Back to GetFilings.com

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

Commission file Number    0-18490

K•SWISS INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code    (818) 706-5100

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

Class A Common Stock, par value $0.01 per share

(Title of class)

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.    x  Yes    ¨  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.    x

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

The aggregate market value of the Class A Common Stock of the Registrant held by non-affiliates of the registrant as of June 30, 2004, the last business day of the registrant’s most recently completed second fiscal quarter, based on the closing price of the Class A Common Stock on the Nasdaq National Market on such date was $527,958,380.

The number of shares of the Registrant’s Class A Common Stock outstanding at February 21, 2005 was 26,247,594 shares. The number of shares of the Registrant’s Class B Common Stock outstanding at February 21, 2005 was 8,380,128 shares.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the proxy statement for the Registrant’s 2005 Annual Stockholders Meeting are incorporated by reference into Part III.

Table of Contents

K•SWISS INC.

INDEX TO ANNUAL REPORT ON FORM 10-K

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004

Table of Contents

PART I

Company History and General Strategy

K•Swiss Inc. designs, develops and markets an array of athletic footwear for high performance sports use, fitness activities and casual wear under the K•Swiss brand. We also design and manufacture footwear under the Royal Elastics brand. Royal Elastics, a wholly owned subsidiary, is a leading innovator of slip-on, laceless footwear. Sales of Royal Elastics brand were not significant during 2004.

K•Swiss was founded in 1966 by two Swiss brothers, who introduced one of the first leather tennis shoes in the United States. The shoe, the K•Swiss “Classic,” has remained relatively unchanged from its original design, and accounts for a significant portion of our sales. The Classic has evolved from a high-performance shoe into a casual, lifestyle shoe. We have emphasized in our marketing the commitment to produce products of high quality and enduring style and we plan to continue to emphasize the high quality and classic design of our products as we introduce new models of athletic footwear.

On December 30, 1986, K•Swiss was purchased by an investment group led by our current President. Thereafter we recruited experienced management and reduced manufacturing costs by increasing offshore production and entering into new, lower cost purchasing arrangements. Our products are manufactured to our specifications by overseas suppliers predominately in China. In June 1991 and September 1992, we established operations in Taiwan and Europe, respectively, to broaden our distribution on a global scale.

In May 2001, we formed a joint venture to license, produce and market a men’s, women’s and children’s collection of National Geographic outdoor-oriented and casual footwear. In the fourth quarter of 2003, we agreed with National Geographic to end our licensing agreement. Operations of the National Geographic brand have been accounted for and shown as a discontinued operation in the accompanying financial information.

In November 2001, we acquired the worldwide rights and business of Royal Elastics (“Royal”), an Australian-based designer and manufacturer of elasticated footwear. The purchase excludes distribution rights in Australia, which were retained by Royal Management Pty, Ltd.

The discussion during the remainder of this Item 1., other than backlog, trademarks and patents, and employees, relates solely to the K•Swiss brand.

K•Swiss is a corporation and was organized under the laws of the State of Delaware on April 16, 1990. The Company is successor in interest to K•Swiss Inc., a Massachusetts corporation, which in turn was successor in interest to K•Swiss Inc., a California corporation. Unless the context otherwise indicates, the terms “we,” “us,” “K•Swiss” and the “Company” as used herein refers to K•Swiss Inc. and its consolidated subsidiaries.

Products

Our product strategy is two pronged. The first combines classic styling with high quality components and technical features designed to meet performance requirements of specific sports. We endeavor to use classic styling to reduce the impact of changes in consumer preferences as we believe that this strategy leads to longer product life cycles than are typical of the products of certain of our competitors. We believe that long product life cycles reduce total markdowns over the life of the

3

Table of Contents

products, thereby enhancing their attractiveness to retailers. This strategy also enables us to maintain inventory with less risk of obsolescence than is typical of more fashion-oriented products. The second product strategy uses fashion-oriented footwear sold principally on a futures only basis usually with little or no planned inventory position taken on these products. This strategy allows us to take advantage of trends in the marketplace that we identify while attempting to minimize the risk generally associated with this type of product.

Presently, we compete in the Classic category (casual), training, basketball, tennis and children’s footwear. Each product category has certain styles designated as core products. Our core products offer style continuity and often include on-going improvement. We believe our core product program is a critical factor in attempting to achieve our goal of becoming the “retailers’ most profitable vendor.” The core program tends to minimize retailers’ markdowns and maximizes the effectiveness of marketing expenditures because of longer product life cycles.

The following table summarizes our K•Swiss brand footwear into categories and sets forth the approximate contribution to revenues (in dollars and as a percentage of revenues) attributable to each footwear category for the periods indicated. All footwear categories come in both men’s (approximately 50% of 2004 revenues) and women’s (approximately 31% of 2004 revenues). Most styles within each footwear category are offered in men’s, women’s and children’s.

Footwear

Our product line through 1987 was primarily the Classic. The Classic was originally developed in 1966 as a high-performance tennis shoe. Since that time, the Classic has become a popular casual shoe. The upper of the Classic includes only three separate pieces of leather, which allows for a relatively simple manufacturing process and yields a product with few seams. This simple construction improves the shoe’s comfort, fit and durability. We have from time to time incorporated certain technical advances in materials and construction, but the Classic has remained relatively unchanged in style since 1966. In 2000, we launched Classic Luxury Edition, which sells for slightly more than the original version.

4

Table of Contents

The Classic, fueled by new products, has evolved into a category of shoes referred to as the Classic category. The Classic category is comprised of the Classic original, as described above, and its derivatives, and other casual athletic styles.

The Classic originals segment contains shoes that we intend to carry in our product assortment for several years. They generally have shoe characteristics such as d-rings and five stripes, and, because they are multiple season shoes, we maintain significant inventory positions of this segment. Significant inventory positions allow for effective electronic data interchange (“EDI”) programs with retailers that fit into our strategy of attempting to become the retailers’ most profitable vendor. The other casual athletic styles category includes the K-S Collection which comprises shoes offered for several seasons and they generally do not contain d-rings and have diffused or no stripes. Sometimes inventory is maintained on these products. Other casual athletic styles also includes the Limited Edition segment which is generally meant as a one-season offering. They are generally fashionable type shoes that are purchased from factories based only on futures orders received from retailers.

In 2000, we entered the training performance category to compete with moderately priced running shoes and moderately priced cross training shoes. In 2004, we entered the basketball category, which is included in the training category in the above table.

Apparel and Accessories

We market a limited line of K•Swiss branded apparel and accessories. The products are designed with the same classic strategies used in the footwear line. Classic styling allows us to appeal to a variety of new markets from an urban distribution to an upscale suburban consumer.

In 1999, we introduced a new 7.0 line of high tech tennis apparel to complement our performance 7.0 footwear. The product line consists of world-class apparel (skirts, shorts, tops, polo’s, dresses and warm-ups) for both men and women. We also offer a collection for the casual athletic consumer consisting of tee shirts, caps, socks and bags.

The apparel line is distributed through the large chain sporting goods stores as well as independent shoe and sporting goods dealers nationwide. The tennis apparel line is sold primarily through tennis specialty and tennis pro shops. It also offers us visible promotional opportunities.

Sales

We sell our products in the United States through our sales executives, and independent sales representatives primarily to a limited number of specialty athletic footwear stores, pro shops, sporting good stores and department stores. We also sell through our website which is becoming increasingly important to us particularly in light of our limited distribution. We also sell our products to a number of foreign distributors. We now have sales offices or distributors throughout the world. In 1992, we established sales offices and now have appointed exclusive distributors in much of Europe.

Financial information relating to international and domestic operations is presented as part of Item 8 of this report. See Note N to our Consolidated Financial Statements.

Marketing

Advertising and Promotion

We believe that our strategy of designing products with longer life cycles and introducing fewer new models relative to our competition enhances the effectiveness of our advertising and promotions.

In 2004, we used television as our largest single marketing expenditure. The campaign was run primarily on network and cable television, and was supported by several sports, music and general interest/fashion magazines.

5

Table of Contents

Advertising and promotion efforts in foreign markets are directed by local distributors. Our agreements with foreign distributors generally require such distributors to spend a certain percentage of their sales of our products on advertising and promotion. We control the nature and content of these promotions.

Domestic Marketing

Our current marketing strategy emphasizes distribution to retailers whose marketing strategies are consistent with our reputation for quality and service.

Our footwear products are sold domestically through 44 independent regional sales representatives and 9 Company-employed sales managers. The independent sales representatives are paid on a commission basis, and are prohibited by contract from representing other brands of athletic footwear and related products. These representatives sold to approximately 2,900, 3,000 and 2,900 separate accounts as of December 31, 2004, 2003 and 2002, respectively.

During 2004, the Foot Locker group of stores and affiliates accounted for approximately 21% of domestic revenues. See Note K to our Consolidated Financial Statements. No other customer accounted for more than 10% of total revenues during this period.

We offer a “futures” program, under which retailers are offered discounts on orders scheduled for delivery more than five months after the order is made. There is no guarantee that such orders will not be canceled prior to acceptance by the customer. This program is similar to programs offered by other athletic shoe companies. The futures program has a positive effect on inventory costs, planning and production scheduling. See “Distribution.” In addition, we engage in certain sales programs from time to time that provide for extended terms on initial domestic orders of new styles.

We maintain a customer service department consisting of 18 persons at our Westlake Village, California facility. The customer service department accepts orders for our products, handles inquiries and notifies retailers of the status of their orders. We have made a substantial investment in computer equipment for general customer support and service, as well as for distribution. See “Distribution.”

In 1999, seeking to expand the brand’s reach, provide product distribution to consumers that do not otherwise have the ability to purchase our products and to take advantage of the new advances in technology and the internet, we initiated an effort to better utilize the internet and the World Wide Web. The approach was two pronged. The K•Swiss website (www.kswiss.com) was enhanced and is visually integrated with the current television campaign. The second part of the strategy led to the creation of a new entity called K•Swiss Direct. K•Swiss Direct’s function is to provide the end consumers an alternate method of acquiring our products when they cannot find the product in their local retail outlets or do not have reasonable access to retail outlets carrying the product. Using the internet, consumers can purchase select footwear and apparel, at prices competitive with our retailers, and have it shipped directly to them.

International Marketing

In 1991, we established a sales management team in Asia. We have exclusive distributors in certain Pacific Rim countries. Exclusive distributors of our products are generally contractually obligated to spend specific amounts on advertising and promotion of our products. We have also established exclusive distributors in other international markets.

To expand the marketing of our products into Europe, we opened our own office in the Netherlands in 1992.

6

Table of Contents

By the end of 2004, K•Swiss was working through 6 international subsidiaries and 16 distributors to market K•Swiss products in potentially 65 countries.

Distribution

During December 1997, we relocated our distribution facility. We maintain 371,000 square feet of warehouse space at two leased facilities in Mira Loma, California. See “Item 2. Properties.”

We purchase footwear from independent manufacturers located predominantly in China. The time required to fill new orders placed by us with our manufacturers is approximately five months. Such footwear is generally shipped in ocean containers and delivered to our facility in California. In some cases, large customers may receive containers of footwear directly from the manufacturer. Distribution to European customers and certain other European distributors is based out of the Netherlands office public distribution facility. We generally arrange shipment of other international orders directly from our independent manufacturers.

We maintain an open-stock inventory on certain products which permits us to ship to retailers on an “at once” basis in response to orders placed by mail, fax, toll-free telephone call or electronically. We have made a significant investment in computer equipment that provides on-line capability to determine open-stock availability for shipment. Additionally, products can be ordered under our “futures” program. See “Marketing—Domestic Marketing.” We ship by package express or truck from California, depending upon size of order, customer location and availability of inventory.

Product Design and Development

We maintain offices in Westlake Village, California and Taichung, Taiwan that include a staff of individuals responsible for the design and development of new styles for all global regions. This staff receives guidance from our management team in California, who meet regularly to review sales, consumer and market trends.

Manufacturing

In 2004, approximately 99% of our footwear products were manufactured in China and 1% in Taiwan. Although we have no long-term manufacturing agreements and compete with other athletic shoe companies for production facilities (including companies that are much larger than us), we believe that our relationships with our footwear producers are satisfactory and that we have the ability to develop, over time, alternative sources for our footwear. Our operations, however, could be materially and adversely affected if a substantial delay occurred in locating and obtaining alternative producers.

All manufacturing of footwear is performed in accordance with detailed specifications furnished by us and is subject to quality control standards, and we retain the right to reject products that do not meet specifications. The bulk of all raw materials used in such production are purchased by manufacturers at our direction. Our inspectors at the manufacturing facilities test and inspect footwear products prior to shipment from those facilities.

During 2004, our apparel and accessory products were manufactured in China, Taiwan, Thailand, Korea and the United States by certain manufacturers selected by us.

Our operations are subject to compliance with relevant laws and regulations enforced by the United States Customs Service and to the customary risks of doing business abroad, including fluctuations in the value of currencies, increases in customs duties and related fees resulting from position changes by the United States Customs Service, import controls and trade barriers (including

7

Table of Contents

the unilateral imposition of import quotas), restrictions on the transfer of funds, work stoppages and, in certain parts of the world, political instability causing disruption of trade. These factors have not had a material adverse impact upon our operations to date. Imports into the United States are also affected by the cost of transportation, the imposition of import duties, and increased competition from greater production demands abroad. The United States or the countries in which our products are manufactured may, from time to time, impose new quotas, duties, tariffs or other restrictions, or adjust presently prevailing quotas, duty or tariff levels, which could affect our operations and ability to import products at current or increased levels. We cannot predict the likelihood or frequency of any such events occurring. A change in any such duties, quotas or restrictions could result in increases in the costs of such products generally and might adversely affect the sales or profitability of K•Swiss and the athletic footwear industry as a whole.

Our use of common elements in raw materials, lasts and dies gives flexibility to duplicate sourcing in various countries in order to reduce the risk that we may not be able to obtain products from a particular country.

Our footwear products are subject to the United States customs duties which range from 8.5% to 10.0% of factory cost on footwear made principally of leather to duties on synthetic footwear ranging from 6.0% to 20.0% plus, for certain styles, $0.90 per pair and duties on moderately priced textile footwear ranging from 20.0% to 37.5%, for certain styles. Currently, approximately 98% of our footwear volume is derived from sales of leather footwear and approximately 2% of our footwear volume is derived from sales of synthetic and textile footwear.

A large portion of our imported products are manufactured in the People’s Republic of China (“China”). As a result of a previous dispute with China over the protection of intellectual property rights, the United States Trade Representative (“USTR”) is currently monitoring China’s adherence to a bilateral agreement with the United States to enforce intellectual property protections within China. In addition, recent concerns with China’s alleged failure to protect intellectual property rights and to comply with other commitments made as part of its accession to the World Trade Organization (“WTO”) have caused the U.S. government to indicate that it would consider filing a case against China in the WTO if China does not more readily fulfill its obligations. If the U.S. government takes action against China, the result of that action could, among other things, include the imposition of trade sanctions that could affect the ability of the Company to continue to import products from China.

Backlog

At December 31, 2004 and 2003, total futures orders with start ship dates from January through June 2005 and 2004 were approximately $224,233,000 and $224,863,000, respectively, a decrease of 0.3%. The 0.3% decrease in total futures orders is comprised of a 6.0% decrease in the first quarter 2005 futures orders and a 9.4% increase in the second quarter 2005 futures orders. At December 31, 2004 and 2003, domestic futures orders with start ship dates from January through June 2005 and 2004 were approximately $170,291,000 and $193,390,000, respectively, a decrease of 11.9%. At December 31, 2004 and 2003, international futures orders with start ship dates from January through June 2005 and 2004 were approximately $53,942,000 and $31,473,000, respectively, an increase of 71.4%. “Backlog,” as of any date, represents orders scheduled to be shipped within the next six months. Backlog does not include orders scheduled to be shipped on or prior to the date of determination of backlog.

The mix of “futures” and “at once” orders can vary significantly from quarter to quarter and year to year and therefore “futures” are not necessarily indicative of revenues for subsequent periods. Orders generally may be canceled by customers without financial penalty. We believe our rate of net customer cancellations of domestic orders approximates industry averages for similar companies. Customers

8

Table of Contents

may also reject nonconforming goods. To date, we believe we have not experienced returns of our products or bad debts of customers materially in excess of industry averages for similar companies.

Competition

The athletic footwear industry is highly competitive. The largest marketers of footwear are Nike, adidas and Reebok. Each of these companies has substantially greater financial, distribution and marketing resources as well as greater brand awareness than us.

We have recently increased our emphasis on product lines beyond our Classic model. In the past, we have introduced products in such highly competitive categories such as court, boating, outdoor and children’s shoes. See “Products.” There can be no assurance that we will penetrate these or other new markets or increase the market share we have established to date.

The principal elements of competition in the athletic footwear market include brand awareness, product quality, design, pricing, fashion appeal, marketing, distribution, performance and brand positioning. Our products compete primarily on the basis of technological innovations, quality, style, and brand awareness among consumers. While we believe that our competitive strategy has resulted in increased brand awareness and market share, there can be no assurance that we will be able to retain or increase our market share or respond to changing consumer preferences.

Trademarks and Patents

We utilize trademarks on all our products and believe that our products are more marketable on a long-term basis when identified with distinctive markings. K•Swiss^® is a registered trademark in the United States and certain other countries. Our name is not registered as a trademark in certain countries because of restrictions on registering names having geographic connotations. However, since K•Swiss is not a geographic name, we have often secured registrations despite such objections. Our shield emblem and the five-stripe design are also registered in the United States and certain foreign countries. The five-stripe design is not presently registered in some countries because it has been deemed ornamental by regulatory authorities. We selectively seek to register the names of our shoes, logos and the names given to certain of our technical and performance innovations, including Aosta^® rubber and Silicone Formula 18^®. The ROYAL ELASTICS and Fleur de Lis trademarks used on ROYAL ELASTICS products are registered in many countries. Both marks are registered in the United States. We have obtained patents in the United States regarding the Bio Feedback^® ankle support system, the Shock Spring^® cushioning system incorporated into K•Swiss’ 7.0 System^® performance tennis shoes and training line, the D.R. Cinch System^®, the stability design incorporated into the Si-18^® tennis shoe, and other features. We vigorously defend our trademarks and patent rights against infringement worldwide and employ independent security consultants to assist in such protection. To date, we are not aware of any significant counterfeiting problems regarding our products.

Employees

At December 31, 2004, we employed 242 persons in the United States, 176 persons in Taiwan and China, 48 persons in the United Kingdom, Germany and the Netherlands and 11 persons elsewhere.

Available Information

K•Swiss’ internet address is www.kswiss.com. We make available free of charge on or through our internet website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the

9

Table of Contents

Exchange Act as soon as reasonably practicable after such material was electronically filed with, or furnished to, the Securities and Exchange Commission (“S.E.C.”). Materials K•Swiss files with the S.E.C. may be read and copied at the S.E.C.’s Public Reference Room at 450 Fifth Street, NW, Washington, D.C. 20549. This information may also be obtained by calling the S.E.C at 1-800-SEC-0330. The S.E.C. also maintains an internet website that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the S.E.C. at www.sec.gov. The Company will provide a copy of any of the foregoing documents to stockholders upon request.

In August 1998, we moved into our new headquarters facility in Westlake Village, California. This facility, which is owned by us, is approximately 50,000 square feet. We occupy approximately sixty percent of this facility and lease the remaining portion.

We lease a 309,000 square foot distribution facility in Mira Loma, California. This lease expires in January 2007, subject to one option, which would extend the term of the lease for three years. We use the Mira Loma facility as our main distribution center. The effective monthly commitment for this facility is approximately $82,000.

The Company is, from time to time, a party to litigation which arises in the normal course of our business operations. We do not believe that we are presently a party to litigation which will have a material adverse effect on our business or operations.

On December 15, 2004, a special meeting of stockholders of K•Swiss was held. There were 20,902,617 shares of Class A Common Stock and 8,528,734 shares of Class B Common Stock represented at the meeting.

10

Table of Contents

PART II

K•Swiss Inc.’s Class A Common Stock began trading June 4, 1990 on the National Market System maintained by the National Association of Securities Dealers (now the Nasdaq National Market) upon completion of our initial public offering. Per share high and low sales prices (in dollars) for the quarterly periods during 2004 and 2003 as reported by Nasdaq were as follows:

The Class A Common Stock is listed on the Nasdaq National Market under the symbol KSWS.

The number of stockholders of record of the Class A Common Stock on December 31, 2004 was 117. However, based on available information, we believe that the total number of Class A Common stockholders, including beneficial stockholders, is approximately 10,100.

There is currently no established public trading market for our Class B Common Stock. The number of stockholders of record of the Class B Common Stock on December 31, 2004 was 11.

Dividend Policy

The Board declared a quarterly dividend of 0.5 cents per share to stockholders of record as of the close of business on the last day of the first and second quarters of 2003. The Board declared a quarterly dividend of 1 cent per share to stockholders of record as of the close of business on the last day of the third quarter of 2003. The Board declared a quarterly dividend of 2 cents per share to stockholders of record as of the close of business on the last day of the fourth quarter of 2003. The board declared a quarterly dividend of 2.5 cents per share to stockholders of record as of the close of business on the last day of the first, second, third and fourth quarters of 2004. The payment of any future dividends will be at the discretion of our Board of Directors and will depend upon, among other things, future earnings, operations, capital requirements, our general financial condition and general business conditions. We are currently limited in the extent to which we are able to pay dividends under our revolving credit agreement. See Note D to our Consolidated Financial Statements.

11

Table of Contents

Purchases of Equity Securities

The following table provides information with respect to purchases made by K•Swiss of K•Swiss Class A Common Stock during the fourth quarter of 2004:

12

Table of Contents

The selected consolidated financial data presented below for each of the five years in the period ended December 31, 2004 have been derived from audited financial statements which for the most recent three years appear elsewhere herein. The data presented below should be read in conjunction with such financial statements, including the related notes thereto and the other information included herein.

13

Table of Contents

Note Regarding Forward-Looking Statements and Analyst Reports

“Forward-looking statements,” within the meaning of the Private Securities Litigation Reform Act of 1995 (the “Act”), include certain written and oral statements made, or incorporated by reference, by us or our representatives in this report, other reports, filings with the Securities and Exchange Commission (the “S.E.C.”), press releases, conferences, or otherwise. Such forward-looking statements include, without limitation, any statement that may predict, forecast, indicate, or imply future results, performance, or achievements, and may contain the words “believe,” “anticipate,” “expect,” “estimate,” “intend,” “plan,” “project,” “will be,” “will continue,” “will likely result,” or any variations of such words with similar meaning. These statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict; therefore, actual results may differ materially from those expressed or forecasted in any such forward-looking statements. Investors should carefully review the risk factors set forth in other reports or documents we file with the S.E.C., including Forms 10-Q, 10-K and 8-K. Some of the other risks and uncertainties that should be considered include, but are not limited to, the following: international, national and local general economic and market conditions; the size and growth of the overall athletic footwear and apparel markets; the size of our competitors; intense competition among designers, marketers, distributors and sellers of athletic footwear and apparel for consumers and endorsers; market acceptance of our training shoe line; market acceptance of new Limited Edition product; market acceptance of our basketball shoe line; market acceptance of non-performance product in Europe; market acceptance of Royal Elastics footwear; demographic changes; changes in consumer preferences; popularity of particular designs, categories of products, and sports; seasonal and geographic demand for our products; the size, timing and mix of purchases of our products; fluctuations and difficulty in forecasting operating results, including, without limitation, the fact that advance “futures” orders may not be indicative of future revenues due to the changing mix of futures and at-once orders; potential cancellation of future orders; our ability to continue, manage or forecast our growth and inventories; new product development and commercialization; the ability to secure and protect trademarks, patents, and other intellectual property; difficulties in implementing, operating and maintaining our increasingly complex information systems and controls; concentration of production in China; potential earthquake disruption due to the location of our warehouse and headquarters; potential disruption in supply chain, due to various factors including but not limited to natural disasters, epidemic diseases or customer purchasing habits; performance and reliability of products; customer service; adverse publicity; the loss of significant customers or suppliers; dependence on distributors; dependence on major customers; concentration of credit risk; business disruptions; increased costs of freight and transportation to meet delivery deadlines; the effects of terrorist actions on business activities, customer orders and cancellations, and the United States and international governments’ responses to these terrorist actions; changes in business strategy or development plans; general risks associated with doing business outside the United States, including, without limitation, exchange rate fluctuations, import duties, tariffs, quotas and political and economic instability; changes in government regulations; liability and other claims asserted against us; the ability to attract and retain qualified personnel; and other factors referenced or incorporated by reference in this report and other reports.

K•Swiss (the “Company,” “we,” “us,” and “our”) operates in a very competitive and rapidly changing environment. New risk factors can arise and it is not possible for management to predict all such risk factors, nor can we assess the impact of all such risk factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. Given these risks and uncertainties, investors should not place undue reliance on forward-looking statements as a prediction of actual results.

14

Table of Contents

Investors should also be aware that while we communicate, from time to time, with securities analysts, it is against our policy to disclose to them any material non-public information or other confidential commercial information. Accordingly, investors should not assume that we agree with any statement or report issued by any analyst irrespective of the content of the statement or report. Furthermore, we have a policy against issuing or confirming financial forecasts or projections issued by others. Thus, to the extent that reports issued by securities analysts or others contain any projections, forecasts or opinions, such reports are not our responsibility.

Overview

The Company designs, develops and markets athletic footwear for high performance sports use, fitness activities and casual wear under the K•Swiss brand, and also designs and manufactures footwear under the Royal Elastics brand. Royal Elastics is our wholly owned subsidiary. The categories of footwear we sell is explained in more detail in Item 1, under the subheading, “Products.” We market our products in the United States (through our sales executives and independent sales representatives) primarily to a limited number of specialty athletic footwear stores, pro shops, sporting good stores and department stores. We also sell our products through our website and to a number of foreign distributors.

In 2004, approximately 99% of our footwear products were manufactured in China. We have no long-term manufacturing agreements, but we believe that our relationships with our producers are satisfactory and that we will have the ability to develop alternative sources for our footwear. Our operations could, however, be materially and adversely affected if a substantial delay occurred in locating and obtaining alternative producers.

Because we record revenues when title passes and the risks and rewards of ownership have passed to the customer, our revenues may fluctuate in cases when our customers delay accepting shipment of products. Our total revenues increased 12.8% in 2004 from 2003, due to an increase in the volume of footwear sold and an increase in the average underlying wholesale price, and our overall gross profit margins, as a percentage of revenues, were 45.7% and 45.1% in 2004 and 2003, respectively. Likewise, our overall selling, general and administrative expenses also increased to 25.3% of revenues in 2004 from 24.8% of revenues in 2003.

At December 31, 2004, our total futures orders with start ship dates from January through June 2005 were $224,233,000, a decrease of 0.3% from the comparable period of the prior year. Of this amount, domestic futures orders were $170,291,000, a decrease of 11.9%, and international futures orders were $53,942,000, an increase of 71.4%. Notwithstanding the foregoing, we recognize that the athletic footwear industry is highly competitive. Each of the largest makers of footwear have substantially greater financial, distribution and marketing resources as well as greater brand awareness than us.

In 2004, our largest single marketing expenditure was television. Our marketing campaign was run mainly on network and cable television, and was supported by sports, music and general interest/fashion magazines. Our independent sales representatives sold to approximately 2,900 separate accounts as of December 31, 2004 (down from 3,000 as of December 31, 2003). Internationally, by the end of 2004, we were working through 6 international subsidiaries and 16 distributors to market our products in potentially 65 countries. Also, during 2004, the Foot Locker group of stores and its affiliates accounted for approximately 20% of total revenues.

In 2004, we had a net cash inflow of approximately $85,841,000 from continuing operating activities and a net cash outflow from investing activities due to the net purchase of property, plant and equipment. We anticipate future cash needs for principal repayments required pursuant to any borrowings under our lines of credit and, depending on future growth, additional funds may be required by operating activities.

15

Table of Contents

At December 31, 2004 we had $6,750,000 of debt and there was no debt outstanding at December 31, 2003 (excluding outstanding letters of credit of $1,682,000 and $2,083,000 at December 31, 2004 and 2003, respectively), and our working capital increased $41,183,000 to approximately $218,569,000 at December 31, 2004 from $177,386,000 at December 31, 2003.

In December 2004, pursuant to the American Jobs Creation Act of 2004, we repatriated dividends of $22,700,000 related to foreign subsidiary earnings which were not considered indefinitely invested. We will receive an 85% dividends received deduction for eligible dividends, resulting in a lower effective tax rate. We will use these funds on qualified expenditures in the United States in accordance with our approved Domestic Reinvestment Plan.

On October 28, 2004, our Board of Directors authorized a new stock repurchase program to repurchase up to an additional 5,000,000 shares of Class A Common Stock from time to time on the open market. This program was adopted because we believe repurchasing our shares can be a good use of excess cash. At December 31, 2004, there remains authorization to repurchase approximately 4,990,000 shares under this stock repurchase program.

Critical Accounting Policies

Our significant accounting policies are described in Note A to the consolidated financial statements included in Item 8 of this Form 10-K. Our 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. 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 disclosure of contingent assets and liabilities.

On an on-going basis, we evaluate our estimates, including those related to the carrying value of inventories, realizability of outstanding accounts receivable, sales returns and allowances, and the provision for income taxes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. In the past, actual results have not been materially different from our estimates. However, results may differ from these estimates under different assumptions or conditions.

We have identified the following as critical accounting policies, based on the significant judgments and estimates used in determining the amounts reported in our consolidated financial statements:

Revenue Recognition

We record revenues when title passes and the risks and rewards of ownership have passed to the customer, based on the terms of sale. Title passes generally upon shipment.

In some instances, we ship product directly from our supplier to the customer. In these cases, we recognize revenue when the product is delivered to the customer. Our revenues may fluctuate in cases when our customers delay accepting shipment of product for periods up to several weeks.

As part of our revenue recognition policy, we record the estimated income reductions from estimated sales returns and allowances. We base our estimates on historical rates of returns and allowances. However, actual returns and allowances in any future period are inherently uncertain and thus may differ from our estimates. If actual or expected future returns and allowances were significantly greater or lower than the reserves we had established, we would record a reduction or increase in the period in which we made such determination.

16

Table of Contents

Accounts Receivable

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We estimate potential losses based on our knowledge of the financial condition of certain customers, as well as an assessment of the overall conditions at retail. Historically, losses have been within our expectations. If the financial condition of our customers were to change, adjustments may be required to these estimates. Furthermore, we provide for estimated losses resulting from differences that arise from the gross carrying value of our receivables and the amounts which customers estimate are owed to us. The settlement or resolution of these differences could result in future changes to these estimates.

Inventory Reserves

We also make ongoing estimates relating to the market value of inventories, based upon our assumptions about future demand and market conditions. If we estimate that the net realizable value of our inventory is less than the cost of the inventory recorded on our books, we record a reserve equal to the difference between the cost of the inventory and the estimated market value. This reserve is recorded as a charge to cost of sales. If changes in market conditions result in reductions in the estimated market value of our inventory below our previous estimate, we would increase our reserve in the period in which we made such a determination and record a charge to cost of sales.

Other Contingencies

In the ordinary course of business, we are involved in legal proceedings involving contractual and employment relationships, product liability claims, trademark rights, and a variety of other matters. We record contingent liabilities resulting from claims against us when it is probable that a liability has been incurred and the amount of the loss is reasonably estimable. We disclose contingent liabilities when there is a reasonable possibility that the ultimate loss will exceed the recorded liability. Estimating probable losses requires analysis of multiple factors, in some cases including judgment about the potential actions of third party claimants and courts. Therefore, actual losses in any future period are inherently uncertain. Currently, we do not believe that any of our pending legal proceedings or claims will have a material impact on our financial position or results of operations. However, if actual or estimated probable future losses exceed our recorded liability for such claims, we would record additional charges during the period in which the actual loss or change in estimate occurred.

Results of Operations

The following table sets forth, for the periods indicated, the percentage of certain items in the consolidated statements of earnings relative to revenues.

17

Table of Contents

2004 Compared to 2003

Revenue and Gross Margin

Total revenues increased 12.8% to $484,079,000 in 2004 from $429,162,000 in 2003. This increase was attributable to an increase in the volume of footwear sold and an increase in the average underlying wholesale price per pair. The volume of footwear sold increased 12.3% to 19,014,000 pair in 2004 from 16,939,000 pair in 2003. The average wholesale price per pair was $24.94 in 2004 and $24.81 in 2003.

Domestic revenues increased 6.7% to $397,390,000 in 2004 from $372,443,000 in 2003. International product revenues increased 54.8% in 2004 to $84,603,000 from $54,640,000 in 2003. Fees earned by the Company on sales by foreign licensees and distributors were $2,086,000 for 2004 and $2,079,000 for 2003. International revenues, as a percentage of total revenues, increased to 17.9% in 2004 from 13.2% in 2003.

K•Swiss brand revenues increased 12.6% to $477,209,000 in 2004 from $423,696,000 in 2003. This increase was the result of an increase in the volume of footwear sold at slightly higher average wholesale prices per pair. The volume of footwear sold increased 11.8% to 18,683,000 pair in 2004 from 16,718,000 pair in 2003. The average wholesale price per pair was $25.03 in 2004 and $24.83 in 2003. The major changes in volume for footwear categories are as follows: Classics, training (includes basketball), tennis and children’s categories increased 12.1%, 8.6%, 20.9% and 10.1%, respectively.

Royal Elastics brand revenues increased 25.7% to $6,870,000 in 2004 (33% domestic) from $5,466,000 in 2003 (28% domestic).

We believe that the athletic and casual footwear industry experiences seasonal fluctuations, due to increased domestic sales during certain selling seasons, including Easter, back-to-school and the year-end holiday seasons. We present full-line offerings for the Easter and back-to-school seasons, for delivery during the first and third quarters, respectively, but not for the year-end holiday season.

At December 31, 2004, domestic and international futures orders with start ship dates from January through June 2005 were approximately $170,291,000 and $53,942,000, respectively, 11.9% lower and 71.4% higher, respectively, than such orders were at December 31, 2003 for start ship dates of the comparable period of the prior year. These orders are not necessarily indicative of revenues for subsequent periods because: (1) the mix of “future” and “at-once” orders can vary significantly from quarter to quarter and year to year and (2) the rate of customer order cancellations can also vary from quarter to quarter and year to year.

Overall gross profit margins, as a percentage of revenues, were 45.7% in 2004 and 45.1% in 2003. Gross profit margin for 2004 was affected by product mix changes, international sales becoming a larger portion of revenues and changes in our at-once business. Our gross margins may not be comparable to some of our competitors as we recognize warehousing costs within selling, general and administrative expenses.

Selling, General and Administrative Expenses

Overall selling, general and administrative expenses increased 15.1% to $122,262,000 (25.3% of revenues) in 2004 from $106,267,000 (24.8% of revenues) in 2003. The increase in the amounts for the year ended December 31, 2004 compared to the year ended December 31, 2003 were due to an impairment recognition and increases in advertising, bad debt and warehousing expenses offset by decreases in compensation and compensation related expenses and legal expenses. During the year ended December 31, 2004, impairment of $2,776,000 was recognized on the trademark and goodwill

18

Table of Contents

of the Royal Elastics brand based on many factors including the brand not growing as rapidly as we had expected. Advertising expenses increased 35.0% for the year December 31, 2004, as part of a strategic effort to drive higher revenues. Bad debt expenses increased 133.4% for the year ended December 31, 2004 as a result of the write-off of The Athlete’s Foot account as a result of the bankruptcy of that company. Warehousing expenses, excluding compensation and compensation related expenses, increased 13.9% for the year ended December 31, 2004, as a result of additional expenses incurred resulting from an increase in sales during the year ended December 31, 2004 and moving our warehouse location in Europe during the second quarter of 2004. Compensation and compensation related expenses, including commissions and bonus/incentive related expenses, decreased 6.9% for the year ended December 31, 2004, due to a decrease in bonus/incentive related expenses that was calculated in accordance with our bonus formula for the year ended December 31, 2004 offset by an increase in headcount and commissions (as a result of the increase in volume). Legal expenses decreased 53.9% for the year ended December 31, 2004, as a result of the defense and settlement of two lawsuits during the year ended December 31, 2003. Corporate expenses of $12,686,000 and $18,835,000, for the years ended December 31, 2004 and 2003, respectively, are included in selling, general and administrative expenses. The decrease in corporate expenses during the year ended December 31, 2004 is due to decreases in bonus/incentive related expenses and legal expenses which have been explained above.

Interest, Other and Taxes

Overall net interest income was $1,038,000 (0.2% of revenues) in 2004 compared to $699,000 (0.2% of revenues) in 2003, an increase of $339,000 or 48.5%. This increase in net interest income was the result of higher average balances and higher average interest rates, offset slightly by interest expense on our lines of credit.

Our effective tax rate was 28.7% and 38.9% in 2004 and 2003, respectively. The $3,899,000 and $3,965,000 income tax benefit of options exercised during 2004 and 2003, respectively, were credited to additional paid-in capital and therefore did not impact the effective tax rate. The decrease in the effective tax rate for the year ended December 31, 2004 is principally attributed to repatriating dividends of $22,700,000 related to foreign subsidiaries earnings, which were not considered indefinitely invested, with an 85% dividends received deduction, for eligible dividends, under the American Jobs Creation Act of 2004. We will use these funds on qualified expenditures in the United States in accordance with our approved Domestic Reinvestment Plan. The lower effective tax rate is also due to our UK operation having become profitable in 2004 thereby realizing net operating loss carryforwards of approximately $3,190,000 for the year ended December 31, 2004, and adjustments to our provision for state income taxes.

The net loss from discontinued operations was $3,736,000 in 2003. Included in 2003 was a $2,000,000 settlement to terminate our agreement with National Geographic and a $746,000 impairment loss on the National Geographic license.

Net earnings increased 42.3% to $71,251,000 or $1.96 per share (diluted earnings per share) in 2004 from $50,056,000 or $1.32 per share (diluted earnings per share) in 2003.

2003 Compared to 2002

Revenue and Gross Margin

Total revenues increased 48.2% to $429,162,000 in 2003 from $289,593,000 in 2002. This increase was attributable to an increase in the volume of footwear sold partially offset by a decrease in the average underlying wholesale price per pair. The volume of footwear sold increased 50.2% to 16,939,000 pair in 2003 from 11,275,000 pair in 2002. The average wholesale price per pair was $24.81 in 2003 and $24.85 in 2002.

19

Table of Contents

Domestic revenues increased 50.1% to $372,443,000 in 2003 from $248,048,000 in 2002. International product revenues increased 37.2% in 2003 to $54,640,000 from $39,819,000 in 2002. Fees earned by the Company on sales by foreign licensees and distributors were $2,079,000 for 2003 and $1,726,000 for 2002. International revenues, as a percentage of total revenues, decreased to 13.2% in 2003 from 14.3% in 2002.

K•Swiss brand revenues increased 48.3% to $423,696,000 in 2003 from $285,780,000 in 2002. This increase was the result of an increase in the volume of footwear sold at slightly lower average wholesale prices per pair. The volume of footwear sold increased 50.4% to 16,718,000 pair in 2003 from 11,117,000 pair in 2002. The average wholesale price per pair was $24.83 in 2003 and $24.88 in 2002. The major changes in volume for footwear categories are as follows: Classics, training, tennis and children’s categories increased 51.4%, 110.7%, 49.2% and 38.5%, respectively.

Royal Elastics brand revenues increased 43.4% to $5,466,000 in 2003 (28% domestic) from $3,813,000 in 2002 (27% domestic).

Overall gross profit margins, as a percentage of revenues, were 45.1% in 2003 and 2002.

Selling, General and Administrative Expenses

Overall selling, general and administrative expenses increased 34.1% to $106,267,000 (24.8% of revenues) in 2003 from $79,258,000 (27.4% of revenues) in 2002. The increase in the amounts for the year ended December 31, 2003 compared to the year ended December 31, 2002 was due to several factors. Advertising expenses increased 37.8% as part of a strategic effort to drive higher revenues for the year ended December 31, 2003. Compensation expenses, which includes commissions and bonus related expenses, increased 44.9% due to an increase in headcount (as a result of the increase in volume) and as a result of an increase in revenues and earnings. Legal expenses increased 35.2% during the year ended December 31, 2003 in connection with the defense and settlement of two lawsuits. Corporate expenses of $18,835,000 and $12,887,000 for the years ended December 31, 2003 and 2002, respectively, are included in selling, general and administrative expenses. The increase in corporate expenses for the year ended December 31, 2003, was primarily due to an 85.0% increase in compensation and bonus related expenses, as a result of an increase in earnings, and a 35.2% increase in legal expenses in connection with the defense and settlement of two lawsuits.

Interest, Other and Taxes

Overall net interest income was $699,000 (0.2% of revenues) in 2003 compared to $1,058,000 (0.4% of revenues) in 2002, a decrease of $359,000 or 33.9%. This decrease in net interest income was the result of significantly lower average interest rates as well as lower average balances.

Our effective tax rate was 38.9% and 39.2% in 2003 and 2002, respectively. The $3,965,000 and $4,474,000 income tax benefit of options exercised during 2003 and 2002, respectively, were credited to additional paid-in capital and therefore did not impact the effective tax rate.

The net loss from discontinued operations was $3,736,000 in 2003 compared to $3,116,000 in 2002. Included in 2003 was a $2,000,000 settlement to terminate our agreement with National Geographic and a $746,000 impairment loss on the National Geographic license.

Net earnings increased 74.4% to $50,056,000 or $1.32 per share (diluted earnings per share) in 2003 from $28,697,000 or $0.73 per share (diluted earnings per share) in 2002.

20

Table of Contents

Liquidity and Capital Resources

We experienced a net cash inflow of approximately $85,481,000, $34,904,000 and $30,330,000 from our continuing operating activities during 2004, 2003 and 2002, respectively. Cash provided by continuing operations in 2004 increased from 2003 due primarily to an increase in earnings from continuing operations and differences in the amounts in changes in inventories and accounts payable and accrued liabilities, offset by changes in deferred income taxes. Cash provided by continuing operations in 2003 increased from 2002 due primarily to differences in the amounts of changes in inventories, accounts receivable and accounts payable and accrued liabilities, as well as an increase in earnings from continuing operations.

We had a net outflow of cash from our investing activities during 2004 and 2003 due to the net purchase of property, plant and equipment.

In 2004 and 2003, the net outflow of cash from our financing activities was used for the purchase of our outstanding stock under our current stock repurchase program and to pay cash dividends, partially offset by proceeds from stock options exercised. In addition in 2004, the net outflow of cash was also offset by borrowings on our lines of credit.

We anticipate future cash needs for principal repayments required pursuant to our borrowings under our lines of credit facilities. In addition, depending on our future growth rate, additional funds may be required by operating activities. No other material capital commitments exist at December 31, 2004. With continued use of our revolving credit facility (as discussed below), we believe our present and currently anticipated sources of capital are sufficient to sustain our anticipated capital needs for the remainder of 2005.

In the fourth quarter of 2004, we completed our October 2003 $25 million stock repurchase program. However, prior to this, on October 26, 2004, the Board of Directors authorized a new stock repurchase program to repurchase through December 2009 up to an additional 5,000,000 shares of our Class A Common Stock from time to time on the open market, as market conditions warrant. We adopted this program because we believe repurchasing our shares can be a good use of excess cash depending on our array of alternatives. Currently, we have made purchases under all stock repurchase programs from August 1996 through February 21, 2005 (the day prior to the filing of the Form 10-K) of 24.4 million shares at an aggregate cost totaling approximately $136,275,000, at an average price of $5.58 per share. See Part II—Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

In May 2003, we signed an amendment to our July 2001 agreement with a bank whereby we may borrow, in the form of an unsecured revolving credit facility, up to $15,000,000. The unused portion of this credit facility, which includes letters of credit and bankers acceptances, was $13,496,000 at December 31, 2004. This facility currently expires in July 2005. The credit facility provides for interest to be paid at the prime rate less 3/4% or, at our discretion and with certain restrictions, other market based rates. We pay a commitment fee of 1/8% of the unused line for availability of the credit facility. We must meet certain restrictive financial covenants as agreed upon in the facility.

Our Asian offices have agreements with a bank whereby they can borrow up to $5,250,000 in the form of unsecured revolving credit facilities. The unused portion of these credit facilities was $500,000 at December 31, 2004. Interest is to be paid at LIBOR plus 1.25%. The interest rate at December 31, 2004 was 3.71%. In January 2005, the bank increased these credit facilities to $12,250,000, to fund our short-term international working capital needs. This facility currently expires in July 2005.

Our European offices have agreements with a bank whereby they can borrow up to $4,500,000 in the form of unsecured revolving credit facilities. The unused portion of these credit facilities, which

21

Table of Contents

includes letters of credit and bankers acceptances, was $2,322,000 at December 31, 2004. Interest is to be paid on one facility at a rate of LIBOR plus 1.25% and on the other facility at IBOR plus 1.25%. The interest rates at December 31, 2004 were 3.71% and 3.67%, respectively. These facilities currently expire in July 2005.

At December 31, 2004 there was debt outstanding of $6,750,000 and there was no debt at December 31, 2003 (excluding outstanding letters of credit of $1,682,000 and $2,083,000 at December 31, 2004 and 2003, respectively). The borrowings on our lines of credit occurred in mid-December 2004, and approximately $5,000 in interest expense was recognized during the year ended December 31, 2004 related to these lines of credit. The increase in debt was to fund our short-term working capital needs of our international subsidiaries.

At December 31, 2004, we were in compliance with all relevant covenants under each of the credit facilities described above.

Our working capital increased $41,183,000 to $218,569,000 at December 31, 2004 from $177,386,000 at December 31, 2003. Working capital increased during 2004 mainly due to higher revenues in 2004 compared to 2003.

We have historically maintained higher levels of inventory relative to sales compared to our competitors because (1) we do not ship directly to our major domestic customers from our foreign contract manufacturers to the same extent as our larger competitors, which would reduce inventory levels and increase inventory turns, and (2) unlike many of our competitors, we designate certain shoes as core products whereby we commit to our retail customers that we will carry core products from season to season and, therefore, we attempt to maintain open-stock positions on our core products in our Mira Loma, California distribution center to meet at-once orders.

Contractual Obligations

At December 31, 2004, our significant contractual obligations were as follows (in thousands):

Off-Balance Sheet Arrangements

We did not enter into any off-balance sheet arrangements during 2004 or 2003, nor did we have any off-balance sheet arrangements outstanding at December 31, 2004 or 2003.

Market Risk

Market risk is the potential change in an instrument’s value caused by, for example, fluctuations in interest and currency exchange rates. Our primary market risk exposure is the risk of unfavorable

22

Table of Contents

movements in exchange rates between the U.S. dollar and the Euro. Monitoring and managing these risks is a continual process carried out by senior management, which reviews and approves our risk management policies. Market risk is managed based on an ongoing assessment of trends in foreign exchange rates and economic developments, giving consideration to possible effects on both total return and reported earnings.

Foreign Exchange Rate Risk

Sales denominated in currencies other than the U.S. dollar, which are primarily sales to customers in Europe, expose the Company to market risk from material movements in foreign exchange rates between the U.S. dollar and the foreign currency. The Company’s historical primary risk exposures have been from changes in the rates between the U.S. dollar and the Euro. This trend is expected to continue. In 2004, the Company entered into forward foreign exchange contracts to exchange Euros for U.S. dollars and Pounds Sterling for Euros. The extent to which forward foreign exchange contracts are used is modified periodically in response to management’s estimate of market conditions and the terms and length of specific sales contracts.

The Company enters into forward foreign exchange contracts in order to reduce the impact of foreign currency fluctuations and not to engage in currency speculation. The use of derivative financial instruments allows the Company to reduce its exposure to the risk that the eventual net cash inflow resulting from the sale of products to foreign customers will be materially affected by changes in exchange rates. The Company does not hold or issue financial instruments for trading purposes. The forward foreign exchange contracts are designated for firmly committed or forecasted sales. These contracts are generally expected to occur in less than one year.

The forward foreign exchange contracts generally require the Company to exchange Euros for U.S. dollars or Pounds Sterling for Euros at maturity, at rates agreed at the inception of the contracts. The counterparties to derivative transactions are major financial institutions with investment grade or better credit ratings; however, the Company is exposed to credit risk with these institutions. The credit risk is limited to the unrealized gains in such contracts should these counterparties fail to perform as contracted.

At December 31, 2004, forward foreign exchange contacts with a notional value of $20,966,000 were outstanding to exchange various currencies (principally U.S. dollars and Euros) with maturities ranging from January 2005 to August 2005 to sell the equivalent of approximately $8,066,000 in foreign currencies at contracted rates and to buy $12,900,000 at contracted rates. These contracts have been designated as cash flow hedges. As of December 31, 2004, assets of $223,000 and liabilities of $1,190,000 have been recorded for the fair value of the forward foreign exchange contracts. Realized gains of $46,000 from cash flow hedges were recorded in cost of goods sold during the year ended December 31, 2004. Realized gains of $14,000 were recorded on the cash flow hedges in selling, general and administrative expenses due to hedge ineffectiveness during the year ended December 31, 2004. The Company did not enter into any derivative financial instruments during 2003 and did not have any derivative financial instruments outstanding at December 31, 2003.

The Company does not anticipate any material adverse effect on its operations or financial position relating to these forward foreign exchange contracts. Based on the Company’s overall currency rate exposure at December 31, 2004, a 10% change in currency rates would not have had a material effect on the financial position, results of operations and cash flows of the Company.

Interest Rate Risk

The Company is exposed to changes in interest rates primarily as a result of its short-term borrowings on its working capital lines of credit. A 10% change in interest rates would not have had a material effect on the financial position, results of operations and cash flows of the Company.

23

Table of Contents

Inflation

We believe that distributors of footwear in the higher priced end of the footwear market, including ours, are able to adjust their prices in response to an increase in direct and general and administrative expenses, without a significant loss in sales. Accordingly, to date, inflation and changing prices have not had a material adverse effect on our revenues or earnings.

The Consolidated Financial Statements required in response to this section are submitted as part of Item 15(a) of this Report.

24

Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

ON INTERNAL CONTROL OVER FINANCIAL REPORTING

Board of Directors and Stockholders

K•Swiss Inc.

We have audited management’s assessment, included in the accompanying K•Swiss Inc. Management’s Report on Internal Control Over Financial Reporting, that K•Swiss Inc. maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). K•Swiss Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting 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 effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design of the operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that K•Swiss Inc. maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, K•Swiss Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of K•Swiss Inc. as of December 31, 2004 and 2003, and the related consolidated statements of earnings and comprehensive earnings, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004 and our report dated January 31, 2005 expressed an unqualified opinion.

/s/ GRANT THORNTON

Los Angeles, California

January 31, 2005

25

Table of Contents

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

Management of K•Swiss Inc. (the “Company”) is responsible for establishing and maintaining adequate internal control over financial reporting and for the assessment of the effectiveness of internal control over financial reporting. As defined by the Securities and Exchange Commission, internal control over financial reporting is a process designed by, or supervised by, the Company’s principal executive and principal financial officers, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with generally accepted accounting principles.

The Company’s internal control over financial reporting is supported by written policies and procedures, that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the Company’s assets; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of the Company’s management and directors; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In connection with the preparation of the Company’s annual financial statements, management of the Company has undertaken an assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004 based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Management’s assessment included an evaluation of the design of the Company’s internal control over financial reporting and testing of the operational effectiveness of the Company’s internal control over financial reporting.

Based on this assessment, management did not identify any material weakness in the Company’s internal control, and management has concluded that the Company’s internal control over financial reporting was effective as of December 31, 2004.

Grant Thornton LLP, the registered public accounting firm that audited the Company’s financial statements, have issued an attestation report on management’s assessment of internal control over financial reporting, a copy of which is included in this annual report on Form 10-K.

January 31, 2005

26

Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Stockholders

K•Swiss Inc.

We have audited the consolidated balance sheets of K•Swiss Inc. as of December 31, 2004 and 2003, and the related consolidated statements of earnings and comprehensive earnings, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004. These financial statements are the responsibility of 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. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of K•Swiss Inc. as of December 31, 2004 and 2003, and the consolidated results of their operations and their consolidated cash flows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America.

We have also audited Schedule II of K•Swiss Inc. for each of the three years in the period ended December 31, 2004. In our opinion, this schedule presents fairly, in all material respects, the information required to be set forth therein.

We have also audited, in accordance with standards of the Public Company Accounting Oversight Board (United States), the effectiveness of K•Swiss Inc.’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated January 31, 2005, expressed an unqualified opinion thereon.

/s/ GRANT THORNTON LLP

Los Angeles, California

January 31, 2005

27

Table of Contents

K•SWISS INC.

CONSOLIDATED BALANCE SHEETS

December 31,

(Dollar amounts in thousands)

The accompanying notes are an integral part of these statements.

28

Table of Contents

K•SWISS INC.

CONSOLIDATED STATEMENTS OF EARNINGS

AND COMPREHENSIVE EARNINGS

Year Ended December 31,

(Dollar amounts in thousands, except per share amounts)

The accompanying notes are an integral part of these statements.

29

Table of Contents

K•SWISS INC.

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

Three years ended December 31, 2004

(Dollar amounts in thousands)