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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 MARCH 31, 2008
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, a non-accelerated filer, or a smaller reporting
company. See the definitions of "large accelerated filer," "accelerated filer,"
and "smaller reporting company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer [_] Accelerated filer [_] Non-accelerated filer [_]
Smaller reporting company [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
May 9, 2008: 32,043,763.
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TARRANT APPAREL GROUP
FORM 10-Q
INDEX
PART I. FINANCIAL INFORMATION
PAGE
----
Item 1. Financial Statements
CONSOLIDATED BALANCE SHEETS at March 31, 2008 (unaudited)
and December 31, 2007......................................... 2
CONSOLIDATED STATEMENTS OF OPERATIONS for the Three Months
Ended March 31, 2008 and March 31, 2007 (unaudited)........... 3
CONSOLIDATED STATEMENTS OF CASH FLOWS for the Three Months
Ended March 31, 2008 and March 31, 2007 (unaudited)........... 4
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited)........... 5
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS .................................... 21
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK ...... 32
Item 4. CONTROLS AND PROCEDURES.......................................... 32
PART II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS................................................ 34
Item 1A. RISK FACTORS..................................................... 34
Item 6. Exhibits......................................................... 36
SIGNATURES....................................................... 37
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
MARCH 31, DECEMBER 31,
2008 2007
------------- -------------
(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents ..................................... $ 2,165,398 $ 491,416
Marketable securities ......................................... 567,786 --
Accounts receivable, net of $927,000 and $2.0 million allowance
for returns, discounts and bad debts at March 31, 2008 and
December 31, 2007, respectively ............................ 36,889,962 34,622,119
Due from related parties ...................................... 7,702,523 6,812,951
Inventory ..................................................... 7,499,801 13,140,598
Temporary quota rights ........................................ 56,916 5,028
Prepaid expenses .............................................. 1,192,528 1,277,361
Deferred tax assets ........................................... 196,969 161,818
------------- -------------
Total current assets ............................................. 56,271,883 56,511,291
Property and equipment, net of $8.3 million accumulated
depreciation at March 31, 2008 and December 31, 2007 .......... 1,358,304 1,531,322
Due from related parties, net of $1.0 million reserve and $0.8
million adjustment to fair value at March 31, 2008 and
December 31, 2007 ............................................. 1,710,837 1,740,707
Equity method investment ......................................... 921,948 945,342
Deferred financing cost, net of $263,000 and $226,000 accumulated
amortization at March 31, 2008 and December 31, 2007,
respectively .................................................. 177,211 213,876
Other assets ..................................................... 101,692 101,692
Goodwill, net .................................................... 9,945,005 9,945,005
------------- -------------
Total assets ..................................................... $ 70,486,880 $ 70,989,235
============= =============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Short-term bank borrowings .................................... $ 8,792,252 $ 9,745,218
Accounts payable .............................................. 8,571,495 11,784,534
Accrued expenses .............................................. 8,241,242 8,627,445
Income taxes .................................................. 5,532,801 16,525,237
Current portion of long-term obligations and factoring
arrangement ................................................. 11,072,150 3,003,131
------------- -------------
Total current liabilities ........................................ 42,209,940 49,685,565
Other long-term obligations ...................................... -- --
Income taxes ..................................................... 7,018,568 --
------------- -------------
Total liabilities ................................................ 49,228,508 49,685,565
Minority interest in PBG7 ........................................ 60,403 60,520
Commitments and contingencies
Shareholders' equity:
Preferred stock, 2,000,000 shares authorized; no shares at
March 31, 2008 and December 31, 2007 issued and outstanding -- --
Common stock, no par value, 100,000,000 shares authorized;
32,043,763 shares at March 31, 2008 and December 31, 2007
issued and outstanding ..................................... 116,672,465 116,672,465
Warrants to purchase common stock ............................. 7,314,239 7,314,239
Contributed capital ........................................... 10,993,336 10,862,902
Accumulated deficit ........................................... (111,916,139) (111,662,856)
Notes receivable from officer/shareholder ..................... (1,865,932) (1,943,600)
------------- -------------
Total shareholders' equity ....................................... 21,197,969 21,243,150
------------- -------------
Total liabilities and shareholders' equity ....................... $ 70,486,880 $ 70,989,235
============= =============
The accompanying notes are an integral part of
these consolidated financial statements
2
TARRANT APPAREL GROUP
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
THREE MONTHS ENDED MARCH 31,
----------------------------
2008 2007
------------ ------------
Net sales .................................................. $ 46,321,716 $ 52,781,318
Net sales to related party ................................. 4,177,081 3,325,274
------------ ------------
Total net sales ............................................ 50,498,797 56,106,592
Cost of sales .............................................. 36,653,414 40,744,265
Cost of sales to related party ............................. 3,805,981 3,015,748
------------ ------------
Total cost of sales ........................................ 40,459,395 43,760,013
Gross profit ............................................... 10,039,402 12,346,579
Selling and distribution expenses .......................... 3,429,235 3,438,732
General and administrative expenses ........................ 6,318,617 6,486,596
Royalty expenses ........................................... 334,278 357,732
Terminated acquisition expenses ............................ -- 2,000,000
------------ ------------
Income (loss) from operations .............................. (42,728) 63,519
Interest expense ........................................... (230,662) (1,343,325)
Interest income ............................................ 39,922 45,100
Interest in income (loss) of equity method investee ........ (23,394) 83,749
Other income ............................................... 181,256 87,651
Adjustment to fair value of derivative ..................... -- 195,429
Other expense .............................................. (63,752) (1,805)
------------ ------------
Loss before provision for income taxes and minority interest (139,358) (869,682)
Provision for income taxes ................................. 114,043 132,167
Minority interest .......................................... (118) (929)
------------ ------------
Net loss ................................................... $ (253,283) $ (1,000,920)
============ ============
Net loss per share - Basic and Diluted ..................... $ (0.01) $ (0.03)
============ ============
Weighted average common and common equivalent shares
outstanding:
Basic and Diluted ....................................... 32,043,763 30,543,763
============ ============
The accompanying notes are an integral part of
these consolidated financial statements
3
TARRANT APPAREL GROUP
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
THREE MONTHS ENDED MARCH 31,
----------------------------
2008 2007
------------ ------------
Operating activities:
Net loss .................................................. $ (253,283) $ (1,000,920)
Adjustments to reconcile net loss to net cash provided by
(used in)
Operating activities:
Deferred taxes ......................................... (35,150) (2,736)
Depreciation and amortization of fixed assets .......... 87,612 91,697
Amortization of deferred financing cost ................ 36,664 493,518
Adjustment to fair value of derivative ................. -- (195,429)
Terminated acquisition expenses ........................ -- 2,000,000
Change in the provision for returns and discounts ...... (498,412) 290,593
Change in the provision for bad debts .................. (552,011) 1,594
Loss on sale of fixed assets ........................... 63,752 1,805
Loss (income) from equity method investment ............ 23,394 (83,749)
Gain on sale of marketable securities .................. (40,245) --
Unrealized gain on marketable securities ............... (65,429) --
Minority interest ...................................... (118) (929)
Stock-based compensation ............................... 130,434 176,000
Changes in operating assets and liabilities:
Accounts receivable .................................. (1,217,420) 4,268,442
Due from related parties ............................. (859,703) (288,450)
Inventory ............................................ 5,640,796 3,194,344
Temporary quota rights ............................... (51,888) (143,412)
Prepaid expenses ..................................... 84,833 (60,213)
Accounts payable ..................................... (3,213,039) (8,094,842)
Accrued expenses and income tax payable .............. (4,360,071) 1,153,051
------------ ------------
Net cash provided by (used in) operating activities .. (5,079,284) 1,800,364
Investing activities:
Purchase of marketable securities ...................... (586,470) --
Proceeds from sale of marketable securities ............ 124,358 --
Purchase of fixed assets ............................... (31,634) (88,543)
Proceeds from sale of fixed assets ..................... 53,290 --
Due diligence fees in acquisition ...................... -- (699,764)
Collection of advances from shareholders/officers ...... 77,668 64,173
------------ ------------
Net cash used in investing activities ................ (362,788) (724,134)
Financing activities:
Short-term bank borrowings, net ........................ (952,966) (953,635)
Proceeds from long-term obligations .................... 52,109,470 52,338,394
Payment of long-term obligations and bank borrowings ... (44,040,450) (51,902,343)
------------ ------------
Net cash provided by (used in) financing activities .. 7,116,054 (517,584)
------------ ------------
Increase in cash and cash equivalents ..................... 1,673,982 558,646
Cash and cash equivalents at beginning of period .......... 491,416 904,553
------------ ------------
Cash and cash equivalents at end of period ................ $ 2,165,398 $ 1,463,199
============ ============
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
March 31, 2008, we own 75% of PBG7, LLC ("PBG7"). We previously owned 50.1% of
United Apparel Ventures, LLC ("UAV"), which was dissolved on February 27, 2007.
The dissolution of UAV did not have a material impact on our consolidated
financial statements. 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 was 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 mass merchandisers, department stores, branded wholesalers and
specialty chains and by designing, merchandising, contracting for the
manufacture of, and selling casual apparel for women, men and children under
private label and private brands.
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 generally accepted accounting principles 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, 2007 is derived from
audited financial statements which are included in our Annual Report on Form
10-K for the year ended December 31, 2007, 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.
The preparation of financial statements in conformity with US GAAP
requires management to make estimates and assumptions that affect the amounts
reported in the financial statements and accompanying notes. Significant
estimates used by us in preparation of the consolidated financial statements
include allowance for returns, discounts and bad debts, inventory, notes
receivable - related parties reserve, valuation of long-lived and intangible
assets and goodwill, accrued expenses, income taxes, stock options valuation,
contingencies and litigation. Actual results could differ from those estimates.
5
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
MARKETABLE SECURITIES
In January 2008, we invested $586,000 in marketable securities which
are classified as trading marketable securities in the consolidated balance
sheet at March 31, 2008. During the three months ended March 31, 2008, we sold
some of the investments in marketable securities. Proceeds on the sale were
$124,000 and the gain of $40,000 was reported in other income in the
consolidated statements of operations. As of March 31, 2008, the unrealized gain
on investment in marketable securities of $65,000 was recorded in other income
in the consolidated statements of operations.
LICENSE AGREEMENTS AND ROYALTY EXPENSES
We enter into license agreements from time to time that allow us to use
certain trademarks and trade names on certain of our products. These agreements
require us to pay royalties, generally based on the sales of such products, and
may require guaranteed minimum royalties, a portion of which may be paid in
advance. Our accounting policy is to match royalty expense with revenue by
recording royalties at the time of sale at the greater of the contractual rate
or an effective rate calculated based on the guaranteed minimum royalty and our
estimate of sales during the contract period. If a portion of the guaranteed
minimum royalty is determined not to be recoverable, the unrecoverable portion
is charged to expense at that time. See Note 14 of the "Notes to Consolidated
Financial Statements" regarding various agreements we have entered into.
Royalty expense in the three months ended March 31, 2008 and 2007 was
$334,000 and $358,000, respectively.
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 March 31, 2008 and December 31, 2007, deferred rent of $273,000 and $260,000,
respectively, was recorded under accrued expense in our consolidated financial
statements.
DERIVATIVE ACTIVITIES
WARRANT DERIVATIVES
Statement 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
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.
FOREIGN CURRENCY FORWARD CONTRACT
We source our product in a number of countries throughout the world, as
a result, are exposed to movements in foreign currency exchange rates. The
primary purpose of our foreign currency hedging activities is to manage the
volatility associated with foreign currency purchases of materials in the normal
course of business. We utilize derivative financial instruments consisting
primarily of forward currency contracts. These instruments are intended to
protect against exposure related to financing transactions and income from
international operations. We do not enter into derivative financial instruments
for speculative or trading purposes. We may enter into certain foreign currency
derivative instruments that do not meet hedge accounting criteria.
SFAS No. 133 requires measurement of certain derivative instruments at
their fair value for accounting purposes. All derivative instruments are
recorded on our balance sheet at fair value; as a result, we mark to market all
6
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
derivative instruments. 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. During 2006, we entered into foreign currency forward contracts
to hedge against the effect of exchange rate fluctuations on cash flows
denominated in foreign currencies and certain inter-company financing
transactions. Hedge ineffectiveness resulted in a gain of $195,000 in our
consolidated statements of operations in the three months ended March 31, 2007.
At March 31, 2008, we had no open foreign exchange forward contracts.
ACCOUNTING FOR UNCERTAIN TAX POSITIONS
In June 2006, the FASB issued Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109." FIN
48 clarifies the accounting for uncertainty in income taxes recognized in an
enterprise's financial statements in accordance with SFAS 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. We adopted the provisions of FIN 48 on
January 1, 2007. As a result of the implementation of FIN 48, we recognized no
material adjustment for unrecognized tax benefits but reduced retained earnings
as of January 1, 2007 by approximately $1 million attributable to penalties
accrued as a component of income tax payable. As of the date of adoption, our
unrecognized tax benefits totaled approximately $8.9 million. There was no
unrecognized tax benefit as of March 31, 2008 and December 31, 2007. As of March
31, 2008, the accrued interest and penalties were $7.3 million and $142,000,
respectively. As of December 31, 2007, the accrued interest and penalties were
$7.2 million and $142,000, respectively. See Note 11 of the "Notes to
Consolidated Financial Statements".
Certain 2008 amounts have been reclassified to conform to the 2007
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 March 31, 2008, there were outstanding options to purchase a
total of 1,041,000 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 the
Tarrant Apparel Group 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 March 31, 2008, there
were outstanding options to purchase a total of 1,763,000 shares of common
stock, and 1,837,000 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.
On January 1, 2006, we adopted SFAS No. 123 (revised 2004),
"Share-Based Payment," ("SFAS No. 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 No. 123(R)
supersedes our previous accounting under Accounting Principles Board Opinion
("APB") No. 25, "Accounting for Stock Issued to Employees" for periods beginning
in fiscal 2006. In March 2005, the Securities and Exchange Commission issued
Staff Accounting Bulletin ("SAB") No. 107 relating to SFAS No. 123(R). We have
applied the provisions of SAB No. 107 in its adoption of SFAS No. 123(R).
We adopted SFAS No. 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 three months ended March 31, 2008 and 2007 reflect the impact of
SFAS No. 123(R). SFAS No. 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.
7
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
A summary of our stock option activity and related information for the
year ended December 31, 2007 and the three months ended March 31, 2008 is as
follows:
EMPLOYEES
----------------------------
NUMBER OF EXERCISE
SHARES PRICE
---------- ------------
Options outstanding at December 31, 2006 ...... 7,673,659 $1.39-$45.50
Granted ....................................... 2,630,000 $1.13-$1.99
Exercised ..................................... (1,500,000) $ 1.13
Forfeited ..................................... (87,450) $1.63-$18.50
Expired ....................................... (502,000) $1.13-$8.50
---------- ------------
Options outstanding at December 31, 2007 ...... 8,214,209 $1.39-$45.50
Granted ....................................... -- --
Exercised ..................................... -- --
Forfeited ..................................... (10,000) $ 1.94
Expired ....................................... -- --
---------- ------------
Options outstanding at March 31, 2008 ......... 8,204,209 $1.39-$45.50
We had no stock options outstanding to non-employees as of December 31,
2007 and March 31, 2008.
The following table summarizes information about stock options
outstanding, expected to vest and exercisable as of December 31, 2007 and March
31, 2008:
WEIGHTED
AVERAGE
WEIGHTED REMAINING
AVERAGE CONTRACTUAL
NUMBER OF EXERCISE LIFE INTRINSIC
SHARES PRICE (YEARS) VALUE
--------- --------- --------- ---------
As of December 31, 2007
Employees - Outstanding .............. 8,214,209 $ 5.28 5.2 $ 0
Employees - Expected to vest ......... 8,078,438 $ 5.34 5.2 $ 0
Employees - Exercisable .............. 6,748,015 $ 6.01 4.5 $ 0
As of March 31, 2008:
Employees - Outstanding .............. 8,204,209 $ 5.28 5.0 $ 0
Employees - Expected to vest ......... 8,078,063 $ 5.34 4.9 $ 0
Employees - Exercisable .............. 7,013,015 $ 5.86 4.4 $ 0
The following table summarizes our non-vested options as of December
31, 2007 and changes during the three months ended March 31, 2008:
WEIGHTED
AVERAGE
NUMBER OF GRANT-DATE
NON-VESTED OPTIONS SHARES FAIR VALUE
--------------------------------------------------- ---------- ----------
Non-vested at December 31, 2007 ................... 1,466,194 $ 1.28
Granted ......................................... -- --
Vested .......................................... (275,000) $ 1.27
Forfeited ....................................... -- --
----------
Non-vested at March 31, 2008 ...................... 1,191,194 $ 1.28
8
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
The following table shows the fair value of each option granted to
employees and directors estimated on the date of grant using the Black-Scholes
model with the following weighted average assumptions used for grants in the
three months ended March 31, 2008 and 2007:
THREE MONTHS ENDED MARCH 30,
----------------------------
2008 2007
---- ----
Expected dividend.......................... n/a 0.0%
Risk free interest rate.................... n/a 4.49 to 4.67%
Expected volatility........................ n/a 70%
Expected term (in years)................... n/a 5.75 to 6.18
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 ended March
31, 2008 and 2007 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 No. 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. As
stock-based compensation expense recognized in the consolidated statements of
operations for the three months ended March 31, 2008 and 2007 is based on awards
ultimately expected to vest, it has been reduced for estimated forfeitures,
which we estimate to be 7.7%. SFAS No. 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.
Our determination of fair value of share-based payment awards to
employees and directors on the date of grant using the Black-Scholes model 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 the expected terms using the "safe harbor" provisions
provided in SAB No. 107 and the volatility using historical data. We did not
grant any options to purchase shares of common stock for the three months ended
March 31, 2008. We granted options to purchase 630,000 shares of common stock in
the three months ended March 31, 2007. The options granted were fair valued in
the aggregate at $805,000 and had a weighted-average exercise of $1.92 in the
three months ended March 31, 2007. The stock-based compensation expense related
to employees or director stock options recognized for the three months ended
March 31, 2008 was $130,000, of which $37,000 was recorded under general and
administrative expenses and $93,000 was recorded under selling and distribution
expenses in our consolidated statements of operation. The stock-based
compensation expense related to employees or director stock options recognized
for the three months ended March 31, 2007 was $176,000, of which $42,000 was
recorded under general and administrative expenses and $134,000 was recorded
under selling and distribution expenses in our consolidated statements of
operation. Basic and dilutive income per share for the three months ended March
31, 2007 was not materially affected by the additional stock-based compensation
recognized. Basic and dilutive earnings per share for the three months ended
March 31, 2008 was decreased by $0.01 from $(0.00) to $(0.01) by the additional
stock-based compensation recognized.
The total intrinsic value of options exercised for the three months
March 31, 2008 and 2007 was $0. Cash received from stock options exercised for
the three months ended March 31, 2008 and 2007 was $0. The total fair value of
shares vested for the three months ended March 31, 2008 and 2007 were
approximately $350,000 and $156,000, respectively.
As of March 31, 2008, there was $1.3 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 2.3 years.
9
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
When options are exercised, our policy is to issue previously unissued
shares of common stock to satisfy share option exercises. As of March 31, 2008,
we had 68.0 million shares of authorized, unissued shares of common stock.
4. Accounts Receivable
Accounts receivable consists of the following:
MARCH 31, DECEMBER 31,
2008 2007
------------ ------------
U.S. trade accounts receivable ................. $ 2,272,820 $ 4,277,218
Foreign trade accounts receivable .............. 6,610,274 6,809,971
Factored accounts receivable ................... 28,504,463 25,294,525
Other receivables .............................. 429,259 217,681
Allowance for returns, discounts and bad debts.. (926,854) (1,977,276)
------------ ------------
$ 36,889,962 $ 34,622,119
============ ============
5. INVENTORY
Inventory consists of the following:
MARCH 31, DECEMBER 31,
2008 2007
------------ ------------
Raw materials - fabric and trim accessories .... $ 589,717 $ 558,996
Work in process ................................ 95 5,040
Finished goods shipments-in-transit ............ 2,119,665 7,023,981
Finished goods ................................. 4,790,324 5,552,581
------------ ------------
$ 7,499,801 $ 13,140,598
============ ============
6. EQUITY METHOD INVESTMENT - AMERICAN RAG
In 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 advance in
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. If a portion of
the guaranteed minimum royalty is determined not to be recoverable, the
unrecoverable portion is charged to expense at that time. The guaranteed annual
minimum royalty for 2008 is $875,000. At March 31, 2008, the total commitment on
royalties remaining on the term was $7.4 million. Private Brands also entered
into a multi-year exclusive distribution agreement with Macy's Merchandising
Group, LLC, the sourcing arm of Federated Department Stores, to supply Macy's
Merchandising Group 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 Macy's Merchandising
Group exclusively to Federated stores across the country. Beginning in August
2003, the American Rag collection was available in select Macy's locations and
is currently available in approximately 600 Macy's stores nationally. The
investment in American Rag Cie, LLC totaling $922,000 at March 31, 2008, is
accounted for under the equity method and included in equity method investment
in the accompanying consolidated balance sheets. Income (loss) from the equity
method investment is recorded in the United States geographical segment. The
change in investment in American Rag during the three month ended March 31, 2008
is as follows:
Balance as of December 31, 2007 .... $ 945,342
Share of loss........................ (23,394)
Distribution......................... --
-------------
Balance as of March 31, 2008........ $ 921,948
=============
10
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
We hold a 45% member interest in American Rag Cie, LLC. The remaining
55% belongs to an unrelated third party who contributed the American Rag
trademark and other assets and liabilities relating to two retail stores
operating under the name of "American Rag". Royalty income paid by us to
American Rag is classified as its other income and is ancillary to the primary
operations.
We have determined that we are not the primary beneficiary of American
Rag under FIN 46. There is no guaranteed return on our investment. We are not
involved in its day to day management decisions and it is effectively controlled
by its Chief Executive Officer who is also the majority shareholder of the 55%
owners. 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 or
(B) $675,000, which guarantee was re-affirmed in September 2007. Upon execution
of the guarantee, we re-evaluated our investment under the provisions of FIN 46
and concluded that consolidation under FIN 46 is still not appropriate. Our
variable interest will not absorb a majority of the VIE's expected losses. We
record its proportionate share of income and losses but are not obligated nor do
we intend to absorb losses beyond its 45% investment interest. Additionally, we
do not expect to receive a majority of the entity's expected residual returns,
other than their 45% ownership interest.
We are currently involved in litigation with American Rag Cie, LLC and
American Rag Cie II with respect to our license rights to the American Rag Cie
trademark. See Note 16 of the "Notes to Consolidated Financial Statements".
7. OTHER ASSETS AND WRITE OFF OF ACQUISITION EXPENSES
On December 6, 2006, we entered into a definitive stock and asset
purchase agreement (the "Purchase Agreement") to acquire certain assets and
entities comprising The Buffalo Group. The Buffalo Group designs, imports and
sells contemporary branded apparel and accessories, primarily in Canada and the
United States.
Pursuant to the Purchase Agreement, we and our subsidiaries agreed to
acquire (1) all the outstanding capital stock of four principal operating
subsidiaries of The Buffalo Group - Buffalo Inc., 3163946 Canada Inc., 3681441
Canada Inc. and Buffalo Corporation, and (2) certain assets, consisting
primarily of intellectual property rights and licenses, from The Buffalo Trust,
for a total aggregate purchase price of up to approximately $120 million. At
signing of the Purchase Agreement, we delivered $5.0 million to the sellers as a
deposit against the purchase price payable under the agreement.
On April 19, 2007, we entered into a Mutual Termination and Release
Agreement with The Buffalo Group, pursuant to which we and the other parties to
the Purchase Agreement mutually agreed to terminate the Purchase Agreement. The
parties determined that it was in the mutual best interest of each party to
terminate the proposed agreement. Under the terms of the Mutual Termination and
Release Agreement, Buffalo agreed to return to us $4,750,000 of the $5,000,000
deposit previously provided by us to The Buffalo Group pursuant to the Purchase
Agreement, and the parties released each other from any claims arising under or
related to the Purchase Agreement. The $5.0 million deposit was previously
recorded in other assets in consolidated balance sheets. We received $4,750,000
in April 2007. The remaining portion of the deposit of $250,000 and other due
diligence fees incurred in the acquisition process were recorded as terminated
acquisition expenses in the consolidated statements of operations in the first
quarter of 2007.
11
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
8. DEBT
Short-term bank borrowings consist of the following:
MARCH 31, DECEMBER 31,
2008 2007
------------ ------------
Import trade bills payable - DBS Bank and Aurora Capital. $ 2,722,410 $ 4,600,293
Bank direct acceptances - DBS Bank ...................... 3,453,839 1,222,998
Other Hong Kong credit facilities - DBS Bank ............ 2,616,003 3,921,927
------------ ------------
$ 8,792,252 $ 9,745,218
============ ============
Long-term obligations consist of the following:
MARCH 31, DECEMBER 31,
2008 2007
------------ ------------
Equipment financing ............................ $ 2,135 $ 5,338
Debt facility and factoring agreement - GMAC CF 11,070,015 2,997,793
------------ ------------
11,072,150 3,003,131
Less current portion ........................... (11,072,150) (3,003,131)
------------ ------------
$ -- $ --
============ ============
IMPORT TRADE BILLS PAYABLE, BANK DIRECT ACCEPTANCES AND OTHER HONG KONG CREDIT
FACILITIES
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 Bank (Hong Kong) Limited ("DBS"), which replaced our prior
letter of credit facility for up to HKD 30 million (equivalent to US $3.9
million). 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 Hong Kong Dollar Standard Bills Rate quoted by
DBS minus 0.5% if paid in Hong Kong Dollars, which the interest rate was 6.00%
per annum at March 31, 2008, or the U.S. Dollar Standard Bills Rate quoted by
DBS plus 0.5% if paid in any other currency, which the interest rate was 5.97%
per annum at March 31, 2008. 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 and Todd Kay; and by our guarantee. The DBS facility includes
customary default provisions. In addition, we are subject to certain restrictive
covenants, including annual covenants that we maintain a specified tangible net
worth and a minimum level of EBITDA at December 31, 2006 and 2007, that we
maintain specified interest coverage ratio, leverage ratio and limitations on
additional indebtedness. We are in the process of revising these covenants for
2008. As of March 31, 2008, $8.5 million was outstanding under this facility. In
addition, $8.7 million of open letters of credit were outstanding and $7.8
million was available for future borrowings as of March 31, 2008.
As of March 31, 2008, the total balance outstanding under the DBS Bank
credit facilities was $8.5 million (classified above as follows: $2.4 million in
import trade bills payable, $3.5 million in bank direct acceptances and $2.6
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 March 31, 2008, $297,000 was outstanding
under this facility (classified above under import trade bills payable) and
$343,000 of letters of credit was open under this arrangement. We pay a
commission fee of 2.25% on all letters of credits issued under this arrangement.
EQUIPMENT FINANCING
We had one equipment loan outstanding at March 31, 2008. The loan bears
interest at 4.75% payable in installments through 2008. As of March 31, 2008,
$2,000 was outstanding under this loan.
12
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
DEBT FACILITY AND FACTORING AGREEMENT - GMAC COMMERCIAL FINANCE
On June 16, 2006, we expanded our previously existing credit facility
with GMAC Commercial Finance Credit, LLC ("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 amount 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 ratio 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 5.75% per annum at March 31, 2008. As of March 31, 2008, we were in
violation of the EBITDA covenant and a waiver was obtained on May 12, 2008. We
are in the process of revising these covenants for the rest of 2008. A total of
$11.1 million was outstanding with respect to receivables factored under the
GMAC CF facility at March 31, 2008.
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 provided for
borrowings of up to $65 million. This facility consisted 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 would be
available under this facility to finance acquisitions acceptable to Guggenheim.
All amounts under the term loans became due and payable in December 2010.
Interest under this facility was 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 were 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.
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. These warrants are exercisable for 3,500,000 shares, and
the remaining 357,143 shares of the warrants will not become exercisable because
a specified portion of the initial term loan was not funded by the lenders. The
warrants were evaluated under 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" 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 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 was 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 was recorded as debt
discount, both of them were amortized over the life of the loan. For the three
months ended March 31, 2007, $302,000 was amortized.
Durham Capital Corporation ("Durham") acted as our advisor in
connection with the Guggenheim credit facility. As compensation for its
services, we agreed to pay Durham 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 a
13
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
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. This warrant is exercisable for
70,000 shares, and the remaining 7,143 shares of this warrant will not become
exercisable because a specified portion of the initial term loan was not 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 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 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 was amortized over the life of the loan. For the three months ended
March 31, 2007, $20,000 was amortized.
In August 2006, as a result of amending the registration rights
relating to the warrants, the warrants were reclassified from debt to equity in
accordance with EITF No. 00-19 in the third quarter of 2006.
On September 26, 2007, we repaid in full the term loan of $15.5 million
outstanding under the Guggenheim credit facility. On November 2, 2007 we
executed a payoff letter with Guggenheim and the lenders, which released all
liens held by Guggenheim and the lenders.
The credit facility with GMAC CF prohibits us from paying dividends or
making other distributions on our common stock. In addition, the credit facility
with GMAC CF prohibits our subsidiaries that are borrowers under the facility
from paying dividends or other distributions to us, and the credit facility with
DBS prohibits our Hong Kong subsidiaries from paying any dividends or making
other distributions or advances to us.
9. DERIVATIVES AND OTHER FINANCIAL INSTRUMENTS
We use forward currency contracts to manage volatility associated with
foreign currency purchases of materials in the normal course of business. During
2006, we entered into foreign currency forward contracts to hedge against the
effect of exchange rate fluctuations on cash flows denominated in foreign
currencies and certain inter-company financing transactions. This transaction is
undesignated and as such an ineffective hedge. Hedge ineffectiveness resulted in
a gain of $195,000 in our consolidated statements of operations in the three
months ended March 31, 2007. At March 31, 2008, we had no open foreign exchange
forward contracts.
10. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In September 2006, the FASB issued SFAS No. 157, "Fair Value
Measurements". SFAS No. 157 establishes a framework for measuring fair value in
generally accepted accounting principles, and expands disclosures about fair
value measurements. SFAS No. 157 is effective for financial statements issued
for fiscal years beginning after November 15, 2007. We adopted the provisions of
SFAS No. 157 beginning January 1, 2008. The adoption of SFAS No. 157 did not
have a material impact on our results of operations and financial condition.
In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option
for Financial Assets and Liabilities- Including an amendment of FASB Statement
No. 115". SFAS No. 159 permits entities to choose to measure certain financial
assets and liabilities at fair value (the "fair value option"). Unrealized gains
and losses, arising subsequent to adoption, are reported in earnings. SFAS No.
159 is effective for fiscal years beginning after November 15, 2007. We adopted
the provisions of SFAS No. 159 beginning January 1, 2008. The adoption of SFAS
No. 159 did not have a material impact on our results of operations and
financial condition.
In December 2007, the FASB issued SFAS No. 141 (revised 2007),
"Business Combinations". The objective of SFAS No. 141(R) is to improve the
relevance, representational faithfulness, and comparability of the information
that a reporting entity provides in its financial reports about a business
combination and its effects. The new standard requires the acquiring entity in a
business combination to recognize all (and only) the assets acquired and
liabilities assumed in the transaction; establishes the acquisition-date fair
value as the measurement objective for all assets acquired and liabilities
14
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
assumed; and requires the acquirer to disclose to investors and other users all
of the information they need to evaluate and understand the nature and financial
effect of the business combination. SFAS No. 141(R) is effective for fiscal
years beginning after December 15, 2008. We are currently assessing the impact
of SFAS No. 141(R) on our results of operations and financial condition.
In December 2007, the FASB issued SFAS No. 160, "Noncontrolling
Interests in Consolidated Financial Statements - an amendment of ARB No.51". The
objective of SFAS No. 160 is to improve the relevance, comparability, and
transparency of the financial information that a reporting entity provides in
its consolidated financial statements by establishing accounting and reporting
standards by requiring all entities to report noncontrolling (minority)
interests in subsidiaries in the same way - as an entity in the consolidated
financial statements. Moreover, SFAS No. 160 eliminates the diversity that
currently exists in accounting for transactions between an entity and
noncontrolling interests by requiring they be treated as equity transactions.
SFAS No. 160 is effective for fiscal years beginning after December 15, 2008. We
are currently assessing the impact of SFAS No. 160 on our results of operations
and financial condition.
In March 2008, the FASB issued SFAS No. 161, "Disclosures about
Derivative Instruments and Hedging Activities, an amendment of FASB Statement
No. 133." SFAS No. 161 requires enhanced disclosures about an entity's
derivative and hedging activities and thereby improves the transparency of
financial reporting. SFAS No. 161 is effective for fiscal periods and interim
periods beginning after November 15, 2008. We are currently assessing the impact
of SFAS No. 161 on our result of operations and financial condition.
11. INCOME TAXES
Our effective tax rate of 19% differs from the statutory rate
principally due to the following reasons: (1) a substantial 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; and (2) 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 June 2006, the FASB issued Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109." FIN
48 clarifies the accounting for uncertainty in income taxes recognized in an
enterprise's financial statements in accordance with SFAS 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. We adopted the provisions of FIN 48 on
January 1, 2007. As a result of the implementation of FIN 48, we recognized no
material adjustment for unrecognized tax benefits but reduced retained earnings
as of January 1, 2007 by approximately $1 million attributable to penalties
accrued as a component of income tax payable. As of the date of adoption, our
unrecognized tax benefits totaled approximately $8.9 million.
We and our subsidiaries file income tax returns in the U.S., Hong Kong,
Luxembourg, Mexico and various state jurisdictions. We are currently subject to
an audit by the State of New York for the years 2003 to 2005, but are not
currently being audited by other states or subject to non-U.S. income tax
jurisdictions for years open in those taxing jurisdictions.
In January 2004, the IRS completed its examination of our Federal
income tax returns for the years ended December 31, 1996 through 2001. The IRS
had proposed adjustments to increase our income tax payable for these 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
December 2007, we received a final assessment from the IRS of $7.4 million for
the years ended December 31, 1996 through 2002, and in the first quarter of
2008, we entered into a final settlement agreement with the IRS. Under the
settlement, which totals $13.9 million, including $6.5 million of interest, we
agreed to pay the IRS $4 million in March 2008 and an additional $250,000 per
month until repayment in full. The settlement with the IRS is within amounts
15
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
accrued for as of December 31, 2007 in our financial statements, and we
therefore do not anticipate the settlement to result in any additional charges
to income other than interest and penalties on the outstanding balance. Due to
the negotiated settlement, we reclassified the IRS and state tax liabilities
from uncertain tax position to current payable on December 31, 2007. In March
2008, we paid the IRS $4 million in accordance with the settlement terms. Due to
the installment agreement with the IRS in March 2008, we reclassified $7.0
million of income tax payable from current payable to long-term as of March 31,
2008.
There was no unrecognized tax benefit as of March 31, 2008 and December
31, 2007. As of March 31, 2008, the accrued interest and penalties were $7.3
million and $142,000, respectively. As of December 31, 2007, the accrued
interest and penalties were $7.2 million and $142,000, respectively.
In many cases, the uncertain tax positions are related to tax years
that remain subject to examination by the relevant tax authorities. Federal and
state statutes are open from 2003 through the present period. Hong Kong statutes
are open from 2001, Luxembourg from 2003 and Mexico from 2001.
12. NET INCOME (LOSS) PER SHARE
Basic and diluted income (loss) per share has been computed in
accordance with SFAS No. 128, "Earnings 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 ENDED MARCH 31,
---------------------------------
2008 2007
------------ ------------
Basic EPS Computation:
Numerator ............................ $ (253,283) $ (1,000,920)
Denominator:
Weighted average common
shares outstanding ................... 32,043,763 30,543,763
------------ ------------
Basic EPS ............................ $ (0.01) $ (0.03)
============ ============
Diluted EPS Computation:
Numerator ............................ $ (253,283) $ (1,000,920)
Denominator:
Weighted average common
shares outstanding ................... 32,043,763 30,543,763
Options .............................. -- --
------------ ------------
Total shares ......................... 32,043,763 30,543,763
------------ ------------
Diluted EPS .......................... $ (0.01) $ (0.03)
============ ============
No shares issuable upon exercise of outstanding options and warrants
were included in the computation of income per share in the three months ended
March 31, 2008 and 2007 as the exercise prices of the options and warrants were
greater than the average market price for the three months ended March 31, 2008
and 2007. The following table presents potentially dilutive securities that were
not included in the computation of loss per share:
AS OF MARCH 31,
----------------------------
2008 2007
------------ ------------
Options ...................... 8,204,209 8,303,659
Warrants ..................... 5,931,732 5,931,732
------------ ------------
Total ........................ 14,135,941 14,235,391
============ ============
16
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
13. RELATED PARTY TRANSACTIONS
As of March 31, 2008, related party affiliates were indebted to us in
the amounts of $11.3 million. These include amounts due from Gerard Guez, our
Chairman and Interim Chief Executive Officer. From time to time in the past, we
had advanced funds to, Mr. Guez. These were net advances to Mr. Guez or payments
paid on his behalf before the enactment of the Sarbanes-Oxley Act in 2002. The
promissory note documenting these advances contains a provision that the entire
amount together with accrued interest is immediately due and payable upon our
written demand. The greatest outstanding balance of such advances to Mr. Guez in
the first quarter of 2008 was approximately $1,944,000. At March 31, 2008, the
entire balance due from Mr. Guez totaling $1.9 million was reflected as a
reduction to shareholders' equity in the accompanying financial statements. All
amounts due from Mr. Guez bore interest at the rate of 7.75% during the period.
Total interest paid by Mr. Guez was $37,000 and $41,000 for the three months
ended March 31, 2008 and 2007, respectively. Mr. Guez paid expenses on our
behalf of approximately $114,000 and $105,000 for the three months ended March
31, 2008 and 2007, 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 United Apparel Ventures, LLC to jointly
market, share certain risks and achieve economies of scale with Azteca
Production International, Inc. ("Azteca"). This entity was created to coordinate
the production of apparel for a single customer of our branded business. Azteca
is owned by the brothers of Gerard Guez. UAV made purchases from a related party
in Mexico, an affiliate of Azteca. UAV was owned 50.1% by Tag Mex, Inc., our
wholly owned subsidiary, and 49.9% by Azteca. Results of the operation of UAV
had 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 until 2004. Due to the restructuring of our Mexico
operations, we discontinued manufacturing for UAV customers in 2004. We had been
consolidating 100% of the results of the operation of UAV into our results since
2005. UAV was dissolved on February 27, 2007. We did not purchase any finished
goods, fabric and service from Azteca and its affiliates in the three months
ended March 31, 2008 and 2007. Based on the repayment history of Azteca and
litigation Azteca is currently subject to, we estimated that our receivable of
$3.4 million will take approximately three years for collection in full. We
therefore made a $1.0 million reserve and then fair-valued the balance of this
asset using our weighted average cost of capital as the discount rate and a term
of three years as the discount period at December 31, 2007. Net amounts due from
this related party as of March 31, 2008 and December 31, 2007 were $1.5 million.
On September 1, 2006, our subsidiary in Hong Kong, Tarrant Company
Limited, entered into an agreement with Seven Licensing Company, LLC ("Seven
Licensing") to be its buying agent to source and purchase apparel merchandise.
Seven Licensing is beneficially owned by Gerard Guez. Total sales to Seven
Licensing in the three months ended March 31, 2008 and 2007 were $4.2 million
and $3.3 million, respectively. Net amount due from this related party as of
March 31, 2008 and December 31, 2007 was $7.6 million and $6.8 million,
respectively.
We purchased $2.7 million and $2.8 million of finished goods from Star
Source, LLC and AJG Inc. dba Astrologie in the three months ended March 31, 2008
and 2007, respectively. Star Source, LLC and AJG Inc. dba Astrologie are
beneficially owned by an adult son of one of our employees. As of March 31,
2008, we had outstanding advances of $132,000 to Star Source, LLC for fabric
purchase.
We lease our executive offices and warehouse in Los Angeles, California
from GET. Additionally, we lease our office space and warehouse in Hong Kong
from Lynx International Limited. GET and Lynx International Limited are each
owned by Gerard Guez, our Chairman and Interim Chief Executive Officer, and Todd
Kay, our Vice Chairman. We paid $284,000 and $279,000 in rent in the three
months ended March 31, 2008 and 2007, respectively, for these office and
warehouse facilities. Our lease for the Los Angeles offices and warehouse has a
term of five years expiring in 2011, with an option to renew for an additional
five year term. Our lease for the office space and warehouse in Hong Kong has
expired and we are currently renting on a month to month basis. On May 1, 2006,
we sublet a portion of our executive office in Los Angeles, California and our
17
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
sales office in New York to Seven Licensing for a monthly payment of $25,000 on
a month to month basis. Seven Licensing is beneficially owned by Gerard Guez. We
received $75,000 in rental income from this sublease in the three months ended
March 31, 2008 and 2007.
At March 31, 2008, we had various employee receivables totaling
$213,000 included in due from related parties.
14. COMMITMENTS AND CONTINGENCIES
In 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 advance in
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. If a portion of
the guaranteed minimum royalty is determined not to be recoverable, the
unrecoverable portion is charged to expense at that time. At March 31, 2008, the
total commitment on royalties remaining on the term was $7.4 million. We are
currently involved in litigation with American Rag Cie, LLC and American Rag Cie
II with respect to our license rights to the American Rag Cie trademark. See
Note 16 of the "Notes to Consolidated Financial Statements".
On September 1, 2006, our subsidiary in Hong Kong, Tarrant Company
Limited, entered into an agreement with Seven Licensing Company, LLC to be its
buying agent to source and purchase apparel merchandise. Seven Licensing is
beneficially owned by Gerard Guez. Total sales to Seven Licensing in the three
months ended March 31, 2008 and 2007 were $4.2 million and $3.3 million,
respectively.
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 two geographic
regions: the United States and Asia. 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 and Asia is presented below. Inter-company
revenues and assets have been eliminated to arrive at the consolidated amounts.
18
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
ADJUSTMENTS
AND
UNITED STATES ASIA ELIMINATIONS TOTAL
--------------- --------------- --------------- ---------------
THREE MONTHS ENDED MARCH 31, 2008
Sales ........................... $ 44,841,000 $ 5,658,000 $ -- $ 50,499,000
Inter-company sales ............. -- 19,122,000 (19,122,000) --
--------------- --------------- --------------- ---------------
Total revenue ................... $ 44,841,000 $ 24,780,000 $ (19,122,000) $ 50,499,000
=============== =============== =============== ===============
Income (loss) from operations (1) $ (319,000) $ 276,000 $ -- $ (43,000)
=============== =============== =============== ===============
Interest income ................. $ 40,000 $ -- $ -- $ 40,000
=============== =============== =============== ===============
Interest expense ................ $ 196,000 $ 35,000 $ -- $ 231,000
=============== =============== =============== ===============
Provision for depreciation
and amortization .............. $ 91,000 $ 33,000 $ -- $ 124,000
=============== =============== =============== ===============
Capital expenditures ............ $ 21,000 $ 11,000 $ -- $ 32,000
=============== =============== =============== ===============
Total assets .................... $ 55,680,000 $ 113,121,000 $ (98,314,000) $ 70,487,000
=============== =============== =============== ===============
THREE MONTHS ENDED MARCH 31, 2007
Sales ........................... $ 52,097,000 $ 4,009,000 $ -- $ 56,106,000
Inter-company sales ............. -- 24,236,000 (24,236,000) --
--------------- --------------- --------------- ---------------
Total revenue ................... $ 52,097,000 $ 28,245,000 $ (24,236,000) $ 56,106,000
=============== =============== =============== ===============
Income (loss) from operations ... $ (554,000) $ 618,000 $ -- $ 64,000
=============== =============== =============== ===============
Interest income ................. $ 45,000 $ -- $ -- $ 45,000
=============== =============== =============== ===============
Interest expense ................ $ 1,299,000 $ 44,000 $ -- $ 1,343,000
=============== =============== =============== ===============
Provision for depreciation
and amortization .............. $ 562,000 $ 23,000 $ -- $ 585,000
=============== =============== =============== ===============
Capital expenditures ............ $ 65,000 $ 23,000 $ -- $ 88,000
=============== =============== =============== ===============
Total assets (2) ................ $ 87,506,000 $ 116,863,000 $ (101,383,000) $ 102,986,000
=============== =============== =============== ===============
(1) Loss from operations in the U.S. included a loss of $201,000 recorded
in Luxembourg.
(2) Total assets in the U.S. included $15,973,000 from Luxembourg and
$7,853,000 from Mexico.
16. LITIGATION
AMERICAN RAG CIE, LLC & AMERICAN RAG CIE II, INC.
On February 1, 2008, Tarrant Apparel Group and our wholly-owned
subsidiary, Private Brands, Inc., filed and served a cross-complaint against
American Rag Cie, LLC (the "LLC") and American Rag Cie II ("ARC II") in the, in
the action AMERICAN RAG CIE V. PRIVATE BRANDS, INC., Superior Court of the State
of California, County of Los Angeles, Central District, Case No. BC 384428. The
original action had been filed on January 28, 2008 against Private Brands by the
LLC. The LLC owns the trademark "American Rag Cie", which mark has been licensed
to Private Brands on an exclusive basis throughout the world except for Japan
and pursuant to which Private Brands sells American Rag Cie branded apparel to
Macy's Merchandising Group and has sub-licensed to Macy's Merchandising Group
the right to manufacture certain categories of American Rag Cie branded apparel
in the United States. The LLC is owned 55% by ARC II and 45% by Tarrant Apparel
Group. In the original complaint the LLC seeks a declaratory judgment that we
have breached the license agreement and that the license agreement has been
properly terminated. Our cross-complaint counters this claim, and seeks a
declaration that the license agreement is valid and continues to be in effect.
Additionally, the cross-complaint seeks relief on a number of causes of action,
including breach of the license agreement, a declaration by the Court imposing a
reasonable term into the agreement for sublicensing royalties, dissolution of
LLC, damages for breach of fiduciary duty, and an accounting of the monies
diverted by defendants' actions. On March 3, 2008, we dismissed, without
prejudice, our claim for dissolution of LLC after being notified that ARC II had
elected to buy out our share in the LLC, a permitted defense to an action for
dissolution. On March 19, 2008, the LLC and ARC II filed an amended complaint,
in which they expanded their claims against us to include claims for breach of
contract, fraud, and breach of fiduciary duty, and seeking further declaratory
relief and compensatory and punitive damages. On April 21, 2008, we filed a
demurrer to four of the causes of action in the amended complaint, and are
seeking dismissal of the LLC and ARC II's claims for fraud and breach of
fiduciary duty, as well as their attempt to force a buy-out. The demurrer will
be argued on on June 16, 2008. The action is in the early stages of discovery.
As we derive a significant amount of revenue from the sale of American Rag Cie
branded products, our business, results of operations and financial condition
could be materially adversely affected if this dispute is not resolved in a
manner favorable to us. Additionally, we have incurred significant legal fees in
19
TARRANT APPAREL GROUP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
this litigation, and unless the case is settled will continue to incur
additional legal fees in increasing amounts as the case accelerates to trial.
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
NASDAQ DEFICIENCY NOTICE
On April 2, 2008, we were notified by The Nasdaq Stock Market that we
are not in compliance with Nasdaq Marketplace Rule 4450(a)(5) because shares of
our common stock had closed at a per share bid price of less than $1.00 for 30
consecutive business days. In accordance with Marketplace Rule 4450(e)(2), we
will be provided with 180 calendar days, or until September 29, 2008, to regain
compliance. This notification has no effect on the listing of our common stock
at this time. To regain compliance with the minimum bid price rule, the closing
bid price of our common stock must close at $1.00 per share or more for a
minimum of ten consecutive business days. If we do not regain compliance by
September 29, 2008, the Nasdaq staff will notify us that our common stock will
be delisted. In that event and at that time, we may appeal Nasdaq's delisting
determination to a Nasdaq Listing Qualifications Panel. Alternatively, if we do
not regain compliance with the minimum bid price rule by September 29, 2008, we
can apply to list our common stock on The Nasdaq Capital Market if we satisfy
the initial listing criteria set forth in Marketplace Rule 4310(c), other than
the minimum bid price requirement. If our application is approved, we will be
granted an additional 180 calendar days to regain compliance with the minimum
bid price rule. We will seek to regain compliance within this 180 day cure
period and will consider alternatives to address compliance with the continued
listing standards of The Nasdaq Stock Market.
U.S. CUSTOMS PENALTIES
In April 2008, we received notices from the U.S. Department of Customs
and Border Protection advising us of its decision to impose liquidated damages
in the amount of approximately $770,000 for customs violations in connection
with specified goods imported by us as the importer of record in 2005 from
certain vendors in Hong Kong. Although we could challenge the violations in
Court, if we were to lose the litigation we could be subject to penalties of
over $3 million plus legal fees. As a result, we have determined not to
challenge the violations further and to pay the liquidated damages. Typically,
we would seek indemnification from our vendors for these liquidated damages.
However, the two vendors involved in these matters are no longer operating. In
connection with these damages, we have recorded a charge for the two vendors and
an additional reserve of $78,000 for another vendor in a similar situation.
ACQUISITION PROPOSAL
On April 25, 2008, Gerard Guez and Todd Kay, our founders, executive
officers and directors, announced to our Board of Directors their intention to
acquire all of the outstanding publicly held shares of our common stock for
$0.80 per share in cash in a going private transaction. In connection with the
proposed acquisition, our Board of Directors has formed a special committee of
the Board to consider the acquisition proposal. The Special Committee is
comprised of Mitchell Simbal and Joseph Mizrachi, who will serve as Co-Chairmen
of the committee, and Milton Koffman and Simon Mani.
20
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
The following management's discussion and analysis should be read
together with the Consolidated Financial Statements of Tarrant Apparel Group and
the "Notes to Consolidated Financial Statements" included elsewhere in this Form
10-Q. This discussion summarizes the significant factors affecting the
consolidated operating results, financial condition and liquidity and cash flows
of Tarrant Apparel Group for the quarterly periods and year to date ended March
31, 2008 and 2007. Except for historical information, the matters discussed in
this management's discussion and analysis of financial condition and results of
operations are forward looking statements that involve risks and uncertainties
and are based upon judgments concerning various factors that are beyond our
control. See "Item 1A. Risk Factors" in Part II of this Form 10-Q.
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 retailers, such as Macy's Merchandising Group, Chico's,
Mothers Work, Mervyn's, New York & Co., Wal-Mart, Charlotte Russe, the Avenue,
Kohl's, and Lane Bryant, as well as wholesalers such as Seven Licensing. Our
products are manufactured in a variety of woven and knit fabrications and
include jeans wear, casual pants, shorts, skirts, dresses, t-shirts, blouses,
shirts and other tops and jackets. Our private brands include American Rag Cie,
Marisa K and American Star.
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 sales in the first
three months of 2008 were $42.2 million compared to $48.2 million in the first
three months of 2007.
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 sales in the first three months of 2008 were $8.3 million
compared to $7.9 million in the first three months of 2007. During the first
quarter of 2008, we sold apparel under the following private brands:
o AMERICAN RAG CIE: During the first quarter of 2005, we
extended our agreement with Macy's Merchandising Group through
2014, pursuant to which we exclusively distribute our American
Rag Cie brand through Macy's Merchandising Group's national
Department Store organization of more than 600 stores. Net
sales of American Rag Cie branded apparel totaled $8.2 million
in the first three months of 2008 compared to $7.8 million in
the first three months of 2007.
o MARISA K: This brand is being sold to specialty stores and
boutiques. Net sales of Marisa K branded apparel totaled
$516,000 in the first three months of 2008 compared to
$204,000 in the first three months of 2007.
o AMERICAN STAR: This brand is currently sold to Mothers' Work.
Sales in the first three months of 2008 were insignificant.
We are currently involved in litigation with American Rag Cie, LLC and
American Rag Cie II with respect to our license rights to the American Rag Cie
trademark. American Rag Cie, LLC owns the trademark "American Rag Cie", which
has been licensed to us on an exclusive basis throughout the world except for
Japan and pursuant to which we sell American Rag Cie branded apparel to Macy's
Merchandising Group and have sub-licensed to Macy's Merchandising Group the
right to manufacture certain categories of American Rag Cie branded apparel in
the United States. American Rag Cie LLC has purported to terminate our license
21
rights, and we have filed a counterclaim seeking to a declaratory judgment that
the termination was invalid and alleging other causes of action. American Rag
Cie, LLC is owned 45% by Tarrant Apparel Group and 55% by American Rag Cie II.
For a further description of this action see "Part II - Item 1. Legal
Proceedings" of this Quarterly Report on Form 10-Q. We derive a significant
portion of our revenues from the sale of American Rag Cie products pursuant to
the license rights. Our business, results of operations and financial condition
could be materially adversely affected if we are unable to reach a settlement in
a manner acceptable to us and ensuing litigation is not resolved in a manner
favorable to us. Additionally, we may incur 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 moves toward trial.
ACQUISITION PROPOSAL
On April 25, 2008, Gerard Guez and Todd Kay, our founders, executive
officers and directors, announced to our Board of Directors their intention to
acquire all of the outstanding publicly held shares of our common stock for
$0.80 per share in cash in a going private transaction. In connection with the
proposed acquisition, our Board of Directors has formed a special committee of
the Board to consider the acquisition proposal. The Special Committee is
comprised of Mitchell Simbal and Joseph Mizrachi, who will serve as Co-Chairmen
of the committee, and Milton Koffman and Simon Mani. The Special Committee is in
the process of interviewing legal counsel and investment bankers to assist the
committee in its consideration and evaluation of the acquisition proposal.
NASDAQ DEFICIENCY NOTICE
On April 2, 2008, we were notified by The Nasdaq Stock Market that we
are not in compliance with Nasdaq Marketplace Rule 4450(a)(5) because shares of
our common stock had closed at a per share bid price of less than $1.00 for 30
consecutive business days. In accordance with Marketplace Rule 4450(e)(2), we
will be provided with 180 calendar days, or until September 29, 2008, to regain
compliance. This notification has no effect on the listing of our common stock
at this time. To regain compliance with the minimum bid price rule, the closing
bid price of our common stock must close at $1.00 per share or more for a
minimum of ten consecutive business days. If we do not regain compliance by
September 29, 2008, the Nasdaq staff will notify us that our common stock will
be delisted. In that event and at that time, we may appeal Nasdaq's delisting
determination to a Nasdaq Listing Qualifications Panel. Alternatively, if we do
not regain compliance with the minimum bid price rule by September 29, 2008, we
can apply to list our common stock on The Nasdaq Capital Market if we satisfy
the initial listing criteria set forth in Marketplace Rule 4310(c), other than
the minimum bid price requirement. If our application is approved, we will be
granted an additional 180 calendar days to regain compliance with the minimum
bid price rule. We will seek to regain compliance within this 180 day cure
period and will consider alternatives to address compliance with the continued
listing standards of The Nasdaq Stock Market.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have been
prepared in accordance with generally accepted accounting principles 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 allowance for returns, discounts and bad debts,
inventory, notes receivable - related parties reserve, valuation of long-lived
and intangible assets and goodwill, accrued expenses, income taxes, stock
options valuation, contingencies and litigation. We base our estimates on
historical experience and on various assumptions believed to be applicable and
reasonable under the circumstances. These estimates may change as new events
occur, as additional information is obtained and as our operating environment
changes. In addition, management is periodically faced with uncertainties, the
outcomes of which are not within its control and will not be known for prolonged
period of time.
22
We believe our financial statements are fairly stated in accordance
with generally accepted accounting principles 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, 2007.
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 March 31, 2008, the balance in the allowance for returns,
discounts and bad debts reserves was $927,000.
INVENTORY
Our inventories are valued at the lower of cost (first-in, first-out)
or market. Under certain market conditions, we use estimates and judgments
regarding the valuation of inventory to properly value inventory. Inventory
adjustments are made for the difference between the cost of the inventory and
the estimated market value and charged to operations in the period in which the
facts that give rise to the adjustments become known.
VALUATION OF LONG-LIVED AND INTANGIBLE ASSETS AND GOODWILL
We have adopted Statement of Financial Accounting Standards No. 142,
"Goodwill and Other Intangible Assets." We assess the need for impairment of
identifiable intangibles, long-lived assets and goodwill with 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. 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.
We utilized the discounted cash flow methodology to estimate fair
value. As of March 31, 2008, we have a goodwill balance of $9.9 million, and a
net property and equipment balance of $1.4 million.
REVENUE RECOGNITION
Revenue is recognized at the point of shipment for all merchandise sold
based on FOB shipping point. For merchandise shipped on landed duty paid (or
"LDP") terms, revenue is recognized at the point of either leaving Customs for
direct shipments or at the point of leaving our warehouse where title is
transferred, net of an estimate of returned merchandise and discounts. Customers
are allowed the rights of return or non-acceptance only upon receipt of damaged
products or goods with quality different from shipment samples. We do not
undertake any after-sale warranty or any form of price protection.
23
We often arrange, on behalf of manufacturers, for the purchase of
fabric from a single supplier. We have the fabric shipped directly to the
cutting factory and invoice the factory for the fabric. Generally, the factories
pay us for the fabric with offsets against the price of the finished goods.
STOCK-BASED COMPENSATION
On January 1, 2006, we adopted SFAS No. 123 (revised 2004),
"Share-Based Payment," ("SFAS No. 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 No. 123(R)
supersedes our previous accounting under Accounting Principles Board Opinion
("APB") No. 25, "Accounting for Stock Issued to Employees" for periods beginning
in fiscal 2006. In March 2005, the Securities and Exchange Commission issued
Staff Accounting Bulletin ("SAB") No. 107 relating to SFAS No. 123(R). We have
applied the provisions of SAB No. 107 in its adoption of SFAS No. 123(R).
We adopted SFAS No. 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 three months ended March 31, 2008 and 2007 reflect the impact of
SFAS No. 123(R). The stock-based compensation expense related to employees or
director stock options recognized for the three months ended March 31, 2008 and
2007 was $130,000 and $176,000, respectively. Basic and dilutive income per
share for the three months ended March 31, 2007 was not materially affected by
the additional stock-based compensation recognized. Basic and dilutive earnings
per share for the three months ended March 31, 2008 was decreased by $0.01 from
$(0.00) to $(0.01) by the additional stock-based compensation recognized.
INCOME TAXES
As part of the process of preparing our consolidated financial
statements, we are 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. We record a valuation allowance to reduce our net
deferred tax assets to the amount that is more likely than not to be realized.
We have 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 audits regarding U.S. tax
issues 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.
In June 2006, the FASB issued Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109." FIN
48 clarifies the accounting for uncertainty in income taxes recognized in an
enterprise's financial statements in accordance with SFAS 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. We adopted the provisions of FIN 48 on
January 1, 2007. As a result of the implementation of FIN 48, we recognized no
material adjustment for unrecognized tax benefits but reduced retained earnings
as of January 1, 2007 by approximately $1 million attributable to penalties
accrued as a component of income tax payable. As of the date of adoption, our
unrecognized tax benefits totaled approximately $8.9 million.
24
We and our subsidiaries file income tax returns in the U.S., Hong Kong,
Luxembourg, Mexico and various state jurisdictions. We are currently subject to
an audit by the State of New York for the years 2003 to 2005, but are not
currently being audited by other states or subject to non-U.S. income tax
jurisdictions for years open in those taxing jurisdictions.
In January 2004, the IRS completed its examination of our Federal
income tax returns for the years ended December 31, 1996 through 2001. The IRS
had proposed adjustments to increase our income tax payable for these 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
December 2007, we received a final assessment from the IRS of $7.4 million for
the years ended December 31, 1996 through 2002, and in the first quarter of
2008, we entered into a final settlement agreement with the IRS. Under the
settlement, which totals $13.9 million, including $6.5 million of interest, we
agreed to pay the IRS $4 million in March 2008 and an additional $250,000 per
month until repayment in full. The settlement with the IRS is within amounts
accrued for as of December 31, 2007 in our financial statements, and we
therefore do not anticipate the settlement to result in any additional charges
to income other than interest and penalties on the outstanding balance. Due to
the negotiated settlement, we reclassified the IRS and state tax liabilities
from uncertain tax position to current payable on December 31, 2007. In March
2008, we paid the IRS $4 million in accordance with the settlement terms. Due to
the installment agreement with the IRS in March 2008, we reclassified $7.0
million of income tax payable from current payable to long-term as of March 31,
2008.
There was no unrecognized tax benefit as of March 31, 2008 and December
31, 2007. As of March 31, 2008, the accrued interest and penalties were $7.3
million and $142,000, respectively. As of December 31, 2007, the accrued
interest and penalties were $7.2 million and $142,000, respectively.
In many cases, the uncertain tax positions are related to tax years
that remain subject to examination by the relevant tax authorities. Federal and
state statutes are open from 2003 through the present period. Hong Kong statutes
are open from 2001, Luxembourg from 2003 and Mexico from 2001.
DEBT COVENANTS
Our debt agreements require certain covenants including a minimum level
of EBITDA and specified tangible net worth; and required interest coverage ratio
and leverage ratio as discussed in Note 8 of the "Notes to Consolidated
Financial Statements." If our results of operations erode and we are not able to
obtain waivers from the lenders, the debt would be in default and callable by
our lenders. In addition, due to cross-default provisions in our debt
agreements, substantially all of our long-term debt would become due in full if
any of the debt is in default. In anticipation of us not being able to meet the
required covenants due to various reasons, we either negotiate for changes in
the relative covenants or 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, including by curtailing operations, and to raise capital through the
sale of assets, issuance of equity or otherwise, any of which could have a
material adverse effect on our financial condition and results of operations. As
of March 31, 2008, we were in violation with the EBITDA covenant and a waiver
was obtained on May 12, 2008.
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."
25
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 ENDED
MARCH 31,
----------------------
2008 2007
-------- --------
Net sales ....................................... 91.7% 94.1%
Net sales to related party ...................... 8.3 5.9
-------- --------
Total net sales ................................. 100.0 100.0
Cost of sales ................................... 72.6 72.6
Cost of sales to related party .................. 7.5 5.4
-------- --------
Total cost of sales ............................. 80.1 78.0
Gross profit .................................... 19.9 22.0
Selling and distribution expenses ............... 6.8 6.1
General and administration expenses ............. 12.5 11.6
Royalty expenses ................................ 0.7 0.6
Terminated acquisition expenses ................. -- 3.6
-------- --------
Income (loss) from operations ................... (0.1) 0.1
Interest expense ................................ (0.5) (2.4)
Interest income ................................. 0.1 0.1
Interest in income (loss) of equity
method investee .............................. (0.0) 0.1
Other income .................................... 0.3 0.2
Adjustment to fair value of derivative .......... -- 0.3
Other expense ................................... (0.1) (0.0)
-------- --------
Loss before provision for income taxes
and minority interest ........................ (0.3) (1.6)
Provision for Income taxes ...................... 0.2 0.2
Minority interest ............................... (0.0) (0.0)
-------- --------
Net Loss ........................................ (0.5)% (1.8)%
======== ========
FIRST QUARTER 2008 COMPARED TO FIRST QUARTER 2007
Total net sales decreased by $5.6 million, or 10.0%, to $50.5 million
in first quarter of 2008 from $56.1 million in the first quarter of 2007. Sales
of private label in the first quarter of 2008 were $42.2 million compared to
$48.2 million in the same period of 2007. The decrease in the first quarter of
2008 resulted primarily from decreased sales to Kohl's and Mervyn's, and was
partially offset by increased sales to Chico's. Sales of private brands in the
first quarter of 2008 were $8.3 million compared to $7.9 million in the same
period of 2007, with the increase resulting primarily from increased sales to
Macy's Merchandising Group in the first quarter of 2008.
Gross profit consists of total net sales less product costs, direct
labor, duty, quota, freight in, and brokerage, warehouse handling and markdown.
Gross profit decreased by $2.3 million, or 18.7%, to $10.0 million in the first
quarter of 2008 from $12.3 million in the first quarter of 2007. The decrease in
gross profit was partially due to a decrease in sales. As a percentage of total
net sales, gross profit decreased from 22.0% in the first quarter of 2007 to
19.9% in the first quarter of 2008. The decrease in gross margin in the first
quarter of 2008 was due primarily to comparatively more discounts and allowances
given to retailers as a result of a slowdown in the economy.
Selling and distribution expenses decreased by $9,000, or 0.3%, to
$3.43 million in the first quarter of 2008 from $3.44 million in the first
quarter of 2007. As a percentage of total net sales, these expenses increased to
6.8% in the first quarter of 2008 from 6.1% in the first quarter of 2007 due to
the decrease in sales during the first quarter of 2008.
26
General and administrative expenses decreased by $168,000, or 2.6%, to
$6.3 million in the first quarter of 2008 from $6.5 million in the first quarter
of 2007. As a percentage of total net sales, these expenses increased to 12.5%
in the first quarter of 2008 from 11.6% in the first quarter of 2007 due to the
decrease in sales during the first quarter of 2008. Included in general and
administrative expenses in the first quarter of 2008 was a charge of $848,000
resulting from liquidated damages imposed by U.S. Customs on two of our overseas
vendors in April 2008. See Note 17 of the "Notes to Consolidated Financial
Statements.
Royalty expenses decreased by $24,000, or 6.6%, to $334,000 in the
first quarter of 2008 from $358,000 in the first quarter of 2007. As a
percentage of total net sales, these expenses increased to 0.7% in the first
quarter of 2008 from 0.6% in the first quarter of 2007.
Terminated acquisition expenses in the first quarter of 2007 were $2.0
million, or 3.6% of total net sales, compared to no such expense in the first
quarter of 2008. These expenses consisted of the non-refunded portion of a
deposit in the amount of $250,000 and other expenses including due diligence and
legal fees incurred in connection with our proposed acquisition of The Buffalo
Group. The transaction was mutually terminated on April 19, 2007.
Loss from operations in the first quarter of 2008 was $43,000, or
(0.1)% of total net sales, compared to income from operations of $64,000, or
0.1% of total net sales, in the comparable period of 2007, because of the
factors discussed above.
Interest expense decreased by $1.1 million, or 82.8%, to $231,000 in
the first quarter of 2008 from $1.3 million in the first quarter of 2007. As a
percentage of total net sales, this expense decreased to 0.5% in the first
quarter of 2008 from 2.4% in the first quarter of 2007. The decrease was
primarily due to decreased borrowings under our credit facilities and the
repayment of our term loan facility in September 2007.
Interest income decreased by $5,000 or 11.5%, to $40,000 in the first
quarter of 2008 from $45,000 in the first quarter of 2007. Other income was
$181,000 in the first quarter of 2008, compared to $88,000 in the first quarter
of 2007. Adjustment to fair value of derivative was $195,000 in the first
quarter of 2007, compared to no such adjustment in the first quarter of 2008.
Other expense was $64,000 in the first quarter of 2008, compared to $2,000 in
the first quarter of 2007.
Interest in income (loss) of equity method investee represented our 45%
share of equity interest in the owner of the trademark "American Rag Cie" and
the operator of American Rag retail stores. Interest in income (loss) of equity
method investee decreased by $107,000 or 127.9%, from $84,000 in the first
quarter of 2007 to $(23,000) in the first quarter of 2008. The decrease was
primarily due to a decrease in the gross margin of American Rag Cie from 53.5%
in the first quarter of 2007 to 42.8% in the first quarter of 2008.
Loss before provision for income taxes and minority interest was
$139,000 in the first quarter of 2008 and $870,000 in the first quarter of 2007,
representing (0.3)% and (1.6)% of total net sales, respectively.
Provision for income taxes was $114,000 in the first quarter of 2008
compared to $132,000 in the first quarter of 2007, representing 0.2% of total
net sales in both years.
Losses allocated to minority interests in the first quarter of 2008
were $0 compared to $1,000 in the first quarter of 2007, representing the
minority partner's share of losses in PBG7.
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.
27
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;
o loss of rights to the American Rag Cie trademark if litigation
in which are involved is resolved in a matter unfavorable to
us; 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.
We significantly strengthened our balance sheet and improved our
liquidity over the last 12 months. The sale of all our Mexico assets for cash in
2007 enabled us to repay our most expensive loans and as a result our financing
costs have since substantially decreased. The IRS settlement and installment
repayment plan has removed a significant uncertainty in our financial condition
which we have operated under for the past several years.
As described elsewhere in this report, we are currently involved in
litigation with American Rag Cie, LLC and American Rag Cie II with respect to
our license rights to the American Rag Cie trademark. American Rag Cie LLC has
purported to terminate our license rights, and we have filed a counterclaim
seeking to a declaratory judgment that the termination was invalid and alleging
other causes of action. We derive a significant portion of our revenues from the
sale of American Rag Cie products pursuant to the license rights. Our business,
results of operations and financial condition could be materially adversely
affected if we are unable to reach a settlement in a manner acceptable to us and
ensuing litigation is not resolved in a manner favorable to us. Additionally, we
may incur 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 moves toward trial.
As of March 31, 2008, we had $2.2 million in cash and cash equivalents
as noted on our consolidated balance sheet and statement of cash flows. This
represented an increase of $1.7 million or 340.6% compared to a total of
$491,000 as of December 31, 2007.
Cash flows for the three months ended March 31, 2008 and 2007 were as
follows (dollars in thousands):
CASH FLOWS: 2008 2007
------- -------
Net cash provided by (used in) operating activities .... $(5,079) $ 1,800
Net cash used in investing activities .................. $ (363) $ (724)
Net cash provided by (used in) financing activities .... $ 7,116 $ (518)
During the first three months of 2008, net cash used in operating
activities was $5.1 million, as compared to net cash provided by operating
activities of $1.8 million for the same period in 2007. Net cash used in
operating activities in the first three months of 2008 resulted primarily from a
net loss of $253,000, an increase of accounts receivable of $1.2 million, a
decrease of accounts payable of $3.2 million, and a decrease of accrued expenses
and income tax payable of $4.4 million due to a payment of $4.0 million to the
IRS. The above were offset by a decrease in inventory of $5.6 million.
28
During the first three months of 2008, net cash used in investing
activities was $363,000, as compared to net cash used in investing activities of
$724,000 in the first three months of 2007. Net cash used in investing
activities in the first three months 2008 resulted primarily from net investment
in marketable securities of $462,000.
During the first three months of 2008, net cash provided by financing
activities was $7.1 million, as compared to net cash used in financing
activities of $518,000 in the first three months of 2007. Net cash provided by
financing activities in the first three months of 2008 resulted primarily from
$8.1 million net proceeds from our long-term bank borrowings offset by $953,000
net repayment of our short-term bank borrowings.
CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
Following is a summary of our contractual obligations and commercial
commitments available to us as of March 31, 2008 (in millions):
PAYMENTS DUE BY PERIOD
---------------------------------------------------------
Less than Between Between After
CONTRACTUAL OBLIGATIONS Total 1 year 2-3 years 4-5 years 5 years
------------------------------------------- --------- --------- --------- --------- ---------
Long-term debt (1) ........................ $ 11.7 $ 11.7 $ -- $ -- $ --
Operating leases .......................... 7.3 1.3 2.6 1.6 1.8
Minimum royalties ......................... 7.4 0.9 2.2 3.0 1.3
--------- --------- --------- --------- ---------
Total Contractual Cash Obligations ........ $ 26.4 $ 13.9 $ 4.8 $ 4.6 $ 3.1
(1) Includes interest on long-term debt obligations. Based on outstanding
borrowings as of March 31, 2008, 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
$637,000.
TOTAL AMOUNT OF COMMITMENT EXPIRATION PER PERIOD
AMOUNTS ---------------------------------------------
COMMERCIAL COMMITMENTS COMMITTED LESS 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 $ -- $ -- $ --
DEBT OBLIGATIONS
The following table summarizes our debt obligations:
MARCH 31, DECEMBER 31,
2008 2007
------------ ------------
Short-term bank borrowings:
Import trade bills payable - DBS Bank and Aurora Capital $ 2,722,410 $ 4,600,293
Bank direct acceptances - DBS Bank ..................... 3,453,839 1,222,998
Other Hong Kong credit facilities - DBS Bank ........... 2,616,003 3,921,927
------------ ------------
$ 8,792,252 $ 9,745,218
============ ============
Long-term obligations:
Equipment financing .................................... $ 2,135 $ 5,338
Debt facility and factoring agreement - GMAC CF ........ 11,070,015 2,997,793
------------ ------------
11,072,150 3,003,131
Less current portion ................................... (11,072,150) (3,003,131)
------------ ------------
$ -- $ --
============ ============
DBS BANK CREDIT FACILITY
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 Bank (Hong Kong) Limited ("DBS"), which replaced our prior
letter of credit facility for up to HKD 30 million (equivalent to US $3.9
million). Under this facility, we may arrange for letters of credit and
29
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 Hong Kong Dollar Standard Bills Rate quoted by
DBS minus 0.5% if paid in Hong Kong Dollars, which the interest rate was 6.00%
per annum at March 31, 2008, or the U.S. Dollar Standard Bills Rate quoted by
DBS plus 0.5% if paid in any other currency, which the interest rate was 5.97%
per annum at March 31, 2008. 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 and Todd Kay; and by our guarantee. The DBS facility includes
customary default provisions. In addition, we are subject to certain restrictive
covenants, including annual covenants that we maintain a specified tangible net
worth and a minimum level of EBITDA at December 31, 2006 and 2007, that we
maintain interest coverage ratio, leverage ratio and limitations on additional
indebtedness. We are in the process of revising these covenants for 2008. As of
March 31, 2008, $8.5 million was outstanding under this facility. In addition,
$8.7 million of open letters of credit were outstanding and $7.8 million was
available for future borrowings as of March 31, 2008.
REVOLVING CREDIT FACILITY - GMAC COMMERCIAL FINANCE
On June 16, 2006, we expanded our previously existing credit facility
with GMAC Commercial Finance Credit, LLC ("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 amount 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 ratio 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 5.75% per annum at March 31, 2008. As of at March 31, 2008, we were
in violation of the EBITDA covenant and a waiver was obtained on May 12, 2008.
We are in the process of revising these covenants for the rest of 2008. A total
of $11.1 million was outstanding with respect to receivables factored under the
GMAC CF facility at March 31, 2008.
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.
EQUIPMENT LOANS
We had one equipment loan outstanding at March 31, 2008. The loan bears
interest at 4.75% payable in installments through 2008. As of March 31, 2008,
$2,000 was outstanding under the loan.
LETTERS OF CREDIT
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 March 31, 2008, $297,000 was outstanding
under this facility and $343,000 of letters of credit was open under this
arrangement. We pay a commission fee of 2.25% on all letters of credits issued
under this arrangement.
30
The credit facility with GMAC CF prohibits us from paying dividends or
making other distributions on our common stock. In addition, the credit facility
with GMAC CF prohibits our subsidiaries that are borrowers under the facility
from paying dividends or making other distributions to us. The credit facility
with DBS prohibits our Hong Kong facilities from paying any dividends or making
other distributions or advances to us.
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 securities. 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.
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.
We do not believe that the moderate levels of inflation in the United
States in the last three years have had a significant effect on net sales or
profitability.
RELATED PARTY TRANSACTIONS
We lease our executive offices and warehouse in Los Angeles, California
from GET. Additionally, we leased office space and warehouse in Hong Kong from
Lynx International Limited. GET and Lynx International Limited are each owned by
Gerard Guez, our Chairman and Interim Chief Executive Officer, and Todd Kay, our
Vice Chairman. We believe, at the time the leases were entered into, the rents
on these properties were comparable to then prevailing market rents. We paid
$284,000 and $279,000 in rent in the three months ended March 31, 2008 and 2007,
respectively, for these office and warehouse facilities. Our lease for the Los
Angeles offices and warehouse has a term of five years expiring in 2011, with an
option to renew for an additional five year term. Our lease for the office space
and warehouse in Hong Kong has expired and we are currently renting on a month
to month basis. On May 1, 2006, we sublet a portion of 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. We received
$75,000 in rental income from this sublease in the three months ended March 31,
2008 and 2007.
From time to time in the past, we had advanced funds to Mr. Guez. These
were net advances to Mr. Guez or payments paid on his behalf before the
enactment of the Sarbanes-Oxley Act in 2002. The promissory note documenting
these advances contains a provision that the entire amount together with accrued
interest is immediately due and payable upon our written demand. The greatest
outstanding balance of such advances to Mr. Guez in the first quarter of 2008
was approximately $1,944,000. At March 31, 2008, the entire balance due from Mr.
Guez totaling $1.9 million was reflected as a reduction to shareholders' equity
in the accompanying financial statements. All amounts due from Mr. Guez bore
interest at the rate of 7.75% during the period. Total interest paid by Mr. Guez
was $37,000 and $41,000 for the three months ended March 31, 2008 and 2007,
respectively. Mr. Guez paid expenses on our behalf of approximately $114,000 and
$105,000 for the three months ended March 31, 2008 and 2007, 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 United Apparel Ventures, LLC to jointly
market, share certain risks and achieve economies of scale with Azteca
Production International, Inc. This entity was created to coordinate the
production of apparel for a single customer of our branded business. Azteca is
owned by the brothers of Gerard Guez. UAV made purchases from a related party in
Mexico, an affiliate of Azteca. UAV was owned 50.1% by Tag Mex, Inc., our wholly
owned subsidiary, and 49.9% by Azteca. Results of the operation of UAV had 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 until 2004. Due to the restructuring of our Mexico
operations, we discontinued manufacturing for UAV customers in 2004. We had been
consolidating 100% of the results of the operation of UAV into our results since
2005. UAV was dissolved on February 27, 2007. We did not purchase any finished
goods, fabric and service from Azteca and its affiliates in the three months
31
ended March 31, 2008 and 2007. Based on the repayment history of Azteca and
litigation Azteca is currently subject to, we estimated that our receivable of
$3.4 million will take approximately three years for collection in full. We
therefore made a $1.0 million reserve and then fair-valued the balance of this
asset using our weighted average cost of capital as the discount rate and a term
of three years as the discount period at December 31, 2007. Net amounts due from
this related party as of March 31, 2008 and December 31, 2007 were $1.5 million.
On September 1, 2006, our subsidiary in Hong Kong, Tarrant Company
Limited, entered into an agreement with Seven Licensing to be its buying agent
to source and purchase apparel merchandise. Seven Licensing is beneficially
owned by Gerard Guez. Total sales to Seven Licensing in the three months ended
March 31, 2008 and 2007 were $4.2 million and $3.3 million, respectively. Net
amount due from this related party as of March 31, 2008 and December 31, 2007
was $7.6 million and $6.8 million, respectively.
We purchased $2.7 million and $2.8 million of finished goods from Star
Source, LLC and AJG Inc. dba Astrologie in the three months ended March 31, 2008
and 2007, respectively. Star Source, LLC and AJG Inc. dba Astrologie are
beneficially owned by an adult son of one of our employees. As of March 31,
2008, we had outstanding advances of $132,000 to Star Source, LLC for fabric
purchase.
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.
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. At March 31, 2008, we had no
open foreign exchange forward contracts. 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. As of March 31, 2008, we had $299,000 of fixed-rate borrowings and $19.6
million of variable-rate borrowings outstanding. A one percentage point increase
in interest rates would result in an annualized increase to interest expense of
approximately $196,000 on our variable-rate borrowings.
ITEM 4. CONTROLS AND PROCEDURES.
EVALUATION OF CONTROLS AND PROCEDURES
Members of the our management, including our Interim 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
Rule 13a-15 or 15d-15, as of March 31, 2008, the end of the period covered by
this report. Members of the our management, including our Interim 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 first quarter of 2008 that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
32
reporting. Based upon that evaluation, the Interim Chief Executive Officer and
Chief Financial Officer concluded that our disclosure controls and procedures
are effective.
CHANGES IN CONTROLS AND PROCEDURES
During the first quarter ended March 31, 2008, there were no changes in
our internal control over financial accounting that has materially affected, or
is reasonably likely to materially affect, our internal control over financial
reporting.
33
PART II -- OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
On February 1, 2008, Tarrant Apparel Group and our wholly-owned
subsidiary, Private Brands, Inc., filed and served a cross-complaint against
American Rag Cie, LLC (the "LLC") and American Rag Cie II ("ARC II") in the, in
the action AMERICAN RAG CIE V. PRIVATE BRANDS, INC., Superior Court of the State
of California, County of Los Angeles, Central District, Case No. BC 384428. The
original action had been filed on January 28, 2008 against Private Brands by the
LLC. The LLC owns the trademark "American Rag Cie", which mark has been licensed
to Private Brands on an exclusive basis throughout the world except for Japan
and pursuant to which Private Brands sells American Rag Cie branded apparel to
Macy's Merchandising Group and has sub-licensed to Macy's Merchandising Group
the right to manufacture certain categories of American Rag Cie branded apparel
in the United States. The LLC is owned 55% by ARC II and 45% by Tarrant Apparel
Group. In the original complaint the LLC seeks a declaratory judgment that we
have breached the license agreement and that the license agreement has been
properly terminated. Our cross-complaint counters this claim, and seeks a
declaration that the license agreement is valid and continues to be in effect.
Additionally, the cross-complaint seeks relief on a number of causes of action,
including breach of the license agreement, a declaration by the Court imposing a
reasonable term into the agreement for sublicensing royalties, dissolution of
LLC, damages for breach of fiduciary duty, and an accounting of the monies
diverted by defendants' actions. On March 3, 2008, we dismissed, without
prejudice, our claim for dissolution of LLC after being notified that ARC II had
elected to buy out our share in the LLC, a permitted defense to an action for
dissolution. On March 19, 2008, the LLC and ARC II filed an amended complaint,
in which they expanded their claims against us to include claims for breach of
contract, fraud, and breach of fiduciary duty, and seeking further declaratory
relief and compensatory and punitive damages. On April 21, 2008, we filed a
demurrer to four of the causes of action in the amended complaint, and are
seeking dismissal of the LLC and ARC II's claims for fraud and breach of
fiduciary duty, as well as their attempt to force a buy-out. The demurrer will
be argued on on June 16, 2008. The action is in the early stages of discovery.
As we derive a significant amount of revenue from the sale of American Rag Cie
branded products, our business, results of operations and financial condition
could be materially adversely affected if this dispute is not resolved in a
manner favorable to us. Additionally, we have incurred significant legal fees in
this litigation, and unless the case is settled will continue to incur
additional legal fees in increasing amounts as the case accelerates to trial.
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 and
in our Annual Report on Form 10-K for the year ended December 31, 2007.
Risk factors relating to our business, industry and common stock are
contained in Item 1A of our Annual Report on Form 10-K for the fiscal year ended
December 31, 2007. Except as set forth below, no material change to such risk
factors has occurred during the three months ended March 31, 2008.
THE ACQUISITION PROPOSAL BY GERARD GUEZ AND TODD KAY HAS CREATED A DISTRACTION
FOR OUR MANAGEMENT, UNCERTAINTY AND RISK OF LITIGATION THAT MAY ADVERSELY AFFECT
OUR BUSINESS.
On April 25, 2008, we received an unsolicited proposal from Gerard Guez
and Todd Kay, our founders, executive officers and directors, to acquire all of
the outstanding publicly held shares of our common stock. Our Board of Directors
has formed a special committee of the Board to consider the acquisition
proposal, and the special committee in the process of interviewing legal counsel
and investment bankers to assist in its consideration and evaluation of the
proposal. The review and consideration of the acquisition proposal (and any
alternate proposals that may be made by other parties) have been, and may
continue to be, a significant distraction for our management and employees and
34
may require, the expenditure of significant time and resources by us. The
acquisition proposal has also created uncertainty for our employees and this
uncertainty may adversely affect our ability to retain key employees and to hire
new talent, and may also create uncertainty for current and potential business
partners, which may cause them to terminate, or not to renew or enter into,
arrangements with us.
In the past, securities class action litigation has often been brought
against a company involved in management buy-outs and going-private
transactions. This risk is especially acute for us because we have experienced
declines in the market price of our shares and greater than average stock price
volatility in recent months. This litigation could result in substantial costs
and divert management's attention and resources, and could seriously harm our
business. We have obligations under certain circumstances to hold harmless and
indemnify each of the members of our Board of Directors against judgments,
fines, settlements and expenses related to claims against such directors and
otherwise to the fullest extent permitted under California law and our bylaws
and certificate of incorporation. An unfavorable outcome in any future lawsuits
could result in substantial costs to us. These consequences, alone or in
combination, may harm our business.
THE ACQUISITION PROPOSAL BY MR. GUEZ AND MR. KAY HAS CREATED UNCERTAINTY AND MAY
RESULT IN INCREASED VOLATILITY IN THE MARKET PRICE OF OUR COMMON STOCK.
The special committee of our Board of Directors is in the process of
evaluating the acquisition proposal submitted by Mr. Guez and Mr. Kay, but has
made no determination on whether to accept the proposal. Even if the proposal is
accepted by the special committee, any potential transaction would be subject to
conditions to closing, including approval of our shareholders. Therefore, an
acquisition may not be completed at all or may not be completed in a timely
manner. This uncertainty could result in speculation and increased volatility in
the market for our shares. If the acquisition proposal is not accepted by the
special committee or any acquisition does not occur for any other reason, the
market price of our common stock may decline. In addition, our stock price may
decline as a result of the fact that we have incurred and will continue to incur
significant expenses related to the proposed acquisition that will not be
recovered whether or not a transaction occurs.
WE MAY NOT BE ABLE TO MAINTAIN OUR LISTING ON THE NASDAQ GLOBAL MARKET AND IF WE
FAIL TO DO SO, THE PRICE AND LIQUIDITY OF OUR COMMON STOCK MAY DECLINE.
The Nasdaq Stock Market has quantitative maintenance criteria for the
continued listing of common stock on the Nasdaq Global Market. The requirement
currently affecting us is maintaining a minimum closing bid price per share of
$1.00. On April 2, 2008, the Nasdaq Stock Market Inc. issued a letter to us
stating that we were not in compliance with the minimum closing bid price
requirement and, therefore, faced delisting proceedings. To regain compliance
with the minimum bid price rule, the closing bid price of our common stock must
close at $1.00 per share or more for a minimum of ten consecutive business days.
If we do not regain compliance by September 29, 2008, the Nasdaq staff will
notify us that our common stock will be delisted. In that event and at that
time, we may appeal Nasdaq's delisting determination to a Nasdaq Listing
Qualifications Panel. Alternatively, if we do not regain compliance with the
minimum bid price rule by September 29, 2008, we can apply to list our common
stock on The Nasdaq Capital Market if we satisfy the initial listing criteria
set forth in Marketplace Rule 4310(c), other than the minimum bid price
requirement. If our application is approved, we will be granted an additional
180 calendar days to regain compliance with the minimum bid price rule. However,
there can be no assurance that we will be able to comply with the maintenance
criteria or any of the Nasdaq Global Market's listing requirements or other
rules, or other markets listing requirements to the extent our stock is listed
elsewhere, in the future. If we fail to maintain continued listing on the Nasdaq
Global Market and must move to a market with less liquidity, our financial
condition could be harmed and our stock price would likely further decline. If
we are delisted, it could have a material adverse effect on the market price of,
and the liquidity of the trading market for, our common stock.
35
ITEM 6. EXHIBITS.
EXHIBIT
NUMBER DESCRIPTION
------- --------------------------------------------------------------
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.
36
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: May 12, 2008 By: /s/ Patrick Chow
--------------------------------------------
Patrick Chow,
Chief Financial Officer and Director
(Principal Financial and Accounting Officer)
Date: May 12, 2008 By: /s/ Gerard Guez
--------------------------------------------
Gerard Guez,
Interim Chief Executive Officer
37