 5.7
Purchase commitment .............. $ 50.0 $ 5.0 $ 10.0 $ 10.0 $ 25.0
-------- ------- ------- ------- -------
Total Contractual Cash Obligations $ 100.7 $ 27.7 $ 30.4 $ 11.9 $ 30.7
- ----------
(1) Excludes interest on long-term debt obligations. Based on outstanding
borrowings as of December 31, 2004, and assuming all such indebtedness
remained outstanding during 2005 and the interest rates remained
unchanged, we estimate that our interest cost on long-term debt would be
approximately $3.2 million.
29
AMOUNT OF COMMITMENT
EXPIRATION PER PERIOD
TOTAL AMOUNTS ----------------------------------------------
OTHER COMMERCIAL COMMITTED Less than Between Between After
COMMITMENTS AVAILABLE TO US TO US 1 year 2-3 years 4-5 years 5 years
- ------------------------------------------ ------------- ---------- --------- --------- -------
Lines of credit........................... $63.9 $63.9 -- -- --
Letters of credit (within lines of credit) $18.9 $18.9 -- -- --
Total Commercial Commitments.............. $63.9 $63.9 -- -- --
On June 13, 2002, we entered into a letter of credit facility of $25
million with UPS Capital Global Trade Finance Corporation ("UPS"). Under this
facility, we may arrange for the issuance of letters of credit and acceptances.
The facility is collateralized by the shares and debentures of all of our
subsidiaries in Hong Kong. In addition to the guarantees provided by Tarrant
Apparel Group and our subsidiaries, Fashion Resource (TCL) Inc. and Tarrant
Luxembourg Sarl, Gerard Guez, our Chairman, also signed a guarantee of $5
million in favor of UPS to secure this facility. This facility bears interest at
6.25% per annum at December 31, 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. On December 31, 2004, we
amended the letter of credit facility with UPS to reduce the maximum amount of
borrowings under the facility to $15 million and extend the expiration date of
the facility to June 30, 2005. Under the amended letter of credit facility, we
are subject to restrictive financial covenants of maintaining tangible net worth
of $22 million at each of December 31, 2004 and March 31, 2005 and $25 million
as of the last day of each fiscal quarter thereafter. There is also a provision
capping maximum capital expenditures per quarter of $800,000. As of December 31,
2004, $12.6 million was outstanding under this facility with UPS, and an
additional $1.3 million was available for future borrowings. In addition, $1.1
million of open letters of credit was outstanding as of December 31, 2004.
On December 31, 2004, our Hong Kong subsidiaries also entered into a
new loan agreement with UPS pursuant to which UPS made a $5 million term loan,
the proceeds of which were used to repay $5 million of indebtedness owed to UPS
under the letter of credit of facility. The principal amount of this loan is due
and payable in 24 equal monthly installments of approximately $208,333 each,
plus interest equivalent to the "prime rate" plus 2% commencing on February 1,
2005. Under the loan agreement, we are subject to restrictive financial
covenants of maintaining tangible net worth of $22 million at each of December
31, 2004 and March 31, 2005 and $25 million as of the last day of each fiscal
quarter thereafter. There is also a provision capping maximum capital
expenditure per quarter at $800,000. As of December 31, 2004, we were in
compliance with the covenants. The obligations under the loan agreement are
collateralized by the same security interests and guarantees as the letter of
credit facility. Additionally, the term loan is secured by two promissory notes
payable to Tarrant Luxembourg Sarl in the amounts of $2,550,000 and $1,360,000
and a pledge by Gerard Guez of 4.6 million shares of our common stock to secure
the obligations.
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 December 31, 2004, $3.4
million was outstanding under this facility. In addition, $1.4 million of open
letters of credit was outstanding as of December 31, 2004. In October 2004, a
tax loan for HKD 7.725 million (equivalent to US $977,000) was also made
available to our Hong Kong subsidiaries. As of December 31, 2004, $916,000 was
outstanding under this tax loan.
30
We were previously party to a revolving credit, factoring and security
agreement (the "Debt Facility") with GMAC Commercial Credit, LLC ("GMAC"). This
Debt Facility provided a revolving facility of $90 million, including a letter
of credit facility not to exceed $20 million, and was scheduled to mature on
January 31, 2005. The Debt Facility also provided a term loan of $25 million,
which was being repaid in monthly installments of $687,500. The Debt Facility
provided for interest at LIBOR plus the LIBOR rate margin determined by the
Total Leverage Ratio (as defined in the Debt Facility agreements), and was
collateralized by our receivables, intangibles, inventory and various other
specified non-equipment assets. In May 2004, the maximum facility amount was
reduced to $45 million in total and we established new financial covenants with
GMAC for the fiscal year of 2004.
On October 1, 2004, we amended and restated the Debt Facility dated
January 21, 2000 by and among us, our subsidiaries, TagMex, Inc. Fashion
Resource (TCL) Inc and United Apparel Ventures, LLC and GMAC. The amended and
restated agreement (the Factoring agreement) adds as parties our subsidiaries
Private Brands, Inc and No! Jeans, Inc. In addition, in connection with the
factoring agreement, our indirect majority-owned subsidiary, PBG7, LLC. entered
into a separate factoring agreement with GMAC. Pursuant to the terms of the
factoring agreement, we and our subsidiaries agree to assign and sell to GMAC,
as factor, all accounts which arise from the Tarrant Parties' sale of
merchandise or rendition of service created on a going forward basis. At
Tarrant's request, GMAC, in its discretion, may make advances to Tarrant Parties
up to the lesser of (a) up to 90% of our accounts on which GMAC has the risk of
loss and (b) forty million dollars, minus in each case, any amount owed to GMAC
by any Tarrant Party. Pursuant to the terms of the PBG7 factoring agreement,
PBG7 agreed to assign and sell to GMAC, as factor, all accounts, which arise
from PBG7's sale of merchandise or rendition of services created on a
going-forward basis. At PBG7's request, GMAC, in its discretion, may make
advances to PBG7 up to the lesser of (a) up to 90% of PBG7's accounts on which
GMAC has the risk of loss, and (b) five million minus in each case, any amounts
owed to GMAC by PBG7. Under both factoring agreement, any amounts, which GMAC
advances in excess of the purchase price of the relevant accounts, are
considered to be loans and are chargeable to the Tarrant Parties' or PBG7's when
paid. Each of the parties only become obligated to GMAC for a direct financial
obligation in the event that GMAC makes and advance in excess of the purchase
price of the relevant accounts, and any such obligations are payable on demand.
This facility bears interest at 6% per annum at December 31, 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. As of December
31, 2004 we were in compliance with the new tangible net worth and capital
expense covenants. A total of $17.0 million was outstanding under the GMAC
facility at December 31, 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 factoring facility with GMAC is
determined based on a defined borrowing base formula related to eligible
accounts receivable. A significant decrease in eligible accounts receivable due
to the aging of receivables, can have an adverse effect on our borrowing
capabilities under our credit facility, which may adversely affect the adequacy
of our working capital. In addition, we have typically experienced seasonal
fluctuations in sales volume. These seasonal fluctuations result in sales volume
decreases in the first and fourth quarters of each year due to the seasonal
fluctuations experienced by the majority of our customers. During these
quarters, borrowing availability under our credit facility may decrease as a
result of decrease in eligible accounts receivables generated from our sales.
31
On December 14, 2004, we completed a $10 million financing through the
issuance of 6% Secured Convertible Debentures ("Debentures") and warrants to
purchase up to 1,250,000 shares of our common stock. Prior to maturity, the
investors may convert the Debentures into shares of our common stock at a price
of $2.00 per share. The warrants have a term of five years and an exercise price
of $2.50 per share. The Debentures bear interest at a rate of 6% per annum and
have a term of three years. We may elect to pay interest on the Debentures in
shares of our common stock if certain conditions are met, including a minimum
market price and trading volume for our common stock. The Debentures contain
customary events of default and permit the holders thereof to accelerate the
maturity if the full principal amount together with interest and other amounts
owing upon the occurrence of such events of default. The Debentures are secured
by a subordinated lien on certain of our accounts receivable and related assets.
The placement agent in the financing, for its services were paid $620,000 in
cash and issued five year warrants to purchase up to 200,000 shares of our
common stock at an exercise price of $2.50 per share.
On February 14, 2005, we borrowed $5 million from Max Azria, which
amount bears interest at the rate of 4% per annum and is payable in weekly
installments of $250,000 beginning on February 28, 2005 and continuing each
Monday until July 11, 2005. This is an unsecured loan.
Tarrant Mexico S. de R.L. de C.V., Famian division was previously
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, which was scheduled to mature in November 2005. The
loan was secured by equipment located in Puebla and Tlaxcala, Mexico, and
interest accrued at a rate of 2.5% over LIBOR. 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. As of December
31, 2004, $135,000 remained outstanding under these notes, which amount was paid
off in February 2005. A portion of the debt was denominated in Euros. Unrealized
transaction (loss) gain associated with the debt denominated in Euros totaled
$(1.0) million, $(561,000) and $367,000 for the years ended December 31, 2002,
2003 and 2004, respectively. These amounts were recorded in other income
(expense) in the accompanying consolidated statements of operations.
From time to time, we open letters of credit under an uncommitted line
of credit from Aurora Capital Associates who issues these letters of credit out
of Israeli Discount Bank. As of December 31, 2004, $1.0 million was outstanding
under this facility and $7.5 million of letters of credit were open under this
arrangement.
The effective interest rates on short-term bank borrowing as of
December 31, 2003 and 2004 were 5.3% and 5.7%, respectively.
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.
32
From time to time in the past, we borrowed funds from, and advanced
funds to, certain officers and principal shareholders, including Gerard Guez and
Todd Kay. See disclosure under "-Related Party Transactions" below.
As discussed above, the Internal Revenue Service has proposed
adjustments to our Federal income tax returns to increase our income tax payable
for the years ended December 31, 1996 through 2001. This adjustment would also
result in additional state taxes and interest. In addition, in July 2004, the
IRS initiated an examination of our Federal income tax return for the year ended
December 31, 2002. In March 2005, the IRS proposed an adjustment to our taxable
income of approximately $6 million related to similar issues identified in their
audit of the 1996 through 2001 federal income tax returns. We believe that we
have meritorious defenses to and intend to vigorously contest the proposed
adjustments made to our federal income tax returns for the years ended 1996
through 2002. We believe that we have meritorious defenses to and intend to
vigorously contest the proposed adjustments. If the proposed adjustments are
upheld through the administrative and legal process, they could have a material
impact on our earnings and, in particular, cash flow. We may not have an
adequate cash reserve to pay the final adjustments resulting from the IRS
examination. As a result, we may be required to arrange for payments over time
or raise additional capital in order to meet these obligations. We believe we
have provided adequate reserves for any reasonably foreseeable outcome related
to these matters on the consolidated balance sheets included in the Consolidated
Financial Statements under the caption "Income Taxes." The maximum amount of
loss in excess of the amount accrued in the financial statements is $12.6
million. We do not believe that the adjustments, if any, arising from the IRS
examination, will result in an additional income tax liability beyond what is
recorded in the accompanying consolidated balance sheets.
We may seek to finance future capital investment programs through
various methods, including, but not limited to, borrowings under our bank credit
facilities, issuance of long-term debt, sales of equity securities, leases and
long-term financing provided by the sellers of facilities or the suppliers of
certain equipment used in such facilities. To date, there is no plan for any
major capital expenditure.
We do not believe that the moderate levels of inflation in the United
States in the last three years have had a significant effect on net sales or
profitability.
RELATED PARTY TRANSACTIONS
We lease our principal offices and warehouse located in Los Angeles,
California from GET and office space in Hong Kong from Lynx International
Limited. GET and Lynx International Limited are each owned by Gerard Guez, our
Chairman of the Board of Directors, and Todd Kay, our Vice Chairman of the Board
of Directors. We believe, at the time the leases were entered into, the rents on
these properties were comparable to then prevailing market rents. We are
currently leasing both of these facilities on a month-to-month basis. We paid
$1,330,000 in 2004 for rent for office and warehouse facilities at these
locations.
In February 2004, our Hong Kong subsidiary entered into a 50/50 joint
venture with Auto Enterprises Limited, an unrelated third party, to source
products for Seven Licensing Company, LLC and our Private Brands subsidiary in
mainland China. On May 31, 2004, after realizing an accumulated loss from the
venture of approximately $200,000 (our share being half), we sold our interest
for $1 to Asia Trading Limited, a company owned by Jacqueline Rose, wife of
Gerard Guez. The venture owed us $221,000 as of December 31, 2004.
On October 16, 2003, we leased to affiliates of Mr. Kamel Nacif, a
shareholder at the time of the transaction, 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,
33
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 agreed to manage the
operation of our remaining facilities in Mexico in exchange for the use of such
facilities. The term of the management services agreement was also for a period
of 6 years. In 2004, $5.5 million of lease income was recorded in other income.
We 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. We purchased $5.3 million of fabric under this agreement in 2004.
Net amount due from Mr. Kamel Nacif and his affiliates was $183,000 as of
December 31, 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 previously leased to Mr.
Nacif's affiliates. Upon completion of this transaction in the fourth quarter of
2004, we entered into a new purchase commitment agreement with Mr. Nacif's
affiliates to replace our previously purchase commitment agreement. Pursuant the
new purchase commitment agreement we agreed to purchase $5 million of fabric
manufactured at the facilities we sold to Mr. Nacif's affiliates annually over
the ten-year term of the agreement, at negotiated market prices. See Note 5 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 and
Todd Kay. The greatest outstanding balance of such advances to Mr. Guez during
2004 was approximately $4,796,000. Mr. Guez paid our expenses of approximately
$456,000 and $400,000 for the years ended December 31, 2003 and 2004,
respectively, which amounts were applied to reduce accrued interest and
principle on Mr. Guez's loan. Subsequently, Mr. Guez repaid $2.3 million of this
indebtedness during January and February of 2005. This $2.3 million was included
in due from related parties in the accompanying consolidated balance sheet as of
December 31, 2004. The remaining balance of $2,466,000 is payable on demand and
had been shown as reductions to shareholders' equity as of December 31, 2004.
There were no outstanding advances from or borrowing to Mr. Kay during 2004. All
advances to, and borrowings from, Mr. Guez bore interest at the rate of 7.75%
during the period. Total interest paid by Mr. Guez was $374,000 and $370,000 for
the years ended December 31, 2003 and 2004, respectively. Since the enactment of
the Sarbanes-Oxley Act in 2002, no further personal loans (or amendments to
existing loans) have been or will be made to officers or directors of Tarrant.
Since June 2003, United Apparel Venture LLC, a majority owned,
controlled and consolidated subsidiary of Tarrant, 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 Gerard Guez. In the third quarter of 2004, in order to
strengthen our own private brand business, we decided to discontinue sourcing
for Seven7. Total sales to Seven Licensing during the year ended December 31,
2004 were $2.6 million.
On July 1, 2001, we formed an entity to jointly market, share certain
risks and achieve economies of scale with Azteca Production International, Inc.
("Azteca"), called United Apparel Ventures, LLC ("UAV"). Azteca is owned by
Hubert Guez, the brother of Gerard Guez, our Chairman. This entity was created
to coordinate the production of apparel for a single customer of our branded
business. UAV is owned 50.1% by Tag Mex, Inc., our wholly owned subsidiary, and
49.9% by Azteca. Results of the operation of UAV have been consolidated into our
results since July 2001 with the minority partner's share of all gains and loses
eliminated through the minority interest line in our financial statements. Due
to the restructuring of our Mexico operations, we discontinued manufacturing for
UAV customers in the second quarter of 2004. Two and one half percent of gross
sales as management fees were paid in 2003 and 2004 to each of the members of
UAV, per the operating agreement. We purchased $37.0 million, $37.1 million and
$11.5 million of finished goods and service from Azteca and its affiliates for
the years
34
ended December 31, 2002, 2003 and 2004, respectively. Our total sales of fabric
and service to Azteca in 2002, 2003 and 2004 were $2.9 million, $9.9 million and
$1.0 million, respectively.
At December 31, 2004, Messrs. Guez and Kay beneficially owned 961,000
and 1,003,500 shares, respectively, of common stock of Tag-It Pacific, Inc.
("Tag-It"), collectively representing 10.8% of Tag-It Pacific's common stock at
December 31, 2004. Tag-It is a provider of brand identity programs to
manufacturers and retailers of apparel and accessories. 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. 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. Due to the restructuring of our Mexico operations, Tag-It no
longer manages our trim and packaging requirements. We purchased $23.9 million,
$16.8 million and $1.0 million of trim from Tag-It during the years ended
December 31, 2002, 2003 and 2004. We sold to Tag-It $1.5 million and $0 from our
trim and fabric inventory during the year ended December 31, 2003 and 2004,
respectively. From time to time we have guaranteed the indebtedness of Tag-It
for the purchase of trim on our behalf. See Note 8 of the "Notes to Consolidated
Financial Statements."
We believe the each of the transactions described above has been
entered into on terms no less favorable to us than could have been obtained from
unaffiliated third parties. We have adopted a policy that any transactions
between us and any of our affiliates or related parties, including our executive
officers, directors, the family members of those individuals and any of their
affiliates, must (i) be approved by a majority of the members of the Board of
Directors and by a majority of the disinterested members of the Board of
Directors and (ii) be on terms no less favorable to us than could be obtained
from unaffiliated third parties.
FACTORS THAT MAY AFFECT FUTURE RESULTS
This Annual Report on Form 10-K 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.
Kohl's accounted for 6.6% and 16.4% of our net sales in fiscal years
2003 and 2004, respectively. Mervyn's accounted for 5.9% and 15.4% of our net
sales in fiscal years 2003 and 2004, respectively. Lerner New York accounted for
8.3% and 15.0% of our net sales in fiscal years 2003 and 2004, respectively.
Affiliated department stores owned by Federated Department Stores accounted for
approximately 5.2% and 10.3% of our net sales in fiscal years 2003 and 2004,
respectively. Wet Seal accounted for approximately 3.3% and 7.9% of our net
sales in fiscal years 2003 and 2004, respectively. We believe that consolidation
in the retail industry has centralized purchasing decisions and given customers
greater leverage over suppliers, like us, and we expect this trend to continue.
If this consolidation continues, our net sales and results of operations may be
increasingly sensitive to deterioration in the financial condition of, or other
adverse developments with, one or more of our customers.
While we have long-standing customer relationships, we generally do not
have long-term contracts with them. Purchases generally occur on an
order-by-order basis, and relationships exist as long
35
as there is a perceived benefit to both parties. A decision by a major customer,
whether motivated by competitive considerations, financial difficulties, and
economic conditions or otherwise, to decrease its purchases from us or to change
its manner of doing business with us, could adversely affect our business and
financial condition. In addition, during recent years, various retailers,
including some of our customers, have experienced significant changes and
difficulties, including consolidation of ownership, increased centralization of
purchasing decisions, restructurings, bankruptcies and liquidations.
These and other financial problems of some of our retailers, as well as
general weakness in the retail environment, increase the risk of extending
credit to these retailers. A significant adverse change in a customer
relationship or in a customer's financial position could cause us to limit or
discontinue business with that customer, require us to assume more credit risk
relating to that customer's receivables, limit our ability to collect amounts
related to previous purchases by that customer, or result in required prepayment
of our receivables securitization arrangements, all of which could harm our
business and financial condition.
FAILURE OF THE TRANSPORTATION INFRASTRUCTURE TO MOVE SEA FREIGHT IN ACCEPTABLE
TIME FRAMES COULD ADVERSELY AFFECT OUR BUSINESS.
Because the bulk of our freight is designed to move through the West
Coast ports in predictable time frames, we are at risk of cancellations and
penalties when those ports operate inefficiently creating delays in delivery. We
experienced such delays from June 2004 until November 2004, and we may continue
to experience similar delays in the future especially during peak seasons. There
can be no assurances of, and we have no control over a return to timely
deliveries. Unpredictable timing for shipping may cause us to utilize air
freight or may result in customer penalties for late delivery, any of which
could reduce our operating margins and adversely effect our results of
operations.
FAILURE TO MANAGE OUR GROWTH AND EXPANSION COULD IMPAIR OUR BUSINESS.
Since our inception, we have experienced periods of rapid growth. No
assurance can be given that we will be successful in maintaining or increasing
our sales in the future. Any future growth in sales will require additional
working capital and may place a significant strain on our management, management
information systems, inventory management, sourcing capability, distribution
facilities and receivables management. Any disruption in our order processing,
sourcing or distribution systems could cause orders to be shipped late, and
under industry practices, retailers generally can cancel orders or refuse to
accept goods due to late shipment. Such cancellations and returns would result
in a reduction in revenue, increased administrative and shipping costs and a
further burden on our distribution facilities.
FAILURE TO MANAGE OUR RESTRUCTURING IN MEXICO COULD IMPAIR OUR BUSINESS.
We determined to cease directly operating a substantial majority of our
equipment and fixed assets in Mexico, and to lease a large portion of our
facilities and operations in Mexico to a related third party, which we
consummated effective September 1, 2003. Subsequently, in August 2004, we
entered into a purchase and sale agreement to sell substantially all of our
assets and real property in Mexico, including the equipment and facilities
previously leased to Mr. Nacif's affiliates, which transaction was consummated
in the fourth quarter of 2004. As a consequence, we have become primarily a
trading company, relying on third party manufacturers to produce the merchandise
we sell to our customers and as a result assume the risks associated with
contracting these services.
OUR OPERATING RESULTS MAY FLUCTUATE SIGNIFICANTLY.
We have experienced, and expect to continue to experience, substantial
variations in our net sales and operating results from quarter to quarter. We
believe that the factors which influence this variability
36
of quarterly results include the timing of our introduction of new product
lines, the level of consumer acceptance of each new product line, general
economic and industry conditions that affect consumer spending and retailer
purchasing, the availability of manufacturing capacity, the seasonality of the
markets in which we participate, the timing of trade shows, the product mix of
customer orders, the timing of the placement or cancellation of customer orders,
the weather, transportation delays, quotas, the occurrence of charge backs in
excess of reserves and the timing of expenditures in anticipation of increased
sales and actions of competitors. Due to fluctuations in our revenue and
operating expenses, we believe that period-to-period comparisons of our results
of operations are not a good indication of our future performance. It is
possible that in some future quarter or quarters, our operating results will be
below the expectations of securities analysts or investors. In that case, our
stock price could fluctuate significantly or decline.
THE FINANCIAL CONDITION OF OUR CUSTOMERS COULD AFFECT OUR RESULTS OF OPERATIONS.
Certain retailers, including some of our customers, have experienced in
the past, and may experience in the future, financial difficulties, which
increase the risk of extending credit to such retailers and the risk that
financial failure will eliminate a customer entirely. These retailers have
attempted to improve their own operating efficiencies by concentrating their
purchasing power among a narrowing group of vendors. There can be no assurance
that we will remain a preferred vendor for our existing customers. A decrease in
business from or loss of a major customer could have a material adverse effect
on our results of operations. There can be no assurance that our factor will
approve the extension of credit to certain retail customers in the future. If a
customer's credit is not approved by the factor, we could assume the collection
risk on sales to the customer itself, require that the customer provide a letter
of credit, or choose not to make sales to the customer.
WE DEPEND ON OUR COMPUTER AND COMMUNICATIONS SYSTEMS.
As a multi-national corporation, we rely on our computer and
communication network to operate efficiently. Any interruption of this service
from power loss, telecommunications failure, weather, natural disasters or any
similar event could have a material adverse affect on our business and
operations. Additionally, hackers and computer viruses have disrupted operations
at many major companies. We may be vulnerable to similar acts of sabotage, which
could have a material adverse effect on our business and operations.
WE MAY REQUIRE ADDITIONAL CAPITAL IN THE FUTURE.
We may not be able to fund our future growth or react to competitive
pressures if we lack sufficient funds. Currently, we believe we have sufficient
cash on hand and cash available through our bank credit facilities, issuance of
long-term debt, proceeds from loans from affiliates, and proceeds from the
exercise of stock options to fund existing operations for the foreseeable
future. However, in the future we may need to raise additional funds through
equity or debt financings or collaborative relationships. This additional
funding may not be available or, if available, it may not be available on
economically reasonable terms. In addition, any additional funding may result in
significant dilution to existing shareholders. If adequate funds are not
available, we may be required to curtail our operations or obtain funds through
collaborative partners that may require us to release material rights to our
products.
OUR BUSINESS IS SUBJECT TO RISKS ASSOCIATED WITH IMPORTING PRODUCTS.
Substantially all of our import operations are subject to tariffs
imposed on imported products and quotas imposed by trade agreements. In
addition, the countries in which our products are manufactured or imported may
from time to time impose additional new duties, tariffs or other restrictions on
our imports
37
or adversely modify existing restrictions. Adverse changes in these import costs
and restrictions, or our suppliers' failure to comply with customs or similar
laws, could harm our business. We cannot assure that future trade agreements
will not provide our competitors with an advantage over us, or increase our
costs, either of which could have an adverse effect on our business and
financial condition.
Our operations are also subject to the effects of international trade
agreements and regulations such as the North American Free Trade Agreement, and
the activities and regulations of the World Trade Organization. Generally, these
trade agreements benefit our business by reducing or eliminating the duties
assessed on products manufactured in a particular country. However, trade
agreements can also impose requirements that adversely affect our business, such
as limiting the countries from which we can purchase raw materials and setting
duties or restrictions on products that may be imported into the United States
from a particular country. In addition, the World Trade Organization may
commence a new round of trade negotiations that liberalize textile trade by
further eliminating 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 determined to cease 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
38
assurance, however, that in the future we will not be subject to sanctions as a
result of violations of applicable labor laws by our contractors, or that such
sanctions will not have a material adverse effect on our business and results of
operations. In addition, certain of our customers, require strict compliance by
their apparel manufacturers, including us, with applicable labor laws and visit
our facilities often. There can be no assurance that the violation of applicable
labor laws by one of our contractors will not have a material adverse effect on
our relationship with our customers.
OUR BUSINESS IS SUBJECT TO RISKS OF OPERATING IN A FOREIGN COUNTRY AND TRADE
RESTRICTIONS.
Approximately 91% of our products were imported from outside the U.S.
in fiscal 2004. We are subject to the risks associated with doing business in
foreign countries, including, but not limited to, transportation delays and
interruptions, political instability, expropriation, currency fluctuations and
the imposition of tariffs, import and export controls, other non-tariff barriers
and cultural issues. Any changes in those countries' labor laws and government
regulations may have a negative effect on our profitability.
RISK ASSOCIATED WITH OUR INDUSTRY
OUR SALES ARE HEAVILY INFLUENCED BY GENERAL ECONOMIC CYCLES.
Apparel is a cyclical industry that is heavily dependent upon the
overall level of consumer spending. Purchases of apparel and related goods tend
to be highly correlated with cycles in the disposable income of our consumers.
Our customers anticipate and respond to adverse changes in economic conditions
and uncertainty by reducing inventories and canceling orders. As a result, any
substantial deterioration in general economic conditions, increases in interest
rates, acts of war, terrorist or political events that diminish consumer
spending and confidence in any of the regions in which we compete, could reduce
our sales and adversely affect our business and financial condition.
OUR BUSINESS IS HIGHLY COMPETITIVE AND DEPENDS ON CONSUMER SPENDING PATTERNS.
The apparel industry is highly competitive. We face a variety of
competitive challenges including:
o anticipating and quickly responding to changing consumer
demands;
o developing innovative, high-quality products in sizes, colors
and styles that appeal to consumers of varying age groups and
tastes;
o competitively pricing our products and achieving customer
perception of value; and
o the need to provide strong and effective marketing support.
WE MUST SUCCESSFULLY GAUGE FASHION TRENDS AND CHANGING CONSUMER PREFERENCES TO
SUCCEED.
Our success is largely dependent upon our ability to gauge the fashion
tastes of our customers and to provide merchandise that satisfies retail and
customer demand in a timely manner. The apparel business fluctuates according to
changes in consumer preferences dictated in part by fashion and season. To the
extent we misjudge the market for our 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.
39
OUR BUSINESS IS SUBJECT TO SEASONAL TRENDS.
Historically, our operating results have been subject to seasonal
trends when measured on a quarterly basis. This trend is dependent on numerous
factors, including the markets in which we operate, holiday seasons, consumer
demand, climate, economic conditions and numerous other factors beyond our
control. There can be no assurance that our historic operating patterns will
continue in future periods as we cannot influence or forecast many of these
factors.
OTHER RISKS RELATED TO AN INVESTMENT IN OUR COMMON STOCK
THE ULTIMATE RESOLUTION OF THE INTERNAL REVENUE SERVICE'S EXAMINATION OF OUR TAX
RETURNS MAY REQUIRE US TO INCUR AN EXPENSE BEYOND WHAT HAS BEEN RESERVED FOR ON
OUR BALANCE SHEET OR MAKE CASH PAYMENTS BEYOND WHAT WE ARE THEN ABLE TO PAY.
In January 2004, the Internal Revenue Service proposed adjustments to
increase our federal income tax payable for the years ended December 31, 1996
through 2001. This adjustment would also result in additional state taxes,
penalties and interest. In addition, in July 2004, the IRS initiated an
examination of our Federal income tax return for the year ended December 31,
2002. In March 2005, the IRS proposed an adjustment to our taxable income of
approximately $6 million related to similar issues identified in their audit of
the 1996 through 2001 federal income tax returns. We believe that we have
meritorious defenses to and intend to vigorously contest the proposed
adjustments made to our federal income tax returns for the years ended 1996
through 2002. If the proposed adjustments are upheld through the administrative
and legal process, they could have a material impact on our earnings and cash
flow. We believe we have provided adequate reserves for any reasonably
foreseeable outcome related to these matters on the consolidated balance sheets
included in the Consolidated Financial Statements. The maximum amount of loss in
excess of the amount accrued in the financial statements is $12.6 million. If
the amount of any actual liability, however, exceeds our reserves, we would
experience an immediate adverse earnings impact in the amount of such additional
liability, which could be material. Additionally, we anticipate that the
ultimate resolution of these matters will require that we make significant cash
payments to the taxing authorities. Presently we do not have sufficient cash or
borrowing ability to make any future payments that may be required. No assurance
can be given that we will have sufficient surplus cash from operations to make
the required payments. Additionally, any cash used for these purposes will not
be available for other corporate purposes, which could have a material adverse
effect on our financial condition and results of operations.
INSIDERS OWN A SIGNIFICANT PORTION OF OUR COMMON STOCK, WHICH COULD LIMIT OUR
SHAREHOLDERS' ABILITY TO INFLUENCE THE OUTCOME OF KEY TRANSACTIONS.
As of March 31, 2005, our executive officers and directors and their
affiliates owned approximately 45% of the outstanding shares of our common
stock. Gerard Guez, our Chairman, and Todd Kay, our Vice Chairman, alone own
approximately 35.1% and 8.9%, respectively, of the outstanding shares of our
common stock at March 31, 2005. Accordingly, our executive officers and
directors have the ability to affect the outcome of, or exert considerable
influence over, all matters requiring shareholder approval, including the
election and removal of directors and any change in control. This concentration
of ownership of our common stock could have the effect of delaying or preventing
a change of control of us or otherwise discouraging or preventing a potential
acquirer from attempting to obtain control of us. This, in turn, could have a
negative effect on the market price of our common stock. It could also prevent
our shareholders from realizing a premium over the market prices for their
shares of common stock.
40
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 7A. 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.
41
INTEREST RATE RISK. Because our obligations under our various credit
agreements bear interest at floating rates (primarily LIBOR rates), we are
sensitive to changes in prevailing interest rates. Any major increase or
decrease in market interest rates that affect our financial instruments would
have a material impact on earning or cash flows during the next fiscal year.
Our interest expense is sensitive to changes in the general level of
U.S. interest rates. In this regard, changes in U.S. interest rates affect
interest paid on our debt. A majority of our credit facilities are at variable
rates.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See "Item 15. Exhibits, Financial Statement Schedules and Reports on
Form 8K" for our financial statements, and the notes thereto, and the financial
statement schedules filed as part of this report.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH THE ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
ITEM 9A. CONTROLS AND PROCEDURES
EVALUATION OF CONTROLS AND PROCEDURES
Members of the company's management, including our Chief Executive
Officer and Chief Financial Officer have evaluated the effectiveness of our
disclosure controls and procedures, as defined by paragraph (e) of Exchange Act
Rules 13a-15 or 15d-15, as of December 31, 2004, the end of the period covered
by this report. Based upon that evaluation, the Chief Executive Officer and
Chief Financial Officer concluded that our disclosure controls and procedures
are effective.
CHANGES IN CONTROLS AND PROCEDURES
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, during the fourth quarter of
2004.
RECOMMENDATIONS OF OUR AUDITORS
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 us.
Grant Thornton LLP considered these matters to be significant deficiencies as
that term is defined under standards established by the Public Company
Accounting Oversight Board (United States). In response to the observations made
by Grant Thornton LLP, in 2004 we implemented certain enhancements to our
financial reporting processes, including hiring a new Chief Financial Officer
and reassigning a member of our financial staff to a newly created "Financial
Reporting" position, and increased training of staff on SEC financial reporting
requirements. We also are evaluating various accounting research tools to
provide more technical resources to our financial reporting group. The member of
our financial staff assigned to the Financial Reporting position has since left
the company, and our corporate controller presently is performing the functions
of this new position. We will continue to evaluate the performance and needs of
our financial staff, including
42
whether to fill the vacancy in the Financial Reporting position, and implement
changes that we determine are necessary or advisable. We believe we are taking
the appropriate steps to address the matters raised by Grant Thornton LLP.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS
The information concerning our directors and executive officers will
appear in our definitive Proxy Statement to be filed pursuant to Regulation 14A
within 120 days after the end of our last fiscal year (the "Proxy Statement"),
and is incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
The information concerning executive compensation will appear in our
definitive Proxy Statement and is incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
The information concerning the security ownership of certain beneficial
owners and management and related stockholder matters will appear in our
definitive Proxy Statement and is incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information concerning certain relationships and related
transactions will appear in our definitive Proxy Statement and is incorporated
herein by reference.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information concerning principal accountant fees and services will
appear in our definitive Proxy Statement and is incorporated herein by
reference.
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a) Financial Statements and Schedule. Reference is made to the
Index to Financial Statements and Schedule on page F-1 for a list of financial
statements and the financial statement schedule filed as part of this report.
All other schedules are omitted because they are not applicable or the required
information is shown in the Company's financial statements or the related notes
thereto.
(b) Exhibits. See the Exhibit Index attached to this Form 10-K
annual report.
43
INDEX TO FINANCIAL STATEMENTS AND SCHEDULE
PAGE
----
Financial Statements
Report of Independent Registered Public Accounting Firm,
Grant Thornton LLP...................................................F-2
Report of Independent Registered Public Accounting Firm,
Ernst & Young LLP....................................................F-3
Consolidated Balance Sheets--December 31, 2003 and 2004..................F-4
Consolidated Statements of Operations and Comprehensive Loss--
Three year period ended December 31, 2004............................F-5
Consolidated Statements of Shareholders' Equity--Three year
period ended December 31, 2004.......................................F-6
Consolidated Statements of Cash Flows--Three year period
ended December 31, 2004..............................................F-7
Notes to Consolidated Financial Statements...............................F-8
Financial Statement Schedule
Schedule II--Valuation and Qualifying Accounts..........................F-39
F-1
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Stockholders
Tarrant Apparel Group
We have audited the accompanying consolidated balance sheets of Tarrant Apparel
Group (a California corporation) and subsidiaries as of December 31, 2004 and
2003, and the related consolidated statements of operations and comprehensive
loss, shareholders' equity, and cash flows for the years then ended. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. The Company is not required to
have, nor were we engaged to perform an audit of its internal control over
financial reporting. Our audit included consideration of internal control over
financial reporting as a basis for designing audit procedures that are
appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company's internal control over financial
reporting. Accordingly, we express no such opinion. An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Tarrant
Apparel Group and subsidiaries at December 31, 2004 and 2003 and the
consolidated results of their operations and their consolidated cash flows for
the years then ended in conformity with accounting principles generally accepted
in the United States of America.
We have also audited Schedule II of Tarrant Apparel Group for the years ended
December 31, 2004 and 2003. In our opinion, this schedule presents fairly, in
all material respects, the information required to be set forth therein.
/S/ GRANT THORNTON LLP
- --------------------------------------
Los Angeles, California
March 24, 2005, except for Note 19,
as to which the date is March 30, 2005
F-2
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors
Tarrant Apparel Group
We have audited the accompanying statements of operations, shareholders' equity,
and cash flows of Tarrant Apparel Group for the year ended December 31, 2002.
Our audit also included the financial statement schedule listed in the Index at
Item 15(a) for the year ended December 31, 2002. These financial statements and
schedule are the responsibility of the Company's management. Our responsibility
is to express an opinion on these financial statements and schedule based on our
audit.
We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. We were not engaged to perform an
audit of the Company's internal control over financial reporting. Our audit
included consideration of internal control over financial reporting as a basis
for designing audit procedures that are appropriate in the circumstances, but
not for the purpose of expressing an opinion on the effectiveness of the
Company's internal control over financial reporting. Accordingly, we express no
such opinion. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, also assessing the
accounting principles used and significant estimates made by management, as well
as evaluating the overall financial statement presentation. We believe that our
audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated results of operations and cash flows of
Tarrant Apparel Group and subsidiaries for the year ended December 31, 2002 in
conformity with accounting principles generally accepted in the United States.
Also, in our opinion, the related financial statement schedule for the year
ended December 31, 2002 when considered in relation to the basic financial
statements, taken as a whole, presents fairly in all material respects the
information set forth therein.
As discussed in Note 6 to the consolidated financial statements, effective
January 1, 2002, the Company adopted Statement of Financial Accounting Standards
No. 142.
/S/ ERNST & YOUNG LLP
- -----------------------
Los Angeles, California
March 14, 2003
F-3
TARRANT APPAREL GROUP
CONSOLIDATED BALANCE SHEETS
DECEMBER 31,
------------------------------
2003 2004
------------- -------------
ASSETS
------
Current assets:
Cash and cash equivalents ........................ $ 3,319,964 $ 1,214,944
Restricted cash .................................. 2,759,742 --
Accounts receivable, net ......................... 57,165,926 37,759,343
Due from related parties ......................... 18,056,488 10,651,914
Inventory ........................................ 23,251,591 19,144,105
Current portion of note receivable from
related party ................................. -- 5,323,733
Prepaid expenses ................................. 1,776,142 1,251,684
Prepaid royalties ................................ -- 2,257,985
Income taxes receivable .......................... 277,695 144,796
------------- -------------
Total current assets ........................... 106,607,548 77,748,504
Property and equipment, net ...................... 135,645,751 1,874,893
Notes receivable - related party, net of
current portion ............................... -- 40,107,337
Equity method investment ......................... 1,434,375 1,880,281
Deferred financing cost, net ..................... 326,932 1,203,259
Other assets ..................................... 507,704 414,161
Goodwill, net .................................... 8,582,845 8,582,845
------------- -------------
Total assets ................................... $ 253,105,155 $ 131,811,280
============= =============
LIABILITIES AND SHAREHOLDERS' EQUITY
------------------------------------
Current liabilities:
Short-term bank borrowings ....................... $ 29,293,323 $ 17,951,157
Accounts payable ................................. 23,514,894 24,394,553
Accrued expenses ................................. 11,194,421 11,243,179
Income taxes ..................................... 16,497,939 16,826,383
Due to related parties ........................... 5,418,795 --
Due to shareholders .............................. 496 --
Current portion of long-term obligations ......... 38,705,240 19,628,701
------------- -------------
Total current liabilities ...................... 124,625,108 90,043,973
Long-term obligations .............................. 588,272 2,544,546
Convertible debentures, net ........................ -- 8,330,483
Deferred tax liabilities ........................... 275,129 213,784
Minority interest in UAV ........................... 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 (2003) and no
shares (2004) issued and outstanding ............. -- --
Common stock, no par value, 100,000,000
shares authorized; 27,614,763 shares
(2003) and 28,814,763 shares (2004)
issued and outstanding ........................... 107,891,426 111,515,091
Warrant to purchase common stock ................... 1,798,733 2,846,833
Contributed capital ................................ 1,505,831 2,470,869
Retained earnings (Accumulated deficit) ............ 20,988,434 (83,688,237)
Notes receivable from officer/shareholder .......... (4,796,428) (2,466,062)
Accumulated other comprehensive loss ............... (19,679,185) --
------------- -------------
Total shareholders' equity ....................... 107,708,811 30,678,494
------------- -------------
Total liabilities and shareholders'
equity ........................................ $ 253,105,155 $ 131,811,280
============= =============
See accompanying notes
F-4
TARRANT APPAREL GROUP
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
YEAR ENDED DECEMBER 31,
-----------------------------------------------
2002 2003 2004
------------- ------------- -------------
Net sales ................................... $ 347,390,930 $ 320,422,850 $ 155,452,663
Cost of sales ............................... 302,082,144 288,445,173 134,492,460
------------- ------------- -------------
Gross profit ................................ 45,308,786 31,977,677 20,960,203
Selling and distribution expenses ........... 10,757,029 11,329,414 9,290,819
General and administrative expenses ......... 30,082,061 31,767,122 32,083,637
Write-off of prepaid expenses ............... -- 2,771,989 --
Impairment charges .......................... -- 19,504,521 77,982,034
Cumulative translation loss attributable to
liquidated Mexico operations ............. -- -- 22,786,125
------------- ------------- -------------
Income (loss) from operations ............... 4,469,696 (33,395,369) (121,182,412)
Interest expense ............................ (5,443,995) (5,602,556) (2,857,096)
Interest income ............................. 4,748,144 424,518 377,587
Minority interest ........................... (4,580,766) 3,461,243 15,331,171
Other income ................................ 2,647,975 4,784,479 7,136,343
Other expense ............................... (2,004,073) (1,425,346) (1,134,145)
------------- ------------- -------------
Loss before provision for income taxes and
cumulative effect of accounting change ... (163,019) (31,753,031) (102,328,552)
Provision for income taxes .................. 1,051,018 4,131,629 2,348,119
------------- ------------- -------------
Loss before cumulative effect of
accounting change ........................ (1,214,037) (35,884,660) (104,676,671)
Cumulative effect of accounting change ...... (4,871,244) -- --
------------- ------------- -------------
Net loss .................................... $ (6,085,281) $ (35,884,660) $(104,676,671)
============= ============= =============
Net loss per share - Basic and Diluted:
Before cumulative effect of
accounting change ..................... $ (0.08) $ (1.97) $ (3.64)
Cumulative effect of accounting change ... (0.30) -- --
------------- ------------- -------------
After cumulative effect of
accounting change ..................... $ (0.38) $ (1.97) $ (3.64)
============= ============= =============
Weighted average common and common equivalent
shares outstanding:
Basic and Diluted ........................... 15,834,122 18,215,071 28,732,796
============= ============= =============
Net loss .................................... $ (6,085,281) $ (35,884,660) $(104,676,671)
Foreign curreny translation adjustment ...... (13,282,977) (9,945,727) --
------------- ------------- -------------
Total Comprehensive loss .................... $ (19,368,258) $ (45,830,387) $(104,676,671)
============= ============= =============
See accompanying notes.
F-5
TARRANT APPAREL GROUP
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2002, 2003 AND 2004
Preferred Number Common Number Contributed
Stock of Shares Stock of Shares Warrants Capital
------------- ------------- ------------- ------------- ------------- -------------
Balance at January 1, 2002 ... $ -- -- $ 69,341,090 15,840,815 -- $ 1,434,259
Net loss ................... -- -- -- -- -- --
Currency translation ....... -- -- -- -- -- --
Comprehensive loss ......... -- -- -- -- -- --
Exercise of stock options .. -- -- 24,135 5,500 -- --
Income tax benefit from
exercise of stock options . -- -- 3,014 -- -- --
Issuance of preferred stock 8,820,573 100,000 -- -- -- --
Repayment from shareholders,
net ....................... -- -- -- -- -- --
------------- ------------- ------------- ------------- ------------- -------------
Balance at December 31, 2002 . 8,820,573 100,000 69,368,239 15,846,315 -- 1,434,259
Net loss ................... -- -- -- -- -- --
Currency translation ....... -- -- -- -- -- --
Comprehensive loss ......... -- -- -- -- -- --
Conversion of preferred
stock to common stock ..... (8,820,573) (100,000) 8,820,573 3,000,000 -- --
Issuance of preferred stock
and warrant, net .......... 29,226,041 881,732 -- -- 1,798,733 --
Conversion of preferred
stock to common stock ..... (29,226,041) (881,732) 29,226,041 8,817,320 -- --
Issuance of common stock ... -- -- 788,000 200,000 -- --
Retirement of stock ........ -- -- (311,427) (248,872) -- --
Compensation expense ....... -- -- -- -- -- 71,572
Repayment from shareholders -- -- -- -- -- --
------------- ------------- ------------- ------------- ------------- -------------
Balance at December 31, 2003 . -- -- 107,891,426 27,614,763 1,798,733 1,505,831
Currency translation ....... -- -- -- -- -- --
Net loss ................... -- -- -- -- -- --
Cumulative translation loss
attributable to liquidated
Mexico operations ........ -- -- -- -- -- --
Compensation expense ....... -- -- -- -- -- 161,038
Issuance of common stock ... -- -- 3,623,665 1,200,000 44,100 --
Issuance of warrants with
debentures ............... -- -- -- -- 1,004,000 --
Intrinsic value of bene-
ficial conversion
associated with con-
vertible debentures ...... -- -- -- -- -- 804,000
Repayment from shareholders -- -- -- -- -- --
Reclassification of share-
holders' receivable to
current asset ............ -- -- -- -- -- --
------------- ------------- ------------- ------------- ------------- -------------
Balance at December 31, 2004 . $ -- -- $ 111,515,091 28,814,763 $ 2,846,833 $ 2,470,869
============= ============= ============= ============= ============= =============
Retained Accumulated
Earnings Other Notes Total
(Accumulated Comprehensive from Shareholders'
Deficit) Income (Loss) Shareholders Equity
------------- ------------- ------------- -------------
Balance at January 1, 2002 ... $ 62,958,375 $ 3,549,519 $ (12,118,773) $ 125,164,470
Net loss ................... (6,085,281) -- -- (6,085,281)
Currency translation ....... -- (13,282,977) -- (13,282,977)
-------------
Comprehensive loss ......... -- -- -- (19,368,258)
Exercise of stock options .. -- -- -- 24,135
Income tax benefit from
exercise of stock options . -- -- -- 3,014
Issuance of preferred stock -- -- -- 8,820,573
Repayment from shareholders,
net ....................... -- -- 6,516,969 6,516,969
------------- ------------- ------------- -------------
Balance at December 31, 2002 . 56,873,094 (9,733,458) (5,601,804) 121,160,903
Net loss ................... (35,884,660) -- -- (35,844,660)
Currency translation ....... -- (9,945,727) -- (9,945,727)
-------------
Comprehensive loss ......... -- -- -- (45,830,387)
Conversion of preferred
stock to common stock ..... -- -- -- --
Issuance of preferred stock
and warrant, net .......... -- -- -- 31,024,774
Conversion of preferred
stock to common stock ..... -- -- -- --
Issuance of common stock ... -- -- -- 788,000
Retirement of stock ........ -- -- -- (311,427)
Compensation expense ....... -- -- -- 71,572
Repayment from shareholders -- -- 805,376 805,376
------------- ------------- ------------- -------------
Balance at December 31, 2003 . 20,988,434 (19,679,185) (4,796,428) 107,708,811
Currency translation ....... -- (3,106,940) -- (3,106,940)
Net loss ................... (104,676,671) -- -- (104,676,671)
Cumulative translation loss
attributable to liquidated
Mexico operations ........ -- 22,786,125 -- 22,786,125
Compensation expense ....... -- -- -- 161,038
Issuance of common stock ... -- -- -- 3,667,765
Issuance of warrants with
debentures ............... -- -- -- 1,004,000
Intrinsic value of bene-
ficial conversion
associated with con-
vertible debentures ...... -- -- -- 804,000
Repayment from shareholders -- -- 30,366 30,366
Reclassification of share-
holders' receivable to
current asset ............ -- -- 2,300,000 2,300,000
------------- ------------- ------------- -------------
Balance at December 31, 2004 . $ (83,688,237) $ -- $ (2,466,062) $ 30,678,494
============= ============= ============= =============
See accompanying notes
F-6
TARRANT APPAREL GROUP
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31,
2002 2003 2004
------------- ------------- -------------
Operating activities:
Net loss .............................................. $ (6,085,281) $ (35,884,660) $(104,676,671)
Adjustments to reconcile net loss to net cash
provided by operating activities:
Deferred taxes ..................................... (107,162) (132,622) (61,345)
Depreciation and amortization ...................... 10,130,132 16,097,595 8,337,946
Accrued interest on note receivable ................ (4,452,490) -- --
Cumulative effect of accounting change ............. 4,871,244 -- --
Impairment charges ................................. -- 22,276,510 77,982,034
Cumulative transaction loss attributable to
the liquidated Mexico operations ................ -- -- 22,786,125
Inventory write-down ............................... -- 10,986,153 --
Income from equity method investment ............... -- -- (769,706)
Loss on sale of fixed assets ....................... 5,291 593,626 (15,272)
Unrealized (gain) loss on foreign currency ......... 1,014,696 560,602 (367,262)
Minority interest .................................. 4,426,080 (3,218,069) (15,331,171)
Gain on legal settlement ........................... (473,041) (235,785) --
Compensation expense related to stock options ...... -- 71,572 161,038
Change in the provision for returns and discounts .. 453,167 (324,387) (1,747,060)
Changes in operating assets and liabilities:
Restricted cash ................................. -- (2,759,742) 2,759,742
Accounts receivable ............................. (7,141,536) 7,856,700 21,224,454
Due to/from related parties ..................... (673,650) (14,801,324) (122,389)
Inventory ....................................... 5,818,431 9,626,509 4,162,158
Temporary quota ................................. 369,849 -- --
Prepaid expenses ................................ 1,551,324 590,046 (1,860,955)
Accounts payable ................................ (3,772,979) (4,207,552) 687,758
Accrued expenses and income tax payable ......... 8,211,770 2,388,976 (981,196)
------------- ------------- -------------
Net cash provided by operating activities .......... 15,493,145 9,484,148 12,168,228
Investing activities:
Purchase of fixed assets .............................. (2,984,547) (368,113) (111,836)
Proceeds from sale of fixed assets .................... -- 209,788
1,219,904
Acquisitions, net of cash ............................. (2,355,954) -- --
(Increase) decrease in other assets ................... 509,524 (983,593) 111,837
Advances to shareholders/officers ..................... (1,008,591) -- --
Collection of advances from shareholders/officers ..... 169,991 88,723 30,366
------------- ------------- -------------
Net cash provided by (used in) investing activities (5,669,577) (1,053,195) 1,250,271
Financing activities:
Short-term bank borrowings, net ....................... 7,241,576 (161,194) (11,342,166)
Proceeds from long-term obligations ................... 198,551,201 239,280,109 129,162,451
Payment of long-term obligations and bank borrowings .. (211,894,730) (275,640,677) (146,375,987)
Repayments of borrowings from shareholders/officers ... (2,359,847) (486,379) --
Proceeds from issuance of preferred stock and warrant . -- 31,024,774 3,623,665
Proceeds from convertible debentures, net ............. -- -- 9,379,965
Repurchase of shares .................................. -- (311,427) --
Exercise of stock options including related tax benefit 27,149 -- --
------------- ------------- -------------
Net cash used in financing activities .............. (8,434,651) (6,294,794) (15,552,072)
Effect of exchange rate on cash ....................... (1,524,882) (204,677) 28,553
------------- ------------- -------------
Increase (decrease) in cash and cash equivalents ...... (135,965) 1,931,482 (2,105,020)
Cash and cash equivalents at beginning of year ........ 1,524,447 1,388,482 3,319,964
------------- ------------- -------------
Cash and cash equivalents at end of year .............. $ 1,388,482 $ 3,319,964 $ 1,214,944
============= ============= =============
See accompanying notes
F-7
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
ORGANIZATION AND BASIS OF CONSOLIDATION
The accompanying financial statements consist of the consolidation of Tarrant
Apparel Group, a California corporation (formerly "Fashion Resource, Inc."), and
its majority owned Subsidiaries located primarily in the U.S., Mexico, and Asia.
At December 31, 2004, we own 50.1% of United Apparel Ventures ("UAV") and 75% of
PBG7, LLC ("PBG7"). We consolidate these entities and reflect the minority
interests in earnings (losses) of the ventures in the accompanying financial
statements. All inter-company amounts are eliminated in consolidation. The 49.9%
minority interest in UAV is owned by Azteca Production International, a
corporation owned by the brothers of our Chairman, Gerard Guez. The 25% minority
interest in PBG7 is owned by BH7, LLC.
We serve specialty retail, mass merchandise and department store chains and
major international brands by designing, merchandising, contracting for the
manufacture of, and selling casual apparel for women, men and children under
private label. Commencing in 1999, we expanded our operations from sourcing
apparel to sourcing and operating our own vertically integrated manufacturing
facilities. In August 2003, we determined to abandon our strategy of being both
a trading and vertically integrated manufacturing company, and effective
September 1, 2003, we leased and outsourced operation of our manufacturing
facilities in Mexico to affiliates of Mr. Kamel Nacif, a shareholder at the time
of the transaction. See Note 15 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 consummated
in the fourth quarter of 2004. See Note 5 and Note 7 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.
RISK AND UNCERTAINTIES - IRS EXAMINATION AND DEBT COVENANTS
As discussed in Note 10 of the "Notes to Consolidated Financial Statements," our
federal income tax returns for the years ended December 31, 1996 through 2002
are under examination by the Internal Revenue Service ("IRS"). The IRS has
proposed adjustments to increase our federal income tax payable for these years.
This adjustment would also result in additional state taxes, penalties and
interest. We believe that we have meritorious defenses to and intend to
vigorously contest the proposed adjustments made to our federal income tax
returns for the years ended 1996 through 2002. If the proposed adjustments are
upheld through the administrative and legal process, they could have a material
impact on our earnings and cash flow. The maximum amount of loss in excess of
the amount accrued in the financial statements is $12.6 million. If the amount
of any actual liability, however, exceeds our reserves, we would experience an
immediate adverse earnings impact in the amount of such additional liability,
which could be material. Additionally, we anticipate that the ultimate
resolution of these matters will require that we make significant cash payments
to the taxing authorities. Presently we do not have sufficient cash or borrowing
ability to make any future payments that may be required. No assurance can be
given that we will have sufficient surplus cash from operations to make the
required payments. Additionally, any cash used for these purposes will not be
available for other corporate purposes, which could have a material adverse
effect on our financial condition and results of operations. See Note 10 of the
"Notes to Consolidated Financial Statements" for a further discussion on the IRS
examination.
F-8
DEBT COVENANTS
As discussed in Note 8 of the "Notes to Consolidated Financial Statements," our
debt agreements require certain covenants including a minimum level of net
worth. If our results of operations erode and we are not able to obtain waivers
from the lenders, the debt would be in default and callable by our lenders. In
addition, due to cross-default provisions in our debt agreements, substantially
all of our long-term debt would become due in full if any of the debt is in
default. In anticipation of us not being able to meet the required covenants due
to various reasons, we either negotiate for changes in the relative covenants or
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, including 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. See Note 8 of the "Notes to Consolidated
Financial Statements" for a further discussion of the credit facilities and
related debt covenants.
REVENUE RECOGNITION
Revenue is recognized at the point of shipment for all merchandise sold based on
FOB shipping point. For merchandise shipped on landed duty paid ("LDP") terms,
revenue is recognized at the point of either leaving Customs for direct
shipments or at the point of leaving our warehouse where title is transferred.
Customers are allowed the rights of return or non-acceptance only upon receipt
of damaged products or goods with quality different from shipment samples. We do
not undertake any after-sale warranty or any form of price protection.
We often arrange, on behalf of manufacturers, for the purchase of fabric from a
single supplier. We have the fabric shipped directly to the cutting factory and
invoice the factory for the fabric. Generally, the factories pay us for the
fabric with offsets against the price of the finished goods.
SHIPPING AND HANDLING COSTS
Freight charges are included in selling and distribution expenses in the
statement of operations and amounted to $2,136,000, $1,817,000 and $783,000 for
the years ended December 31, 2002, 2003 and 2004, respectively. We did not bill
customers for shipping and handling costs for the years 2002, 2003 and 2004.
CASH AND CASH EQUIVALENTS AND RESTRICTED CASH
Cash equivalents consist of cash and highly liquid investments with an original
maturity of three months or less when purchased. Restricted cash refers to cash
deposit(s) held as collateral by lending institution(s) to either guarantee our
liabilities and/or loans. Cash and cash equivalents, including restricted cash,
held in foreign financial institutions totaled $3,930,000 and $1,206,000 as of
December 31, 2003 and 2004, respectively. Restricted cash is not considered a
cash equivalent for purposes of the statement of cash flows.
ACCOUNTS RECEIVABLE--ALLOWANCE FOR RETURNS, DISCOUNTS AND BAD DEBTS
We evaluate the collectibility of accounts receivable and chargebacks (disputes
from the customer) based upon a combination of factors. In circumstances where
we are aware of a specific customer's inability to meet its financial
obligations (such as in the case of bankruptcy filings or substantial
downgrading of credit sources), a specific reserve for bad debts is taken
against amounts due to reduce the net recognized receivable to the amount
reasonably expected to be collected. For all other customers, we recognize
reserves for bad debts and uncollectible chargebacks 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 December 31, 2003 and 2004,
the balance of the allowance for returns, discounts and bad debts was $4.2
million and $2.4 million, respectively.
F-9
INVENTORIES
Inventories are stated (valued) at the lower of cost (first-in, first-out) 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.
COST OF SALES
Cost of sales includes costs related to product costs, direct labor,
manufacturing overhead, duty, quota, freight in, brokerage and warehousing
expense.
SELLING AND DISTRIBUTION EXPENSES
Selling and distribution expenses include expenses related to samples, travel
and entertainment, salaries, rent and other office expenses, professional fees,
freight out and selling commissions incurred in the sales process.
GENERAL AND ADMINISTRATIVE EXPENSES
General and administrative expenses include expenses related to research and
product development, travel and entertainment, salaries, rent and other office
expenses, depreciation and amortization, professional fees and bank charges.
PRODUCT DESIGN, ADVERTISING AND SALES PROMOTION COSTS
Product design, advertising and sales promotion costs are expensed as incurred.
Product design, advertising and sales promotion costs included in selling,
general and administrative expenses in the accompanying statements of operations
(excluding the costs of manufacturing production samples) amounted to
approximately $1,225,000, $1,306,000 and $2,106,000 in 2002, 2003 and 2004,
respectively.
QUOTA
We purchase quota rights to be used in the importation of our products from
certain foreign countries. The effect of quota transactions is accounted for as
a product cost.
Permanent quota entitlements were principally obtained through free allocations
by the Hong Kong Government pursuant to an import restraint between Hong Kong
and the United States and are renewable on an annual basis, based upon the prior
year utilization. Permanent quota entitlements acquired from outside parties are
amortized over three years on a straight-line basis, and were fully amortized at
December 31, 2003 and 2004.
Temporary quota represents quota rights acquired from other permanent quota
entitlement holders on a temporary basis. Temporary quota has a maximum life of
twelve months. The cost of temporary quota purchased for use in the current year
is assigned to inventory purchases while the cost of temporary quota acquired
for usage in the year following the balance sheet date is recorded as a current
asset. At December 31, 2003 and 2004, there were no temporary quota rights
included in current assets.
PROPERTY AND EQUIPMENT
Property and equipment is recorded at cost. Additions and betterments are
capitalized while repair and maintenance costs are charged to operations as
incurred. Depreciation of property and equipment is provided for by the
straight-line method over their estimated useful lives. Leasehold improvements
are amortized using the straight-line method over the lesser of their estimated
useful lives or the term of the lease. Upon retirement or disposal of property
and equipment, the cost and related accumulated depreciation are eliminated from
the accounts and any gain or loss is reflected in the statement of operations.
Repair and maintenance costs are charged to expense as incurred. The estimated
useful lives of the assets are as follows:
F-10
Buildings 35 to 40 years
Equipment 7 to 15 years
Furniture and Fixtures 5 to 7 years
Vehicles 5 years
Leasehold Improvements Term of lease
INTANGIBLES
The excess of cost over fair value of net assets acquired was amortized over
five to thirty years through December 31, 2001. Effective January 1, 2002, we
adopted Statement of Financial Accounting Standards ("SFAS") 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 adopted SFAS No. 142 in fiscal 2002 and performed our first annual
assessment of impairment, which resulted in an impairment loss of $4.9 million.
This amount is presented as cumulative effect of accounting change in our
Consolidated Statements of Operations and Cash Flows.
IMPAIRMENT OF LONG-LIVED ASSETS
The carrying value of long-lived assets are reviewed when events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. If it is determined that an impairment loss has occurred based on
the lowest level of identifiable expected future cash flow, then a loss is
recognized in the statement of operations using a fair value based model.
VALUATION OF LONG-LIVED AND INTANGIBLE ASSETS AND GOODWILL
Effective January 1, 2002, we adopted Statement of Financial Accounting
Standards No. 142, "Goodwill and Other Intangible Assets." According to this
statement, goodwill and other intangible assets with indefinite lives are no
longer subject to amortization, but rather an assessment of impairment applied
on a fair-value-based test on an annual basis or more frequently if an event
occurs or circumstances change that would more likely than not reduce the fair
value of a reporting unit below its carrying amount.
We utilized the discounted cash flow methodology to estimate fair value. At
December 31, 2004, we have a goodwill balance of $8.6 million, and a net
property and equipment balance of $1.9 million, as compared to a goodwill
balance of $8.6 million and a net property and equipment balance of $135.6
million at December 31, 2003. 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 at December 31, 2004 reflects the disposal of our Mexico fixed
assets of $123.3 million in the fourth quarter of 2004. See Note 5 and Note 7 of
the "Notes to Consolidated Financial Statements."
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.
DEFERRED FINANCING COST
Deferred financing costs were $327,000 and $1,203,000 at December 31, 2003 and
2004, respectively. These costs of obtaining financing and issuance of
convertible debt instruments are being amortized on a straight-line basis over
the term of the related debt. Amortization expenses for deferred charges were
$311,000, $408,000 and $387,000 for the years ended December 31, 2002, 2003 and
2004, respectively.
F-11
INCOME TAXES
We utilize SFAS No. 109, "Accounting for Income Taxes," which prescribes the use
of the liability method to compute the differences between the tax basis of
assets and liabilities and the related financial reporting amounts using
currently enacted tax laws and rates. A valuation allowance is recorded to
reduce deferred taxes to the amount that is more likely than not to be realized.
Our Hong Kong corporate affiliates are taxed at an effective Hong Kong rate of
17.5%. As of December 31, 2004, no domestic tax provision has been provided for
$64.9 million of un-remitted retained earnings of these Hong Kong corporations,
as we intend to maintain these amounts outside of the U.S. on a permanent basis.
NET LOSS PER SHARE
Basic and diluted loss per share has been computed in accordance with SFAS No.
128, "Earnings Per Share". All options and warrants have been excluded from the
computation in 2002, 2003 and 2004, as the impact would be anti-dilutive.
The following potentially dilutive securities were not included in the
computation of loss per share, because to do so would have been anti-dilutive:
2002 2003 2004
--------- --------- ---------
Options ...... 6,376,487 8,926,087 8,331,962
Warrants ..... -- 881,732 2,361,732
Total ..... 6,376,487 9,807,819 10,693,694
DIVIDENDS
We did not declare or pay any cash dividends in 2002, 2003 or 2004. We intend to
retain any future earnings for use in our business and, therefore, do not
anticipate declaring or paying any cash dividends in the foreseeable future. The
declaration and payment of any cash dividends in the future will depend upon our
earnings, financial condition, capital needs and other factors deemed relevant
by the Board of Directors. In addition, our credit agreements prohibit the
payment of dividends during the term of the agreements.
FOREIGN CURRENCY TRANSLATION
Assets and liabilities of the 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 year. The
functional currencies in which we transact business are the Hong Kong dollar and
the peso in Mexico.
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. In 2004, we
substantially liquidated our Mexico subsidiaries following the sale of the fixed
assets in Mexico. The accumulated foreign currency translation adjustment
related to the Mexico subsidiaries of $22.8 million of loss was reclassified and
charged to income. The adjustment occurred in the fourth quarter of 2004. See
Note 5 of the "Notes to Consolidated Financial Statements."
FAIR VALUE OF FINANCIAL INSTRUMENTS
The fair value of financial instruments is determined by reference to various
market data and other valuation techniques as appropriate. Considerable judgment
is required in estimating fair values. Accordingly, the estimates may not be
indicative of the amounts that we could realize in a current market exchange.
The carrying amounts of cash and cash equivalents, receivables and accounts
payable approximate fair values. The carrying amounts of our
F-12
variable rate borrowings under the various short-term borrowings and long-term
debt arrangements approximate fair value.
CONCENTRATION OF CREDIT RISK
Financial instruments, which potentially expose us to concentration of credit
risk, consist primarily of cash equivalents, trade accounts receivable, related
party receivables and amounts due from factor.
Our products are primarily sold to mass merchandisers and specialty retail
stores. These customers can be significantly affected by changes in economic,
competitive or other factors. We make substantial sales to a relatively few,
large customers. In order to minimize the risk of loss, we assign certain of our
domestic accounts receivable to a factor without recourse or requires letters of
credit from our customers prior to the shipment of goods. For non-factored
receivables, account-monitoring procedures are utilized to minimize the risk of
loss. Collateral is generally not required. At December 31, 2003 and 2004,
approximately 22.0% and 19.6% of accounts receivable were due from two
customers, respectively. The following table presents the percentage of net
sales concentrated with certain customers.
PERCENTAGE OF NET SALES
----------------------------------
CUSTOMER 2002 2003 2004
--------------------- ------ ------ ------
Kohl's............................. 5.1 6.6 16.4
Mervyn's........................... 7.3 5.9 15.4
Lerner New York (2)................ 9.9 8.3 15.0
Federated.......................... 0.5 5.2 10.3
Wet Seal........................... 0.8 3.3 7.9
Wal-Mart........................... 9.7 8.7 5.9
The Limited (1).................... 12.7 15.3 4.6
Lane Bryant........................ 17.6 12.1 2.0
Tommy Hilfiger..................... 17.4 6.7 0.0
----------
(1) Includes Express and Limited stores.
(2) Sold by Limited Brands Inc. in November 2002.
We maintain demand deposits with several major banks. At times, cash balances
may be in excess of Federal Deposit Insurance Corporation or equivalent foreign
insurance limits.
USE OF ESTIMATES
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the amounts reported in the financial statements and
accompanying notes. Significant estimates used by us in preparation of the
financial statements include allowance for returns, discounts and bad debts,
valuation of long-lived and intangible assets and goodwill, and tax provision.
Actual results could differ from those estimates.
EMPLOYEE STOCK OPTIONS
We account for employee stock options using the intrinsic value method 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 years ended December 31, 2002, 2003 and 2004, $0, $72,000
and $161,000 were recorded as an expense related to our stock options,
respectively.
Pro forma information regarding net income and earnings per share is required by
SFAS 148, and has been determined as if we had accounted for our employee stock
options under the fair value method of that Statement. The fair value for these
options was estimated at the date of grant using a Black-Scholes option pricing
model with the following weighted-average assumptions: weighted-average
risk-free interest rate of 4% for 2002 and 2003, 3% to 4% for 2004; dividend
yields of 0% for 2002, 2003 and 2004; weighted-average volatility factors of the
expected
F-13
market price of our common stock of 0.65 for 2002 and 2003 and 0.51 to 0.55 for
2004; and a weighted-average expected life of the option of four years for 2002,
2003 and 2004.
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:
2002 2003 2004
-------------- -------------- --------------
Net loss as reported ........................ $ (6,085,281) $ (35,884,660) $ (104,676,671)
Add stock-based employee compensation charges
reported in net loss ..................... $ 0 $ 71,572 $ 161,038
Pro forma compensation expense, net of tax .. $ (3,433,779) $ (4,115,263) $ (3,852,990)
Pro forma net loss .......................... $ (9,519,060) $ (39,928,351) $ (108,368,623)
Net loss per share
Basic and diluted ......................... $ (0.38) $ (1.97) $ (3.64)
Add stock-based employee compensation charges
reported in net loss
Basic and diluted ........................ $ 0.00 $ 0.00 $ 0.01
Pro forma compensation expense per share
Basic and diluted ........................ $ (0.22) $ (0.22) $ (0.14)
Pro forma loss per share
Basic and diluted ......................... $ (0.60) $ (2.19) $ (3.77)
OTHER COMPREHENSIVE INCOME (LOSS)
Other comprehensive income (loss) includes all changes in equity (net assets)
from non-owner sources such as foreign currency translation adjustments. We
account for other comprehensive income (loss) in accordance with SFAS 130,
"Reporting Comprehensive Income."
IMPACT OF 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's"), until the first fiscal year or interim period ending after
March 15, 2004. FIN 46(R) delayed the effective date for special-purpose
entities until the first fiscal year or interim period after December 15, 2003.
We were not the primary beneficiaries of any SPE's at December 31, 2003 and
2004. We adopted FIN 46(R) for non-SPE entities as of March 31, 2004. The
adoption of FIN 46 and FIN 46(R) did not result in the consolidation of any
VIEs.
In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based
Payment," which addresses the accounting for employee stock options. SFAS No.
123R eliminates the ability to account for shared-based compensation
transactions using APB Opinion No. 25 and generally would require instead that
such transactions be accounted for using a fair value-based method. SFAS No.
123R also requires that tax benefits associated with these share-based payments
be classified as financing activities in the statement of cash flow rather than
operating activities as currently permitted. SFAS No. 123R becomes effective for
interim or annual periods beginning after June 15, 2005. Accordingly, we are
required to apply SFAS No. 123R beginning in the quarter ending September 30,
2005. SFAS No. 123R offers alternative methods of adopting this final rule. We
have not yet determined which alternative method it will use.
F-14
In November 2004, the FASB issued SFAS No. 151, "Inventory Costs, an amendment
of ARB No. 43, Chapter 4," SFAS No. 151 clarifies that abnormal inventory costs
such as costs of idle facilities, excess freight and handling costs, and wasted
materials (spoilage) are required to be recognized as current period costs. The
provisions of SFAS No. 151 are effective for our fiscal 2006. We are currently
evaluating the provisions of SFAS No. 151 and do not expect that adoption will
have a material effect on our financial position, results of operations or cash
flows.
CURRENCY RATE HEDGING
We manufacture in a number of countries throughout the world, including Hong
Kong, and, as a result, are exposed to movements in foreign currency exchange
rates. Periodically we will enter into various currency rate hedges. The primary
purpose of our foreign currency hedging activities is to manage the volatility
associated with foreign currency purchases of materials and equipment in the
normal course of business. We utilize forward exchange contracts with maturities
of one to three months. We do not enter into derivative financial instruments
for speculative or trading purposes. We enter into certain foreign currency
derivative instruments that do not meet hedge accounting criteria. As a result,
we mark to market all derivative instruments with the gain or loss included in
other income and expense. See Note 18 of the "Notes to Consolidated Financial
Statements." These instruments are intended to protect against exposure related
to financing transactions (equipment) and income from international operations.
The fair value of the exchange contracts was not significant at December 31,
2003 and there were no exchange contracts at December 31, 2004.
RECLASSIFICATIONS
Certain prior year amounts have been reclassified to conform to the current year
presentation.
2. ACCOUNTS RECEIVABLE
Accounts receivable consists of the following:
DECEMBER 31,
---------------------------------
2003 2004
------------ ------------
U.S. trade accounts receivable ......... $ 31,685,308 $ 3,248,887
Foreign trade accounts receivable ...... 24,528,500 17,148,600
Factored accounts receivable ........... -- 19,452,756
Other receivables ...................... 5,178,501 346,965
Allowance for returns, discounts
and bad debts ....................... (4,226,383) (2,437,865)
------------ ------------
$ 57,165,926 $ 37,759,343
============ ============
Under the asset-based lending arrangement we had with GMAC before September 29,
2004, we factored trade receivables from clients with credit ratings below BBB.
GMAC did not advance any funds to us and only afforded us a credit insurance
coverage. We received funds from GMAC only after such funds were collected from
customers at their respective due dates. Effective as of September 29, 2004, the
asset based lending arrangement was amended and converted to a factoring
arrangement. At December 31, 2004, substantially all trade receivables,
irrespective of their debt ratings, were factored and GMAC advances up to 90% of
the invoice value to us immediately upon the submission of invoices. See Note 8
of "Notes to Consolidated Financial Statements."
3. INVENTORY
Inventory consists of the following:
DECEMBER 31,
----------------------------
2003 2004
----------- -----------
Raw materials, fabric and trim accessories ... $ 5,859,558 $ 1,164,977
Work-in-process .............................. 1,094,786 --
Finished goods shipments-in-transit .......... 7,522,464 9,283,022
Finished goods ............................... 8,774,783 8,696,106
----------- -----------
$23,251,591 $19,144,105
=========== ===========
F-15
We recorded a write down of our inventory totaling $10,986,000 in 2003 following
our decision to withdraw from our owned and operated facilities in Mexico
effective September 1, 2003. The write down reflected an adjustment to net
realizable value of inventory identified for liquidation at reduced prices.
4. PROPERTY AND EQUIPMENT
Property and equipment consists of the following:
DECEMBER 31,
----------------------------------
2003 2004
------------- -------------
Land ................................. $ 4,301,138 $ 85,000
Buildings ............................ 54,871,724 819,372
Equipment ............................ 111,742,558 5,966,453
Furniture and fixtures ............... 2,441,058 2,228,375
Leasehold improvements ............... 11,357,892 2,605,763
Vehicles ............................. 496,942 330,564
------------- -------------
185,211,312 12,035,527
Less accumulated depreciation and
amortization ...................... (49,565,561) (10,160,634)
------------- -------------
$ 135,645,751 $ 1,874,893
============= =============
Depreciation expense, including amortization of assets recorded under capital
leases, totaled $10,056,000, $15,663,000 and $7,853,000 for the years ended
December 31, 2002, 2003 and 2004, respectively.
5. RESTRUCTURING AND SALE OF MEXICO OPERATIONS
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 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 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. The entire impairment charge was recorded in
the Mexico geographic reporting segment.
In connection with our restructuring of our Mexico operations, we incurred $2.5
million and $1.1 million of severance costs in 2003 and 2004, respectively, in
the Mexico reportable segment. We did not relocate any employees in connection
with this restructuring and therefore did not incur any relocation costs. In
addition, we did not incur any contract termination costs. There was no ending
liability balance for the severance costs incurred in 2003 and 2004 since such
amounts were all paid in 2003 and 2004. Severance costs incurred in 2003 were
included in costs of goods sold and such costs incurred in 2004 were included in
general and administrative expenses in the accompanying consolidated statements
of operations.
F-16
In August 2004, through Tarrant Mexico, S. de R.L. de C.V., our majority owned
and controlled subsidiary in Mexico, we entered into an Agreement for Purchase
of Assets with affiliates of Mr. Kamel Nacif, a shareholder at the time of the
transaction, which agreement was amended in October 2004. Pursuant to the
agreement, as amended, on November 30, 2004, we sold to the purchasers
substantially all of our assets and real property in Mexico 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; 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.
Included in the $45.4 million notes receivable - related party on the
accompanying balance sheet as of December 31, 2004 was $1,317,000 of Mexico
valued added taxes on the real property component of this transaction. The
future maturities of the note receivable from the purchasers, including the
Mexican value added tax to be paid by the purchasers, is as follows:
Year ending December 31, Amount
2005 $ 5,323,733
2006 $ 5,323,733
2007 $ 5,323,733
2008 $ 4,020,400
2009 $ 4,020,400
2010 and thereafter $21,419,000
Total $45,431,000
Upon consummation of the sale, we entered into a purchase commitment agreement
with the purchasers, pursuant to which we have agreed to purchase annually over
the ten-year term of the agreement, $5 million of fabric manufactured at our
former facilities acquired by the purchasers at negotiated market prices. This
agreement replaced an existing purchase commitment agreement whereby we were
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. The annual future
purchase commitments approximate the annual maturities of the notes receivable
from the related party. As a result, we expect to fully realize the note
receivable from related party through the receipt of fabric manufactured at
these facilities over the maturity period of the notes receivable.
6. EQUITY METHOD INVESTMENT - AMERICAN RAG
In the second quarter of 2003, we acquired a 45% equity interest in the owner of
the trademark "American Rag CIE" and the operator of American Rag retail stores
for $1.4 million, and our subsidiary, Private Brands, Inc., acquired a license
to certain exclusive rights to this trademark. We have guaranteed the payment to
the licensor of minimum royalties of $10.4 million over the initial 10-year term
of the agreement. Private Brands also entered into a multi-year exclusive
distribution agreement with 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 will
design and manufacture a full collection of American Rag apparel, which will be
distributed by FMG exclusively to Federated stores across the country. Beginning
in August 2003, the American Rag collection was available in approximately 100
select Macy's, the Bon Marche, Burdines, Goldsmith's, Lazarus and Rich's-Macy's
locations. The investment in American Rag CIE, LLC totaling $1.4 million and
$1.9 million at
F-17
December 31, 2003 and 2004, respectively, is accounted for under the equity
method and included in equity method investment on the accompanying consolidated
balance sheets. Income from the equity method investment is recorded in the
United States geographical segment. The change in investment in American Rag for
2004 was as follows:
Balance as of December 31, 2003 ..... $ 1,434,375
Additional capital contribution ..... 137,000
Share of income...................... 769,706
Distribution ........................ (460,800)
-------------
Balance as of December 31, 2004..... $ 1,880,281
=============
We hold a 45% member interest in American Rag. The remaining 55% owners are an
unrelated third party who contributed the American Rag trademark and other
assets and liabilities relating to two retail stores operating under the name of
"American Rag". American Rag has sufficient equity investment to finance its
activities without additional subordinated financial support. The entity is
generating positive cash flow and net operating profit from its retail stores.
The royalty income paid by us to American Rag is considered other income and is
ancillary to the primary operations. Reported revenue from the retail business
in fiscal 2004 was approximately $9 million. The amount of royalty income paid
by us to American Rag in 2003 and 2004 was $250,000 and $500,000, respectively.
Since inception, American Rag has demonstrated that it can finance its
activities without additional subordinated financial support. We do not have
sole decision-making ability. Day to day management of American Rag is
effectively controlled by one of the 55% owners.
We have not entered into any obligations to guarantee the entity's debt nor do
we expect to receive a guaranteed return on its investment. We determined that
we are not the primary beneficiary of American Rag. Our variable interest will
not absorb a majority of the VIE's expected losses. We record its proportionate
share of income and losses but are not obligated nor do we intend to absorb
losses beyond its 45% investment interest. Additionally, we do not expect to
receive a majority of the entity's expected residual returns, other than their
45% ownership interest.
7. IMPAIRMENT OF ASSETS
IMPAIRMENT OF GOODWILL
Goodwill is classified as "excess of costs over fair value of net assets
acquired" on the accompanying consolidated balance sheets. SFAS No. 142,
"Goodwill and Other Intangible Assets," requires that goodwill and other
intangibles be tested for impairment using a two-step process. The first step is
to determine the fair value of the reporting unit, which may be calculated using
a discounted cash flow methodology, and compare this value to its carrying
value. If the fair value exceeds the carrying value, no further work is required
and no impairment loss would be recognized. The second step is an allocation of
the fair value of the reporting unit to all of the reporting unit's assets and
liabilities under a hypothetical purchase price allocation. Based on the
evaluation performed to adopt SFAS No. 142 along with continuing difficulties
being experienced in the industry, we recorded a non-cash charge of $4.9 million
in the first quarter of 2002 to reduce the carrying value of goodwill to the
estimated fair value.
F-18
The following table presents our results on a comparable basis:
YEAR ENDED DECEMBER 31,
--------------------------------------------
2002 2003 2004
------------- ------------- ------------
Reported net loss before cumulative effect
of accounting change .................... $ (1,214,037) $ (35,884,660) $(104,676,671)
Cumulative effect of accounting change ..... (4,871,244) -- --
------------- ------------- -------------
Reported net loss after cumulative effect
of accounting change .................. $ (6,085,281) $ (35,884,660) $(104,676,671)
============= ============= =============
Basic and diluted earnings per common share:
Reported net loss before cumulative effect
of accounting change .................... $ (0.08) $ (1.97) $ (3.64)
Cumulative effect of accounting change ..... (0.30) -- --
------------- ------------- -------------
Adjusted net loss after cumulative effect
of accounting change .................. $ (0.38) $ (1.97) $ (3.64)
============= ============= =============
In 2003, we ceased directly operating a substantial majority of our equipment
and fixed assets in Mexico, and started leasing a large portion of our
manufacturing facilities and operations in Mexico to affiliates of Mr. Kamel
Nacif, a shareholder at the time of the transaction, effective September 1,
2003. During 2003, we made an interim review of our goodwill and intangible
assets and wrote off all goodwill and intangible assets affected by our
strategic changes in Mexico. Write-offs included $9.1 million and $2.7 million
directly relating to Tarrant Mexico - Famian and Ajalpan divisions,
respectively, and another $7.5 million relating to of Rocky Apparel LLC
("Rocky"). It is unlikely that Tommy Hilfiger, whose business we acquired in the
Rocky acquisition, would continue to purchase merchandise from UAV following
implementation of the restructuring in Mexico. In 2003, we had also written off
the remaining goodwill of $150,000 relating to the acquisition of Jane Doe
International, LLC due to the litigation with the minority shareholder.
The following table displays the change in the gross carrying amount of goodwill
by reporting units for the years ended December 31, 2003 and 2004. The reporting
units below are one level below the reportable segments included in Note 16,
"Operations by Geographic Areas". The reporting units Jane Doe, Tag Mex Inc. -
Rocky Division and Tag Mex Inc. - Chazz & MGI Division were included within the
United States geographical segment of Note 16. The reporting units Tarrant
Mexico - Ajalpan and Tarrant Mexico - Famian were included in the Mexico
geographical segment of Note 16 of the "Notes to the Consolidated Financial
Statements."
REPORTING UNITS
----------------------------------------------------------------------------
TAG MEX FR TCL -
TARRANT TARRANT INC. - CHAZZZ &
MEXICO - MEXICO - ROCKY MGI
TOTAL JANE DOE AJALPAN FAMIAN DIVISION DIVISION
------------ ------------ ------------ ------------ ------------ ------------
Balance as of
January 1, 2003 ...... $ 28,064,019 $ 150,338 $ 2,739,378 $ 9,069,922 $ 7,521,536 $ 8,582,845
Impairment losses ..... (19,504,521) (150,338) (2,739,378) (9,093,269) (7,521,536) --
Foreign currency
translations ......... 23,347 -- -- 23,347 -- --
------------ ------------ ------------ ------------ ------------ ------------
Balance as of
December 31, 2003 .... 8,582,845 -- -- -- -- 8,582,845
Activities for the year -- -- -- -- -- --
------------ ------------ ------------ ------------ ------------ ------------
Balance as of
December 31, 2004 .... $ 8,582,845 $ -- $ -- $ -- $ -- $ 8,582,845
============ ============ ============ ============ ============ ============
F-19
IMPAIRMENT OF OTHER ASSETS
On June 28, 2000, we signed an exclusive production agreement with Manufactures
Cheja ("Cheja") through February 2002. We had agreed on a new contract to extend
the agreement for an additional quantity of 6.4 million units beginning April 1,
2002, which was amended on November 8, 2002, for the manufacturing of 5.7
million units through September 30, 2004. In June 2003, we determined that we no
longer expected to recoup advances to Cheja related to the production agreement.
In June 2003, we wrote off $2.8 million of remaining advances to Cheja.
8. DEBT
Debt consists of the following:
DECEMBER 31,
------------------------------
2003 2004
------------ ------------
Short-term bank borrowings:
Import trade bills payable - UPS, DBS
Bank and Aurora Capital ............... $ 3,113,030 $ 3,902,714
Bank direct acceptances - UPS and DBS
Bank .................................. 12,660,945 10,447,855
Other Hong Kong credit facilities -
UPS and DBS Bank ...................... 11,375,363 3,600,588
Other Mexican credit facilities .......... 2,143,985 --
------------ ------------
$ 29,293,323 $ 17,951,157
============ ============
Long-term debt:
Vendor financing ......................... $ 3,971,490 $ 135,145
Equipment financing ...................... 3,710,355 78,038
Term loan - UPS .......................... -- 5,000,000
Debt facility - GMAC ..................... 31,611,667 16,960,064
------------ ------------
39,293,512 22,173,247
Less current portion ..................... (38,705,240) (19,628,701)
------------ ------------
$ 588,272 $ 2,544,546
============ ============
IMPORT TRADE BILLS PAYABLE, BANK DIRECT ACCEPTANCES AND OTHER HONG KONG CREDIT
FACILITIES
On June 13, 2002, we entered into a letter of credit facility of $25 million
with UPS Capital Global Trade Finance Corporation ("UPS"). Under this facility,
we may arrange for the issuance of letters of credit and acceptances. The
facility is collateralized by the shares and debentures of all of our
subsidiaries in Hong Kong. In addition to the guarantees provided by Tarrant
Apparel Group and our subsidiaries, Fashion Resource (TCL) Inc. and Tarrant
Luxembourg Sarl, Gerard Guez, our Chairman, also signed a guarantee of $5
million in favor of UPS to secure this facility. This facility bears interest at
6.25% per annum at December 31, 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. On December 31, 2004, we
amended the letter of credit facility with UPS to reduce the maximum amount of
borrowings under the facility to $15 million and extend the expiration date of
the facility to June 30, 2005. Under the amended letter of credit facility, we
are subject to restrictive financial covenants of maintaining tangible net worth
of $22 million at December 31, 2004 and March 31, 2005 and $25 million as of the
last day of each fiscal quarter thereafter. There is also a provision capping
maximum capital expenditures per quarter of $800,000. As of December 31, 2004,
$12.6 million was outstanding under this facility with UPS (classified above as
follows: $1.1 million in import trade bills payable; $9.8 million in bank direct
acceptances and $1.7 million in other Hong Kong facilities) and an additional
$1.3 million was available for future borrowings. In addition, $1.1 million of
open letters of credit was outstanding as of December 31, 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 December 31, 2004, $3.4
million was
F-20
outstanding under this facility. In addition, $1.4 million of open letters of
credit was outstanding as of December 31, 2004. In October 2004, a tax loan for
HKD 7.725 million (equivalent to US $977,000) was also made available to our
Hong Kong subsidiaries. As of December 31, 2004, $916,000 was outstanding under
this loan.
As of December 31, 2004, the total balance outstanding under the DBS Bank credit
facilities were $4.3 million (classified above as follows: $1.8 million in
import trade payable; $.6 million in bank direct acceptances and $1.9 million in
other Hong Kong facilities).
From time to time, we open letters of credit under an uncommitted line of credit
from Aurora Capital Associates who issues these letters of credits out of
Israeli Discount Bank. As of December 31, 2004, $1.0 million was outstanding
under this facility (classified above under import trade bills payable) and $7.5
million of letters of credit were open under this arrangement. This letters of
credits arrangement is charged a commission fee of 2.25% on all letters of
credits issued.
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
semiannual payments commencing in February 2000. Of this amount, $135,000 was
outstanding as of December 31, 2004. All of the $135,000 was payable in U.S.
dollars and the debt was paid off in February 2005. A portion of the debt was
denominated in Euros. Unrealized transaction (loss) gain associated with the
debt denominated in Euros totaled $(1.0) million, $(561,000) and $367,000 for
the years ended December 31, 2002, 2003 and 2004, respectively. These amounts
were recorded in other income (expense) in the accompanying consolidated
statements of operations.
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.
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.
We also had an equipment loan of $5.2 million from Bank of America Leasing
("BOA"). In October 2003, we paid off the BOA facility in its entirety.
We also had two equipment loans outstanding at December 31, 2004 totaling
$78,000 bearing interest at 6% payable in installments through 2009.
TERM LOAN - UPS
On December 31, 2004, our Hong Kong subsidiaries also entered into a new loan
agreement with UPS pursuant to which UPS made a $5 million term loan, the
proceeds of which were used to repay $5 million of indebtedness owed to UPS
under the letter of credit of facility. The principal amount of this loan is due
and payable in 24 equal monthly installments of approximately $208,333 each,
plus interest equivalent to the "prime rate" plus 2% commencing on February 1,
2005. Under the loan agreement, we are subject to restrictive financial
covenants of maintaining tangible net worth of $22 million at December 31, 2004
and March 31, 2005 and $25 million as of the last day of each fiscal quarter
thereafter. There is also a provision capping maximum capital expenditure per
quarter at $800,000. As of December 31, 2004, we were in compliance with the
covenants. The obligations under the loan agreement are collateralized by the
same security interests and guarantees as the letter of credit facility.
F-21
Additionally, the term loan is secured by two promissory notes payable to
Tarrant Luxembourg Sarl in the amounts of $2,550,000 and $1,360,000 and a pledge
by Gerard Guez of 4.6 million shares of our common stock to secure the
obligations.
DEBT FACILITY- GMAC
We were previously party to a revolving credit, factoring and security agreement
(the "Debt Facility") with GMAC Commercial Credit, LLC ("GMAC"). This Debt
Facility provided a revolving facility of $90 million, including a letter of
credit facility not to exceed $20 million, and was scheduled to mature on
January 31, 2005. The Debt Facility also provided a term loan of $25 million,
which was being repaid in monthly installments of $687,500. The Debt Facility
provided for interest at LIBOR plus the LIBOR rate margin determined by the
Total Leverage Ratio (as defined in the Debt Facility agreements), and was
collateralized by our receivables, intangibles, inventory and various other
specified non-equipment assets. In May 2004, the maximum facility amount was
reduced to $45 million in total and we established new financial covenants with
GMAC for the fiscal year of 2004.
On October 1, 2004, we amended and restated the Debt Facility dated January 21,
2000 by and among us, our subsidiaries, TagMex, Inc. Fashion Resource (TCL) Inc
and United Apparel Ventures, LLC and GMAC. The amended and restated agreement
(the Factoring agreement) extended the expiration date of the facility to
September 30, 2007 and added as parties our subsidiaries Private Brands, Inc and
No! Jeans, Inc. In addition, in connection with the factoring agreement, our
indirect majority-owned subsidiary, PBG7, LLC. entered into a separate factoring
agreement with GMAC. Pursuant to the terms of the factoring agreement, we and
our subsidiaries agree to assign and sell to GMAC, as factor, all accounts which
arise from the Tarrant Parties' sale of merchandise or rendition of service
created on a going forward basis. At Tarrant's request, GMAC, in its discretion,
may make advances to Tarrant Parties up to the lesser of (a) up to 90% of our
accounts on which GMAC has the risk of loss and (b) forty million dollars, minus
in each case, any amount owed to GMAC by any Tarrant Party. Pursuant to the
terms of the PBG7 factoring agreement, PBG7 agreed to assign and sell to GMAC,
as factor, all accounts, which arise from PBG7's sale of merchandise or
rendition of services created on a going-forward basis. At PBG7's request, GMAC,
in its discretion, may make advances to PBG7 up to the lesser of (a) up to 90%
of PBG7's accounts on which GMAC has the risk of loss, and (b) five million
minus in each case, any amounts owed to GMAC by PBG7. Under both factoring
agreement, any amounts, which GMAC advances in excess of the purchase price of
the relevant accounts, are considered to be loans and are chargeable to the
Tarrant Parties' or PBG7's when paid. Each of the parties only become obligated
to GMAC for a direct financial obligation in the event that GMAC makes and
advance in excess of the purchase price of the relevant accounts, and any such
obligations are payable on demand. This facility bears interest at 6% per annum
at December 31, 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. As of December 31, 2004 we were in compliance with the new
tangible net worth and capital expense covenants. A total of $17.0 million was
outstanding under the GMAC facility at December 31, 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.
Annual maturities for the long-term debt, convertible debentures and capital
lease obligations are $19,628,701 (2005), $2,512,726 (2006), $10,013,512 (2007),
$14,345 (2008), and $3,963 (2009). The effective interest rate on short-term
bank borrowing as of December 31, 2002, 2003 and 2004 were 4.1%, 5.3% and 5.7%,
respectively.
GUARANTEES
Guarantees have been issued since 2001 in favor of YKK, Universal Fasteners, and
RVL Inc. for $750,000, $500,000 and 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
F-22
anticipate that we will incur losses as a result of these guarantees. As of
December 31, 2004, Tag-It Pacific Inc. had approximately $205,000 due to RVL
Inc. and $18,000 due to Universal Fasteners.
9. CONVERTIBLE DEBENTURES AND WARRANTS
On December 14, 2004, we completed a $10 million financing through the issuance
of (i) 6% Secured Convertible Debentures ("Debentures") and (ii) warrants to
purchase up to 1,250,000 shares of our common stock. Prior to maturity, the
investors may convert the Debentures into shares of our common stock at a price
of $2.00 per share. The warrants have a term of five years and an exercise price
of $2.50 per share. The warrants were valued at $866,000 using the Black-Scholes
option valuation model with the following assumptions: risk-free interest rate
of 4%; dividend yields of 0%; volatility factors of the expected market price of
our common stock of 0.55; and an expected life of four years. The Debentures
bear interest at a rate of 6% per annum and have a term of three years. We may
elect to pay interest on the Debentures in shares of our common stock if certain
conditions are met, including a minimum market price and trading volume for our
common stock. The closing market price of our common stock on the closing date
of the financing was $1.96. The convertible debenture was thus valued at
$8,996,000, resulting in an effective conversion price of $1.799 per share. The
intrinsic value of the conversion option of $804,000 is being amortized over the
life of the loan. The value of the warrants of $866,000 and the intrinsic value
of the conversion option of $804,000 were netted from the $10 million presented
as the convertible debentures, net on our accompanying balance sheets.
The Debentures contain customary events of default and permit the holders
thereof to accelerate the maturity if the full principal amount together with
interest and other amounts owing upon the occurrence of such events of default.
Additionally, upon a holder's election to accelerate payment, we are obligated
to pay 120% of the principal amount of the Debenture plus all accrued and unpaid
interest thereon, or, in the absence of certain conditions, the greater of the
preceding amount and the amount such holder would receive had such holder
converted the Debenture and sold the underlying shares at the then current
market price. The Debentures are secured by a subordinated lien on certain of
our accounts receivable and related assets.
The placement agent in the financing, for its services was paid $620,000 in cash
and issued five year warrants to purchase up to 200,000 shares of our common
stock at an exercise price of $2.50 per share. The 200,000 warrants were valued
at $138,000 using the Black-Scholes option valuation model with the following
assumptions: risk-free interest rate of 4%; dividend yields of 0%; volatility
factors of the expected market price of our common stock of 0.55; and an
expected life of four years. The $620,000 financing cost paid to the placement
agent and the value of the 200,000 warrants of $138,000 are included in the
deferred financing cost, net on our accompanying balance sheets and are
amortized over the life of the loan.
F-23
10. INCOME TAXES
The provision (credit) for domestic and foreign income taxes is as follows:
YEAR ENDED DECEMBER 31,
-------------------------------------------------
2002 2003 2004
----------- ----------- -----------
Current:
Federal ............. $ (307,684) $ 2,400,000 $ 1,000,000
State ............... 293,055 (241,948) 8,511
Foreign ............. 1,162,798 2,106,199 1,400,953
----------- ----------- -----------
1,148,169 4,264,251 2,409,464
Deferred:
Federal ............. -- -- --
State ............... -- -- --
Foreign ............. (97,151) (132,622) (61,345)
----------- ----------- -----------
(97,151) (132,622) (61,345)
----------- ----------- -----------
Total ............. $ 1,051,018 $ 4,131,629 $ 2,348,119
=========== =========== ===========
The source of loss before the provision for taxes and cumulative effect of
accounting change is as follows:
YEAR ENDED DECEMBER 31,
---------------------------------------------------
2002 2003 2004
------------- ------------- -------------
Federal ............... $ (11,061,937) $ (18,609,818) $ (14,271,441)
Foreign ............... 10,898,918 (13,143,213) (88,057,111)
------------- ------------- -------------
Total ........ $ (163,019) $ (31,753,031) $(102,328,552)
============= ============= =============
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, it is 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.
A reconciliation of the statutory federal income tax provision (benefit) to the
reported tax provision (benefit) on income is as follows:
YEAR ENDED DECEMBER 31,
--------------------------------------------
2002 2003 2004
------------ ------------ ------------
Income tax (benefit) based on federal
statutory rate ........................... $ (1,761,992) $(11,113,561) $(35,814,993)
State income taxes, net of federal benefit .. 190,486 (157,266) 5,532
Effect of foreign income taxes .............. 1,162,798 2,862,550 2,749,376
Nondeductible goodwill impairment ........... -- 4,141,426 --
Nondeductible impairment of long-lived assets -- -- 30,463,663
Increase in tax reserve ..................... -- 2,400,000 1,000,000
Increase in valuation allowance
and other ................................ 1,459,726 5,998,480 3,944,541
------------ ------------ ------------
$ 1,051,018 $ 4,131,629 $ 2,348,119
============ ============ ============
F-24
Deferred income taxes reflect the net effects of temporary differences between
the carrying amounts of assets and liabilities for financial reporting purposes
and the amounts used for income tax purposes. Significant components of the
deferred tax assets (liabilities) are as follows:
DECEMBER 31,
----------------------------
2003 2004
------------ ------------
Deferred tax assets:
Provision for doubtful accounts and
unissued credits ......................... $ 1,149,051 $ 433,261
Provision for other reserves ................ 2,711,566 1,533,620
Domestic and foreign loss carry forwards
and foreign tax credits .................. 2,050,179 9,789,485
Deferred compensation and benefits .......... 197,486 0
Goodwill impairment ......................... 4,422,837 2,719,294
------------ ------------
Total deferred tax assets ................ 10,531,119 14,475,660
Deferred tax liabilities:
Other ....................................... (275,129) (213,784)
------------ ------------
(275,129) (213,784)
Valuation allowance for deferred tax assets .... (10,531,119) (14,475,660)
------------ ------------
Net deferred tax liabilities ................... $ (275,129) $ (213,784)
============ ============
At December 31, 2004, we have $18.8 million of federal net operating loss
carryforwards expiring in 2029. We also have foreign tax credits carryforwards
totaling $824,000 that do not expire.
In January 2004, the Internal Revenue Service ("IRS") completed its examination
of our Federal income tax returns for the years ended December 31, 1996 through
2001. The IRS has proposed adjustments to increase our income tax payable for
the six years under examination. In addition, in July 2004, the IRS initiated an
examination of our Federal income tax return for the year ended December 31,
2002. In March 2005, the IRS proposed an adjustment to our taxable income of
approximately $6 million related to similar issues identified in their audit of
the 1996 through 2001 federal income tax returns. The proposed adjustments to
our 2002 federal income tax return would not result in additional tax due for
that year due to the tax loss reported in the 2002 federal return. However, it
could reduce the amount of net operating losses available to offset taxes due
from the preceding tax years. This adjustment would also result in additional
state taxes and interest. We believe that we have meritorious defenses to and
intend to vigorously contest the proposed adjustments. If the proposed
adjustments are upheld through the administrative and legal process, they could
have a material impact on our earnings and cash flow. We believe we have
provided adequate reserves for any reasonably foreseeable outcome related to
these matters on the consolidated balance sheets included in the Consolidated
Financial Statements under the caption "Income Taxes". The maximum amount of
loss in excess of the amount accrued in the financial statements is $12.6
million. We do not believe that the adjustments, if any, arising from the IRS
examination, will result in an additional income tax liability beyond what is
recorded in the accompanying consolidated balance sheets.
F-25
11. COMMITMENTS AND CONTINGENCIES
We have entered into various non-cancelable operating lease agreements,
principally for executive office, warehousing facilities and production
facilities with unexpired terms in excess of one year. Certain of these leases
provided for scheduled rent increases. We record rent expense on a straight-line
basis over the term of the lease. The future minimum lease payments under these
non-cancelable operating leases are as follows:
2005................................................ $ 267,106
2006................................................ 181,642
2007................................................ 118,516
2008................................................ --
2009................................................ --
Thereafter.......................................... --
-----------
Total future minimum lease payments........... $ 567,264
===========
Several of the operating leases contain provisions for additional rent based
upon increases in the operating costs, as defined, per the agreement. Total rent
expense under the operating leases amounted to approximately $3,166,000,
$3,101,000 and $2,128,000 for 2002, 2003 and 2004, respectively.
We had open letters of credit of $15,458,000, $5,976,000 and $9,987,000 as of
December 31, 2002, 2003 and 2004, respectively.
We have two employment contracts dated January 1, 1998 with two executives
providing for base compensation and other incentives. On April 1, 2004, we
amended each of these contracts to extend the term through March 31, 2006, and
to provide one contract for base salary per annum of $500,000 for the period
from April 1, 2003 to March 31, 2006, and the other contract for base salary per
annum of $50,000 from April 1, 2003 to March 31, 2006. Additionally, we agreed
to pay each of these executives an annual bonus (the "Annual Bonus") for fiscal
years ended December 31, 2003, 2004 and 2005 in an amount, if any, equal to ten
percent (10%) of the amount by which our actual pre-tax income for such fiscal
year exceeds the amount of projected pre-tax income set forth in our annual
budget for the same fiscal year as approved by our Board of Directors. No
bonuses were paid to these executives for the fiscal year ended December 31,
2003 and 2004.
On October 17, 2004, Private Brands, Inc, our wholly owned subsidiary, entered
into a term sheet exclusive licensing agreement with J. S. Brand Management to
design, manufacture and distribute Jessica Simpson branded jeans and casual
apparel in missy, juniors and large sizes. This agreement is a three-year
contract, and providing compliance with all terms of the license, is renewable
for one additional two-year term. Minimum net sales are $20 million in year 1,
$25 million in year 2 and $30 million in year 3. The agreement also provides
payment of sales royalty and advertising royalty at the rate of 8% and 3%,
respectively, based on net sales; the total commitment on royalties over the
term is $8.3 million. As of December 31, 2004, we have advanced $2.2 million as
payment for the first year's minimum royalties.
In the second quarter of 2003, we acquired a 45% equity interest in the owner of
the trademark "American Rag CIE" and the operator of American Rag retail stores
for $1.4 million, and our subsidiary, Private Brands, Inc., acquired a license
to certain exclusive rights to this trademark. We have guaranteed the payment to
the licensor of minimum royalties of $10.4 million over the initial 10-year term
of the agreement. At December 31, 2004, the total commitment on royalties
remaining on the term was $9.6 million.
On October 16, 2003, we entered into a lease with affiliates of Mr. Kamel Nacif,
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. Mr. Nacif was a stockholder at the time of transaction. In connection
with this transaction, we also entered into a management services agreement
pursuant to which Mr. Nacif's affiliates managed the operation of our remaining
facilities in Mexico in exchange for use of the remaining facilities. The term
of the management services agreement was also for a period of 6 years.
Additionally, we 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. See Note 15 of the "Notes to Consolidated
Financial Statements." Using current market prices, the purchase commitment
would be approximately $18 million per year.
F-26
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 of these actions, we experienced a
significant decline in revenue of approximately $75 million from sales of
Mexico-produced merchandise in 2004 as compared to 2003.
In August 2004, we entered into an Agreement for Purchase of Assets with
affiliates of Mr. Kamel Nacif, a shareholder at the time of the transaction,
with agreement was amended in October 2004. Pursuant to the agreement, as
amended, on November 30, 2004, we sold to the purchasers substantially all of
our assets and real property in Mexico, including the equipment and facilities
we previously leased to Mr. Nacif's affiliates. Upon consummation of the sale,
we entered into a purchase commitment agreement with the purchasers, pursuant to
which we have agreed to purchase annually over the ten-year term of the
agreement, $5 million of fabric manufactured at our former facilities acquired
by the purchasers at negotiated market prices. This agreement replaced an
existing purchase commitment agreement with Mr. Nacif's affiliates. In August
2004, upon entering into an Agreement for Purchase of Assets, Mr. Nacif's
affiliates agreed to suspend our fabric purchase obligations under the existing
purchase commitment, and we agreed to suspend the affiliates of Mr. Nacif's
lease payment obligations under the lease agreements pursuant to which Mr.
Nacif's affiliates operated our manufacturing facilities in Mexico. See Note 15
of the "Notes to Consolidated Financial Statements."
We are involved from time to time in routine legal matters incidental to our
business. In our opinion, resolution of such matters will not have a material
effect on our financial position or results of operations.
12. EQUITY
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.
Our Employee Incentive Plan, formerly the 1995 Stock Option Plan, as amended and
restated in May 1999 (the Plan), has authorized the grant of both incentive and
non-qualified stock options to officers, employees, directors and consultants of
the Company for up to 5,100,000 shares (as adjusted for a stock split effective
May 1998) of our common stock. The exercise price of incentive options must be
equal to 100% of fair market value of common stock on the date of grant and the
exercise price of non-qualified options must not be less than the par value of a
share of common stock on the date of grant. The Plan was also amended to expand
the types of awards, which may be granted pursuant thereto to include stock
appreciation rights, restricted stock and other performance-based benefits. At
December 31, 2004, the Plan has 2,918,038 options available for future grant.
In October 1998, we granted 1,000,000 non-qualified stock options not under the
Plan. The options were granted to our Chairman and Vice Chairman at $13.50 per
share, the closing sales price of the common stock on the day of the grant. The
options expire in 2008 and vest over four years. In May 2002, we granted
3,000,000 non-qualified stock options not under the Plan. The options were
granted to our Chairman, Vice Chairman and Mr. Kamel Nacif at $5.50 per share,
the closing sales price of the common stock on the day of the grant. The options
expire in 2012 and vest over three years. In May 2003, we granted 2,000,000
non-qualified stock options not under the Plan to our Chairman and Vice
Chairman. The options were granted at $3.65 per share, the closing sales price
of the common stock on the day of the grant. The options expire in 2013 and vest
over four years. In December 2003, we granted 400,000 non-qualified stock
options not under the Plan to our President. The options were granted at $3.94
per share, the closing sales price of the common stock on the day of the grant.
The options expire in 2013 and vest over four years.
F-27
A summary of our stock option activity, and related information is as follows:
2002 2003 2004
--------------------- --------------------- ---------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
OPTIONS PRICE OPTIONS PRICE OPTIONS PRICE
--------- -------- --------- -------- --------- -------
Options outstanding at
beginning of year . 3,520,737 $11.90 6,376,487 $ 8.89 8,926,087 $7.13
Granted ........ 3,004,000 5.50 3,288,100 3.67 83,000 3.04
Exercised ...... (5,500) 4.39 -- -- -- --
Forfeited ...... (142,750) 12.14 (738,500) 6.91 (677,125) 5.43
--------- --------- ---------
Outstanding at end of
year .............. 6,376,487 $ 8.89 8,926,087 $ 7.13 8,331,962 $7.22
========= ========= =========
Exercisable at end of
year .............. 3,535,487 $11.35 4,028,487 $10.56 5,251,250 $9.04
Weighted average per
option fair value
of options granted
during the year ... $ 2.89 $ 1.92 $1.36
The following table summarizes information about stock options outstanding at
December 31, 2004:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
------------------------------------ -----------------------
WEIGHTED
AVERAGE WEIGHTED WEIGHTED
REMAINING AVERAGE AVERAGE
NUMBER CONTRACTUAL EXERCISE NUMBER EXERCISE
EXERCISE PRICE OUTSTANDING LIFE PRICE EXERCISABLE PRICE
- --------------------------------------------------------------------------------
$ 1.39 - $ 3.60 374,350 9.0 $ 3.41 86,138 $ 3.53
$ 3.65 - $ 3.68 2,255,000 8.4 3.65 625,000 3.65
$ 3.94 - $ 5.09 896,612 7.5 4.37 441,612 4.82
$ 5.50 2,754,000 7.3 5.50 2,002,000 5.50
$ 5.55 - $ 9.97 474,500 3.5 7.02 444,000 7.09
$13.50 - $15.50 1,011,000 3.7 13.51 1,011,000 13.51
$18.44 - $18.50 23,000 3.7 18.50 23,000 18.50
$25.00 500,000 4.3 25.00 500,000 25.00
$33.13 - $39.97 41,500 4.2 39.31 41,500 39.31
$45.50 2,000 4.3 45.50 2,000 45.50
---------- ----------
$ 1.39 - $45.50 8,331,962 6.8 $ 7.22 5,176,250 $ 9.11
========== ==========
13. EQUITY TRANSACTIONS
In connection with the twill mill acquisition in December 2002, we issued
100,000 Series A Convertible Preferred Shares ("Preferred Shares"). The
Preferred Shares accrue dividends at an annual rate of 7% of the initial stated
value of $88.20 per share and have no voting rights. The Shares issued had been
converted into 3,000,000 shares of common stock at the annual meeting held on
May 28, 2003 in accordance with the original conversion terms. We granted the
holder of the shares of common stock issuable upon conversion of the Preferred
Shares "piggyback" registration rights, which provide such holder the right,
under certain circumstances, to have such shares registered for resale under the
Securities Act of 1933. In the event of our liquidation, dissolution or
winding-up, the Preferred Shares were entitled to receive, prior to any
distribution on the common stock, a distribution equal to the initial stated
value of the Preferred Shares plus all accrued and unpaid dividends.
F-28
In October 2003, we sold an aggregate of 881,732 shares of the Series A
Convertible Preferred Stock, at $38 per share, to a group of institutional
investors and high net worth individuals and raised an aggregate of
approximately $31 million, after payment of commissions and expenses. We used
the proceeds of this offering to pay down vendors and reduce debts. The
preferred stock was converted into an aggregate of 8,817,320 shares of common
stock following a special meeting of shareholders held on December 4, 2003 in
accordance with the original conversion terms. We have registered the shares of
common stock issued upon conversion of the Series A Preferred Stock with the
Securities and Exchange Commission for resale by the investors. In conjunction
with the private placement transaction, we issued a warrant to purchase 881,732
shares of common stock to the placement agent. The warrants are exercisable
beginning April 17, 2004 through October 17, 2008 and have a per share exercise
price of $4.65. Warrants were valued using the Black-Scholes option valuation
model with the following assumptions: risk-free interest rate of 4%; dividend
yields of 0%; volatility factors of the expected market price of our common
stock of 0.51; and an expected life of four years.
In November 2003, we issued an aggregate of 200,000 shares of common stock to
Antonio Haddad Haddad, Miguel Angel Haddad Yunes, Mario Alberto Haddad Yunes,
and Marco Antonio Haddad Yunes in partial settlement of the balance of
approximately $2.5 million in obligations owed these parties arising from our
acquisition of their factories in 1998. The fair value of the common stock
issued on the date of issuance was $3.94 per share, resulting in a reduction of
our obligation by $788,000. Each of these investors represented to us that the
investor was an "accredited investor" within the meaning of Rule 501 of
Regulation D under the Securities Act of 1933, and that the investor was
purchasing the securities for investment and not in connection with a
distribution thereof. The issuance and sale of the common stock was exempt from
the registration and prospectus delivery requirements of the Securities Act
pursuant to Section 4(2) of the Securities Act and Regulation D promulgated
thereunder as a transaction not involving any public offering.
During the year of 2003, we retired a total of 248,872 shares of common stock
relating to shares repurchased but uncancelled before 2001 and shares
repurchased this year from Gabe Zeitouni, upon exercising his put option under
an agreement dated July 10, 2000.
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. 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 four years.
In November 2003, our board of directors adopted a shareholders rights plan.
Pursuant to the plan, we issued a dividend of one right for each share of our
common stock held by shareholders of record as of the close of business on
December 12, 2003. Each right initially entitled shareholders to purchase a
fractional share of our Series B Preferred Stock for $25.00. However, the rights
are not immediately exercisable and will become exercisable only upon the
occurrence of certain events. Generally, if a person or group acquires, or
announces a tender or exchange offer that would result in the acquisition of 15%
or more of our common stock while the shareholder rights plan remains in place,
then, unless the rights are redeemed by us for $0.001 per right, the rights will
become exercisable, by all rights holders other than the acquiring person or
group, for our shares or shares of the third party acquirer having a value of
twice the right's then-current exercise price. The shareholder rights plan is
designed to guard against partial tender offers and other coercive tactics to
gain control of our company without offering a fair and adequate price and terms
to all of our shareholders. The plan was not adopted in response to any efforts
to acquire our company, and we are not aware of any such efforts.
Our credit agreement prohibits the payment of dividends during the term of the
agreement.
F-29
14. SUPPLEMENTAL SCHEDULE OF CASH FLOW INFORMATION
YEAR ENDED DECEMBER 31,
--------------------------------------------
2002 2003 2004
----------- ----------- -----------
Cash paid for interest ........ $ 2,361,000 $ 2,856,000 $ 1,796,000
=========== =========== ===========
Cash paid (refunded) for
income taxes ............... $(5,086,000) $ 378,000 $ 1,196,000
=========== =========== ===========
In 2002, we acquired certain assets of a twill mill located in Puebla, Mexico.
Included in the consideration paid were 100,000 shares of Series A Preferred
Stock valued at $8.8 million, a 25% equity stake in our wholly-owned subsidiary,
Tarrant Mexico and the cancellation of approximately $56.9 million of certain
notes and accounts receivable due from the sellers and their affiliates for a
total purchase price of $87.4 million. These non-cash transactions have been
excluded from the respective statements of cash flows.
In 1999, we acquired Industrial Exportadora Famian from the Haddad family. In
accordance with the acquisition agreement, we had to pay certain amount of
earnouts to the vendors annually. As of October 31, 2003, total earnouts accrued
but not paid amounted to about $2.5 million. In November 2003, we entered into
an agreement with the Haddad family to satisfy the amount owed by issuing to
four family members a total of 200,000 shares of common stock, with a fair value
of $788,000. In addition, we gave them 400,000 yards of our stock fabric,
100,000 pairs of pants, and a fleet of old vehicles, with an aggregate book
value of approximately $1.5 million. Included in other income was a gain of
$236,000 resulting from this settlement in 2003.
In 2003, we reduced a shareholder receivable for $722,000 from Mr. Kamel Nacif
against vendor payables owed to entities controlled by Mr. Nacif.
In 2004, as consideration for the sale of our assets and real property in
Mexico, we received $45.4 million of notes receivable. See Note 5 of "Notes to
Consolidated Financial Statements."
On December 14, 2004, we completed a $10 million financing through the issuance
of 6% Secured Convertible Debentures ("Debentures"), we issued warrants to
purchase up to 1,250,000 shares of our common stock. The warrants were valued at
$866,000 using the Black-Scholes option valuation model. The placement agent in
the financing, for its services were paid $620,000 in cash and issued five year
warrants to purchase up to 200,000 shares of our common stock at an exercise
price of $2.50 per share. The 200,000 warrants were valued at $138,000 using the
Black-Scholes option valuation model.
15. RELATED-PARTY TRANSACTIONS
Related-party transactions, consisting primarily of purchases and sales of
finished goods and raw materials, are as follows:
YEAR ENDED DECEMBER 31,
-----------------------------------------
2002 2003 2004
----------- ----------- -----------
Sales to related parties .......... $ 4,864,000 $22,296,000 $ 3,598,000
Purchases from related parties .... $76,231,000 $72,329,000 $17,875,000
As of December 31, 2003 and 2004, related party affiliates were indebted to us
in the amounts of $22.9 million and $13.1 million, respectively. These include
amounts due from our shareholders of $4.8 million and $2.5 million at December
31, 2003 and 2004, respectively, which have been shown as reductions to
shareholders' equity in the accompanying financial statements. Total interest
paid by related party affiliates, the Chairman and the Vice Chairman were
$374,000 and $370,000 for the years ended December 31, 2003 and 2004,
respectively.
From time to time in the past, we borrowed funds from, and advanced funds to,
certain officers and principal shareholders, including Gerard Guez and Todd Kay.
The greatest outstanding balance of such advances to Mr. Guez during 2004 was
approximately $4,796,000. At December 31, 2003, the entire balance due from Mr.
Guez totaling $4.8 million was reflected as a reduction of shareholders' equity.
In January and February of 2005, Mr. Guez repaid
F-30
$2.3 million of this indebtedness. As a result, $2.3 million was reclassified to
a short-term asset and included in due from related parties in the accompanying
consolidated balance sheet as of December 31, 2004. The remaining balance of
$2,466,000 is payable on demand and had been shown as reductions to
shareholders' equity as of December 31, 2004. There were no outstanding advances
from or borrowing to Mr. Kay during 2004. All advances to, and borrowings from,
Mr. Guez bore interest at the rate of 7.75% during the period. Total interest
paid by Mr. Guez was $374,000 and $370,000 for the years ended December 31, 2003
and 2004, respectively. Mr. Guez paid expenses on our behalf of approximately
$456,000 and $400,000 for the years ended December 31, 2003 and 2004,
respectively, which amounts were applied to reduce accrued interest and
principal on Mr. Guez's loan. Since the enactment of the Sarbanes-Oxley Act in
2002, no further personal loans (or amendments to existing loans) have been or
will be made to officers or directors of Tarrant.
In February 2004, our Hong Kong subsidiary entered into a 50/50 joint venture
with Auto Enterprises Limited, an unrelated third party, to source products for
Seven Licensing Company, LLC and our Private Brands subsidiary in mainland
China. On May 31, 2004, after realizing an accumulated loss from the venture of
approximately $200,000 (our share being half), we sold our interest for $1 to
Asia Trading Limited, a company owned by Jacqueline Rose, wife of Gerard Guez.
The venture owed us $221,000 as of December 31, 2004.
On July 1, 2001, we formed an entity to jointly market, share certain risks and
achieve economics of scale with Azteca Production International, Inc.
("Azteca"), a corporation owned by the brothers of Gerard Guez, our Chairman,
called United Apparel Ventures, LLC ("UAV"). This entity was created to
coordinate the production of apparel for a single customer of our branded
business. UAV is owned 50.1% by Tag Mex, Inc., our wholly owned subsidiary, and
49.9% by Azteca. Results of the operation of UAV have been consolidated into our
results since July 2001 with the minority partner's share of gain and losses
eliminated through the minority interest line in our financial statements. Due
to the restructuring of our Mexico operations, we discontinued manufacturing for
UAV customers in the second quarter of 2004. UAV makes purchases from two
related parties in Mexico, an affiliate of Azteca and Tag-It Pacific, Inc.
Since June 2003, United Apparel Venture, 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
Gerard Guez. In the third quarter of 2004, in order to strengthen our own
private brand business, we decided to discontinue sourcing for Seven7. Total
sales to Seven Licensing during the years ended December 31, 2003 and 2004 were
$8.1 million and $2.6 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. 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. Due to the restructuring of
our Mexico operations, Tag-It no longer manages our trim and packaging
requirements. We purchased $23.9 million, $16.8 million and $1.0 million of trim
inventory from Tag-It for the years ended December 31, 2002, 2003 and 2004,
respectively. We also sold to Tag-It $1.5 million from our trim and fabric
inventory for the year ended December 31, 2003. We purchased $37.0 million,
$37.1 million and $11.5 million of finished goods and service from Azteca and
its affiliates for the years ended December 31, 2002, 2003 and 2004,
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 service to Azteca in 2002, 2003 and 2004 were $2.9
million, $9.9 million and $1.0 million, respectively. Two and one half percent
of gross sales as management fees were paid in 2002, 2003 and 2004 to each of
the members of UAV, per the operating agreement. The amount paid to Azteca, the
minority member of UAV, totaled $2.0 million, $1.7 million and $179,000 in 2002,
2003 and 2004, respectively. Net amounts due from these related parties as of
December 31, 2003 and 2004 were $17.5 million and $7.8 million, respectively.
On December 2, 1998, we contracted to acquire a fully operational facility being
constructed in Puebla, Mexico by Tex Transas, S.A. de C.V. ("Tex Transas").
Construction of this facility commenced in the third quarter of 1998, and it was
anticipated that we would take possession of this facility in fiscal 2000. On
October 16, 2000, we revised our agreement regarding the fully operational
facility to extend our option to purchase the facility.
F-31
On December 31, 2002, we acquired certain assets of this twill mill located in
Puebla, Mexico from Tex Transas, S.A. de C.V. ("Tex Transas") and Inmobiliaria
Cuadros, S.A. de C.V. ("Cuadros"), both of which were affiliated with Kamel
Nacif. The price paid for the asset acquisition consisted of 100,000 shares (the
Shares) of our Series A Preferred Stock valued at $8.8 million, a 25% equity
stake in Tarrant's wholly-owned subsidiary, Tarrant Mexico S. de R.L. de C.V.,
the cancellation of approximately $56.9 million of certain notes and accounts
receivables due from the sellers and their affiliates and a cash payment of $500
resulting in a total purchase price of $87.4 million. The acquisition of the
twill mill had been accounted for as the acquisition of a discrete operating
asset. Therefore no amounts were recorded as goodwill, but were allocated to
either the assets acquired or the consideration paid based on independent
valuations received by us. As discussed in Note 7 of the "Notes to Consolidated
Financial Statements," we ceased operating our facilities in Mexico and leased
these assets back to affiliates of Mr. Kamel Nacif.
On December 31, 2002, we recorded $4.5 million of interest income, which
represented accrued interest on one of the canceled notes receivable. The
interest was recorded as the cash was collected. Pursuant to the terms of the
purchase agreement, interest was accrued through December 31, 2002 as part of
the purchase price.
On December 31, 2002, our wholly owned subsidiaries, Tarrant Mexico and Tarrant
Luxembourg Sarl (previously known as Machrima Luxembourg Sarl), acquired a denim
and twill manufacturing plant in Tlaxcala, Mexico, including all machinery and
equipment used in the plant, the buildings, and the real estate on which the
plant is located. Pursuant to an Agreement for the Purchase of Assets and Stock,
dated as of December 31, 2002, Tarrant Mexico purchased from Trans Textil
International, S.A. de C.V. ("Trans Textil") all of the machinery and equipment
used in and located at the plant, and the Purchasers acquired from Jorge Miguel
Echevarria Vazquez and Rosa Lisette Nacif Benavides (the "Inmobiliaria
Shareholders") all the issued and outstanding capital stock of Inmobiliaria
Cuadros, S.A. de C.V. ("Inmobiliaria"), which owns the buildings and real
estate. The purchase price for the machinery and equipment was paid by
cancellation of $42 million in indebtedness owed by Trans Textil to Tarrant
Mexico. The purchase price for the Inmobiliaria shares consisted of a nominal
cash payment to the Inmobiliaria Shareholders of $500, and subsequent repayment
by us and our affiliates of approximately $34.7 million in indebtedness of
Inmobiliaria to Kamel Nacif Borge, his daughter Rosa Lisette Nacif Benavides,
and certain of their affiliates, which payment was made by: (i) delivery to Rosa
Lisette Nacif Benavides of 100,000 shares of our newly created, non-voting
Series A Convertible Preferred Stock, which shares will become convertible into
3,000,000 shares of common stock if our common stockholders approve the
conversion at the Annual Meeting; (ii) delivery to Rosa Lisette Nacif Benavides
of an ownership interest representing twenty-five percent of the voting power of
and profit participation in Tarrant Mexico; and (iii) cancellation of
approximately $14.9 million of indebtedness of Mr. Nacif and his affiliates. The
Series A Preferred Stock was converted into 3,000,000 shares of common stock
following approval of the conversion by our shareholders at the annual
shareholders' meeting held on May 28, 2003.
Trans Textil, an entity controlled by Mr. Nacif and his family members, was
initially commissioned by us to construct and develop the plant in December
1998. Subsequent to completion, Trans Textil purchased and/or leased the plant's
manufacturing equipment from us and entered into a production agreement that
gave us the first right to all production capacity of the plant. This production
agreement included the option for us to purchase the facility and discontinue
the production agreement with Trans Textil through September 30, 2002. We
exercised the option and acquired the plant as described above. We purchased
$12.3 million, $14.9 million and $0 million of fabric from Trans Textil in 2002,
2003 and 2004, respectively. We sold $2.0 million, $2.6 million and $0 million
of fabric to Trans Textil in 2002, 2003 and 2004, respectively.
On October 16, 2003, we entered into a lease with affiliates of Mr. Kamel Nacif,
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. Mr. Nacif was a shareholder at the time of the transaction. In
connection with this transaction, we also entered into a management services
agreement pursuant to which Mr. Nacif's affiliates managed the operation of our
remaining facilities in Mexico. The term of the management services agreement
was also for a period of 6 years. Additionally, we entered into a purchase
commitment agreement with Mr. Nacif's 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. See Note 11
"Commitments and Contingencies", of the "Notes to Consolidated Financial
Statements." Using current market prices, the purchase commitment would be
approximately $18 million per year. We had to pay $1 for each yard of
F-32
fabric that we fail to purchase under the agreement. We purchased $3.6 million
and $5.3 million of fabric from Acabados y Terminados under this agreement in
2003 and 2004. Net amount due from these related parties as of December 31, 2004
was $183,000.
In August 2004, we entered into an Agreement for Purchase of Assets with
affiliates of Mr. Kamel Nacif, a shareholder at the time of the transaction,
with agreement was amended in October 2004. Pursuant to the agreement, as
amended, on November 30, 2004, we sold to the purchasers substantially all of
our assets and real property in Mexico, including the equipment and facilities
we previously leased to Mr. Nacif's affiliates. Upon consummation of the sale,
we entered into a purchase commitment agreement with the purchasers, pursuant to
which we have agreed to purchase annually over the ten-year term of the
agreement, $5 million of fabric manufactured at our former facilities acquired
by the purchasers at negotiated market prices. This agreement replaced an
existing purchase commitment agreement with Mr. Nacif's affiliates.
We were indebted to Mr. Kamel Nacif and his affiliates in the amount of $5.4
million and $0 as of December 31, 2003 and December 31, 2004, respectively.
Under lease agreements we entered into between two entities, GET and Lynx
International Limited., owned by our Chairman and Vice Chairman, we paid
$1,330,000 in rent annually in 2002, 2003 and 2004 for office and warehouse
facilities. We currently lease both facilities on a month-to-month basis.
We reimbursed Mr. Guez, our Chairman, for fuel and related expenses incurred by
477 Aviation LLC, a company owned by Mr. Guez, when our executives used this
company's aircraft for business purposes.
At December 31, 2003 and 2004, we had various employees receivable totaling
$450,000 and $403,000, respectively, included in due from related parties.
We entered into lease agreements with the former owners of Industrial
Exportadora Famian and our former employees. Under theses leases, we paid
$843,000 and $943,000 in 2002 and 2003, respectively, for rent for sewing and
washing facilities in Tehuacan, Mexico. All these lease agreements were
cancelled in November 2003.
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 $1.9 million at December 31, 2004 was accounted for under the
equity method and included in equity method of investment on the accompanying
consolidated balance sheets.
We believe the each of the transactions described above has been entered into on
terms no less favorable to us than could have been obtained from unaffiliated
third parties.
F-33
16. 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
------------- ------------- -------------- ------------- --------------
2002
- ----
Sales...................... $ 332,877,000 $ 3,943,000 $ 10,571,000 $ -- $ 347,391,000
Inter-company sales........ 14,474,000 90,830,000 82,531,000 (187,835,000) --
------------- ------------- -------------- ------------- --------------
Total revenue.............. $ 347,351,000 $ 94,773,000 $ 93,102,000 $(187,835,000) $ 347,391,000
============= ============= ============== ============= ==============
Income (loss) from operations $ 6,916,000 $ 4,950,000 $ (7,396,000) $ -- $ 4,470,000
============= ============= ============== ============= ==============
Interest income............ $ 287,000 $ 4,453,000 $ 8,000 $ -- $ 4,748,000
============= ============= ============== ============= ==============
Interest expense........... $ 5,160,000 $ -- $ 284,000 $ -- $ 5,444,000
============= ============= ============== ============= ==============
Provision for depreciation
and amortization.......... $ 1,231,000 $ 452,000 $ 8,447,000 $ -- $ 10,130,000
============= ============= ============== ============= ==============
Capital expenditures....... $ 367,000 $ 34,000 $ 2,584,000 $ -- $ 2,985,000
============= ============= ============== ============= ==============
Total assets............... $ 165,036,000 $ 107,266,000 $ 292,113,000 $(247,971,000) $ 316,444,000
============= ============= ============== =============== ==============
2003
- ----
Sales...................... $ 291,993,000 $ 7,359,000 $ 21,071,000 $ -- $ 320,423,000
Inter-company sales........ 33,441,000 112,481,000 75,716,000 (221,638,000) --
------------- ------------- -------------- ------------- --------------
Total revenue.............. $ 325,434,000 $ 119,840,000 $ 96,787,000 $(221,638,000) $ 320,423,000
============= ============= ============== ============= ==============
Income (loss) from operations $ (10,835,000) $ 7,556,000 $ (30,116,000) $ -- $ (33,395,000)
============= ============= ============== ============= ==============
Interest income............ $ 419,000 $ -- $ 6,000 $ -- $ 425,000
============= ============== ============== ============= ==============
Interest expense........... $ 5,215,000 $ 41,000 $ 347,000 $ -- $ 5,603,000
============= ============= ============== ============= ==============
Provision for depreciation
and amortization.......... $ 1,547,000 $ 261,000 $ 14,290,000 $ -- $ 16,098,000
============= ============= ============== ============= ==============
Capital expenditures....... $ 94,000 $ 84,000 $ 190,000 $ -- $ 368,000
============= ============= ============== ============= ==============
Total assets............... $ 128,058,000 $ 117,783,000 $ 201,050,000 $(193,786,000) $ 253,105,000
============= ============= ============== ============= ==============
2004
- ----
Sales...................... $ 149,568,000 $ 1,838,000 $ 4,047,000 $ -- $ 155,453,000
Inter-company sales........ -- 80,420,000 7,453,000 (87,873,000) --
-------------- ------------- -------------- ------------- --------------
Total revenue.............. $ 149,568,000 $ 82,258,000 $ 11,500,000 $ (87,873,000) $ 155,453,000
============= ============= ============== ============= ==============
Income (loss) from operations $ (12,659,000) $ 3,663,000 $ (89,400,000) $ (22,786,000) $(121,182,000)
============= ============= ============== ============== =============
Interest income............ $ 378,000 $ -- $ -- $ -- $ 378,000
============== ============= ============== ============= ==============
Interest expense........... $ 2,764,000 $ 55,000 $ 38,0000 $ -- $ 2,857,000
============= ============= ============== ============= ==============
Provision for depreciation
and amortization.......... $ 1,283,000 $ 219,000 $ 6,836,000 $ -- $ 8,338,000
============= ============= ============== ============= ==============
Capital expenditures....... $ 48,000 $ 64,000 $ -- $ -- $ 112,000
============= ============= ============== ============= ==============
Total assets............... $ 113,046,000 $ 121,007,000 $ 31,603,000 $(133,845,000) $ 131,811,000
============= ============= ============== ============= ==============
F-34
17. EMPLOYEE BENEFIT PLANS
On August 1, 1992, Tarrant Hong Kong established a defined contribution
retirement plan covering all of its Hong Kong employees whose period of service
exceeds 12 months. Plan assets are monitored by a third-party investment manager
and are segregated from those of Tarrant Hong Kong. Participants may contribute
up to 5% of their salary to the plan. We make annual matching contributions.
Costs of the plan charged to operations for 2002, 2003 and 2004 amounted to
approximately $149,000, $157,000 and $131,000, respectively.
On July 1, 1994, we established a defined contribution retirement plan covering
all of our U.S. employees whose period of service exceeds 12 months. Plan assets
are monitored by a third-party investment manager and are segregated from those
of ours. Participants may contribute from 1% to 15% of their pre-tax
compensation up to effective limitations specified by the Internal Revenue
Service. Our contributions to the plan are based on a 50% (100% effective July
1, 1995) matching of participants' contributions, not to exceed 6% (5% effective
July 1, 1995) of the participants' annual compensation. In addition, we may also
make a discretionary annual contribution to the plan. Costs of the plan charged
to operations for 2002, 2003 and 2004 amounted to approximately $249,000,
$256,000 and $226,000, respectively.
On December 27, 1995, we established a deferred compensation plan for executive
officers. Participants may contribute a specific portion of their salary to such
plan. We do not contribute to the Plan.
18. OTHER INCOME AND EXPENSE
Other income and expense consists of the following:
YEAR ENDED DECEMBER 31,
------------------------------------
2002 2003 2004
---------- ---------- ----------
Rental income ........................... $ 495,754 $3,957,365 $5,854,698
Unrealized gain on foreign currency ..... -- -- 367,262
Realized gain on foreign currency ....... 1,123,076 304,060 --
Unrealized gain on investment ........... -- -- 769,706
Royalty income .......................... 62,166 -- --
Gain on legal settlement ................ 473,041 235,785 --
Other items ............................. 493,938 287,269 144,677
---------- ---------- ----------
Total other income ...................... $2,647,975 $4,784,479 $7,136,343
========== ========== ==========
Royalty expense ......................... $ 655,691 $ 242,426 $ 604,888
Unrealized loss on foreign currency ..... 1,014,696 560,602 --
Realized loss on foreign currency ....... -- -- 511,586
Loss on sale of fixed assets ............ -- 593,626 --
Other items ............................. 333,686 28,692 17,671
---------- ---------- ----------
Total other expense ..................... $2,004,073 $1,425,346 $1,134,145
========== ========== ==========
19. LEGAL PROCEEDINGS
1. PATRICK BENSIMON
On April 12, 2000, we formed a company, Jane Doe International, LLC ("JDI").
This company was formed for the purpose of purchasing the assets of Needletex,
Inc., owner of the Jane Doe brand. JDI was owned 51% by Fashion Resource (TCL),
Inc., our subsidiary, and 49% by Needletex, Inc. In connection with the
establishment of JDI, JDI entered into an employment agreement with Patrick
Bensimon, the principal shareholder of Needletex, Inc., which provided for the
payment of a salary to Patrick Bensimon and a bonus tied to the new company's
sales performance.
F-35
In March 2001, we converted JDI from an operating company to a licensing company
and entered into two licenses in regard to the use of the Jane Doe trademark.
Thereafter a dispute arose as to whether Patrick Bensimon had performed in
accordance with his terms of employment set forth in the Employment Agreement.
When an amicable resolution of this dispute could not be achieved, Patrick
Bensimon commenced an arbitration preceding against his employer, JDI, Fashion
Resource (TCL), Inc., the managing member of Jane Doe International and us.
On April 7, 2003, the arbitration panel issued a final award in favor of Patrick
Bensimon of $1,425,655 for salary and bonus, plus interest accrued and his costs
and attorneys fees in the amount of $489,640. We had a total of $1.6 million
reserve for litigation as of December 31, 2002. In January 2004, we settled the
employment litigation with Patrick Bensimon for $1.2 million in cash and
forgiveness of approximately $859,000 in debts owed by Needletex Inc. As part of
the settlement, we received the remaining 49% interest in JDI. We also settled
with our insurance carrier for a cash payment of $330,000. An additional expense
of approximately $379,000 was made in the fourth quarter of 2003 to cover the
forgiveness of debts.
2. NICOLAS NUNEZ
In March 2005, we reached a settlement of a dispute involving a former employee
named Nicolas Nunez. Mr. Nunez was employed by us pursuant to a written
employment agreement until he was terminated in or about November 2000. In
connection to this employment, we agreed to acquire Nunez' company by merger.
Mr. Nunez claimed to be entitled to shares of our common stock up to a value of
$500,000 assuming we did not otherwise have valid defenses to such claims. In
connection with the settlement, we agreed to compensate Mr. Nunez in the total
amount of $875,000, by paying him $500,000 cash, payable in April 2005, and the
balance of $375,000 in our common stock (195,313 shares based on the fair value
of our common stock at March 24, 2005.) The full amount of $875,000 has been
accrued and included in accrued liabilities in the accompanying balance sheet at
December 31, 2004. All parties to both proceedings have agreed to exchange full
mutual releases of any and all claims, known or unknown, and will dismiss both
proceedings with prejudice, without admitting any liability.
3. MR. BENJAMIN DOMINGUEZ GONZALEZ
On December 10, 2004 and December 14, 2004, Mr. Benjamin Dominguez Gonzalez
brought suits against our Mexico Subsidiary, Tarrant Mexico, S. de R.L. de C.V.,
in Puebla, Puebla, Mexico: (a) "Juicio Ejecutivo Mercantil 887/2004, Juzgado
Dicimo de lo Civil del Estado de Puebla, Puebla, Mexico, Dominguez Gonzalez
Benjamin vs. Tarrant Mexico S. de R.L. de C.V. e Inmobiliaria Cuadros S.A. de
C.V."; and (b) "Juicio Ejecutivo Mercantil 889/2004, Juzgado Noveno de lo Civil
del Estado de Puebla, Puebla, Mexico, Dominguez Gonzalez Benjamin vs. Tarrant
Mexico S. de R.L. de C.V. e Inmobiliaria Cuadros S.A. de C.V.", for the
non-payment of approximately $14 million in principal amount and accrued
interest on two promissory notes, which Mr. Gonzalez asserts were issued by
Tarrant Mexico. The amounts Mr. Gonzalez claimed were due and owing under the
notes previously had been paid in full. In April 2005, Mr. Gonzalez agreed to
dismiss his claims, which agreement has been submitted to and is pending final
approval of the court.
F-36
20. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
QUARTER ENDED
--------------------------------------------
MAR. 31 JUN. 30 SEP. 30 DEC. 31
-------- -------- -------- --------
(in thousands, except per share data)
2003
- ----
Net sales ...................... $ 78,736 $ 78,194 $ 96,458 $ 67,035
Gross profit ................... 8,802 (432) 11,514 12,094
Operating income (loss) ........ (1,310) (34,367) 1,448 834
Net income (loss) .............. $ (3,879) $(32,571) $ 138 $ 427
Net income (loss) per common
share:
Basic ....................... $ (0.24) $ (1.94) $ 0.01 $ 0.02
Diluted ..................... $ (0.24) $ (1.94) $ 0.01 $ 0.02
Weighted average shares
outstanding:
Basic ....................... 15,837 16,832 18,765 21,426
Diluted ..................... 15,837 16,832 18,767 26,250
2004
- ----
Net sales ...................... $ 42,155 $ 38,489 $ 38,102 $ 36,707
Gross profit ................... 7,500 5,266 4,135 4,060
Operating loss ................. (5,921) (84,393) (3,442) (27,426)
Net loss ....................... $ (2,974) $(68,567) $ (4,019) $(29,117)
Net loss per common share:
Basic ....................... $ (0.10) $ (2.39) $ (0.14) $ (1.01)
Diluted ..................... $ (0.10) $ (2.39) $ (0.14) $ (1.01)
Weighted average shares
outstanding:
Basic ....................... 28,485 28,649 28,815 28,815
Diluted ..................... 28,485 28,649 28,815 28,815
F-37
21. SUBSEQUENT EVENTS
On February 14, 2005, we borrowed $5 million from Max Azria, which amount bears
interest at the rate of 4% per annum and is payable in weekly installments of
$250,000 beginning on February 28, 2005 and continuing each Monday until July
11, 2005. This is an unsecured loan.
On January 3, 2005, Private Brands, Inc, our wholly owned subsidiary, entered
into a term sheet exclusive licensing agreement with Beyond Productions, LLC and
Kids Headquarters to collaborate on the design, manufacturing and distribution
of women's contemporary, large sizes and junior apparel bearing the brand name
"House of Dereon", Couture, Kick and Soul. This agreement is a three-year
contract, and providing compliance with all terms of the license, is renewable
for one additional three-year term. Minimum net sales are $10 million in year 1,
$20 million in year 2 and $30 million in year 3. The agreement also provides
payment of royalty at the rate of 8% on net sales and 3% on net sales for
marketing fund commitments. As of March 30, 2005, we have advanced $1.2 million
as payment for the first year's minimum royalty and marketing fund commitment.
F-38
SCHEDULE II
TARRANT APPAREL GROUP
VALUATION AND QUALIFYING ACCOUNTS
ADDITIONS ADDITIONS
BALANCE AT CHARGED TO CHARGED BALANCE
BEGINNING COSTS AND TO OTHER AT END
OF YEAR EXPENSES ACCOUNTS DEDUCTIONS OF YEAR
----------- ----------- ------------ ----------- -----------
For the year ended December 31, 2002
Allowance for returns and discounts... $ 2,681,601 $ 453,167 $ -- $ -- $ 3,134,768
Allowance for bad debt ............... $ 3,484,647 $ -- $ -- $(2,302,794) $ 1,181,853
=========== =========== ============ =========== ===========
For the year ended December 31, 2003
Allowance for returns and discounts... $ 3,134,768 $ -- $ -- $ (324,387) $ 2,810,381
Allowance for bad debt ............... $ 1,181,853 $ 234,149 $ -- $ -- $ 1,416,002
Inventory reserve .................. $ -- $10,986,153 $ -- $ -- $10,986,153
=========== =========== ============ =========== ===========
For the year ended December 31, 2004
Allowance for returns and discounts .. $ 2,810,381 $ 738,326 $ -- $(2,485,386) $ 1,063,321
Allowance for bad debt ............... $ 1,416,002 $ 476,016 $ -- $ (517,474) $ 1,374,544
Inventory reserve .................. $10,986,153 $ -- $ -- $(9,869,491) $ 1,116,662
=========== =========== ============ =========== ===========
F-39
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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
By: /S/ GERARD GUEZ
------------------------------------
Gerard Guez
Chairman of the Board
POWER OF ATTORNEY
The undersigned directors and officers of Tarrant Apparel Group do
hereby constitute and appoint Barry Aved and Corazon Reyes, and each of them,
with full power of substitution and resubstitution, as their true and lawful
attorneys and agents, to do any and all acts and things in our name and behalf
in our capacities as directors and officers and to execute any and all
instruments for us and in our names in the capacities indicated below, which
said attorney and agent, may deem necessary or advisable to enable said
corporation to comply with the Securities Exchange Act of 1934, as amended and
any rules, regulations and requirements of the Securities and Exchange
Commission, in connection with this Annual Report on Form 10-K, including
specifically but without limitation, power and authority to sign for us or any
of us in our names in the capacities indicated below, any and all amendments
(including post-effective amendments) hereto, and we do hereby ratify and
confirm all that said attorneys and agents, or either of them, shall do or cause
to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
--------- ----- ----
/S/ GERARD GUEZ Chairman of the Board April 15, 2005
- -------------------------- of Directors
Gerard Guez
/S/ TODD KAY Vice Chairman of the Board April 15, 2005
- -------------------------- of Directors
Todd Kay
/S/ BARRY AVED Chief Executive Officer April 15, 2005
- -------------------------- and Director (Principal
Barry Aved Executive Officer)
/S/ CORAZON REYES Chief Financial Officer, April 15, 2005
- -------------------------- Treasurer and Director
Corazon Reyes (Principal Financial and
Accounting Officer)
/S/ MILTON KOFFMAN Director April 15, 2005
- --------------------------
Milton Koffman
/S/ STEPHANE FAROUZE Director April 15, 2005
- --------------------------
Stephane Farouze
/S/ MITCHELL SIMBAL Director April 15, 2005
- --------------------------
Mitchell Simbal
/S/ JOSEPH MIZRACHI Director April 15, 2005
- --------------------------
Joseph Mizrachi
/S/ SIMON MANI Director April 15, 2005
- --------------------------
Simon Mani
S-1
TARRANT APPAREL GROUP
EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION
- ------------ ------------------------------------------------------------------
3.1 Restated Articles of Incorporation. (1)
3.1.1 Certificate of Amendment of Restated Articles of Incorporation.
(9)
3.1.2 Certificate of Amendment of Restated Articles of Incorporation.
(9)
3.1.3 Certificate of Amendment of Restated Articles of Incorporation.
(17)
3.2 Restated Bylaws. (1)
4.1 Specimen of Common Stock Certificate. (2)
4.2 Rights Agreement dated as of November 21, 2003, between Tarrant
Apparel Group and Computershare Trust Company, as Rights Agent,
including the Form of Rights Certificate and the Summary of Rights
to Purchase Preferred Stock, attached thereto as Exhibits B and C,
respectively. (16)
4.3 Certificate of Determination of Preferences, Rights and
Limitations of Series B Preferred Stock. (18)
4.4 Form of 6% Secured Convertible Debenture. (25)
10.1 Tarrant Apparel Group Employee Incentive Plan.* (22)
10.2 Tenancy Agreement dated July 15, 1994 between Lynx International
Limited and Tarrant Company Limited as amended by that certain
Supplementary Tenancy Agreement dated December 30, 1994 and that
certain Second Supplementary Tenancy Agreement dated December 31,
1994. (1)
10.3 Services Agreement dated as of October 1, 1994, by and between the
Company and Lynx International Limited. (1)
10.4 Indemnification Agreement dated as of March 14, 1995, by and among
Tarrant Apparel Group, Gerard Guez and Todd Kay. (2)
10.5 Employment Agreement effective January 1, 1998, by and between
Tarrant Apparel Group and Gerard Guez.* (4)
10.5.1 First amendment to Employment Agreement dated as of January 10,
2000 by and between Gerard Guez and Tarrant Apparel Group.* (8)
10.5.2 Second Amendment to Employment Agreement dated April 1, 2003
between Tarrant Apparel Group and Gerard Guez.* (12)
10.5.3 Third Amendment to Employment Agreement, effective as of April 1,
2004, between Tarrant Apparel Group and Gerard Guez.* (23)
10.6 Employment Agreement effective January 1, 1998, by and between
Tarrant Apparel Group and Todd Kay.* (4)
10.6.1 First Amendment to Employment Agreement dated as of January 10,
2000 by and between Todd Kay and Tarrant Apparel Group.* (8)
EX-1
EXHIBIT
NUMBER DESCRIPTION
- ------------ ------------------------------------------------------------------
10.6.2 Second Amendment to Employment Agreement dated April 1, 2003
between Tarrant Apparel Group and Todd Kay.* (12)
10.6.3 Third Amendment to Employment Agreement, effective as of April 1,
2004, between Tarrant Apparel Group and Todd Kay.* (23)
10.7 Buying Agency Agreement executed as of April 4, 1995, by Azteca
Production International, Inc. and Tarrant Company Ltd., with
Tarrant Apparel Group acknowledging as to certain matters. (2)
10.8 Form of Indemnification Agreement with directors and certain
executive officers. (3)
10.9 Employment Agreement effective as of the twenty-third day of
March, 1999, by and between Charles Ghailian and Tarrant Apparel
Group to pay CMG Inc.* (5)
10.10 Loan Agreement dated December 30, 1999 by and between Standard
Chartered Bank and Tarrant Apparel Group. (6)
10.11 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. (23)
10.12 Promissory note dated February 28, 2001 in the amount of US
$4,119,545.06 to pay to the order of Standard Chartered Bank (7)
10.13 Amended and Restated Limited Liability Company Operating Agreement
of United Apparel Ventures, dated as of October 1, 2002, between
Azteca Production International, Inc. and Tag Mex, Inc. (11)
10.14 Guaranty Agreement dated as of May 30, 2002 by and between UPS
Capital Global Trade Finance Corporation and Tarrant Apparel Group
and Fashion Resource (TCL), Inc. (9)
10.14.1 Conditional Consent Agreement dated December 31, 2002, between UPS
Capital Global Trade Finance Corporation and Fashion Resource
(TCL), Inc. (10)
10.15 Guaranty Agreement dated as of May 30, 2002 by and between UPS
Capital Global Trade Finance Corporation and Gerard Guez. (9)
10.16 Syndicated Letter of Credit Facility dated June 13, 2002 by and
between Tarrant Company Limited, Marble Limited and Trade Link
Holdings Limited as Borrowers and UPS Capital Global Trade Finance
Corporation as Agent and Issuer and Certain Banks and Financial
Institutions as Banks. (9)
10.16.1 Charge Over Shares dated June 13, 2002 by Fashion Resource (TCL),
Inc. in favor of UPS Capital Global Trade Finance Corporation. (9)
10.16.2 Syndicated Composite Guarantee and Debenture dated June 13, 2002
between Tarrant Company Limited, Marble Limited and Trade link
Holdings Limited and UPS Capital Global Trade Finance Corporation.
(9)
10.16.3 Charge Over Shares dated February 26, 2003, between Machrima
Luxembourg International Sarl and UPS Global Trade Finance
Corporation. (11)
10.16.4 Fourth Deed of Variation to Syndicated Letter of Credit Facility
dated June 18, 2003 among Tarrant Company Limited, Marble Limited
and Trade Link Holdings Limited and UPS Capital Global Trade
Finance Corporation. (12)
EX-2
EXHIBIT
NUMBER DESCRIPTION
- ------------ ------------------------------------------------------------------
10.16.5 Letter Agreement dated September 1, 2003, among Tarrant Company
Limited, Marble Limited, Trade Link Holdings Limited and UPS
Capital Global Trade Finance Corporation. (15)
10.16.6 Fifth Deed of Variation to Syndicated Letter of Credit Facility
dated December 23, 2003 among Tarrant Company Limited, Marble
Limited and Trade Link Holdings Limited and UPS Capital Global
Trade Finance Corporation. (20)
10.16.7 Sixth Deed of Variation to Syndicated Letter of Credit Facility
dated March 17, 2004 among Tarrant Company Limited, Marble Limited
and Trade Link Holdings Limited and UPS Capital Global Trade
Finance Corporation. (21)
10.16.8 Seventh Deed of Variation to Syndicated Letter of Credit Facility
dated May 5, 2004 among Tarrant Company Limited, Marble Limited
and Trade Link Holdings Limited and UPS Capital Global Trade
Finance Corporation. (22)
10.16.9 Eighth Deed of Variation to Syndicated Letter of Credit Facility
effective as of May 10, 2004 among Tarrant Company Limited, Marble
Limited and Trade Link Holdings Limited and UPS Capital Global
Trade Finance Corporation. (22)
10.16.10 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. (23)
10.16.11
Tenth Deed of Variation to Syndicated Letter of Credit Facility
effective as of December 31, 2004 among Tarrant Company Limited,
Marble Limited and Trade Link Holdings Limited and UPS Capital
Global Trade Finance Corporation.
10.16.12 Loan Agreement dated December 31, 2004 by and among Tarrant
Company Limited, Marble Limited and Trade Link Holdings Limited
and UPS Capital Global Trade Finance Corporation.
10.16.13 Amendment Agreement to Syndicated Composite Guarantee and
Debenture dated December 31, 2004, by and among Tarrant Company
Limited, Marble Limited and Trade Link Holdings Limited and UPS
Capital Global Trade Finance Corporation.
10.16.14 Guaranty and Security Agreement dated December 31, 2004 by and
among Tarrant Apparel Group, Fashion Resource (TCL), Inc. and UPS
Capital Global Trade Finance Corporation.
10.16.15 Guaranty and Security Agreement dated December 31, 2004 by and
between Tarrant Luxembourg Sarl and UPS Capital Global Trade
Finance Corporation.
10.16.16 Amendment Agreement to Charge Over Shares dated December 31, 2004
by and between Tarrant Luxembourg Sarl and UPS Capital Global
Trade Finance Corporation.
10.17 Assignment of Promissory Note by Tarrant Apparel Group to Tarrant
Company Limited and to Trade Link Holdings Company dated December
26, 2001. (9)
10.18 Exclusive Distribution Agreement dated April 1, 2003, between
Federated Merchandising Group, an unincorporated division of
Federated Department Stores, and Private Brands, Inc. (11)
10.18.1 Amendment No. 1 to Exclusive Distribution Agreement dated as of
June 22, 2004, between Federated Merchandising Group, an
unincorporated division of Federated Department Stores, and
Private Brands, Inc. (22)
10.19 Unconditional Guaranty of Performance dated April 1, 2003, by
Tarrant Apparel Group. (11)
EX-3
EXHIBIT
NUMBER DESCRIPTION
- ------------ ------------------------------------------------------------------
10.20 Promissory Note dated May 31, 2003 made by Gerard Guez in favor of
Tarrant Apparel Group. (12)
10.21 Indemnification Agreement dated April 10, 2003 between Tarrant
Apparel Group and Seven Licensing Company, LLC. (12)
10.22 Form of Subscription Agreement, by and between Tarrant Apparel
Group and the Purchaser to be identified therein. (13)
10.23 Registration Rights Agreement dated October 17, 2003, by and among
Tarrant Apparel Group and Sanders Morris Harris Inc. as agent and
attorney-in-fact for the Purchasers identified therein. (13)
10.24 Placement Agent Agreement dated October 13, 2003, by and between
Tarrant Apparel Group and Sanders Morris Harris Inc. (13)
10.25 Common Stock Purchase Warrant dated October 17, 2003, by and
between Tarrant Apparel Group and Sanders Morris Harris Inc. (13)
10.26 Form of Voting Agreement, by and between Sanders Morris Harris
Inc. and the Shareholder to be identified therein. (14)
10.27 Lease Agreement, dated as of August 29, 2003, between Tarrant
Mexico S. de R.L. de C.V. and Acabados Y Cortes Textiles S.A. de
C.V. (13)
10.28 Lease Agreement, dated as of August 29, 2003, between Tarrant
Mexico S. de R.L. de C.V. and Acabados Y Cortes Textiles S.A. de
C.V. (13)
10.29 Purchase Commitment Agreement, dated October 16, 2003, between
Tarrant Mexico S. de R.L. de C.V. and Acabados Y Cortes Textiles
S.A. de C.V. (13)
10.30 Employment Agreement, effective as of September 1, 2003, between
the Company and Barry Aved. (15)
10.31 Employment Agreement, dated October 24, 2003, between the Company
and Henry Chu. (15)
10.32 Placement Agent Agreement dated January 23, 2004 between Tarrant
Apparel Group and Sanders Morris Harris Inc. (19)
10.33 Form of Subscription Agreement between Tarrant Apparel Group and
the investor to be identified therein. (19)
10.34 Common Stock Purchase Warrant dated January 26, 2004 between
Tarrant Apparel Group and Sanders Morris Harris Inc. (19)
10.35 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. (23)
10.35.1 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. (23)
10.36 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. (23)
10.37 Securities Purchase Agreement dated December 6, 2004, by and
between Tarrant Apparel Group and the investors listed on the
signature pages thereto. (24)
10.38 Registration Rights Agreement dated December 14, 2004, by and
among Tarrant Apparel Group and the investors listed on the
signature pages thereto. (25)
EX-4
EXHIBIT
NUMBER DESCRIPTION
- ------------ ------------------------------------------------------------------
10.39 Security Agreement dated December 14, 2004, by and among Tarrant
Apparel Group and the investors listed on the signature pages
thereto. (25)
10.40 Intercreditor Agreement dated December 14, 2004 by and among
Tarrant Apparel Group, GMAC Commercial Finance, LLC, UPS Capital
Global Trade Finance Corporation and T.R. Winston & Company, LLC.
(25)
10.41 Common Stock Purchase Warrant dated December 14, 2004 issued by
Tarrant Apparel Group in favor of T.R. Winston & Company, LLC.
(25)
10.42 Form of Common Stock Purchase Warrant. (25)
14.1 Code of Ethical Conduct. (20)
21.1 Subsidiaries.
23.1 Consent of Grant Thornton LLP.
23.2 Consent of Ernst & Young LLP.
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.
- ----------
+ All schedules and or exhibits have been omitted. Any omitted schedule or
exhibit will be furnished supplementally to the Securities and Exchange
Commission upon request.
* Management contract or compensatory plan or arrangement.
(1) Filed as an exhibit to the Company's Registration Statement on Form S-1
filed with the Securities and Exchange Commission on May 4, 1995 (File No.
33-91874).
(2) Filed as an exhibit to Amendment No. 1 to Registration Statement on Form
S-1 filed with the Securities and Exchange Commission on July 15, 1995.
(3) Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the
quarter ended June 30, 1997.
(4) Filed as an exhibit to the Company's Annual Report on Form 10-K for the
year ended December 31, 1998.
(5) Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the
quarter ended March 31, 1999.
(6) Filed as an exhibit to the Company's Annual Report on Form 10-K for the
year ended December 31, 1999.
(7) Filed as an exhibit to the Company's Annual Report on Form 10-K for the
year ending December 31, 2000.
(8) Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the
quarter ending March 31, 2001.
(9) Filed as an exhibit to the Company's Quarterly Report on Form 10Q for the
quarter ending June 30, 2002.
(10) Filed as an exhibit to the Company's Annual Report on Form 10K for the
year ending December 31, 2002.
(11) Filed as an exhibit to the Company's Quarterly Report on Form 10Q for the
quarter ending March 31, 2003.
(12) Filed as an exhibit to the Company's Quarterly Report on Form 10Q for the
quarter ending June 30, 2003.
EX-5
(13) Filed as an exhibit to the Company's Current Report on Form 8-K dated
October 16, 2003.
(14) Filed as an exhibit to the Company's Registration Statement on Form S-3
filed with the Securities and Exchange Commission on October 30, 2003
(File No. 333-110090).
(15) Filed as an exhibit to the Company's Quarterly Report on Form 10Q for the
quarter ending September 30, 2003.
(16) Filed as an exhibit to the Company's Current Report on Form 8-K dated
November 12, 2003.
(17) Filed as an exhibit to the Company's Current Report on Form 8-K dated
December 4, 2003.
(18) Filed as an exhibit to the Company's Amendment to Current Report on Form
8-K/A, filed December 12, 2003.
(19) Filed as an exhibit to the Company's Current Report on Form 8-K dated
January 23, 2004.
(20) Filed as an exhibit to the Company's Annual Report on Form 10-K for year
ending December 31, 2003.
(21) Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the
quarter ending March 31, 2004.
(22) Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the
quarter ending June 30, 2004.
(23) Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the
quarter ending September 30, 2004.
(24) Filed as an exhibit to the Company's Current Report on Form 8-K dated
December 6, 2004.
(25) Filed as an exhibit to the Company's Current Report on Form 8-K dated
December 14, 2004.
EX-6