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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934.
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2006
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 OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)
3151 EAST WASHINGTON BOULEVARD
LOS ANGELES, CALIFORNIA 90023
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (323) 780-8250
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer or a non-accelerated filer. See definition of
"accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange
Act. Large accelerated filer [_] Accelerated filer [_] Non-accelerated filer [X]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Act). Yes [_] No [X]
Number of shares of Common Stock of the Registrant
outstanding as of August 10, 2006: 30,543,763.
--------------------------------------------------------------------------------
TARRANT APPAREL GROUP
FORM 10-Q
INDEX
PART I. FINANCIAL INFORMATION
PAGE
-------
Item 1. Financial Statements
Consolidated Balance Sheets at June 30, 2006
(unaudited) and December 31, 2005.................................. 2
Consolidated Statements of Operations for
the Three Months and Six Months Ended June 30, 2006 and
June 30, 2005 (unaudited).......................................... 3
Consolidated Statements of Cash Flows for
the Six Months Ended June 30, 2006 and June 30, 2005
(unaudited)........................................................ 4
Notes to Consolidated Financial Statements (unaudited)............... 5
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations .............................. 23
Item 3. Quantitative and Qualitative Disclosures About Market Risk ......... 37
Item 4. Controls and Procedures............................................. 37
PART II. OTHER INFORMATION
Item 1. Legal Proceedings................................................... 38
Item 1A. Risk Factors........................................................ 38
Item 4. Submission of Matters to a Vote of Security Holders................. 43
Item 6. Exhibits............................................................ 44
SIGNATURES.......................................................... 46
CAUTIONARY LEGEND REGARDING FORWARD-LOOKING STATEMENTS
Some of the information in this Quarterly Report on Form 10-Q may
constitute forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934,
both as amended. These forward-looking statements are subject to various risks
and uncertainties. The forward-looking statements include, without limitation,
statements regarding our future business plans and strategies and our future
financial position or results of operations, as well as other statements that
are not historical. You can find many of these statements by looking for words
like "will", "may", "believes", "expects", "anticipates", "plans" and
"estimates" and for similar expressions. Because forward-looking statements
involve risks and uncertainties, there are many factors that could cause the
actual results to differ materially from those expressed or implied. These
include, but are not limited to, economic conditions. This Quarterly Report on
Form 10-Q contains important cautionary statements and a discussion of many of
the factors that could materially affect the accuracy of Tarrant's
forward-looking statements and such statements and discussions are incorporated
herein by reference. Any subsequent written or oral forward-looking statements
made by us or any person acting on our behalf are qualified in their entirety by
the cautionary statements and factors contained or referred to in this section.
We do not intend or undertake any obligation to update any forward-looking
statements to reflect events or circumstances after the date of this document or
the date on which any subsequent forward-looking statement is made or to reflect
the occurrence of unanticipated events.
1
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
TARRANT APPAREL GROUP
CONSOLIDATED BALANCE SHEETS
JUNE 30, DECEMBER 31,
2006 2005
------------- -------------
(unaudited)
ASSETS
Current assets:
Cash and cash equivalents ............................. $ 1,691,311 $ 1,641,768
Accounts receivable, net .............................. 60,116,050 54,598,443
Due from related parties .............................. 4,003,654 3,100,928
Inventory ............................................. 20,188,225 31,628,960
Temporary quota rights ................................ 59,154 --
Current portion of notes receivable-
related parties ..................................... 5,139,387 5,139,387
Prepaid expenses ...................................... 1,062,897 1,292,441
Prepaid royalties ..................................... -- 1,123,531
Income taxes receivable ............................... 25,468 25,468
------------- -------------
Total current assets .................................... 92,286,146 98,550,926
Property and equipment, net of $11.0 million and
$10.8 million accumulated depreciation at
June 30, 2006 and December 31, 2005, respectively ... 1,517,776 1,702,840
Notes receivable - related parties, net of current
portion ............................................... 35,616,780 36,268,446
Due from related parties .............................. 2,213,378 2,994,945
Equity method investment .............................. 2,181,687 2,138,865
Deferred financing cost, net of $1.2 million and
$711,250 accumulated amortization at June 30, 2006
and December 31, 2005, respectively ................. 2,634,666 838,786
Other assets .......................................... 162,223 164,564
Goodwill .............................................. 8,582,845 8,582,845
------------- -------------
Total assets ............................................ $ 145,195,501 $ 151,242,217
============= =============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Short-term bank borrowings ............................ $ 12,129,769 $ 13,833,532
Accounts payable ...................................... 20,983,320 33,278,959
Accrued expenses ...................................... 9,096,878 9,503,806
Income taxes .......................................... 16,717,337 16,828,538
Current portion of long-term obligations and factoring
arrangement ......................................... 33,434,952 36,109,699
------------- -------------
Total current liabilities ................................ 92,362,256 109,554,534
Term loan, net ........................................... 10,671,173 --
Other long-term obligations .............................. 9,936 239,935
Derivative liability for free-standing warrants .......... 5,196,800 --
Convertible debentures, net .............................. -- 5,965,098
Deferred tax liabilities ................................. 24,684 47,098
Minority interest in consolidated subsidiary ............. 71,110 75,241
Commitment and Contingencies
Shareholders' equity:
Preferred stock, 2,000,000 shares authorized; no shares
at June 30, 2006 and December 31, 2005 issued and
outstanding ........................................ -- --
Common stock, no par value, 100,000,000 shares
authorized; 30,543,763 shares at June 30, 2006 and
30,553,763 shares at December 31, 2005 issued and
outstanding ......................................... 114,977,465 114,977,465
Warrants to purchase common stock ..................... 2,846,833 2,846,833
Contributed capital ................................... 10,011,385 10,004,331
Accumulated deficit ................................... (88,741,960) (90,189,615)
Notes receivable from officer/shareholder ............. (2,234,181) (2,278,703)
------------- -------------
Total shareholders' equity .............................. 36,859,542 35,360,311
------------- -------------
Total liabilities and shareholders' equity .............. $ 145,195,501 $ 151,242,217
============= =============
The accompanying notes are an integral part of these
consolidated financial statements
2
TARRANT APPAREL GROUP
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
THREE MONTHS ENDED JUNE 30 SIX MONTHS ENDED JUNE 30
------------------------------ ------------------------------
2006 2005 2006 2005
------------- ------------- ------------- -------------
Net sales .............................. $ 59,082,541 $ 50,537,704 $ 120,343,785 $ 95,367,995
Cost of sales .......................... 46,419,973 39,083,324 95,162,454 74,967,897
------------- ------------- ------------- -------------
Gross profit ........................... 12,662,568 11,454,380 25,181,331 20,400,098
Selling and distribution expenses ...... 2,798,086 2,404,177 5,727,776 4,966,031
General and administrative expenses .... 6,903,093 7,015,603 13,363,236 12,871,426
Royalty expenses ....................... 352,864 597,927 1,835,809 892,692
------------- ------------- ------------- -------------
Income from operations ................ 2,608,525 1,436,673 4,254,510 1,669,949
Interest expense ....................... (1,945,797) (1,285,624) (3,133,854) (2,098,809)
Interest income ........................ 480,859 516,590 966,202 1,069,813
Interest in income of equity method
investee ............................ 62,909 183,049 110,322 346,360
Other income ........................... 90,568 174,801 124,373 239,358
Adjustment to fair value of derivative . (218,307) -- (218,307) --
Other expense .......................... (400,000) 5,509 (400,000) (330)
Minority interest in consolidated
subsidiary .......................... (7,363) -- 4,131 --
------------- ------------- ------------- -------------
Income before provision for income taxes 671,394 1,030,998 1,707,377 1,226,341
Provision for income taxes ............. 60,110 160,159 259,722 461,322
------------- ------------- ------------- -------------
Net income ............................. $ 611,284 $ 870,839 $ 1,447,655 $ 765,019
============= ============= ============= =============
Net income per share:
Basic ............................... $ 0.02 $ 0.03 $ 0.05 $ 0.03
============= ============= ============= =============
Diluted ............................. $ 0.02 $ 0.03 $ 0.05 $ 0.03
============= ============= ============= =============
Weighted average common and common
equivalent shares:
Basic ............................... 30,543,763 29,155,855 30,378,715 28,986,251
============= ============= ============= =============
Diluted ............................. 30,544,420 29,163,070 30,378,840 28,993,466
============= ============= ============= =============
The accompanying notes are an integral part
of these consolidated financial statements
3
TARRANT APPAREL GROUP
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
SIX MONTHS ENDED JUNE 30,
------------- -------------
2006 2005
------------- -------------
Operating activities:
Net income ............................................ $ 1,447,655 $ 765,019
Adjustments to reconcile net income to net cash used in
operating activities:
Deferred taxes ..................................... (22,414) (86,461)
Depreciation and amortization ...................... 1,781,938 1,251,439
Adjustment to fair value of derivative ............. 218,307 --
Provision for returns and discounts ................ 277,656 210,178
Gain on sale of fixed assets ....................... (1,283) (113,852)
Interest in income of equity method investee ....... (110,322) (346,360)
Minority interest in consolidated subsidiary ....... (4,131) --
Stock-based compensation ........................... 7,054 --
Changes in operating assets and liabilities:
Accounts receivable .............................. (5,795,263) (20,881,371)
Due to/from related parties ...................... (121,160) 1,691,349
Inventory ........................................ 11,440,735 (4,927,248)
Temporary quota rights ........................... (59,153) --
Prepaid expenses ................................. 1,353,074 (765,894)
Accounts payable ................................. (12,295,638) 6,447,618
Accrued expenses and income tax payable .......... (518,128) 333,113
------------- -------------
Net cash used in operating activities ............ (2,401,073) (16,422,470)
Investing activities:
Purchase of fixed assets ........................... (63,418) (79,690)
Proceeds from sale of fixed assets ................. 2,800 --
Distribution from equity method investee ........... 67,500 81,000
Collection on notes receivable, related parties .... 651,666 598,482
Collection of advances from shareholders/officers .. 44,522 2,413,994
------------- -------------
Net cash provided by investing activities ........ 703,070 3,013,786
Financing activities:
Short-term bank borrowings, net .................... (1,300,390) 1,385,954
Proceeds from long-term obligations ................ 132,805,154 98,905,667
Payment of financing costs ......................... (2,231,318) --
Repayments of borrowings from convertible debentures (6,912,626) --
Payment of long-term obligations and bank borrowings (120,613,274) (86,918,487)
------------- -------------
Net cash provided by financing activities ........ 1,747,546 13,373,134
------------- -------------
Increase (decrease) in cash and cash equivalents ...... 49,543 (35,550)
Cash and cash equivalents at beginning of period ...... 1,641,768 1,214,944
------------- -------------
Cash and cash equivalents at end of period ............ $ 1,691,311 $ 1,179,394
============= =============
The accompanying notes are an integral part
of these consolidated financial statements
4
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. ORGANIZATION AND BASIS OF CONSOLIDATION
The accompanying financial statements consist of the consolidation of
Tarrant Apparel Group, a California corporation, and its majority owned
subsidiaries located primarily in the U.S., Asia, Mexico, and Luxembourg. At
June 30, 2006, 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 and Interim Chief Executive Officer, Gerard
Guez. The 25% minority interest in PBG7 is owned by BH7, LLC, an unrelated
party.
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. In August 2004, we entered into a purchase and sale
agreement to sell these facilities to affiliates of Mr. Nacif, which transaction
was consummated in the fourth quarter of 2004. See Note 13 of the "Notes to
Consolidated Financial Statements".
Historically, our operating results have been subject to seasonal
trends when measured on a quarterly basis. This trend is dependent on numerous
factors, including the markets in which we operate, holiday seasons, consumer
demand, climate, economic conditions and numerous other factors beyond our
control. Generally, the second and third quarters are stronger than the first
and fourth quarters. There can be no assurance that the historic operating
patterns will continue in future periods.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accompanying unaudited financial statements have been prepared in
accordance with accounting principles generally accepted in the United States of
America ("US GAAP") for interim financial information and with the instructions
to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include
all of the information and footnotes required by US GAAP for complete financial
statements. In the opinion of management, all adjustments (consisting of normal
recurring accruals) considered necessary for a fair presentation of the results
of operations for the periods presented have been included.
The consolidated financial data at December 31, 2005 is derived from
audited financial statements which are included in our Annual Report on Form
10-K for the year ended December 31, 2005, and should be read in conjunction
with the audited financial statements and notes thereto. Interim results are not
necessarily indicative of results for the full year.
The accompanying unaudited consolidated financial statements include
all majority-owned subsidiaries in which we exercise control. Investments in
which we exercise significant influence, but which we do not control, are
accounted for under the equity method of accounting. The equity method of
accounting is used when we have a 20% to 50% interest in other entities, except
for variable interest entities for which we are considered the primary
beneficiary under Financial Accounting Standards Board ("FASB") Interpretation
No. 46, "Consolidation of Variable Interest Entities," an interpretation of ARB
No. 51. Under the equity method, original investments are recorded at cost and
adjusted by our share of undistributed earnings or losses of these entities. All
significant inter-company transactions and balances have been eliminated from
the consolidated financial statements.
5
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
The preparation of financial statements in conformity with US GAAP
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Significant estimates used by
us in preparation of the consolidated financial statements include: (i)
allowance for returns, discounts and bad debts, (ii) inventory, (iii) valuation
of long lived and intangible assets and goodwill, (iv) income taxes, and (v)
stock options valuation. Actual results could differ from those estimates.
ROYALTY EXPENSES
Royalty expenses consist of the royalty payments and marketing fund
commitments according to the various licensing agreements we have entered into.
Royalty expenses are calculated based on certain percentage of net sales. Some
of these agreements include minimum royalties. See Note 14 of the "Notes to
Consolidated Financial Statements" regarding various agreements we have entered
into.
DEFERRED RENT PROVISION
When a lease requires fixed escalation of the minimum lease payments,
rental expense is recognized on a straight line basis over the initial term of
the lease, and the difference between the average rental amount charged to
expense and amounts payable under the lease is included in deferred amount. As
of June 30, 2006, deferred rent of $50,000 was recorded under accrued expense in
our consolidated financial statements.
VALUATION OF DERIVATIVE INSTRUMENTS
Statements of Financial Accounting Standards ("SFAS") No. 133
"Accounting for Derivative Instruments and Hedging Activities" requires
measurement of certain derivative instruments at their fair value for accounting
purposes. In determining the appropriate fair value, we use the
Black-Scholes-Metron Option Pricing Formula (the "Black-Scholes Model").
Derivative liabilities are adjusted to reflect fair value at each period end,
with any increase or decrease in the fair value being recorded in consolidated
statements of operations as adjustments to fair value of derivatives.
STOCK-BASED COMPENSATION
On January 1, 2006, we adopted Statements of Financial Accounting
Standards (SFAS) No. 123 (revised 2004), "Share-Based Payment," ("SFAS 123(R)")
which requires the measurement and recognition of compensation expense for all
share-based payment awards made to employees and directors based on estimated
fair values. SFAS 123(R) supersedes our previous accounting under Accounting
Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to
Employees" ("APB 25") for periods beginning in fiscal 2006. In March 2005, the
Securities and Exchange Commission issued Staff Accounting Bulletin (SAB) No.
107 ("SAB 107") relating to SFAS 123(R). We have applied the provisions of SAB
107 in our adoption of SFAS 123(R).
We adopted SFAS 123(R) using the modified prospective transition
method, which requires the application of the accounting standard as of January
1, 2006, the first day of our fiscal year 2006. Our financial statements as of
and for the six months ended June 30, 2006 reflect the impact of SFAS 123(R). In
accordance with the modified prospective transition method, our financial
statements for prior periods have not been restated to reflect, and do not
include, the impact of SFAS 123(R). Stock-based compensation expense recognized
under SFAS 123(R) during the three and six months ended June 30, 2006 was
$7,000. Basic and dilutive earnings per share for the three and six months ended
June 30, 2006 were not affected by the additional stock-based compensation
recognized.
The fair value of each option granted to employees and directors is
estimated on the date of grant using the Black-Scholes option-pricing model with
the following weighted average assumptions used for grants in 2006 and 2005:
weighted-average volatility factors of the expected market price of our common
stock of 0.70 and 0.55 for the three months ended June 30, 2006 and 2005,
weighted-average risk-free interest rates of 5.13% and 4% for the three months
ended June
6
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
30, 2006 and 2005, dividend yield of 0% for the three months ended June 30, 2006
and 2005, and weighted-average expected life of the options of 6.25 years and 4
years for the three months ended June 30, 2006 and 2005.
The following table illustrates the effect on net loss and net loss per
share if we had applied the fair value recognition provisions of SFAS 123 to
stock-based payment awards granted under our stock option plans for the three
and six months ended June 30, 2005:
THREE SIX
MONTHS ENDED MONTHS ENDED
JUNE 30, 2005 JUNE 30, 2005
------------- -------------
Net income as reported ........................... $ 870,839 $ 765,019
Add stock-based employee compensation
charges reported in net income ................. -- --
Pro forma compensation expense, net of tax ....... (973,463) (1,049,972)
------------- -------------
Pro forma net loss ............................... $ (102,624) $ (284,953)
============= =============
Net income per share as reported - Basic ......... $ 0.03 $ 0.03
Add stock-based employee compensation
charges reported in net income - Basic ......... -- --
Pro forma compensation expense per share - Basic . (0.03) (0.04)
------------- -------------
Pro forma net loss per share - Basic ............. $ (0.00) $ (0.01)
============= =============
Net income per share as reported -Diluted ........ $ 0.03 $ 0.03
Add stock-based employee compensation
charges reported in net income - Diluted ....... -- --
Pro forma compensation expense per share - Diluted (0.03) (0.04)
------------- -------------
Pro forma net loss per share -Diluted ............ $ (0.00) $ (0.01)
============= =============
SFAS 123(R) requires companies to estimate the fair value of
share-based payment awards to employees and directors on the date of grant using
an option-pricing model. The value of the portion of the award that is
ultimately expected to vest is recognized as expense over the requisite service
periods in our consolidated statements of operations. Prior to the adoption of
SFAS 123(R), we accounted for stock-based payment awards to employees and
directors using the intrinsic value method in accordance with APB 25 as allowed
under SFAS No. 123, "ACCOUNTING FOR STOCK-BASED COMPENSATION" ("SFAS 123").
Under the intrinsic value method, no stock-based compensation expense had been
recognized in our consolidated statements of operations for awards to employees
and directors because the exercise price of our stock options equaled the fair
market value of the underlying stock at the date of grant.
On September 23, 2005, the Board of Directors approved the acceleration
of vesting of all our unvested stock options, including those not issued under
the plan; see Note 3 of the "Notes to Consolidated Financial Statements." In
total, 1.7 million stock options with an average exercise price of $3.69 and an
average remaining contractual life of 7.9 years were subject to this
acceleration. The exercise prices and number of shares subject to the
accelerated options were unchanged. The acceleration was effective as of
September 23, 2005. As a result, there were no stock options granted prior to,
but not yet vested as of January 1, 2006. There was no stock-based compensation
expense related to employees or directors stock options recognized during the
three months and six months ended June 30, 2005.
Stock-based compensation expense recognized during the period is based
on the value of the portion of share-based payment awards that is ultimately
expected to vest during the period. Stock-based compensation expense recognized
in the consolidated statements of operations for the three months and six months
of 2006 consisted of compensation expense for the share-based payment awards
granted subsequent to January 1, 2006 based on the grant date fair value
estimated in accordance with the provisions of SFAS 123(R). For stock-based
payment awards issued to employees and directors, stock-based compensation is
attributed to expense using the straight-line single option method, which is
consistent with how the prior-period pro-formas were provided. As stock-based
compensation expense recognized in the consolidated statements of operations for
the three months and six months of 2006 is based on awards ultimately expected
to vest, it has been reduced for estimated forfeitures which we estimate to be
7.7%. SFAS 123(R) requires forfeitures to be estimated at the time of grant and
revised, if necessary, in subsequent periods if actual forfeitures differ from
those estimates. In our pro-forma information for the periods prior to fiscal
2006, we accounted for forfeitures as they occurred.
7
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Our determination of fair value of share-based payment awards to
employees and directors on the date of grant using the Black-Scholes model,
which is affected by our stock price as well as assumptions regarding a number
of highly complex and subjective variables. These variables include, but are not
limited to our expected stock price volatility over the term of the awards. When
valuing awards, we estimate its expected terms using the "safe harbor"
provisions provided in SAB 107 and its volatility using historical data. We
granted 973,259 shares of stock options during the second quarter of 2006. The
options granted were fair valued in the aggregate at $1.2 million or $1.25 per
share. The stock-based compensation expense related to employees or director
stock options recognized during the three months and six months ended June 30,
2006 was $7,000.
Certain 2005 amounts have been reclassified to conform to the 2006
presentation.
3. STOCK-BASED COMPENSATION
Our Employee Incentive Plan, formerly the 1995 Stock Option Plan (the
"1995 Plan"), authorized the grant of both incentive and non-qualified stock
options to our officers, employees, directors and consultants for shares of our
common stock. As of June 30, 2006, there were outstanding options to purchase a
total of 1,321,000 shares of common stock granted under the 1995 Plan. No
further grants may be made under the 1995 Plan. On May 25, 2006, we adopted 2006
Stock Incentive Plan (the "2006 Plan"), which authorizes the issuance of up to
5,100,000 shares of our common stock pursuant to options or awards granted under
the 2006 Plan. As of June 30, 2006, there were outstanding options to purchase a
total of 973,000 shares of common stock, and 4,127,000 shares remained available
for issuance pursuant to award granted under the 2006 Plan. The exercise price
of options under the plan must be equal to 100% of fair market value of common
stock on the date of grant. The 2006 Plan also permits other types of awards,
including stock appreciation rights, restricted stock and other
performance-based benefits.
In October 1998, we granted 1,000,000 non-qualified stock options
outside of 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, expire in 2008 and vested over four years. In May 2002, we granted
3,000,000 non-qualified stock options outside of the plan. Theses 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, expire in
2012 and vested over three years. The 1,000,000 stock options granted to Kamel
Nacif were forfeited in 2005. In May 2003, we granted 2,000,000 non-qualified
stock options outside of the plan to our Chairman and Vice Chairman. These
options were granted at $3.65 per share, the closing sales price of the common
stock on the day of the grant, expire in 2013 and initially provided for vesting
over four years. In December 2003, we granted 400,000 non-qualified stock
options outside of the plan to one of our employees. The options were granted at
$3.94 per share, the closing sales price of the common stock on the day of the
grant, expire in 2013 and initially provided for vesting over four years. In
June 2006, we granted 290,000 non-qualified stock options in the plan to one of
our employees. The options were granted at $1.84 per share, the closing sales
price of the common stock on the day of the grant, expire in 2016 and vested
over four years.
A summary of our stock option activity, and related information for the
year ended December 31, 2005 and the six months ended June 30, 2006 is as
follows:
EMPLOYEES
----------------------------
NUMBER OF EXERCISE
SHARES PRICE
---------- ------------
Options outstanding at December 31, 2004....... 8,331,962 $1.39-$45.50
Granted ....................................... 42,000 $1.95-$3.68
Exercised ..................................... -- --
Forfeited ..................................... (1,573,300) $1.95-$25.00
Expired ....................................... (67,612) $4.50
---------- ------------
Options outstanding at December 31, 2005 ...... 6,733,050 $1.39-$45.50
Granted ....................................... 973,259 $1.84
Exercised ..................................... -- --
Forfeited ..................................... (12,150) $3.60-$33.13
Expired ....................................... -- --
---------- ------------
Options outstanding at June 30, 2006 .......... 7,694,159 $1.39-$45.50
8
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
We had no stock option outstanding to non-employees as of December 31,
2005 and June 30, 2006.
The following table summarizes information about stock options
outstanding and exercisable as of December 31, 2005 and June 30, 2006:
WEIGHTED
WEIGHTED AVERAGE
AVERAGE REMAINING
NUMBER OF EXERCISE CONTRACTUAL INTRINSIC
SHARES PRICE LIFE (YEARS) VALUE
------------- ------------- ------------ -------------
As of December 31, 2005:
Employees - Outstanding .............. 6,733,050 $ 6.25 6.0 $ 12,440
Employees - Expected to vest ......... 6,733,050 $ 6.25 6.0 $ 12,440
Employees - Exercisable .............. 6,733,050 $ 6.25 6.0 $ 12,440
As of June 30, 2006:
Employees - Outstanding .............. 7,694,159 $ 5.69 6.1 $109,898
Employees - Expected to vest ......... 7,619,218 $ 5.72 6.0 $101,655
Employees - Exercisable .............. 6,720,900 $ 6.24 5.6 $ 2,840
The total intrinsic value of options exercised during 2005 was $0. Cash
received from stock options exercised during 2005 was $0. The total fair value
of shares vested during the years ended December 31, 2003, 2004 and 2005, were
approximately $2.8 million, $4.3 million, and $5.7 million, respectively.
As of June 30, 2006, there was $1.2 million of total unrecognized
compensation cost related to non-vested share-based compensation arrangements
granted under the plans. That cost is expected to be recognized over the
weighted-average period of 3.99 years.
When options are exercised, our policy is to issue previously un-issued
shares of common stock to satisfy share option exercises. As of June 30, 2006,
we had 69.5 million shares of un-issued shares of common stock.
4. ACCOUNTS RECEIVABLE
Accounts receivable consists of the following:
JUNE 30, DECEMBER 31,
2006 2005
------------ ------------
U.S. trade accounts receivable ................. $ 5,247,165 $ 2,893,217
Foreign trade accounts receivable .............. 14,313,011 19,619,172
Factored accounts receivable ................... 42,080,909 33,222,354
Other receivables .............................. 1,698,931 1,815,450
Allowance for returns, discounts and bad debts . (3,223,966) (2,951,750)
------------ ------------
$ 60,116,050 $ 54,598,443
============ ============
5. INVENTORY
Inventory consists of the following:
JUNE 30, DECEMBER 31,
2006 2005
----------- -----------
Raw materials - fabric and trim accessories ........ $ 3,606,143 $ 5,079,428
Finished goods shipments-in-transit ................ 7,297,315 8,800,014
Finished goods ..................................... 9,284,767 17,749,518
----------- -----------
$20,188,225 $31,628,960
=========== ===========
9
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
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. The guaranteed annual minimum
royalty is payable in equal monthly installments during the term of the
agreement. The royalty owed to the licensor in excess of the guaranteed minimum,
if any, is payable no later than 30 days after the end of the preceding full
quarter with the amount for last quarter adjusted based on actual royalties owed
for the year. The guaranteed annual minimum royalty for 2006 is $661,000. The
minimum royalty paid and expensed for the three months and six months ended June
30, 2006 was $165,000 and $331,000, respectively. At June 30, 2006, the total
commitment on royalties remaining on the term was $8.7 million. Private Brands
also entered into a multi-year exclusive distribution agreement with Macy's
Merchandising Group, LLC ("MMG"), the sourcing arm of Federated Department
Stores, to supply MMG with American Rag CIE, a casual sportswear collection for
juniors and young men. Under this arrangement, Private Brands designs and
manufactures American Rag apparel, which is distributed by MMG exclusively to
Federated stores across the country. Beginning in August 2003, the American Rag
collection was available in approximately 100 select Macy's locations, and is
currently available in approximately 600 Macy's stores nationally. In June 2006,
we signed a guarantee of certain liabilities of American Rag CIE to California
United Bank to the aggregate amount equal at all times to the lesser of (A) 45%
of the aggregate amount of the outstanding liabilities and (B) $675,000. Upon
execution of the guarantee, we re-evaluated our investment under the provisions
of FIN 46. In our analysis, we determined that consolidation under FIN 46 was
still not appropriate. The investment in American Rag CIE, LLC totaling $2.2
million at June 30, 2006, 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 during the six
months ended June 30, 2006 was as follows:
Balance as of December 31, 2005 ..... $ 2,138,865
Share of income...................... 110,322
Distribution......................... (67,500)
-------------
Balance as of June 30, 2006.......... $ 2,181,687
=============
7. DEBT
Short-term bank borrowings consist of the following:
JUNE 30, DECEMBER 31,
2006 2005
----------- -----------
Import trade bills payable -
UPS, DBS Bank and Aurora Capital ........... $ 5,340,285 $ 4,165,306
Bank direct acceptances -
UPS and DBS Bank ........................... 3,312,317 1,471,476
Other Hong Kong credit facilities -
UPS and DBS Bank ........................... 3,477,167 8,196,750
----------- -----------
$12,129,769 $13,833,532
=========== ===========
Long-term obligations consist of the following:
JUNE 30, DECEMBER 31,
2006 2005
------------ ------------
Loan from Max Azria ...................... $ 403,374 $ --
Equipment financing ...................... 29,887 83,206
Term loan - UPS .......................... -- 2,708,333
Debt facility - GMAC CF .................. 33,011,627 33,558,095
Credit facility - Guggenheim, net ........ 10,671,173 --
Warrants ................................. 5,196,800 --
------------ ------------
49,312,861 36,349,634
Less current portion ..................... (33,434,952) (36,109,699)
------------ ------------
$ 15,877,909 $ 239,935
============ ============
10
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
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 could arrange for the issuance of letters of credit and
acceptances. The facility was collateralized by the shares and debentures of all
of our subsidiaries in Hong Kong. In addition to the guarantees provided by us
and our subsidiaries, Fashion Resource (TCL) Inc. and Tarrant Luxembourg Sarl,
Gerard Guez, our Chairman and Interim Chief Executive Officer, also signed a
guarantee of $5 million in favor of UPS to secure this facility. Under this
facility, we were subject to certain restrictive covenants, including that we
maintain a specified tangible net worth, fixed charge ratio, and leverage ratio.
Additionally, Gerard Guez, our Chairman and Interim Chief Executive Officer,
pledged to UPS 4.6 million shares of our common stock held by Mr. Guez to secure
the obligations under the credit facility. On June 9, 2006, we completed the
pay-off of all remaining amounts due under the letter of credit facility with
UPS. As a result of the payment of these obligations, the letter of credit
facility was terminated and all collateral released. There was no prepayment
penalty under this arrangement. As of June 30, 2006, $0 was outstanding under
this facility with UPS.
Since March 2003, DBS Bank (Hong Kong) Limited ("DBS") had 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 was a demand facility and
was secured by the pledge of our office property, which is owned by Gerard Guez,
our Chairman and Interim Chief Executive Officer, 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. In October 2005, a
tax loan for HKD 6.233 million (equivalent to US $804,000) was also made
available to our Hong Kong subsidiaries and bears interest at the rate equal to
the Hong Kong prime rate plus 1% and are subject to the same security. It bore
interest at 9.25% per annum at June 30, 2006. As of June 30, 2006, $276,000 was
outstanding under this tax loan.
In June 2006, our subsidiaries in Hong Kong, Tarrant Company Limited,
Marble Limited and Trade Link Holdings Limited, entered into a new credit
facility with DBS. Under this facility, we may arrange for letters of credit and
acceptances. The maximum amount our Hong Kong subsidiaries may borrow under this
facility at any time is US $25 million. The interest rate under the letter of
credit facility is equal to the Standard Bills Rate quoted by DBS minus 0.5% if
paid in Hong Kong Dollars, which the interest rate was 8.75% per annum at June
30, 2006, or the Standard Bills Rate quoted by DBS plus 0.5% if paid in any
other currency, which the interest rate was 8.71% per annum at June 30, 2006.
This is a demand facility and is secured by a security interest in all the
assets of the Hong Kong subsidiaries, by a pledge of our office property where
our Hong Kong office is located, which is owned by Gerard Guez, our Chairman and
Interim Chief Executive Officer, and Todd Kay, our Vice Chairman and by our
guarantee. The DBS facility includes customary default provisions. In addition,
we are subject to certain restrictive covenants, including that we maintain a
specified tangible net worth, and a minimum level of EBITDA at December 31,
2006, interest coverage ratio, leverage ratio and limitations on additional
indebtedness. As of June 30, 2006, $10.7 million was outstanding under this
facility. In addition, $5.9 million of open letters of credit was outstanding
and $8.4 million was available for future borrowings as of June 30, 2006.
As of June 30, 2006, the total balance outstanding under the DBS credit
facilities was $11.0 million (classified above as follows: $4.2 million in
import trade bills payable, $3.3 million in bank direct acceptances and $3.5
million in other Hong Kong credit facilities).
From time to time, we open letters of credit under an uncommitted line
of credit from Aurora Capital Associates which issues these letters of credits
out of Israeli Discount Bank. As of June 30, 2006, $1.1 million was outstanding
under this facility (classified above under import trade bills payable) and $1.3
million of letters of credit were open under this arrangement. We pay a
commission fee of 2.25% on all letters of credits issued under this arrangement.
LOAN FROM MAX AZRIA
On January 19, 2006, we borrowed $4.0 million from Max Azria pursuant
to the terms of a promissory note, which amount bears interest at the rate of
5.5% per annum and is payable in weekly installments of $200,000 beginning on
March 1, 2006. This is an unsecured loan. As of June 30, 2006, $403,000 was
outstanding under this loan.
11
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
EQUIPMENT FINANCING
We had three equipment loans outstanding at December 31, 2005. One of
these equipment loans bore interest at 6% payable in installments through 2009,
which we paid off in January 2006. The second loan bears interest at 15.8%
payable in installment through 2007 and the third loan bears interest at 6.15%
payable in installment through 2007. As of June 30, 2006, $30,000 was
outstanding under the two remaining loans.
TERM LOAN - UPS
On December 31, 2004, our Hong Kong subsidiaries entered into a 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 was
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 amended loan agreement, we were subject to restrictive financial
covenants of maintaining tangible net worth of $25 million at December 31, 2005
and the last day of each fiscal quarter thereafter. There was also a provision
capping maximum capital expenditure per quarter at $800,000. The obligations
under the loan agreement were collateralized by the same security interests and
guarantees provided under our letter of credit facility with UPS. Additionally,
the term loan was 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,
our Chairman and Interim Chief Executive Officer, of 4.6 million shares of our
common stock. On June 9, 2006, we completed the pay-off of all remaining amounts
due under the term loan agreement with UPS. As a result of the payment of these
obligations, the term loan agreement was terminated and all collateral released.
There was no prepayment penalty under this arrangement.
DEBT FACILITY AND FACTORING AGREEMENT - GMAC CF
On October 1, 2004, we amended and restated our previously existing
credit facility with GMAC Commercial Finance Credit, LLC ("GMAC CF") by entering
into a new factoring agreement with GMAC CF. 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 CF. Pursuant to the terms of the factoring agreement, we and
our subsidiaries agree to assign and sell to GMAC CF, as factor, all accounts
which arise from our sale of merchandise or rendition of service created on a
going forward basis. At our request, GMAC CF, in its discretion, may make
advances to us up to the lesser of (a) up to 90% of our accounts on which GMAC
CF has the risk of loss and (b) $40 million, minus in each case, any amount owed
by us to GMAC CF. In May 2005, we amended our factoring agreement with GMAC CF
to permit our subsidiaries party thereto and us, to borrow up to the lesser of
$3 million or 50% of the value of eligible inventory. In connection with this
amendment, we granted GMAC CF a lien on certain of our inventory located in the
United States. On January 23, 2006, we further amended our factoring agreement
with GMAC CF to increase the amount we may borrow against inventory to the
lesser of $5 million or 50% of the value of eligible inventory. The $5 million
limit was reduced to $4 million on April 1, 2006.
On June 16, 2006, we expanded our credit facility with GMAC CF by
entering into a new Loan and Security Agreement and amending and restating our
previously existing Factoring Agreement with GMAC CF. UPS Capital Corporation is
also a lender under the Loan and Security Agreement. This is a revolving credit
facility and has a term of 3 years. The amount we may borrow under this credit
facility is determined by a percentage of eligible accounts receivable and
inventory, up to a maximum of $55 million, and includes a letter of credit
facility of up to $4 million. Interest on outstanding amounts under this credit
facility is payable monthly and accrues at the rate of the "prime rate" plus
0.5%. Our obligations under the GMAC CF credit facility are secured by a lien on
substantially all our domestic assets, including a first priority lien on our
accounts receivable and inventory. This credit facility contains customary
financial covenants, including covenants that we maintain minimum levels of
EBITDA and interest coverage ratios and limitations on additional indebtedness.
This facility includes customary default provisions, and all outstanding
obligations may become immediately due and payable in the event of a default.
The facility bore interest at 8.75% per annum at June 30, 2006. As of June 30,
2006, we were in violation with the EBITDA covenant and a waiver was obtained
during the default. A total of $33.0 million was outstanding with respect to
receivables factored under the GMAC CF facility at June 30, 2006.
12
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
CREDIT FACILITY FROM GUGGENHEIM CORPORATE FUNDING LLC AND WARRANTS
On June 16, 2006, we entered into a Credit Agreement with certain
lenders and Guggenheim Corporate Funding LLC ("Guggenheim"), as administrative
agent and collateral agent for the lenders. This credit facility provides for
borrowings of up to $65 million. This facility consists of an initial term loan
of up to $25 million, of which we borrowed $15.5 million at the initial funding,
to be used to repay certain existing indebtedness and fund general operating and
working capital needs. An additional term loan of up to $40 million will be
available under this facility to finance acquisitions acceptable to Guggenheim.
All amounts under the term loans become due and payable in December 2010.
Interest under this facility is payable monthly, with the interest rate equal to
the LIBOR rate plus an applicable margin based on our debt leverage ratio (as
defined in the credit agreement). Our obligations under the Guggenheim credit
facility are secured by a lien on substantially all of our assets and our
domestic subsidiaries, including a pledge of the equity interests of our
domestic subsidiaries and 65% of our Luxembourg subsidiary. This credit facility
contains customary financial covenants, including covenants that we maintain
minimum levels of EBITDA and interest coverage ratios and limitations on
additional indebtedness.
In connection with Guggenheim credit facility, on June 16, 2006, we
issued the lenders under this facility warrants to purchase up to an aggregate
of 3,857,143 shares of our common stock. These warrants have a term of 10 years.
These warrants are exercisable at a price of $1.88 per share with respect to 20%
of the shares, $2.00 per share with respect to 20% of the shares, $3.00 per
share with respect to 20% of the shares, $3.75 per share with respect to 20% of
the shares and $4.50 per share with respect to 20% of the shares. The exercise
prices are subject to adjustment for certain dilutive issuances pursuant to the
terms of the warrants. 357,143 shares of the warrants will not become
exercisable unless and until a specified portion of the initial term loan is
actually funded by the lenders. The warrants were evaluated under SFAS No 133
and EITF 00-19 and determined to be a derivative instrument due to certain
registration rights. As such, the warrants excluding the ones not exercisable
were valued at $4.9 million using the Black-Scholes option valuation model with
the following assumptions: risk-free interest rate of 5.1%; dividend yields of
0%; volatility factors of the expected market price of our common stock of 0.70;
and contractual term of ten years. We also paid to Guggenheim 2.25% of the
committed principal amount of the loans which was $563,000 on June 16, 2006. The
$563,000 fee paid to Guggenheim is included in the deferred financing cost, and
the value of the warrants to purchase 3.5 million shares of our common stock of
$4.9 million is recorded as debt discount, both of them are amortized over the
life of the loan. As of June 30, 2006, $50,000 was amortized.
Durham Capital Corporation acted as our advisor in connection with the
Guggenheim credit facility. As compensation for its services, we agreed to pay
Durham Capital a cash fee in an amount equal to 1% of the committed principal
amount of the loans under the Guggenheim credit facility. As a result, $250,000
was paid on June 16, 2006. In addition, we issued Durham Capital a warrant to
purchase 77,143 shares of our common stock. This warrant has a term of 10 years
and is exercisable at a price of $1.88 per share, subject to adjustment for
certain dilutive issuances. 7,143 shares of this warrant will not become
exercisable unless and until a specified portion of the initial term loan is
actually funded by the lenders. The warrants were evaluated under SFAS No 133
and EITF 00-19 and determined to be a derivative instrument due to certain
registration rights. As such, the warrants excluding the ones not exercisable
were valued at $105,000 using the Black-Scholes option valuation model with the
following assumptions: risk-free interest rate of 5.1%; dividend yields of 0%;
volatility factors of the expected market price of our common stock of 0.70; and
contractual term of ten years. The $250,000 fee paid to Durham Capital and the
value of the warrants to purchase 70,000 shares of our common stock of $105,000
is included in the deferred financing cost, and is amortized over the life of
the loan. As of June 30, 2006, $3,000 was amortized.
The Guggenheim facility bore interest at 12.21% per annum at June 30,
2006. As of June 30, 2006, we were in violation with the EBITDA covenant and a
waiver was obtained during the default. A total of $10.7 million, net of $4.8
million of debt discount, was outstanding under this facility at June 30, 2006.
As of June 30, 2006, the warrants were being accounted for as a
liability pursuant to the provisions of SFAS No. 133 and Emerging Issues Task
Force (EITF) No. 00-19, "Accounting for Derivative Financial Instruments Indexed
to, and Potentially Settled in, a Company's Own Stock" ("EITF 00-19"). This is
because we granted the warrant holders certain registration rights that are
outside our control. In accordance with SFAS No. 133, the warrants are being
valued at each reporting period. Changes in fair value are recorded as
adjustment to fair value of derivative in the statements of operations. The
outstanding warrants were fair valued on June 16, 2006, the date of transaction,
at $4.9 million and we, in accordance with SFAS 133, revaluated the warrants on
June 30, 2006 at the closing stock price on June 30, 2006 to $5.2 million; as a
result, an expense of $218,000 was recorded as an adjustment to fair value of
derivative on our consolidated statements of operations. On August 11, 2006, we
amended the registration rights relating to the warrants. As a result, the
warrants will be reclassified to equity in accordance with EITF 00-19 in the
third quarter of 2006.
13
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
The credit facilities with GMAC CF and Guggenheim include cross-default
clauses subject to certain conditions. An event of default under the GMAC CF
facility would constitute an event of default under the Guggenheim facility
entitling Guggenheim to demand payment in full of all outstanding amounts under
its facility. An event of default under the Guggenheim facility, under
circumstances where Guggenheim has accelerated the debt or has exercised any
other remedy available to Guggenheim which constitutes a Lien Enforcement Action
under its Intercreditor Agreement with GMAC CF, would entitle GMAC CF to demand
payment in full of all outstanding amounts under its debt facilities.
8. 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 Debentures contain customary events of
default and permit the holder 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
closing market price of our common stock on the closing date of the financing
was $1.96. The Debentures were 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 was 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 at December 31, 2004.
The placement agent in the financing, received compensation for its
services in the amount of $620,000 in cash and issuance of five year warrants to
purchase up to 200,000 shares of our common stock at an exercise price of $2.50
per share. The warrants to purchase 200,000 shares of our common stock 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 financing cost paid to the placement agent
of $620,000, and the value of the warrants to purchase 200,000 shares of our
common stock of $138,000 were included in the deferred financing cost, net on
our accompanying balance sheets and was amortized over the life of the loan.
In June 2005, holders of our Debentures converted an aggregate of $2.3
million of Debentures into 1,133,687 shares of our common stock. In August 2005,
holders of our Debentures converted an aggregate of $820,000 of Debentures into
410,000 shares of our common stock. The Debentures were converted at the option
of the holders at a price of $2.00 per share. Debt discount of $248,000 related
to the intrinsic value of the conversion option of $804,000 was expensed upon
the conversion. Of the $620,000 financing cost paid to the placement agent,
$191,000 was expensed upon the conversion. The intrinsic value of the conversion
option, and the value of the warrant amortized in the first six months of 2006
was $237,000. Total deferred financing cost amortized in the first six months of
2006 was $95,000. Total interest paid to the holders of the Debentures in the
first six months of 2006 was $198,000. On June 26, 2006, we paid off the
remaining balance of the outstanding Debentures of $6.9 million plus all accrued
and unpaid interest and a prepayment penalty of $171,000. As a result of the
repayment, the convertible debentures were terminated effective June 26, 2006.
Upon paying off the Debentures, debt discount of $278,000 related to the
intrinsic value of the conversion option of $804,000 was expensed, and of the
$620,000 financing cost paid to the placement agent, $214,000 was expensed. The
remaining value of the warrants to holders of our Debentures of $433,000 and
warrants to the placement agent of $69,000 was also expensed.
9. EQUITY TRANSACTIONS
In March 2005, in connection with a settlement of a dispute involving a
former employee named Nicolas Nunez, we agreed to compensate Mr. Nunez in the
total amount of $875,000. In April 2005, we issued 195,313 shares of our common
stock (having a value of $375,000) to Mr. Nunez pursuant to the terms of an
agreement and plan of reorganization and paid Mr. Nunez
14
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
$500,000 in settlement of all remaining claims by Mr. Nunez against us. In
connection with this settlement, in March 2006, we cancelled 10,000 shares of
our common stock previously issued to him.
10. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In June 2006, the FASB issued Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109,"
("FIN 48"). FIN 48 clarifies the accounting for uncertainty in income taxes
recognized in an enterprise's financial statements in accordance with FASB
Statement No. 109, "Accounting for Income Taxes." FIN 48 also prescribes a
recognition threshold and measurement attribute for the financial statement
recognition and measurement of a tax position taken or expected to be taken in a
tax return that results in a tax benefit. Additionally, FIN 48 provides guidance
on de-recognition, income statement classification of interest and penalties,
accounting in interim periods, disclosure, and transition. This interpretation
is effective for fiscal years beginning after December 15, 2006. We are
currently evaluating the effect that the application of FIN 48 will have on our
results of operations and financial condition.
In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing
of Financial Assets" ("SFAS No. 156"), which provides an approach to simplify
efforts to obtain hedge-like (offset) accounting. This Statement amends FASB
Statement No. 140, "Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities", with respect to the accounting for
separately recognized servicing assets and servicing liabilities. The Statement
(1) requires an entity to recognize a servicing asset or servicing liability
each time it undertakes an obligation to service a financial asset by entering
into a servicing contract in certain situations; (2) requires that a separately
recognized servicing asset or servicing liability be initially measured at fair
value, if practicable; (3) permits an entity to choose either the amortization
method or the fair value method for subsequent measurement for each class of
separately recognized servicing assets or servicing liabilities; (4) permits at
initial adoption a one-time reclassification of available-for-sale securities to
trading securities by an entity with recognized servicing rights, provided the
securities reclassified offset the entity's exposure to changes in the fair
value of the servicing assets or liabilities; and (5) requires separate
presentation of servicing assets and servicing liabilities subsequently measured
at fair value in the balance sheet and additional disclosures for all separately
recognized servicing assets and servicing liabilities. SFAS No. 156 is effective
for all separately recognized servicing assets and liabilities as of the
beginning of an entity's fiscal year that begins after September 15, 2006, with
earlier adoption permitted in certain circumstances. The Statement also
describes the manner in which it should be initially applied. We are currently
evaluating the impact of this Statement.
11. INCOME TAXES
Our effective tax rate differs from the statutory rate principally due
to the following reasons: (1) a full valuation allowance has been provided for
deferred tax assets as a result of the operating losses in the United States and
Mexico, since recoverability of those assets has not been assessed as more
likely than not; (2) although we have taxable losses in Mexico, we are subject
to a minimum tax; and (3) the earnings of our Hong Kong subsidiary are taxed at
a rate of 17.5% versus the 35% U.S. federal rate. The impairment charge in
Mexico did not result in a tax benefit due to an increase in the valuation
allowance against the future tax benefit. We believe it is more likely than not
that the tax benefit will not be realized based on our future business plans in
Mexico.
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
15
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
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
$7.7 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.
12. NET INCOME (LOSS) PER SHARE
A reconciliation of the numerator and denominator of basic earnings
(loss) per share and diluted earnings (loss) per share is as follows:
THREE MONTHS SIX MONTHS
ENDED JUNE 30, ENDED JUNE 30,
------------------------- -------------------------
2006 2005 2006 2005
----------- ----------- ----------- -----------
Basic EPS Computation:
Numerator ..................... $ 611,284 $ 870,839 $ 1,447,655 $ 765,019
Denominator:
Weighted average common shares
outstanding ................. 30,543,763 29,155,855 30,378,715 28,986,251
----------- ----------- ----------- -----------
Basic EPS ..................... $ 0.02 $ 0.03 $ 0.05 $ 0.03
=========== =========== =========== ===========
Diluted EPS Computation:
Numerator ..................... $ 611,284 $ 870,839 $ 1,447,655 765,019
Denominator:
Weighted average common share
outstanding ................. 30,543,763 29,155,855 30,378,715 28,986,251
Incremental shares from assumed
exercise of warrants .......... -- -- -- --
Options ....................... 657 7,215 125 7,215
----------- ----------- ----------- -----------
Total shares .................. 30,544,420 29,163,070 30,378,840 28,993,466
----------- ----------- ----------- -----------
Diluted EPS ................... $ 0.02 $ 0.03 $ 0.05 $ 0.03
=========== =========== =========== ===========
Basic and diluted loss per share has been computed in accordance with
SFAS No. 128, "Earnings Per Share".
Only 125 shares and 7,215 shares of outstanding options were included
in the computation of income per share in the six months ended June 30, 2006 and
2005, respectively, as the exercise prices of the remaining shares were greater
than the average market price for the six months ended June 30, 2006 and 2005.
All warrants were excluded from the computation of net income (loss) per share
in the six months ended June 30, 2006 and 2005, as the impact would be
anti-dilutive. The effect of applying "IF Converted Method" to the convertible
debenture was anti-dilutive; therefore, it was excluded from the computation of
income per share in the six months ended June 30, 2006 and 2005. The following
table presents outstanding options, warrants and convertible debentures.
AS OF JUNE 30,
-----------------------------
2006 2005
---------- ----------
Options .................................. 7,694,159 6,857,687
Warrants ................................. 5,931,732 2,361,732
Convertible debentures ................... -- 3,866,313
---------- ----------
Total .................................... 13,625,891 13,085,732
========== ==========
16
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
13. RELATED PARTY TRANSACTIONS
As of June 30, 2006, related party affiliates were indebted to us in
the amounts of $8.4 million. These include amounts due from Gerard Guez, our
Chairman and Interim Chief Executive Officer. From time to time in the past, we
borrowed funds from, and advanced funds to, Mr. Guez. The greatest outstanding
balance of such advances to Mr. Guez in the second quarter of 2006 was
approximately $2,255,000. At June 30, 2006, the entire balance due from Mr. Guez
totaling $2.2 million is payable on demand and has been shown as reductions to
shareholders' equity in the accompanying financial statements. All advances to
Mr. Guez bore interest at the rate of 7.75% during the period. Total interest
paid by Mr. Guez was $87,000 and $120,000 for the six months ended June 30, 2006
and 2005, respectively. Mr. Guez paid expenses on our behalf of approximately
$132,000 and $234,000 for the six months ended June 30, 2006 and 2005,
respectively, which amounts were applied to reduce accrued interest and
principal on Mr. Guez's loan. These amounts included 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. 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 our executive officers or directors.
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 and
Interim Chief Executive Officer, called United Apparel Ventures, LLC. 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
made purchases from two related parties in Mexico, an affiliate of Azteca and
Tag-It Pacific, Inc.
At June 30, 2006, Messrs. Guez and Kay beneficially owned 590,000 and
1,003,500 shares, respectively, of common stock of Tag-It Pacific, Inc.,
collectively representing approximately 8.7% of Tag-It Pacific's common stock.
Tag-It Pacific is a provider of brand identity programs to manufacturers and
retailers of apparel and accessories. Starting from 1998, Tag-It Pacific 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. Due to
the restructuring of our Mexico operations, Tag-It Pacific no longer manages our
trim and packaging requirements. We purchased $202,000 and $35,000 of trim
inventory from Tag-It Pacific in the six months ended June 30, 2006 and 2005,
respectively. We purchased $0 and $135,000 of finished goods and services from
Azteca and its affiliates in the six months ended June 30, 2006 and 2005,
respectively. Our sales of fabric and services to Azteca in the six months ended
June 30, 2006 and 2005 was $9,000 and $63,000, respectively. Pursuant to the
operating agreement for UAV, two and one half percent of gross sales of UAV were
paid to each of the members of UAV as management fees. Net amount due from these
related parties as of June 30, 2006 was $5.5 million.
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, 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, including the
equipment and facilities we previously leased to Mr. Nacif's affiliates in
October 2003, for an aggregate purchase price consisting of: a) $105,400 in cash
and $3,910,000 by delivery of unsecured promissory notes bearing interest at
5.5% per annum; and b) $40,204,000, by delivery of secured promissory notes
bearing interest at 4.5% per annum, maturing on December 31, 2005 and every year
thereafter until December 31, 2014. The secured promissory notes are payable in
partial or total amounts anytime prior to the maturity of each note. Included in
the $41.0 million notes receivable - related party on the accompanying balance
sheet as of June 30, 2006 was $1.3 million of Mexico value added taxes on the
real property component of this transaction. 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. We purchased $0 and $1.8 million
of fabric from Acabados y Terminados in the six months ended June 30, 2006 and
2005, respectively. Net amount due from these parties as of June 30, 2006 was
$437,000.
17
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
We lease our executive offices in Los Angeles, California from GET, a
corporation which is owned by Gerard Guez (our Chairman and Interim Chief
Executive Officer) and Todd Kay (our Vice Chairman). 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. We paid $538,000 and
$510,000 in rent in the six months ended June 30, 2006 and 2005, respectively,
for office and warehouse facilities. During the first six months of 2006, our
Los Angeles offices and warehouse was leased on a month to month basis. On
August 1, 2006, we entered into a lease agreement with GET for the Los Angeles
offices and warehouse, which lease has a term of five years with an option to
renew for an additional five year term. On January 1, 2006, we renewed our lease
agreement with Lynx International Limited for our office space in Hong Kong for
one year.
On May 1, 2006, we sublet our executive office in Los Angeles,
California and our sales office in New York to Seven Licensing Company, LLC
("Seven Licensing") for a monthly payment of $25,000 on a month to month basis.
Seven Licensing is beneficially owned by Gerard Guez, our Chairman and Interim
Chief Executive Officer. We received $50,000 in rental income from this sublease
in the six months ended June 30, 2006.
At June 30, 2006, we had various employee receivables totaling $265,000
included in due from related parties.
We believe that 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.
14. COMMITMENTS AND CONTINGENCIES
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 was a
three-year contract, and providing compliance with all terms of the license, was
renewable for one additional three-year term. The agreement also provided
payment of royalties at the rate of 8% on net sales and 3% on net sales for
marketing fund commitments. In the first quarter of 2005, we advanced $1.2
million as payment for the first year's minimum royalty and marketing fund
commitment. We had applied $34,000 from the above advance against the royalty
and marketing expenses in 2005. In March 2006, we agreed to terminate our
agreement to design, market and sell House of Dereon by Tina Knowles branded
apparel and we agreed to sell all remaining inventory to the licensor or its
designee. As a result, we will no longer be involved in the sales of this
private brand. Prior to December 31, 2005, we had written off the capitalized
balance of $1.2 million related to the first year term of the agreement and
recognized a corresponding loss in 2005.
On October 17, 2004, Private Brands, Inc. entered into an agreement
with J. S. Brand Management to design, manufacture and distribute Jessica
Simpson branded jeans and casual apparel. This agreement has an initial
three-year term, and provided we are in compliance with the terms of the
agreement, 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 provides for payment of a sales royalty and advertising commitment at
the rate of 8% and 3%, respectively, of net sales, for a total minimum payment
obligation of $8.3 million over the initial term of the agreement. In December
2004, we advanced $2.2 million as payment for the first year's minimum
royalties. We applied $1.1 million from the above advance against the royalty
and marketing expenses in 2005 and $884,000 in the first three months of 2006.
In March 2006, we had written off the capitalized balance of $192,000 and
recognized a corresponding loss. The loss was classified as royalty expense on
our consolidated statements of operations. In March 2006, we became involved in
a dispute with the licensor of the Jessica Simpson brands over our continued
rights to these brands. We are presently in litigation with the licensor.
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. The guaranteed annual minimum
royalty is payable in equal monthly installments during the term of the
agreement. The royalty owed to the licensor in excess of the guaranteed minimum,
if any, is payable no later than 30 days after the end of the preceding full
quarter with the amount for last quarter adjusted based on actual royalties owed
for the year. At June 30, 2006, the total commitment on royalties remaining on
the term was $8.7 million.
18
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
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. We purchased
$0 and $954,000 of fabric under this agreement in the six months ended June 30,
2006 and 2005, respectively.
19
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
15. 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 four geographic
regions: the United States, Asia, Mexico and Luxembourg. 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, Mexico and Luxembourg is
presented below. Inter-company revenues and assets have been eliminated to
arrive at the consolidated amounts.
ADJUSTMENTS
UNITED AND
STATES ASIA MEXICO LUXEMBOURG ELIMINATIONS TOTAL
------------ ------------ ------------ ------------ ------------ ------------
THREE MONTHS ENDED
JUNE 30, 2006
Sales ....................... $ 58,876,000 $ 300,000 $ (93,000) $ -- $ -- $ 59,083,000
Inter-company sales ......... -- 31,573,000 -- -- (31,573,000) --
------------ ------------ ------------ ------------ ------------ ------------
Total revenue ............... $ 58,876,000 $ 31,873,000 $ (93,000) $ -- $(31,573,000) $ 59,083,000
============ ============ ============ ============ ============ ============
Income (loss) from operations $ 1,778,000 $ 1,147,000 $ (316,000) $ -- $ -- $ 2,609,000
============ ============ ============ ============ ============ ============
Interest income ............. $ 48,000 $ 737,000 $ -- $ 432,000 $ (736,000) $ 481,000
============ ============ ============ ============ ============ ============
Interest expense ............ $ 1,868,000 $ 70,000 $ 8,000 $ 736,000 $ (736,000) $ 1,946,000
============ ============ ============ ============ ============ ============
Provision for depreciation
and amortization ........... $ 1,382,000 $ 27,000 $ -- $ -- $ -- $ 1,409,000
============ ============ ============ ============ ============ ============
Capital expenditures ........ $ 23,000 $ 18,000 $ -- $ -- $ -- $ 41,000
============ ============ ============ ============ ============ ============
THREE MONTHS ENDED
JUNE 30, 2005
Sales ....................... $ 50,205,000 $ 246,000 $ 87,000 $ -- $ -- $ 50,538,000
Inter-company sales ......... -- 35,165,000 -- -- (35,165,000) --
------------ ------------ ------------ ------------ ------------ ------------
Total revenue ............... $ 50,205,000 $ 35,411,000 $ 87,000 $ -- $(35,165,000) $ 50,538,000
============ ============ ============ ============ ============ ============
Income (loss) from operations $ (150,000) $ 1,743,000 $ (156,000) $ -- -- $ 1,437,000
============ ============ ============ ============ ============ ============
Interest income ............. $ 47,000 $ 447,000 $ -- $ 469,000 $ (446,000) $ 517,000
============ ============ ============ ============ ============ ============
Interest expense ............ $ 1,094,000 $ 191,000 $ 1,000 $ 446,000 $ (446,000) $ 1,286,000
============ ============ ============ ============ ============ ============
Provision for depreciation
and amortization ........... $ 729,000 $ 25,000 $ (71,000) $ -- $ -- $ 683,000
============ ============ ============ ============ ============ ============
Capital expenditures ........ $ 45,000 $ 76,000 $ (112,000) $ -- $ -- $ 9,000
============ ============ ============ ============ ============ ============
20
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
ADJUSTMENTS
UNITED AND
STATES ASIA MEXICO LUXEMBOURG ELIMINATIONS TOTAL
------------ ------------ ------------ ------------ ------------ ------------
SIX MONTHS ENDED
JUNE 30, 2006
Sales...................... $119,446,000 $ 981,000 $ (83,000) $ -- $ -- $120,344,000
Inter-company sales........ -- 60,924,000 -- -- (60,924,000) --
------------ ------------ ------------ ------------ ------------- ------------
Total revenue.............. $119,446,000 $ 61,905,000 $ (83,000) $ -- $ (60,924,000) $120,344,000
============ ============ ============ ============ ============= ============
Income (loss) from operations $ 2,349,000 $ 2,311,000 $ (403,000) $ (2,000) $ -- $ 4,255,000
============ ============ ============ ============ ============= ============
Interest income............ $ 92,000 $ 1,394,000 $ -- $ 873,000 $ (1,393,000) $ 966,000
============ ============ ============ ============ ============= ============
Interest expense........... $ 2,995,000 $ 128,000 $ 11,000 $ 1,393,000 $ (1,393,000) $ 3,134,000
============ ============ ============ ============ ============= ============
Provision for depreciation
and amortization.......... $ 1,728,000 $ 54,000 $ -- $ -- $ -- $ 1,782,000
============ ============ ============ ============ ============= ============
Capital expenditures....... $ 32,000 $ 31,000 $ -- $ -- $ -- $ 63,000
============ ============ ============ ============ ============= ============
Total assets............... $127,172,000 $115,445,000 $ 12,806,000 $211,496,000 $(321,723,000) $145,196,000
============ ============ ============ ============ ============= ============
SIX MONTHS ENDED
JUNE 30, 2005
Sales...................... $ 94,805,000 $ 470,000 $ 93,000 $ -- $ -- $ 95,368,000
Inter-company sales........ -- 62,000,000 -- -- (62,000,000) --
------------ ------------ ------------ ------------ ------------- ------------
Total revenue.............. $ 94,805,000 $ 62,470,000 $ 93,000 $ -- $ (62,000,000) $ 95,368,000
============ ============ ============ ============ ============= ============
Income (loss) from operations $ (846,000) $ 2,876,000 $ (360,000) $ -- $ -- $ 1,670,000
============ ============ ============ ============ ============= ============
Interest income............ $ 122,000 $ 821,000 $ -- $ 947,000 $ (820,000) $ 1,070,000
============ ============ ============ ============ ============= ============
Interest expense........... $ 1,883,000 $ 215,000 $ 1,000 $ 820,000 $ (820,000) $ 2,099,000
============ ============ ============ ============ ============= ============
Provision for depreciation
and amortization.......... $ 1,202,000 $ 49,000 $ -- $ -- $ -- $ 1,251,000
============ ============ ============ ============ ============= ============
Capital expenditures....... $ 92,000 $ 100,000 $ (112,000) $ -- $ -- $ 80,000
============ ============ ============ ============ ============= ============
Total assets............... $127,498,000 $132,866,000 $ 28,563,000 $212,291,000 $(347,818,000) $153,400,000
============ ============ ============ ============ ============= ============
21
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
16. LITIGATION
On or about April 6, 2006, we commenced an action against the licensor
of the Jessica Simpson brands (captioned TARRANT APPAREL GROUP V. CAMUTO
CONSULTING GROUP, INC., VCJS LLC, WITH YOU, INC. AND JESSICA SIMPSON) in the
Supreme Court of the State of New York, County of New York. The suit named
Camuto Consulting Group, Inc., VCJS LLC, With You, Inc. and Jessica Simpson as
defendants, and asserts that the defendants failed to provide promised support
in connection with our sublicense agreement for the Jessica Simpson brands. Our
complaint includes eight causes of action, including two seeking a declaration
that the sublicense agreement is exclusive and remains in full force and effect,
as well as claims for breach of contract by Camuto Consulting, breach of the
duty of good faith and fair dealing and fraudulent inducement against Camuto
Consulting, and a claim against With You, Inc. and Ms. Simpson that we are an
intended third party beneficiary of the licenses between those defendants and
Camuto Consulting. On or about April 26, 2006, Camuto Consulting served its
answer to our complaint and included a counterclaim against us for breach of the
sublicense agreement and alleging damages of no less than $100 million. Camuto
Consulting has also served a motion to dismiss our cause of action for
fraudulent inducement. On or about May 22, 2006, we served our reply to Camuto
Consulting's counterclaim. On or about April 17, 2006, Ms. Simpson served a
motion seeking dismissal of the cause of action asserted against her. On or
about May 10, 2006, we served our opposition to Ms. Simpson motion to dismiss.
We intend to continue to vigorously defend Camuto's counterclaim and vigorously
oppose Ms. Simpson's motion. On or about June 14, 2006, we served a cross-motion
seeking leave to amend our complaint to add Vincent Camuto as a defendant. Oral
arguments on the motions are scheduled For September 7, 2006. Discovery in the
matter has been underway since May 2006.
Shortly before May 2004, Bazak International Corp. commenced an action
against us in the New York County Supreme Court claiming that we breached an
oral contract to sell a quantity of close-out goods, as a consequence of which
Bazak was damaged to the extent of $1.3 million. Bazak International Corp.
claimed that our liability exists under a theory of breach of contract or unjust
enrichment. This case is currently pending in the United States District Court
for the Southern District of New York and is scheduled for trial on December 18,
2006. We will continue to vigorously defend against the breach of contract and
unjust enrichment claim.
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.
17. SUBSEQUENT EVENTS
In July 2006, we terminated our License Agreements and the parent
guaranty with Cynthia Rowley. In consideration of termination of the License
Agreements, $400,000 was paid to Cynthia Rowley in July. As of June 30, 2006, we
accrued $400,000 as part of the termination agreement.
On August 1, 2006, we entered into a lease agreement with GET for the
Los Angeles offices and warehouse, which lease has a term of five years with an
option to renew for an additional five year term.
22
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
BUSINESS OVERVIEW AND RECENT DEVELOPMENTS
We are 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 leading retailers, such as Kohl's, Chico's, Macy's
Merchandising Group, Mervyn's, Mothers Work, Sears, Wal-Mart, Dillard's, Lane
Bryant, Lerner New York, the Avenue, and J.C. Penney. 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. Our private brands include American Rag Cie and Alain Weiz.
PRIVATE LABEL
Private label business has been our core competency for over twenty
years, and involves a one to one relationship with a large, centrally controlled
retailer with whom we can develop product lines that fit with the
characteristics of their particular customer. Private label net sales in the
first six months of 2006 were $89.7 million compared to $72.6 million in the
first six months of 2005.
The exposure of developing private brands collections has created new
opportunities within the private label business to add value in the development
and marketing of new initiatives for Sears, Mothers Work, Avenue, Chico's, and
other retailers. These initiatives were launched during 2005, and are on track
to be significant growth areas for 2006.
PRIVATE BRANDS
We launched our private brands initiative in 2003, pursuant to which we
acquire ownership of or license rights to a brand name and sell apparel products
under this brand, generally to a single retail company within a geographic
region. Private brands net sales in the first six months of 2006 were $30.6
million compared to $22.8 million in the first six months of 2005. At June 30,
2006, we owned or licensed rights to the following private brands:
o AMERICAN RAG CIE: During the first quarter of 2005, we
extended our agreement with Macy's Merchandising Group for six
years, pursuant to which we exclusively distribute our
American Rag Cie brand through Macy's Merchandising Group's
national Department Store organization of more than 500
stores. Net sales of American Rag Cie branded apparel totaled
$15.5 million in the first six months of 2006.
o ALAIN WEIZ: We continue to sell Alan Weiz apparel exclusively
to Dillard's Department Stores. Net sales of Alain Weiz
branded apparel totaled $3.2 million in the first six months
of 2006.
o SOUVENIR BY CYNTHIA ROWLEY: In July 2006, we terminated our
License Agreements and the parent guaranty with Cynthia
Rowley. In consideration of termination of the License
Agreements, $400,000 was paid to Cynthia Rowley in July. As of
June 30, 2006, we accrued $400,000 as part of the termination
agreement.
o GEAR 7: During the fourth quarter of 2005, K-Mart discontinued
sales of Gear 7 products, which resulted in a decline in sales
for this brand in the fourth quarter of 2005. We do not
anticipate sales of Gear 7 branded apparel in 2006.
o JESSICA SIMPSON brands: The JS by Jessica Simpson brand was
originally launched as a denim line with Charming Shoppes. Net
sales of JS by Jessica Simpson and Princy by Jessica Simpson,
which is the department store and better specialty store
brand, totaled $9.7 million in the first quarter of 2006. In
March 2006, we became involved in a dispute with the licensor
of the Jessica Simpson brands over our continued rights to
these brands, and we are presently in litigation with this
licensor. Accordingly, we did not have any sales of Jessica
Simpson branded apparel after the
23
first quarter of 2006 and do not anticipate any sales unless
and until we are able to successfully resolve our dispute and
retain our rights to these brands.
o HOUSE OF DEREON BY TINA KNOWLES: We began shipping products
for the House of Dereon by Tina Knowles brand in the fourth
quarter of 2005, resulting in net sales of $309,000 in 2005.
In March 2006, we terminated our license agreement for this
brand, and sold our remaining inventory to the licensor or its
designee. Prior to December 31, 2005, we had written off the
capitalized balance of $1.2 million related to the agreement
and recognized a corresponding loss in 2005. Net sales of
House of Dereon by Tina Knowles branded apparel totaled $2.2
million in the first quarter of 2006 which included $1.5
million of sales of inventory to a designee of the licensor.
CREDIT FACILITY REFINANCING
In June 2006, we entered into a new $65 million credit facility with
Guggenheim Corporate Funding, LLC (as agent for certain lenders) and expanded
our existing facilities with GMAC Commercial Finance Credit, LLC and DBS Bank
(Hong Kong) Limited. The credit facility with Guggenheim consists of an initial
term loan of $25 million, of which $15.5 million was advanced at the initial
closing. The initial term loan was or will be used to repay certain existing
indebtedness and fund general operating and working capital needs. A second term
loan of up to $40 million will be available to finance acquisitions acceptable
to Guggenheim as agent. In addition, in June 2006, our credit facility with GMAC
Commercial Finance Credit, LLC and other lenders was increased from $45 million
to $55 million, and our credit facility with DBS Bank (Hong Kong) Limited was
increased from $4.5 million to $25 million. These financings significant expand
our borrowing base, which provides enhanced financial flexibility to us.
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 $7.7
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.
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
24
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.
We believe 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" included in our Annual Report on Form 10-K for the year ended
December 31, 2005.
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 our 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 June 30, 2006, the balance in the allowance for returns,
discounts and bad debts reserves was $3.2 million.
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 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. As of June 30, 2006, we have a goodwill balance of $8.6 million, and a
net property and equipment balance of $1.5 million.
25
INCOME TAXES
As part of the process of preparing our consolidated financial
statements, management is required to estimate income taxes in each of the
jurisdictions in which we operate. The process involves estimating actual
current tax expense along with assessing temporary differences resulting from
differing treatment of items for book and tax purposes. These timing differences
result in deferred tax assets and liabilities, which are included in our
consolidated balance sheet. Management records a valuation allowance to reduce
our net deferred tax assets to the amount that is more likely than not to be
realized. Management has considered future taxable income and ongoing 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 11 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 EBITDA and tangible net worth as discussed in Note 7 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 obtain an advance waiver or reclassify the
relevant debt as current. We also believe that our lenders would provide waivers
if necessary. However, our expectations of future operating results and
continued compliance with other debt covenants cannot be assured and our
lenders' actions are not controllable by us. If projections of future operating
results are not achieved and the debt is placed in default, we would be required
to reduce our expenses, by curtailing operations, and to raise capital through
the sale of assets, issuance of equity or otherwise, any of which could have a
material adverse effect on our financial condition and results of operations.
VALUATION OF DERIVATIVE INSTRUMENTS
Statements of Financial Accounting Standards ("SFAS") No. 133
"Accounting for Derivative Instruments and Hedging Activities" requires
measurement of certain derivative instruments at their fair value for accounting
purposes. In determining the appropriate fair value, we use the
Black-Scholes-Metron Option Pricing Formula (the "Black-Scholes Model").
Derivative liabilities are adjusted to reflect fair value at each period end,
with any increase or decrease in the fair value being recorded in consolidated
statements of operations as adjustments to fair value of derivatives.
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 10 of the "Notes to Consolidated Financial
Statements."
26
RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, certain
items in our consolidated statements of operations as a percentage of net sales:
THREE MONTHS SIX MONTHS
ENDED JUNE 30, ENDED JUNE 30,
----------------- -----------------
2006 2005 2006 2005
------ ------ ------ ------
Net sales ............................ 100.0 % 100.0 % 100.0 % 100.0 %
Cost of sales ........................ 78.6 77.3 79.1 78.6
------ ------ ------ ------
Gross profit ......................... 21.4 22.7 20.9 21.4
Selling and distribution expenses .... 4.7 4.8 4.8 5.2
General and administration expenses .. 11.7 13.9 11.1 13.5
Royalty expenses ..................... 0.6 1.2 1.5 0.9
------ ------ ------ ------
Income from operations ............... 4.4 2.8 3.5 1.8
Interest expense ..................... (3.3) (2.5) (2.6) (2.2)
Interest Income ...................... 0.8 1.0 0.8 1.1
Interest in income of equity method
investee .......................... 0.1 0.4 0.1 0.4
Other income ......................... 0.2 0.3 0.1 0.2
Adjustment to fair value of
derivative ........................ (0.4) (0.0) (0.2) (0.0)
Other expense ........................ (0.7) (0.0) (0.3) (0.0)
Minority interest in consolidated
subsidiary ........................ 0.0 0.0 0.0 0.0
------ ------ ------ ------
Income before taxes .................. 1.1 2.0 1.4 1.3
Income taxes ......................... 0.1 0.3 0.2 0.5
------ ------ ------ ------
Net income ........................... 1.0 % 1.7 % 1.2 % 0.8 %
====== ====== ====== ======
SECOND QUARTER 2006 COMPARED TO SECOND QUARTER 2005
Net sales increased by $8.5 million, or 16.9%, to $59.1 million in the
second quarter of 2006 from $50.5 million in the second quarter of 2005. Sales
of private label in the second quarter of 2006 were $47.6 million compared to
$39.1 million in the same period of 2005, with the increase resulting primarily
from increased sales to Kohl's, Charlotte Russe and Mothers Work and offset by
decreased sales to Lerner. Sales of private brands in the second quarter of 2006
were $11.4 million compared to $11.4 million in the same period of 2005.
Gross profit consists of net sales less product costs, direct labor,
manufacturing overhead, duty, quota, freight in, brokerage, and warehousing.
Gross profit increased by $1.2 million to $12.7 million in the second quarter of
2006 from $11.5 million in the second quarter of 2005. The increase in gross
profit occurred primarily because of an increase in sales. As a percentage of
net sales, gross profit decreased from 22.7% in the second quarter of 2005 to
21.4% in the second quarter of 2006. The decrease in gross margin is primarily
attributable to lower margins in private brands business in the second quarter
of 2006 as compared to the same period of 2005.
Selling and distribution expenses increased by $394,000, or 16.4%, to
$2.8 million in the second quarter of 2006 from $2.4 million in the second
quarter of 2005. As a percentage of net sales, these expenses decreased to 4.7%
in the second quarter of 2006 from 4.8% in the second quarter of 2005 due to
increased sales during the second quarter of 2006.
General and administrative expenses decreased by $113,000, or 1.6%, to
$6.9 million in the second quarter of 2006 from $7.0 million in the second
quarter of 2005. As a percentage of net sales, these expenses decreased to 11.7%
in the second quarter of 2006 from 13.9% in the second quarter of 2005 due to
increased sales during the second quarter of 2006. Included in the general and
administrative expenses in the second quarter of 2006 was $284,000 of expensing
the financing cost paid to the placement agent and the remaining value of the
warrants to placement agent and $171,000 of prepayment penalty paid to the
debenture holders as a result of the repayment of the Debentures.
Royalty and marketing allowance expenses decreased by $245,000, or
41.0%, to $353,000 in the second quarter of 2006 from $598,000 in the second
quarter of 2005. As a percentage of net sales, these expenses decreased to 0.6%
in the second quarter of 2006 from 1.2% in the second quarter of 2005.
27
Operating income in the second quarter of 2006 was $2.6 million, or
4.4% of net sales, compared to operating income of $1.4 million, or 2.8% of net
sales, in the comparable period of 2005, because of the factors discussed above.
Interest expense increased by $660,000, or 51.4%, to $1.9 million in
the second quarter of 2006 from $1.3 million in the second quarter of 2005. As a
percentage of net sales, this expense increased to 3.3% in the second quarter of
2006 from 2.5% in the second quarter of 2005. The increase was primarily due to
expensing $711,000 in the second quarter of 2006 of debt discount related to the
intrinsic value of the conversion option of Debentures and the remaining value
of the warrants to holders of Debentures as a result of the repayment of the
Debentures in June 2006. Interest income decreased by $36,000, or 6.9%, to
$481,000 in the second quarter of 2006 from $517,000 in the second quarter of
2005. Other income was $91,000 in the second quarter of 2006, compared to
$175,000 in the second quarter of 2005. Adjustment to fair value of derivative
was $218,000 in the second quarter of 2006, compared to $0 in the second quarter
of 2005. Other expense was $400,000 in the second quarter of 2006, compared to
$(5,000) in the second quarter of 2005.
Income allocated to minority interests in the second quarter of 2006
were $7,000, representing the minority partner's share of profit in PBG7. None
of the losses in the equity method investments was allocated to the minority
members in the second quarter of 2005.
FIRST SIX MONTHS OF 2006 COMPARED TO FIRST SIX MONTHS OF 2005
Net sales increased by $25.0 million, or 26.2%, to $120.3 million in
the first six months of 2006 from $95.4 million in the first six months of 2005.
Sales of private label in the six months of 2006 were $89.7 million compared to
$72.6 million in the same period of 2005, with the increase resulting primarily
from increased sales to Kohl's, Charlotte Russe, Chico's, Mervyn's and Mothers
Work and offset by decreased sales to Lerner. Sales of private brands in the six
months of 2006 were $30.6 million compared to $22.8 million in the same period
of 2005.
Gross profit increased by $4.8 million to $25.2 million in the first
six months of 2006 from $20.4 million in the first six months of 2005. The
increase in gross profit occurred primarily because of an increase in sales. As
a percentage of net sales, gross profit decreased from 21.4% in the first six
months of 2005 to 20.9% in the first six months of 2006. The decrease in gross
margin is primarily attributable to lower margins in private brands business in
the six months of 2006 as compared to the same period of 2005.
Selling and distribution expenses increased by $762,000, or 15.3%, to
$5.7 million in the first six months of 2006 from $5.0 million in the first six
months of 2005. As a percentage of net sales, these expenses decreased from 5.2%
for the first six months of 2005 to 4.8% for the first six months of 2006 due to
increased sales during the six months of 2006.
General and administrative expenses increased by $492,000, or 3.8%, to
$13.4 million in the first six months of 2006 from $12.9 million in the first
six months of 2005. As a percentage of net sales, these expenses decreased to
11.1% in the six months of 2006 from 13.5% in the six months of 2005 due to
increased sales during the six months 2006. Included in the general and
administrative expenses in the six months of 2006 was $284,000 of expensing the
financing cost paid to the placement agent and the remaining value of the
warrants to placement agent and $171,000 of prepayment penalty paid to the
debenture holders as a result of the repayment of the Debentures.
Royalty and marketing allowance expenses increased by $943,000, or
105.6%, to $1.8 million in the six months of 2006 from $893,000 in the six
months of 2005. As a percentage of net sales, these expenses increased to 1.5%
in the six months of 2006 from 0.9% in the six months of 2005.
Operating income for the first six months of 2006 was $4.3 million, or
3.5% of net sales, compared to operating income of $1.7 million, or 1.8% of net
sales, in the comparable prior period of 2005 as a result of the factors
discussed above.
Interest expense increased by $1 million or 49.3%, to $3.1 million in
the six months of 2006 from $2.1 million in the six months of 2005. As a
percentage of net sales, this expense increased to 2.6% in the six months of
2006 from 2.2% in the six months of 2005. The increase was primarily due to
expensing $711,000 in the six months of 2006
28
of debt discount related to the intrinsic value of the conversion option of
Debentures and the remaining value of the warrants to holders of Debentures as a
result of the repayment of the Debentures in June 2006. Interest income
decreased by $104,000 or 9.7% of net sales, to $966,000 in the six months of
2006 from $1.1 million in the six months of 2005. Other income was $124,000 in
the six months of 2006, compared to $239,000 in the six months of 2005.
Adjustment to fair value of derivative was $218,000 in the six months of 2006,
compared to $0 in the six months of 2005. Other expense was $400,000 in the six
months of 2006, compared to $0 in the six months of 2005.
Losses allocated to minority interests in the six months of 2006 were
$4,000, representing the minority partner's share of losses in PBG7. None of the
losses in the equity method investments was allocated to the minority members in
the six months of 2005.
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.
Cash flows for the six months ended June 30, 2006 and 2005 were as
follows (dollars in thousands):
CASH FLOWS: 2006 2005
---------- ----------
Net cash (used in) operating activities......... $ (2,401) $ (16,422)
Net cash provided by investing activities....... $ 703 $ 3,014
Net cash provided by financing activities....... $ 1,748 $ 13,373
During the first six months of 2006, net cash used in operating
activities was $2.4 million, as compared to net cash used in operating
activities of $16.4 million for the same period in 2005. Net cash used in
operating activities in the first six months of 2006 resulted primarily from an
increase of $5.8 million in accounts receivable and a decrease of $12.3 million
in accounts payable, partially offset by income of $1.8 million and depreciation
and amortization expense of $1.8 million and a decrease in inventory of $11.4
million. The increase in accounts receivable and decrease in inventory was
primarily due to the increase in sales in the first six months of 2006, and the
decrease in accounts payable resulted from the pay down of payables.
29
During the first six months of 2006, net cash provided by investing
activities was $703,000, as compared to net cash provided by investing
activities of $3.0 million for the same period in 2005. Net cash provided by
investing activities in the first six months of 2006 resulted primarily from
approximately $652,000 of collection on notes receivable.
During the first six months of 2006, net cash provided by financing
activities was $1.7 million, as compared to net cash provided by financing
activities of $13.4 million for the same period in 2005. Net cash provided by
financing activities in the first six months of 2006 resulted primarily from
$1.3 million net repayments of our short-term bank borrowings and financing of
$15.5 million under our credit facility with Guggenheim, offset by repayments of
borrowings from convertible debentures of $6.9 million.
CONTRACTUAL OBLIGATIONS AND COMMITMENTS
Following is a summary of our contractual obligations and commercial
commitments available to us as of June 30, 2006 (in millions):
PAYMENTS DUE BY PERIOD
----------------------------------------------- ---------
CONTRACTUAL OBLIGATIONS Total Less than Between Between After
1 year 2-3 years 4-5 years 5 years
--------- --------- --------- --------- ---------
Long-term debt (1) .................... $ 60.2 $ 38.2 $ 3.8 $ 18.2 $ --
Operating leases ...................... 6.2 1.0 1.2 1.2 2.8
Minimum royalties ..................... 14.8 5.1 3.4 2.3 4.0
Purchase commitment ................... 45.4 7.9 10.0 10.0 17.5
--------- --------- --------- --------- ---------
Total Contractual Cash Obligations .... $ 126.6 $ 52.2 $ 18.4 $ 31.7 $ 24.3
(1) Includes interest on long-term debt obligations. Based on
outstanding borrowings as of June 30, 2006, and assuming all
such indebtedness remained outstanding and the interest rates
remained unchanged, we estimate that our interest cost on
long-term debt would be approximately $11.3 million.
AMOUNT OF COMMITMENT EXPIRATION PER PERIOD
TOTAL ---------------------------------------------
AMOUNTS LESS
COMMERCIAL COMMITMENTS COMMITTED THAN BETWEEN BETWEEN AFTER
AVAILABLE TO US TO US 1 YEAR 2-3 YEARS 4-5 YEARS 5 YEARS
---------------------------------- --------- --------- --------- --------- ---------
Lines of credit .................. $ 80.0 $ 80.0 $ -- $ -- $ --
Letters of credit (within lines of
credit) ....................... $ 25.0 $ 25.0 $ -- $ -- $ --
Total commercial commitments ..... $ 80.0 $ 80.0 $ -- $ -- $ --
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 could arrange for the issuance of letters of credit and
acceptances. The facility was collateralized by the shares and debentures of all
of our subsidiaries in Hong Kong. In addition to the guarantees provided by us
and our subsidiaries, Fashion Resource (TCL) Inc. and Tarrant Luxembourg Sarl,
Gerard Guez, our Chairman and Interim Chief Executive Officer, also signed a
guarantee of $5 million in favor of UPS to secure this facility. Under this
facility, we were subject to certain restrictive covenants, including that we
maintain a specified tangible net worth, fixed charge ratio, and leverage ratio.
Additionally, Gerard Guez, our Chairman and Interim Chief Executive Officer,
pledged to UPS 4.6 million shares of our common stock held by Mr. Guez to secure
the obligations under the credit facility. On June 9, 2006, we completed the
pay-off of all remaining amounts due under the letter of credit facility with
UPS. As a result of the payment of these obligations, the letter of credit
facility was terminated and all collateral released. There was no prepayment
penalty under this arrangement. As of June 30, 2006, $0 was outstanding under
this facility with UPS.
On December 31, 2004, our Hong Kong subsidiaries entered into a 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 was
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 amended loan agreement, we were subject to restrictive financial
covenants of maintaining tangible net worth of $25 million at December 31, 2005
and the last day of each fiscal quarter thereafter. There was also a provision
capping maximum capital expenditure per quarter at $800,000. The obligations
under the loan agreement were collateralized by the
30
same security interests and guarantees provided under our letter of credit
facility with UPS. Additionally, the term loan was 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, our Chairman and Interim Chief Executive
Officer, of 4.6 million shares of our common stock. On June 9, 2006, we
completed the pay-off of all remaining amounts due under the term loan agreement
with UPS. As a result of the payment of these obligations, the term loan
agreement was terminated and all collateral released. There was no prepayment
penalty under this arrangement.
Since March 2003, DBS Bank (Hong Kong) Limited ("DBS") had 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 was a demand facility and
was secured by the pledge of our office property, which is owned by Gerard Guez,
our Chairman and Interim Chief Executive Officer, 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. In October 2005, a
tax loan for HKD 6.233 million (equivalent to US $804,000) was also made
available to our Hong Kong subsidiaries and bears interest at the rate equal to
the Hong Kong prime rate plus 1% and are subject to the same security. It bore
interest at 9.25% per annum at June 30, 2006. As of June 30, 2006, $276,000 was
outstanding under this tax loan.
In June 2006, our subsidiaries in Hong Kong, Tarrant Company Limited,
Marble Limited and Trade Link Holdings Limited, entered into a new credit
facility with DBS. Under this facility, we may arrange for letters of credit and
acceptances. The maximum amount our Hong Kong subsidiaries may borrow under this
facility at any time is US $25 million. The interest rate under the letter of
credit facility is equal to the Standard Bills Rate quoted by DBS minus 0.5% if
paid in Hong Kong Dollars, the interest rate was 8.75% per annum at June 30,
2006, or the Standard Bills Rate quoted by DBS plus 0.5% if paid in any other
currency, the interest rate was 8.71% per annum at June 30, 2006. This is a
demand facility and is secured by a security interest in all the assets of our
Hong Kong subsidiaries, by a pledge of our office property where our Hong Kong
office is located, which is owned by Gerard Guez, our Chairman and Interim Chief
Executive Officer, and Todd Kay, our Vice Chairman and by our guarantee. The DBS
facility includes customary default provisions. In addition, we are subject to
certain restrictive covenants, including that we maintain a specified tangible
net worth, and a minimum level of EBITDA at December 31, 2006, interest coverage
ratio, leverage ratio and limitations on additional indebtedness. As of June 30,
2006, $10.7 million was outstanding under this facility. In addition, $5.9
million of open letters of credit was outstanding and $8.4 million was available
for future borrowings as of June 30, 2006.
As of June 30, 2006, the total balance outstanding under the DBS credit
facilities was $11.0 million (classified above as follows: $4.2 million in
import trade bills payable, $3.3 million in bank direct acceptances and $3.5
million in other Hong Kong credit facilities).
On October 1, 2004, we amended and restated our previously existing
credit facility with GMAC Commercial Finance Credit, LLC ("GMAC CF") by entering
into a new factoring agreement with GMAC CF. 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 CF. Pursuant to the terms of the factoring agreement, we and
our subsidiaries agree to assign and sell to GMAC CF, as factor, all accounts
which arise from our sale of merchandise or rendition of service created on a
going forward basis. At our request, GMAC CF, in its discretion, may make
advances to us up to the lesser of (a) up to 90% of our accounts on which GMAC
CF has the risk of loss and (b) $40 million, minus in each case, any amount owed
by us to GMAC CF. In May 2005, we amended our factoring agreement with GMAC CF
to permit our subsidiaries party thereto and us, to borrow up to the lesser of
$3 million or 50% of the value of eligible inventory. In connection with this
amendment, we granted GMAC CF a lien on certain of our inventory located in the
United States. On January 23, 2006, we further amended our factoring agreement
with GMAC CF to increase the amount we may borrow against inventory to the
lesser of $5 million or 50% of the value of eligible inventory. The $5 million
limit was reduced to $4 million on April 1, 2006.
On June 16, 2006, we expanded our credit facility with GMAC CF by
entering into a new Loan and Security Agreement and amending and restating our
previously existing Factoring Agreement with GMAC CF. UPS Capital Corporation is
also a lender under the Loan and Security Agreement. This is a revolving credit
facility and has a term of 3 years. The amount we may borrow under this credit
facility is determined by a percentage of eligible accounts receivable and
inventory, up to a maximum of $55 million, and includes a letter of credit
facility of up to $4 million. Interest on outstanding amounts under this credit
facility is payable monthly and accrues at the rate of the "prime rate" plus
0.5%. Our
31
obligations under the GMAC CF credit facility are secured by a lien on
substantially all our domestic assets, including a first priority lien on our
accounts receivable and inventory. This credit facility contains customary
financial covenants, including covenants that we maintain minimum levels of
EBITDA and interest coverage ratios and limitations on additional indebtedness.
This facility includes customary default provisions, and all outstanding
obligations may become immediately due and payable in the event of a default.
The facility bore interest at 8.75% per annum at June 30, 2006. As of June 30,
2006, we were in violation with the EBITDA covenant and a waiver was obtained
during the default. A total of $33.0 million was outstanding with respect to
receivables factored under the GMAC CF facility at June 30, 2006.
The credit facilities with GMAC CF and Guggenheim include cross-default
clauses subject to certain conditions. An event of default under the GMAC CF
facility would constitute an event of default under the Guggenheim facility
entitling Guggenheim to demand payment in full of all outstanding amounts under
its facility. An event of default under the Guggenheim facility, under
circumstances where Guggenheim has accelerated the debt or has exercised any
other remedy available to Guggenheim which constitutes a Lien Enforcement Action
under its Intercreditor Agreement with GMAC CF, would entitle GMAC CF to demand
payment in full of all outstanding amounts under its debt facilities.
The amount we can borrow under the factoring facility with GMAC CF 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.
On June 16, 2006, we entered into a Credit Agreement with certain
lenders and Guggenheim Corporate Funding LLC ("Guggenheim"), as administrative
agent and collateral agent for the lenders. This credit facility provides for
borrowings of up to $65 million. This facility consists of an initial term loan
of up to $25 million, of which we borrowed $15.5 million at the initial funding,
to be used to repay certain existing indebtedness and fund general operating and
working capital needs. An additional term loan of up to $40 million will be
available under this facility to finance acquisitions acceptable to Guggenheim.
All amounts under the term loans become due and payable in December 2010.
Interest under this facility is payable monthly, with the interest rate equal to
the LIBOR rate plus an applicable margin based on our debt leverage ratio (as
defined in the credit agreement). Our obligations under the Guggenheim credit
facility are secured by a lien on substantially all of our assets and our
domestic subsidiaries, including a pledge of the equity interests of our
domestic subsidiaries and 65% of our Luxembourg subsidiary. This credit facility
contains customary financial covenants, including covenants that we maintain
minimum levels of EBITDA and interest coverage ratios and limitations on
additional indebtedness.
In connection with Guggenheim credit facility, on June 16, 2006, we
issued the lenders under this facility warrants to purchase up to an aggregate
of 3,857,143 shares of our common stock. These warrants have a term of 10 years.
These warrants are exercisable at a price of $1.88 per share with respect to 20%
of the shares, $2.00 per share with respect to 20% of the shares, $3.00 per
share with respect to 20% of the shares, $3.75 per share with respect to 20% of
the shares and $4.50 per share with respect to 20% of the shares. The exercise
prices are subject to adjustment for certain dilutive issuances pursuant to the
terms of the warrants. 357,143 shares of the warrants will not become
exercisable unless and until a specified portion of the initial term loan is
actually funded by the lenders. The warrants were evaluated under SFAS No 133
and EITF 00-19 and determined to be a derivative instrument due to certain
registration rights. As such, the warrants excluding the ones not exercisable
were valued at $4.9 million using the Black-Scholes option valuation model with
the following assumptions: risk-free interest rate of 5.1%; dividend yields of
0%; volatility factors of the expected market price of our common stock of 0.70;
and contractual term of ten years. We also paid to Guggenheim 2.25% of the
committed principal amount of the loans which was $563,000 on June 16, 2006. The
$563,000 fee paid to Guggenheim is included in the deferred financing cost, and
the value of the warrants to purchase 3.5 million shares of our common stock of
$4.9 million is recorded as debt discount, both of them are amortized over the
life of the loan. As of June 30, 2006, $50,000 was amortized.
Durham Capital Corporation acted as our advisor in connection with the
Guggenheim credit facility. As compensation for its services, we agreed to pay
Durham Capital a cash fee in an amount equal to 1% of the committed principal
amount of the loans under the Guggenheim credit facility. As a result, $250,000
was paid on June 16, 2006. In addition, we issued Durham Capital a warrant to
purchase 77,143 shares of our common stock. This warrant has a term of
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10 years and is exercisable at price of $1.88 per share, subject to adjustment
for certain dilutive issuances. 7,143 shares of this warrant will not become
exercisable unless and until a specified portion of the initial term loan is
actually funded by the lenders. The warrants were evaluated under SFAS No 133
and EITF 00-19 and determined to be a derivative instrument due to certain
registration rights. As such, the warrants excluding the ones not exercisable
were valued at $105,000 using the Black-Scholes option valuation model with the
following assumptions: risk-free interest rate of 5.1%; dividend yields of 0%;
volatility factors of the expected market price of our common stock of 0.70; and
contractual term of ten years. The $250,000 paid to Durham Capital and the value
of the warrants to purchase 70,000 shares of our common stock of $105,000 was
included in the deferred financing cost, and is amortized over the life of the
loan. As of June 30, 2005, $3,000 was amortized.
The Guggenheim facility bore interest at 12.21% per annum at June 30,
2006. As of June 30, 2006, we were in violation with the EBITDA covenant and a
waiver was obtained during the default. A total of $10.7 million, net of $4.8
million of debt discount, was outstanding under this facility at June 30, 2006.
As of June 30, 2006, the warrants were being accounted for as a
liability pursuant to the provisions of SFAS No. 133 and Emerging Issues Task
Force (EITF) No. 00-19, "Accounting for Derivative Financial Instruments Indexed
to, and Potentially Settled in, a Company's Own Stock" ("EITF 00-19"). This is
because we granted the warrant holders certain registration rights that are
outside our control. In accordance with SFAS No. 133, the warrants are being
valued at each reporting period. Changes in fair value are recorded as
adjustment to fair value of derivative in the statements of operations. The
outstanding warrants were fair valued on June 16, 2006, the date of transaction,
at $4.9 million and we, in accordance with SFAS 133, revaluated the warrants on
June 30, 2006 at the closing stock price on June 30, 2006 to $5.2 million; as a
result, an expense of $218,000 was recorded as an adjustment to fair value of
derivative on our consolidated statements of operations. On August 11, 2006, we
amended the registration rights relating to the warrants. As a result, the
warrants will be reclassified to equity in accordance with EITF 00-19 in the
third quarter of 2006.
On December 14, 2004, we completed a $10 million financing through the
issuance of (i) 6% Secured Convertible Debentures and (ii) warrants to purchase
up to 1,250,000 shares of our common stock. Prior to maturity, the investors may
convert the convertible 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 convertible
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 convertible 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 convertible debentures contain
customary events of default and permit the holder 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 convertible debentures
are secured by a subordinated lien on certain of our accounts receivable and
related assets. The closing market price of our common stock on the closing date
of the financing was $1.96. The convertible debentures were 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 was 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
at December 31, 2004.
The placement agent in the financing, received compensation for its
services in the amount of $620,000 in cash and issuance of five year warrants to
purchase up to 200,000 shares of our common stock at an exercise price of $2.50
per share. The warrants to purchase 200,000 shares of our common stock 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 financing cost paid to the placement agent
of $620,000, and the value of the warrants to purchase 200,000 shares of our
common stock of $138,000 were included in the deferred financing cost, net on
our accompanying balance sheets and was amortized over the life of the loan.
In June 2005, holders of our convertible debentures converted an
aggregate of $2.3 million of convertible debentures into 1,133,687 shares of our
common stock. In August 2005, holders of our convertible debentures converted an
aggregate of $820,000 of Debentures into 410,000 shares of our common stock.
These convertible debentures were converted at the option of the holders at a
price of $2.00 per share. Debt discount of $248,000 related to the intrinsic
value of the conversion option of $804,000 was expensed upon the conversion. Of
the $620,000 financing cost paid to the placement agent, $191,000 was expensed
upon the conversion. The intrinsic value of the conversion option, and the value
of the warrant amortized in the first six months of 2006 was $237,000. Total
deferred financing cost amortized in the first six months of 2006 was $95,000.
Total interest paid to the holders of the convertible debentures in the first
six months of 2006 was $198,000. On June 26, 2006, we paid off the remaining
balance of the outstanding convertible debentures of $6.9 million plus all
accrued and unpaid interest and a prepayment penalty of $171,000. As a result of
the repayment, the
33
convertible debentures were terminated effective June 26, 2006. Upon paying off
the convertible debentures, debt discount of $278,000 related to the intrinsic
value of the conversion option of $804,000 was expensed, and of the $620,000
financing cost paid to the placement agent, $214,000 was expensed. The remaining
value of the warrants to holders of the convertible debentures of $433,000 and
warrants to the placement agent of $69,000 was also expensed.
On January 19, 2006, we borrowed $4.0 million from Max Azria pursuant
to the terms of a promissory note, which amount bears interest at the rate of
5.5% per annum and is payable in weekly installments of $200,000 beginning on
March 1, 2006. This is an unsecured loan. As of June 30, 2006, $403,000 was
outstanding under this loan.
We had three equipment loans outstanding at December 31, 2005. One of
these equipment loans bore interest at 6% payable in installments through 2009,
which we paid off in January 2006. The second loan bears interest at 15.8%
payable in installment through 2007 and the third loan bears interest at 6.15%
payable in installment through 2007. As of June 30, 2006, $30,000 was
outstanding under the two remaining loans.
From time to time, we open letters of credit under an uncommitted line
of credit from Aurora Capital Associates which issues these letters of credits
out of Israeli Discount Bank. As of June 30, 2006, $1.1 million was outstanding
under this facility (classified above under import trade bills payable) and $1.3
million of letters of credit were open under this arrangement. We pay a
commission fee of 2.25% on all letters of credits issued under this arrangement.
We have financed our operations from our cash flow from operations,
borrowings under our bank and other credit facilities, issuance of long-term
debt, and sales of equity and debt security. Our short-term funding relies very
heavily on our major customers, banks, and suppliers. From time to time, we have
had temporary over-advances from our banks. Any withdrawal of support from these
parties will have serious consequences on our liquidity.
From time to time in the past, we borrowed funds from, and advanced
funds to, certain officers and principal shareholders, including Gerard Guez and
Todd Kay. See disclosure under "-Related Party Transactions" below.
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. 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, to borrow additional funds under our bank
facilities 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 $7.7 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.
34
RELATED PARTY TRANSACTIONS
We lease our executive offices in Los Angeles, California from GET, a
corporation which is owned by Gerard Guez (our Chairman and Interim Chief
Executive Officer) and Todd Kay (our Vice Chairman), both of which are
significant shareholders. 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. We paid $538,000 and $510,000 in rent in the six
months ended June 30, 2006 and 2005, respectively, for office and warehouse
facilities. During the first six months of 2006, our Los Angeles offices and
warehouse was leased on a month to month basis. On August 1, 2006, we entered
into a lease agreement with GET for the Los Angeles offices and warehouse, which
lease has a term of five years with an option to renew for an additional five
year term. On January 1, 2006, we renewed our lease agreement with Lynx
International Limited for our office space in Hong Kong for one year.
On May 1, 2006, we sublet our executive office in Los Angeles,
California and our sales office in New York to Seven Licensing Company, LLC
("Seven Licensing") for a monthly payment of $25,000 on a month to month basis.
Seven Licensing is beneficially owned by Gerard Guez, our Chairman and Interim
Chief Executive Officer. We received $50,000 in rental income from this sublease
in the six months ended June 30, 2006.
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, 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, including the
equipment and facilities we previously leased to Mr. Nacif's affiliates in
October 2003, for an aggregate purchase price consisting of: a) $105,400 in cash
and $3,910,000 by delivery of unsecured promissory notes bearing interest at
5.5% per annum; and b) $40,204,000, by delivery of secured promissory notes
bearing interest at 4.5% per annum, maturing on December 31, 2005 and every year
thereafter until December 31, 2014. The secured promissory notes are payable in
partial or total amounts anytime prior to the maturity of each note. Included in
the $41.0 million notes receivable - related party on the accompanying balance
sheet as of June 30, 2006 was $1.3 million of Mexico value added taxes on the
real property component of this transaction. 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. We purchased $0 and $1.8 million
of fabric from Acabados y Terminados in the six months ended June 30, 2006 and
2005, respectively. Net amount due from these parties as of June 30, 2006 was
$437,000.
From time to time in the past, we borrowed funds from, and advanced
funds to, Mr. Guez. The greatest outstanding balance of such advances to Mr.
Guez in the second quarter of 2006 was approximately $2,255,000. At June 30,
2006, the entire balance due from Mr. Guez totaling $2.2 million is payable on
demand and has been shown as reductions to shareholders' equity in the
accompanying financial statements. All advances to Mr. Guez bore interest at the
rate of 7.75% during the period. Total interest paid by Mr. Guez was $87,000 and
$120,000 for the six months ended June 30, 2006 and 2005, respectively. Mr. Guez
paid expenses on our behalf of approximately $132,000 and $234,000 for the six
months ended June 30, 2006 and 2005, respectively, which amounts were applied to
reduce accrued interest and principal on Mr. Guez's loan. These amounts included
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.
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 our executive
officers or directors.
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"), a corporation owned by the brothers of Gerard Guez, our Chairman and
Interim Chief Executive Officer, called United Apparel Ventures, LLC. 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
made purchases from two related parties in Mexico, an affiliate of Azteca and
Tag-It Pacific, Inc.
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At June 30, 2006, Messrs. Guez and Kay beneficially owned 590,000 and
1,003,500 shares, respectively, of common stock of Tag-It Pacific, Inc.,
collectively representing approximately 8.7% of Tag-It Pacific's common stock.
Tag-It Pacific is a provider of brand identity programs to manufacturers and
retailers of apparel and accessories. Starting from 1998, Tag-It Pacific 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. Due to
the restructuring of our Mexico operations, Tag-It Pacific no longer manages our
trim and packaging requirements. We purchased $202,000 and $35,000 of trim
inventory from Tag-It in the six months ended June 30, 2006 and 2005,
respectively. We purchased $0 and $135,000 of finished goods and services from
Azteca and its affiliates in the six months ended June 30, 2006 and 2005,
respectively. Our sales of fabric and services to Azteca in the six months ended
June 30, 2006 and 2005 was $9,000 and $63,000, respectively. Pursuant to the
operating agreement for UAV, two and one half percent of gross sales of UAV were
paid to each of the members of UAV as management fees. Net amount due from these
related parties as of June 30, 2006 was $5.5 million.
We believe that 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.
36
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
FOREIGN CURRENCY RISK. Our earnings are affected by fluctuations in the
value of the U.S. dollar as compared to foreign currencies as a result of doing
business in foreign jurisdictions. As a result, we bear the risk of exchange
rate gains and losses that may result in the future. 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. We do not utilize derivative
financial instruments for trading or other speculative purposes. We actively
evaluate the creditworthiness of the financial institutions that are counter
parties to derivative financial instruments, and we do not expect any counter
parties to fail to meet their obligations.
INTEREST RATE RISK. Because our obligations under our various credit
agreements bear interest at floating rates, 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 4. CONTROLS AND PROCEDURES.
EVALUATION OF CONTROLS AND PROCEDURES
Members of the our 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 June 30, 2006, the end of the period covered by this
report. Members of the our management, including our Chief Executive Officer and
Chief Financial Officer, also conducted an evaluation of our internal control
over financial reporting to determine whether any changes occurred during the
further quarter of 2006 that have materially affected, or are reasonably likely
to materially affect, our internal control over financial reporting. 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 second quarter of
2006.
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PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
On or about April 6, 2006, we commenced an action against the licensor
of the Jessica Simpson brands (captioned TARRANT APPAREL GROUP V. CAMUTO
CONSULTING GROUP, INC., VCJS LLC, WITH YOU, INC. AND JESSICA SIMPSON) in the
Supreme Court of the State of New York, County of New York. The suit named
Camuto Consulting Group, Inc., VCJS LLC, With You, Inc. and Jessica Simpson as
defendants, and asserts that the defendants failed to provide promised support
in connection with our sublicense agreement for the Jessica Simpson brands. Our
complaint includes eight causes of action, including two seeking a declaration
that the sublicense agreement is exclusive and remains in full force and effect,
as well as claims for breach of contract by Camuto Consulting, breach of the
duty of good faith and fair dealing and fraudulent inducement against Camuto
Consulting, and a claim against With You, Inc. and Ms. Simpson that we are an
intended third party beneficiary of the licenses between those defendants and
Camuto Consulting. On or about April 26, 2006, Camuto Consulting served its
answer to our complaint and included a counterclaim against us for breach of the
sublicense agreement and alleging damages of no less than $100 million. Camuto
Consulting has also served a motion to dismiss our cause of action for
fraudulent inducement. On or about May 22, 2006, we served our reply to Camuto
Consulting's counterclaim. On or about April 17, 2006, Ms. Simpson served a
motion seeking dismissal of the cause of action asserted against her. On or
about May 10, 2006, we served our opposition to Ms. Simpson motion to dismiss.
We intend to continue to vigorously defend Camuto's counterclaim and vigorously
oppose Ms. Simpson's motion. On or about June 14, 2006, we served a cross-motion
seeking leave to amend our complaint to add Vincent Camuto as a defendant. Oral
arguments on the motions are scheduled For September 7, 2006. Discovery in the
matter has been underway since May 2006.
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 1A. RISK FACTORS.
This Quarterly Report on Form 10-Q contains forward-looking statements,
which are subject to a variety of risks and uncertainties. Our actual results
could differ materially from those anticipated in these forward-looking
statements as a result of various factors, including those set forth below.
RISKS RELATED TO OUR BUSINESS
WE DEPEND ON A GROUP OF KEY CUSTOMERS FOR A SIGNIFICANT PORTION OF OUR SALES. A
SIGNIFICANT ADVERSE CHANGE IN A CUSTOMER RELATIONSHIP OR IN A CUSTOMER'S
FINANCIAL POSITION COULD HARM OUR BUSINESS AND FINANCIAL CONDITION.
Four customers accounted for approximately 55% and 47% of our net sales
in first six months of 2006 and 2005, 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 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,
38
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
experience similar delays in the future especially during peak seasons.
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 affect our results of operations.
UNPREDICTABLE DELAYS AS THE RESULT OF INCREASED AND INTENSIFIED CUSTOMS
ACTIVITY.
U.S. Customs has stepped up efforts to scrutinize imports from Hong
Kong in order to verify all details of shipments under the OPA rules allowing
certain processes to be performed in China without shipping under China country
of origin documentation. Such "detentions" are unpredictable and cause serious
interruption of normally expected freight movement timetables.
THE OUTCOME OF LITIGATION IN WHICH WE ARE INVOLVED IS UNPREDICTABLE AND AN
ADVERSE DECISION IN ANY SUCH MATTER COULD HAVE A MATERIAL ADVERSE AFFECT ON OUR
FINANCIAL POSITION AND RESULTS OF OPERATIONS.
We are currently in litigation with the licensors of the Jessica
Simpson brands regarding our rights to sell apparel under these brands. See Part
II of this report, Item 1 "Legal Proceedings" for a detailed description of this
lawsuit. The licensor has filed a counterclaim against us seeking damage. These
claims may divert financial and management resources that would otherwise be
used to benefit our operations. Although we believe that we have meritorious
defenses to the claims made against us, and intend to contest the lawsuit
vigorously, no assurances can be given that the results of these matters will be
favorable to us. An adverse resolution of any of these lawsuits could have a
material adverse affect on our financial position and results of operations.
Additionally, we have incurred significant legal fees in this litigation, and
unless the case is settled, we will continue to incur additional legal fees in
increasing amounts as the case accelerates to trial.
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.
OUR OPERATING RESULTS MAY FLUCTUATE SIGNIFICANTLY.
We have experienced, and expect to continue to experience, substantial
variations in our net sales and operating results from quarter to quarter. We
believe that the factors which influence this variability of quarterly results
include the timing of our introduction of new product lines, the level of
consumer acceptance of each new product line, general economic and industry
conditions that affect consumer spending and retailer purchasing, the
availability of manufacturing capacity, the seasonality of the markets in which
we participate, the timing of trade shows, the product mix of customer orders,
the timing of the placement or cancellation of customer orders, the weather,
transportation delays, 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.
39
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 and equity securities, 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, safeguards and growth targets 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 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 or reducing tariffs. The elimination of quotas on World
Trade Organization member countries in 2005 has resulted in explosive growth in
textile imports from China, and subsequent safeguard measures including embargo
of certain China country of origin products. Actions taken to avoid these
measures caused disruption, and a negative impact on margins. Such disruption
may continue to affect us to some extent in the future.
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
40
their relationship with us at any time. To the extent we are not able to secure
or maintain relationships with independent contractors that are able to fulfill
our requirements, our business would be harmed.
We have initiated a factory compliance agreement with our suppliers,
and monitor our independent contractors' compliance with applicable labor laws,
but we do not control our contractors or their labor practices. The violation of
federal, state or foreign labor laws by one of the our contractors could result
in our being subject to fines and our goods that are manufactured in violation
of such laws being seized or their sale in interstate commerce being prohibited.
From time to time, we have been notified by federal, state or foreign
authorities that certain of our contractors are the subject of investigations or
have been found to have violated applicable labor laws. To date, we have not
been subject to any sanctions that, individually or in the aggregate, have had a
material adverse effect on our business, and we are not aware of any facts on
which any such sanctions could be based. There can be no assurance, however,
that in the future we will not be subject to sanctions as a result of violations
of applicable labor laws by our contractors, or that such sanctions will not
have a material adverse effect on our business and results of operations. In
addition, certain of our customers, 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 DEPENDENCE ON THIRD PARTIES FOR BRANDED APPAREL PRODUCTS REDUCES OUR ABILITY
TO CONTROL THE MARKETING PROCESS, WHICH COULD HARM OUR SALES, REPUTATION AND
OVERALL PROFITABILITY.
For certain branded apparel lines, in particular celebrity brands, we
depend on the cooperation and efforts of the celebrity personality and/or master
licensor to support our design and marketing efforts for apparel products. A
celebrity's failure to adequately support our marketing efforts could adversely
affect the sales for new products and lines. In addition, we are subject to the
terms of our agreements with the master licensor for licensed brands, and our
rights to exploit certain brands may therefore be limited. Further, we may, from
time to time, become involved in disputes with the master licensor with respect
to our contractual relationship. To the extent we are not able to receive
adequate support from the master licensor and/or celebrity or maintain good
working relationships with master licensors, our business would be harmed.
OUR BUSINESS IS SUBJECT TO RISKS OF OPERATING IN A FOREIGN COUNTRY AND TRADE
RESTRICTIONS.
Approximately 90% of our products were imported from outside the U.S.
in fiscal 2005. 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;
41
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.
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 $7.7 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 June 30, 2006, our executive officers and directors and their
affiliates owned approximately 43% of the outstanding shares of our common
stock. Gerard Guez, our Chairman and Interim Chief Executive Officer, and Todd
Kay, our Vice Chairman, alone own approximately 33.1% and 8.4%, respectively, of
the outstanding shares of our common stock at June 30, 2006. Accordingly, our
executive officers and directors have the ability to affect the
42
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.
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 Global Market, 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 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
On May 25, 2006, we held our 2006 Annual Meeting of Shareholders. At
the annual meeting, there were 30,543,763 shares entitled to vote, and
27,541,859 shares (90%) were represented at the meeting in person or by proxy.
Immediately prior to and following the meeting, the Board of Directors was
comprised of Gerard Guez, Todd Kay, Corazon Reyes, Joseph Mizrachi, Mitchell
Simbal, Milton Koffman, Stephane Farouze and Simon Mani.
The following summarizes vote results for those matters submitted to
our shareholders for action at the annual meeting:
43
1. Proposal to elect Gerard Guez, Todd Kay, Corazon Reyes, Joseph
Mizrachi and Simon Mani to serve as our Class I directors for two years and
until their successors has been elected.
DIRECTOR FOR WITHHELD
--------------- ---------- --------
Gerard Guez 26,558,670 983,189
Todd Kay 26,560,939 980,920
Corazon Reyes 26,560,870 980,989
Joseph Mizrachi 26,583,434 958,425
Simon Mani 26,584,927 956,932
2. Proposal to approve the 2006 Stock Incentive Plan, which
authorizes the issuance of up to 5,100,000 shares of common stock pursuant to
awards granted under the plan.
FOR AGAINST ABSTAIN BROKER NON-VOTES
---------- --------- ------- ----------------
10,488,647 1,893,689 9,885 15,149,638
3. Proposal to ratify the appointment of Singer Lewak Greenbaum &
Goldstein LLP as the Company's independent public accountants for the year ended
December 31, 2006.
FOR AGAINST ABSTAIN BROKER NON-VOTES
---------- --------- ------- ----------------
27,513,954 12,576 15,329 0
ITEM 6. EXHIBITS.
EXHIBIT
NUMBER DESCRIPTION
------- -----------------------------------------------------------------------
10.35 Debenture, dated June 9, 2006, by and among Tarrant Company Limited,
Trade Link Holdings Limited and Marble Limited and DBS Bank (Hong Kong)
Limited.
10.36 Form of Guaranty and Indemnity of Tarrant Apparel Group in favor of DBS
Bank (Hong Kong) Limited.
10.37 Loan and Security Agreement, dated June 16, 2006, by and among GMAC
Commercial Finance LLC, the Lenders signatory thereto, Tarrant Apparel
Group, Fashion Resource (TCL), Inc., Tag Mex, Inc., United Apparel
Ventures, LLC, Private Brands, Inc., and NO! Jeans, Inc.
10.38 Amended and Restated Factoring Agreement, dated June 16, 2006, GMAC
Commercial Finance LLC and Tarrant Apparel Group, Fashion Resource
(TCL), Inc., Tag Mex, Inc., United Apparel Ventures, LLC, Private
Brands, Inc., and NO! Jeans, Inc.
10.39 Credit Agreement, dated June 16, 2006, by and among Tarrant Apparel
Group, Fashion Resource (TCL), Inc., Tag Mex, Inc., United Apparel
Ventures, LLC, Private Brands, Inc. and NO! Jeans, Inc., the Guarantor
a party thereto, the Lenders a party thereto and Guggenheim Corporate
Funding, LLC.
10.40 Security Agreement, dated June 16, 2006, by and among Tarrant Apparel
Group, the other Credit Parties and Guggenheim Corporate Funding, LLC.
10.41 Pledge Agreement, dated June 16, 2006, by and among Tarrant Apparel
Group, the other Pledgors party thereto and Guggenheim Corporate
Funding, LLC.
10.42 Warrants Purchase Agreement dated June 16, 2006, by and among Tarrant
Apparel Group, Orpheus Holdings, LLC, North American Company for Life
and Health Insurance, Midland National Life Insurance Company and
Durham Capital Corporation. (1)
44
10.43 Registration Rights Agreement, dated as of June 16, 2006, by and among
Tarrant Apparel Group, Orpheus Holdings, LLC, North American Company
for Life and Health Insurance, Midland National Life Insurance Company
and Durham Capital Corporation. (1)
10.44 Form of Warrants to Purchase Common Stock issued June 16, 2006. (1)
10.45 Warrant dated June 16, 2006, issued by the Registrant to Durham Capital
Corporation. (1)
10.46 Tarrant Apparel Group 2006 Stock Incentive Plan.*
10.47 Commercial Lease, dated August 1, 2006, between Tarrant Apparel Group
and GET.
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.
--------------------------------------------------------------------------------
* Management contract or compensatory plan or arrangement.
(1) Incorporated by reference to our Registration Statement on
Form S-3 filed on August 10, 2006.
45
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
TARRANT APPAREL GROUP
Date: August 14, 2006 By: /s/ Corazon Reyes
-------------------------------
Corazon Reyes,
Chief Financial Officer
Date: August 14, 2006 By: /s/ Gerard Guez
-------------------------------
Gerard Guez,
Interim Chief Executive Officer
46