We operate the following business segments: Wholesale Apparel, Wholesale Non-Apparel and Retail.
• | Wholesale Apparel consists of women’s and men’s apparel designed and marketed worldwide under various trademarks owned by the Company or licensed by the Company from third-party owners. This segment includes our businesses in our LIZ CLAIBORNE brand along with our better apparel (CLAIBORNE (men’s), INTUITIONS and SIGRID OLSEN), bridge priced (DANA BUCHMAN and ELLEN TRACY), Special Markets (which is comprised of our mid-tier brands (AXCESS, BELONGINGS, CRAZY HORSE, FIRST ISSUE, LATINA, METROCONCEPTS, TINT and VILLAGER) and moderate department store brands (EMMA JAMES, J.H. COLLECTIBLES and TAPEMEASURE)), denim/street wear (ENYCE and LUCKY BRAND DUNGAREES) and contemporary sportswear (JUICY COUTURE, C&C CALIFORNIA and LAUNDRY BY SHELLI SEGAL) businesses, as well as our licensed DKNY® JEANS, DKNY® ACTIVE, and CITY DKNY® businesses. The Wholesale Apparel segment also includes wholesale sales of women’s, men’s and children’s apparel designed and marketed in Europe, Canada, the Asia-Pacific region and the Middle East under our MEXX brand names. |
• | Wholesale Non-Apparel consists of handbags, small leather goods, fashion accessories, jewelry and cosmetics designed and marketed worldwide under certain of the above listed and other owned or licensed trademarks, including our MONET, TRIFARI and MARVELLA labels. |
• | Retail consists of our worldwide retail operations that sell most of these apparel and non-apparel products to the public through our 316 outlet stores, 309 specialty retail stores and 620 international concession stores (where the retail selling space is either owned and operated by the department store in which the retail selling space is located, or leased and operated by a third party, while, in each case, the Company owns the inventory), and our e-commerce sites. This segment includes specialty retail and outlet stores operating under the following formats: MEXX, LUCKY BRAND DUNGAREES, LIZ CLAIBORNE, ELISABETH, DKNY® JEANS, DANA BUCHMAN, ELLEN TRACY, SIGRID OLSEN, MONET, LAUNDRY BY SHELLI SEGAL and JUICY COUTURE, as well as our Special Brands outlets which include products from our Special Markets divisions. |
The Company, as licensor, also licenses to third parties the right to produce and market products bearing certain Company-owned trademarks. The resulting royalty income is not allocated to any of the specified operating segments, but is rather included in the line “Sales from external customers” under the caption “Corporate/Eliminations” in Note 13 of Notes to Condensed Consolidated Financial Statements.
We operate in global fashion markets that are intensely competitive. Our ability to continuously evaluate and respond to changing consumer demands and tastes, across multiple market segments, distribution channels and geographies, is critical to our success. Although our brand portfolio approach is aimed at diversifying our risks in this regard, misjudging shifts in consumer preferences could have a negative effect. Other key aspects of competition include quality, brand image, distribution methods, price, customer service and intellectual property protection. Our size and global operating strategies help us to compete successfully by positioning us to take advantage of synergies in product design, development, sourcing and distribution of our products throughout the world. We believe we owe much of our recent success to our ability to identify strategic acquisitions, our ability to grow our existing businesses including the creation of internally developed brands, to our product designs and to our having successfully leveraged our competencies in technology and supply chain management for the benefit of existing and new (both acquired and internally developed) businesses.
As a result of macroeconomic pressures, including expectations of higher inflation and interest rates, concerns about a slowing economy and declining consumer confidence, coupled with increasing transportation and energy costs and the impacts of recent hurricanes, we see further pressures on consumer spending. In addition, consumers are migrating away from traditional mall formats and instead turning to national chains and off-priced retailers to stretch their dollars. These issues, when combined with the complexities and unknown impacts of retail consolidation, including the recent Federated Department Stores and May Company mergers and associated integration and transitional activities, the uncertainty regarding the Sears apparel business and internal distractions of certain other retailers, all speak to the multitude of challenges in the sector. As those customers continue to focus on inventory
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productivity and product differentiation to gain competitive market share, they continue to execute their buying activities very cautiously. This conservative operating environment has adversely impacted our domestic wholesale apparel business, which represents an increasingly smaller portion of our total company. In response to this challenging business climate, we are focusing our investment on trending categories and trending businesses and developing strategies to address those businesses that are underperforming to be more responsive to our customers.
Looking forward, we expect that the challenges of our retail partners will continue over the near term and the conservative approach to planning inventory levels will continue to be a major focus. Retailers will turn to wholesalers who can respond quickly to market trends allowing those retailers to maintain lean retail inventory stock levels of faster turning differentiated products. We believe that our technology coupled with our modern business models and evolving supply chain enable us to partner with our customers, to quickly identify and reorder those items that are trending well with customers and appeal to consumers. With our acquisitions and the growth in our mid-tier department store brands, non-apparel businesses and specialty retail businesses, we have diversified and will continue to diversify our operations to leverage the strength of our multi-brand portfolio to meet demands of multiple types of consumers. We have also diversified geographically, with our international operations representing nearly 26% of total Company net sales. We view the international markets as an important area of growth for us as we continue to build the capability to launch brands from our domestic portfolio and evaluate business development opportunities in markets outside of the United States. Additionally, we will continue to focus on our rigorous internal inventory control management activities as well as our process improvement and expense control initiatives. In summary, our success in the future will depend on our ability to continue to design and execute products that are acceptable to the marketplaces that we serve, to source the manufacture of our products on a competitive basis, particularly in light of uncertainty regarding quota for apparel products, and to leverage our technology competencies. We are convinced that a multi-brand, multi-channel strategy speaks to our vision to support future and sustained growth.
Reference is also made to the other economic, competitive, governmental and technological factors affecting the Company’s operations, markets, products, services and prices as are set forth under “Statement Regarding Forward-Looking Disclosure” below and in our 2004 Annual Report on Form 10-K, including, without limitation, those set forth under the heading “Business-Competition; Certain Risks.”
Overall Results for the Nine Months Ended October 1, 2005
Net Sales
Net sales for the first nine months of 2005 were $3.648 billion, an increase of $212.9 million, or 6.2%, over 2004 nine months net sales, primarily reflecting increases in our Specialty Retail, Cosmetics, MEXX Europe and JUICY COUTURE businesses, partially offset by declines in our LIZ CLAIBORNE Wholesale Apparel business. We continue the disciplined execution of our brand portfolio strategy, under which we strive to offer consumers apparel and non-apparel products across a range of styles, price points and channels of distribution. Most notably, we have targeted growth in the contemporary and premium denim categories and our international and Specialty Retail businesses. The execution of our portfolio strategy is highlighted by strategic acquisitions, internal brand development, including brand extensions, such as the creation of an international, multi-brand platform, and the extension of our brands into non-apparel categories, both internally and through third party licensing, as well as expansion of our Specialty Retail formats.
Gross Profit and Net Income
Our gross profit improved in the nine months of 2005, resulted from increased sales, continued focus on lower sourcing costs and changing business mix, offsetting gross margin pressure resulting from a challenging retail environment. Our gross profit benefited from the continued growth of our domestic and international Specialty Retail businesses, as each of these businesses run at gross profit rates higher than the Company average, and the reimbursement from a customer of improperly collected markdown allowances. Overall net income increased to $239.1 million in the first nine months of 2005 from $230.9 million in 2004, reflecting the benefit received from our sales and gross profit rate improvements partially offset by increased SG&A.
Balance Sheet
Our financial position continues to be strong. We ended the first nine months of 2005 with a net debt position of $387.8 million as compared to $461.9 million at October 2, 2004. We generated $414.9 million in cash from operations over the past twelve months, which enabled us to fund the first quarter acquisition of C&C California, the
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purchase of an additional 8.25% of the outstanding minority interest in Lucky Brand, the final payment to acquire Mexx Europe and Mexx Canada, our second quarter 2005 share repurchase of $105.2 million and our capital expenditures of $155.5 million, while decreasing our net debt by $74.1 million. The effect of foreign currency translation on our Eurobond reduced our debt balance by $12.5 million.
International Operations
In the first nine months of 2005, sales from our international segment represented 25.6% of our overall sales, compared to 23.9% in the first nine months of 2004. We expect our international sales to continue to represent an increasingly higher percentage of our overall sales volume as a result of further anticipated growth in our MEXX Europe business and from the recent launch of a number of our current domestic brands in Europe utilizing the Mexx corporate platform. Accordingly, our overall results can be greatly impacted by changes in foreign currency exchange rates. For example, the impact of foreign currency exchange rates represented $33.8 million, or 29.7%, of the increase of international sales from the first nine months of 2004. Over the past few years, the euro and the Canadian dollar have strengthened against the U.S. dollar. While this trend has benefited our sales results and earnings in light of the growth of our MEXX Europe and our Canadian businesses, these businesses’ inventory, accounts receivable and debt balances have likewise increased. Although we use foreign currency forward contracts and options to hedge against our exposure to exchange rate fluctuations affecting the actual cash flows associated with our international operations, unanticipated shifts in exchange rates could have a negative impact on our financial results.
Recent Acquisitions
On November 3, 2005, we announced that we have agreed to purchase 100% of the equity interest of Skylark Sport Marketing Corporation, doing business as prAna (“prAna”). Based in California and established in 1993, prAna is a designer, marketer and wholesaler of climbing, yoga and outdoor/active lifestyle apparel and accessories. The purchase price is currently estimated to be $34.4 million, consisting of an initial payment of approximately $32.5 million (representing 60% of prAna’s initial valuation) and the retirement of debt at closing (estimated at approximately $1.9 million), plus contingent payments to be determined as a multiple of prAna’s earnings in fiscal years 2008, 2009 and 2010. Consummation of the transaction is subject to customary closing conditions. The transaction is expected to close in the fourth quarter of 2005.
On January 6, 2005, we acquired 100 percent of the equity interest of C&C California, Inc. (“C&C”). Based in California and founded in 2002, C&C is a designer, marketer and wholesaler of premium apparel for women, men and children through its C&C CALIFORNIA brand. C&C sells its products primarily through select specialty stores as well as through international distributors in Canada, Europe and Asia. The purchase price consisted of payments totaling $29.3 million, including fees, plus contingent payments based upon a multiple of C&C’s earnings in fiscal years 2007, 2008 and 2009. We estimate that the aggregate of the contingent payments will be in the range of approximately $20-25 million. The contingent payments will be accounted for as additional purchase price. Based on a preliminary independent third-party valuation of the trademarks, trade names and customer relationships acquired from C&C, $7.5 million of purchase price has been allocated to the value of trademarks and trade names associated with the business, and $10.6 million has been allocated to the value of customer relationships. The trademarks and trade names have been classified as having definite lives and will be amortized over their estimated useful life of 20 years. Goodwill of $8.0 million is deemed to have an indefinite life and is subject to an annual test for impairment as required by Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.” The value of customer relationships is being amortized over periods ranging from 10 to 20 years. Unaudited pro forma information related to this acquisition is not included as the impact of this transaction is not material to the consolidated results of the Company.
On June 8, 1999, we acquired 85.0 percent of the equity interest of Lucky Brand Dungarees, Inc. (“Lucky Brand”), whose core business consists of the LUCKY BRAND DUNGAREES line of women’s and men’s denim-based sportswear. The acquisition was accounted for using the purchase method of accounting. The total purchase price consisted of a cash payment made at the closing date of approximately $85 million and a payment made in April 2003 of $28.5 million. An additional payment of $12.7 million was made in 2000 for tax-related purchase price adjustments. On January 28, 2005, we entered into an agreement to acquire the remaining 15% of Lucky Brand shares that were owned by the sellers of Lucky Brand for an aggregate consideration of $65.0 million, plus a contingent payment for the final 2.25% based upon a multiple of Lucky Brand’s 2007 earnings. On January 28, 2005, we paid $35.0 million for 8.25% of the equity interest of Lucky Brand. The excess of the amount paid over the related amount of minority interest has been recorded to goodwill. In January 2006, 2007 and 2008, we will acquire 1.9%, 1.5% and 1.1% of the equity interest of Lucky Brand for payments of $10.0 million each. We have recorded
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the present value of fixed amounts owed ($28.2 million) as an increase in Accrued Expenses and Other Non-Current Liabilities. The excess of the liability recorded over the related amount of minority interest has been recorded as goodwill. In June 2008, we will acquire the remaining 2.25% minority share for an amount based on a multiple of Lucky Brand’s 2007 earnings, which we estimate will be in the range of $20-24 million.
On December 1, 2003, we acquired 100 percent of the equity interest of Enyce Holding LLC (“Enyce”), a privately held fashion apparel company, for a purchase price of approximately $121.9 million, including fees and the retirement of debt at closing, and an additional $9.7 million for certain closing adjustments and assumptions of liabilities that were accounted for as additional purchase price. Based upon an independent third-party valuation of the tangible and intangible assets acquired from Enyce, $27.0 million of purchase price has been allocated to the value of trademarks and trade names associated with the business, and $17.5 million has been allocated to the value of customer relationships. The trademarks and trade names have been classified as having indefinite lives and are subject to an annual test for impairment as required by SFAS No. 142. The value of customer relationships is being amortized over periods ranging from 9 to 25 years.
On April 7, 2003, we acquired 100 percent of the equity interest of Juicy Couture, Inc. (formerly, Travis Jeans Inc.) (“Juicy Couture”), a privately held fashion apparel company. The total purchase price consisted of: (a) a payment, including the assumption of debt and fees, of $53.1 million, and (b) a contingent payment to be determined as a multiple of Juicy Couture’s earnings for one of the years ended 2005, 2006 or 2007. The selection of the measurement year for the contingent payment is at either party’s option. We estimate that if the 2005 measurement year is selected, the contingent payment would be in the range of approximately $106-109 million. The contingent payment will be accounted for as additional purchase price. In March 2005, the contingent payment agreement was amended to include an advance option for the sellers. If the 2005 measurement year is not selected, the sellers may elect to receive up to 75% of the estimated contingent payment based upon 2005 results. If the 2005 and 2006 measurement years are not selected, the sellers are eligible to elect to receive up to 85% of the estimated contingent payment based on the 2006 measurement year net of any 2005 advances. Based upon an independent third-party valuation of the tangible and intangible assets acquired from Juicy Couture, $27.3 million of purchase price has been allocated to the value of trademarks and trade names associated with the business. The trademarks and trade names have been classified as having indefinite lives and are subject to an annual test for impairment as required by SFAS No. 142.
On July 9, 2002, we acquired 100 percent of the equity interest of Mexx Canada, Inc., a privately held fashion apparel and accessories company (“Mexx Canada”). The total purchase price consisted of: (a) an initial cash payment made at the closing date of $15.2 million; (b) a second payment made at the end of the first quarter 2003 of 26.4 million Canadian dollars (or $17.9 million based on the exchange rate in effect as of April 5, 2003); and (c) a contingent payment to be determined as a multiple of Mexx Canada’s earnings and cash flow performance for the year ended either 2004 or 2005. The fair market value of assets acquired was $20.5 million and liabilities assumed were $17.7 million resulting in goodwill of $29.6 million. In December 2004, the 2004 measurement year was selected by the seller for the calculation of the contingent payment. The contingency was settled on April 26, 2005 for 45.3 million Canadian dollars (or $37.1 million based on the exchange rate on such date). The contingent payment was accounted for as additional purchase price.
On May 23, 2001, we acquired 100 percent of the equity interest of Mexx Group B.V. (“Mexx”), a privately held fashion apparel company incorporated and existing under the laws of The Netherlands, for a purchase price consisting of: (a) $255.1 million (295 million euro), in cash at closing (including the assumption of debt), and (b) a contingent payment determined as a multiple of Mexx’s earnings and cash flow performance for the year ended 2003, 2004 or 2005. The 2003 measurement year was selected by the sellers for the calculation of the contingent payment, and on August 16, 2004, we made the required final payment of $192.4 million (160 million euro). The contingent payment was accounted for as additional purchase price.
Share-Based Compensation
On July 3, 2005 we adopted SFAS No. 123(R) “Share-Based Payment” requiring the recognition of compensation expense in the Consolidated Statements of Income related to the fair value of our employee share-based options. SFAS No. 123(R) revises SFAS No. 123 “Accounting for Stock-Based Compensation” and supercedes Accounting Principles Board (“APB”) Opinion No. 25 “Accounting for Stock Issued to Employees.”
We will recognize the cost of all employee stock options on a straight-line attribution basis over their respective vesting periods, net of estimated forfeitures. We have selected the modified prospective method of transition; accordingly, prior periods have not been restated. We have not modified any unvested awards. We have migrated
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our equity-based management compensation program toward restricted stock and away from stock options. Prior to adopting SFAS No. 123(R), we applied APB Opinion No. 25, and related Interpretations in accounting for our stock-based compensation plans. All employee stock options were granted at or above the grant date market price. Accordingly, no compensation cost was recognized for fixed stock option grants in prior periods. In the third quarter of 2005, we expensed $4.7 million of stock options; we expect a comparable amount to be expensed in the fourth quarter of 2005 and $16.2 million of stock option expense in fiscal 2006. As of October 1, 2005, we expect $23.0 million of unvested stock options to be expensed in future periods.
We changed the valuation model used for estimating the fair value of options granted in the first quarter of 2005, from a Black-Scholes option-pricing model to a Binomial lattice-pricing model. This change was made in order to provide a better estimate of fair value since the Binomial model is a more flexible analysis to value employee stock options than the Black-Scholes model. The flexibility of the simulated Binomial model stems from the ability to incorporate inputs that change over time, such as volatility and interest rates, and to allow for actual exercise behavior of option holders.
RESULTS OF OPERATIONS
We present our results of operations, based on the three business segments, which were discussed in the Overview section, as well as on the following geographic basis based on selling location:
• | Domestic: wholesale customers, Company specialty retail and outlet stores located in the United States and our e-commerce sites; and |
• | International: wholesale customers and Company specialty retail and outlet stores and concession stores located outside of the United States, primarily in our MEXX Europe and our Canadian operations. |
All data and discussion with respect to our specific segments included within this “Management’s Discussion and Analysis” is presented after applicable intercompany eliminations.
THREE MONTHS ENDED OCTOBER 1, 2005 COMPARED TO THREE MONTHS ENDED OCTOBER 2, 2004
The following table sets forth our operating results for the three months ended October 1, 2005 (comprised of 13 weeks) compared to the three months ended October 2, 2004 (comprised of 13 weeks):
| Three months ended | | Variance |
Dollars in millions | October 1,
2005 | | October 2,
2004 | | $ | | % |
Net Sales | $ | 1,336.7 | | $ | 1,306.6 | | $ | 30.1 | | 2.3% | |
| | | | | | | | | | | |
Gross Profit | | 634.5 | | | 593.6 | | | 40.9 | | 6.9% | |
| | | | | | | | | | | |
Selling, general & administrative expenses | | 450.2 | | | 413.6 | | | 36.6 | | 8.9% | |
| | | | | | | | | | | |
Restructuring gain | | (0.2 | ) | | (0.1 | ) | | 0.1 | | 110.5% | |
| | | | | | | | | | | |
Operating Income | | 184.5 | | | 180.1 | | | 4.4 | | 2.4% | |
| | | | | | | | | | | |
Other income (expense) - net | | (0.5 | ) | | -- | | | (0.5 | ) | -- | |
| | | | | | | | | | | |
Interest (expense) - net | | (8.3 | ) | | (7.9 | ) | | 0.4 | | 4.5% | |
| | | | | | | | | | | |
Provision for income taxes | | 62.2 | | | 60.6 | | | 1.6 | | 2.6% | |
| | | | | | | | | | | |
Net Income | $ | 113.5 | | $ | 111.6 | | $ | 1.9 | | 1.7% | |
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Net Sales
Net sales for the third quarter of 2005 were $1.337 billion, an increase of $30.1 million, or 2.3%, compared to net sales for the third quarter of 2004. The impact of foreign currency exchange rates in our international business was not material to sales during the quarter. Net sales results for our business segments are provided below:
• | Wholesale Apparel net sales decreased $19.3 million, or 2.3%, to $837.3 million as a result of: |
| - | A $35.5 million net decrease across our Wholesale Apparel business (excluding C&C CALIFORNIA), primarily reflecting a 29.2% year-over-year decrease in our domestic LIZ CLAIBORNE business (resulting from lower unit volume and, to a lesser extent, lower unit pricing), the discontinuation of our KENNETH COLE womenswear license and decreases in our CRAZY HORSE women’s (resulting from lower unit volume), CLAIBORNE (due to lower unit pricing), ELLEN TRACY (due to lower unit volume and increased retailer support), ENYCE (due to lower unit volume in Specialty Retail stores partially offset by increased unit volume in department stores) and DANA BUCHMAN (due to lower unit volume) businesses, partially offset by the continued growth of our MEXX Europe business, growth in our moderate and mid-tier department store businesses (due to higher unit volume, most notably growth in our EMMA JAMES, J.H. COLLECTIBLES and AXCESS brands and the launch of new brands including TAPEMEASURE, BELONGINGS and TINT), the launch of METROCONCEPTS in the men’s category, continued growth in our JUICY COUTURE business (due to increased customer demand mostly reflected in higher unit volume), and increases in our licensed DKNY® JEANS (due to the addition of new retail customers) and LUCKY BRAND DUNGAREES (due to higher unit pricing and an increase in department store locations within existing customers) businesses; partially offset by |
| - | The inclusion of $3.9 million of sales from our recently acquired C&C CALIFORNIA business; and |
| - | The reimbursement of $12.3 million from a customer of improperly collected markdown allowances. |
• | Wholesale Non-Apparel net sales increased $19.2 million, or 10.7%, to $198.5 million. The increase was due to growth in our LUCKY BRAND, LIZ CLAIBORNE and moderate and mid-tier department store Handbags businesses, our MONET, LUCKY BRAND and SIGRID OLSEN Jewelry businesses, as well as increases in our Cosmetics business (due to continued growth of our LUCKY, CURVE and LIZ fragrances) and the addition of our TINT Jewelry and AXCESS Jewelry and Fashion Accessories businesses. |
• | Retail net sales increased $28.9 million, or 11.1%, to $289.8 million primarily driven by a 6.6% comparable store sales increase in our Specialty Retail business (including an 18.1% comparable store sales increase in our LUCKY BRAND DUNGAREES business) and the net addition over the last twelve months of 54 Specialty Retail and 35 Outlet stores, reflecting in part the opening of 18 SIGRID OLSEN, 15 MEXX international, 16 LUCKY BRAND and 5 MEXX USA Specialty Retail stores, and 18 LIZ CLAIBORNE and 19 MEXX Outlet stores in the United States, Canada and Europe. These increases were partially offset by a 5.6% comparable store sales decrease in our Outlet business as a result of reduced levels of customer traffic. Comparable store sales in our Company-operated stores decreased 0.6% overall. |
| |
| We ended the quarter with a total of 316 Outlet stores, 309 Specialty Retail stores and 620 international concession stores. Comparable store sales are calculated as sales from existing stores, plus new stores, less closed stores as follows: new stores become comparable after 15 full months of being open. Closed stores become non-comparable one month before they close. If a store undergoes renovations and increases or decreases substantially in size as the result of renovations, it becomes non-comparable. If a store is relocated, stays the same size, and has no interruption of selling, then the store remains comparable. If, however, a location change causes a significant increase or decrease in size, then the location becomes non-comparable. Stores that are acquired are not considered comparable until they have been reflected in our results for a period of 12 months. Comparable store sales do not include concession sales. |
| |
• | Corporate net sales, consisting of licensing revenue, increased $1.4 million to $11.0 million as a result of revenues from new licenses and growth from our existing license portfolio. |
Viewed on a geographic basis, Domestic net sales decreased by $3.7 million, or 0.4%, to $984.5 million, primarily reflecting the declines in our LIZ CLAIBORNE apparel business, partially offset by continued growth in our JUICY COUTURE apparel and accessories, moderate and our mid-tier department store businesses as well as our Specialty Retail business. International net sales increased $33.8 million, or 10.6%, to $352.2 million. The international increase reflected the results of our MEXX Europe and Canadian businesses.
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Gross Profit
Gross profit increased $40.9 million, or 6.9%, to $634.4 million in the third quarter of 2005 over the third quarter of 2004. Gross profit as a percent of net sales increased to 47.5% in 2005 from 45.4% in 2004. The increased gross profit rate reflected the impact of lower sourcing costs, the reimbursement from a customer of improperly collected markdown allowances and a change in the mix of product offerings within our portfolio, primarily reflecting an increased proportion of sales from our MEXX Europe business and our Canadian Retail and domestic Specialty Retail businesses, which run at higher gross profit rates than the Company average, as well as a decreased proportion of sales from our domestic LIZ CLAIBORNE apparel business, which runs at a lower gross profit rate than the Company average, partially offset by additional liquidation of excess inventory. The impact of foreign currency exchange rates in our international businesses was not material.
Warehousing activities including receiving, storing, picking, packing and general warehousing charges are included in Selling, general & administrative expenses (“SG&A”); accordingly, our gross margin may not be comparable to others who may include these expenses as a component of cost of goods sold.
Selling, General & Administrative Expenses
SG&A increased $36.7 million, or 8.9%, to $450.0 million in the third quarter of 2005 over the third quarter of 2004 as a result of:
• | The inclusion of $3.8 million of expenses from our recently acquired C&C CALIFORNIA business and the start-up of internally developed businesses; |
• | The inclusion of $6.5 million of expense resulting from the expensing of stock options due to the adoption of SFAS No. 123(R), discussed above as well as the migration of our equity-based management compensation plan primarily to restricted stock; |
• | $5.7 million of expense associated with reductions and repositioning of our workforces, primarily in our wholesale apparel brands reflecting efforts necessary to maximize the efficiency of our overhead cost structure; |
• | $3.2 million of costs associated with office and distribution center real estate consolidation and the closure of our LIZ CLAIBORNE retail store in London; and |
• | A $17.5 million net increase primarily resulting from the expansion of our domestic and international retail businesses. |
The SG&A rate in the third quarter as a percent of net sales increased year over year to 33.7% from 31.7%. The increase primarily reflected the impact of expenses described above, in addition to the increased proportion of expenses related to our domestic Specialty Retail and MEXX Europe businesses, which run at higher SG&A rates than the Company average, and reduced expense leverage resulting from the decreased proportion of expenses related to our domestic LIZ CLAIBORNE Wholesale Apparel business, which runs at a lower SG&A rate than the Company average, partially offset by Company-wide expense control initiatives. The impact of foreign currency exchange rates in our international businesses was not material.
Restructuring (Gain)
In the third quarter 2005 and 2004, we recorded pretax restructuring gains of $221,000 ($143,000 after tax) and $105,000 ($68,000 after tax), respectively. The 2005 gain representing the reversal of the portion of the $9.8 million pretax ($6.5 million after tax) 2004 restructuring reserve (established to cover the costs associated with restructuring of our European business and the closure of our Secaucus, NJ distribution center) that was no longer required due to the completion of the activities associated with the reserve. The 2004 gain represents the reversal of the portion of the $7.1 million pretax ($4.5 million after tax) 2002 restructuring reserve (established to cover the costs associated with the closure of all 22 domestic Specialty Retail stores operating under the LIZ CLAIBORNE brand name) that was no longer required due to the completion of the activities associated with the reserve.
Operating Income
Operating income for the third quarter of 2005 was $184.5 million (or 13.8% of net sales), compared to $180.1 million (or 13.8% of net sales) in the third quarter of 2004. The impact of foreign currency exchange rates was immaterial in the quarter. The increase in operating income primarily resulted from higher sales, lower sourcing costs and the reimbursement from a customer of improperly collected markdown allowances, partially offset by the inclusion of expenses related to the workforce reductions and real estate consolidations, the inclusion of expenses resulting from the adoption of SFAS No. 123(R) and the shift in our equity-based management compensation plan,
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increased expenses associated with the expansion of our domestic and international retail businesses and the additional liquidation of excess inventory. Operating income by business segment is provided below:
• | Wholesale Apparel operating income was $121.8 million (14.6% of net sales) in 2005 compared to $120.8 million (14.1% of net sales) in 2004, principally reflecting increased profits in our MEXX Europe business, growth in our moderate department store businesses, mostly offset by reduced profits in our LIZ CLAIBORNE business as a result of the lower sales discussed above, as well as reduced profits in our ENYCE, CRAZY HORSE women’s, CLAIBORNE men’s, ELLEN TRACY and SIGRID OLSEN businesses; |
• | Wholesale Non-Apparel operating income was $49.1 million (24.7% of net sales) in 2005 compared to $41.0 million (22.9% of net sales) in 2004, principally due to increased profits in our Cosmetics business, LIZ CLAIBORNE and LUCKY BRAND Handbags businesses, and MONET, SIGRID OLSEN and LUCKY BRAND Jewelry businesses as well as the addition of our TINT and AXCESS Jewelry businesses, partially offset by reduced profits in our LIZ CLAIBORNE Fashion Accessories and Jewelry businesses; |
• | Retail operating income was $5.3 million (1.8% of net sales) in 2005 compared to $10.8 million (4.1% of net sales) in 2004, principally reflecting reduced profits in our Outlet business, partially offset by increased profits in our LUCKY BRAND DUNGAREES business; and |
• | Corporate operating income, primarily consisting of licensing operating income, increased $0.7 million to $8.2 million as a result of revenues from our new licenses and growth from our existing license portfolio. |
Viewed on a geographic basis, Domestic operating profit decreased slightly to $140.1 million, predominantly reflecting reduced profits in our LIZ CLAIBORNE business, mostly offset by increased profitability in our Cosmetics, Wholesale and LUCKY BRAND DUNGAREES Retail businesses as well as increased profits in our moderate department store businesses. International operating profit increased $7.0 million to $44.4 million, primarily related to the increased profitability of our European business.
Other Expense - net
In 2005, other expense - net was mostly comprised of $0.4 million of minority interest expense. In 2004, other expense - net was comprised of $0.5 million of minority interest expense, mostly offset by other non-operating income. (See “Commitments and Capital Expenditures” for discussion of the purchase of the remaining Lucky Brand minority interest.)
Interest Expense - net
Interest expense - net in the third quarter of 2005 was $8.3 million compared to $7.9 million in the third quarter of 2004, both of which were principally related to borrowings incurred to finance our strategic initiatives, including acquisitions.
Provision for Income Taxes
The income tax rate was 35.4% in the third quarter of 2005 and 35.2% in the prior year.
Net Income
Net income in the third quarter of 2005 increased to $113.5 million from $111.6 million in the third quarter of 2004, both of which were 8.5% of net sales. Diluted earnings per common share (“EPS”) increased to $1.06 in 2005, from $1.03 in 2004, a 2.9% increase.
Average diluted shares outstanding decreased by 1.2 million shares to 107.3 million in the third quarter of 2005 on a period-to-period basis, as a result of share repurchases, partially offset by the exercise of stock options and the effect of dilutive securities.
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NINE MONTHS ENDED OCTOBER 1, 2005 COMPARED TO NINE MONTHS ENDED OCTOBER 2, 2004
The following table sets forth our operating results for the nine months ended October 1, 2005 (comprised of 39 weeks) compared to the nine months ended October 2, 2004 (comprised of 39 weeks):
| Nine months ended | | Variance |
Dollars in millions | October 1,
2005 | | October 2,
2004 | | $ | | % |
| | | | | | | |
Net Sales | $ | 3,648.2 | | $ | 3,435.3 | | $ | 212.9 | | 6.2% | |
| | | | | | | | | | | |
Gross Profit | | 1,722.1 | | | 1,584.0 | | | 138.1 | | 8.7% | |
| | | | | | | | | | | |
Selling, general & administrative expenses | | 1,327.1 | | | 1,203.8 | | | 123.3 | | 10.2% | |
| | | | | | | | | | | |
Restructuring gain | | (0.2 | ) | | (0.1 | ) | | 0.1 | | 110.5% | |
| | | | | | | | | | | |
Operating Income | | 395.2 | | | 380.3 | | | 14.9 | | 3.9% | |
| | | | | | | | | | | |
Other income (expense) – net | | (1.5 | ) | | (1.5 | ) | | -- | | -- | |
| | | | | | | | | | | |
Interest (expense) – net | | (23.6 | ) | | (22.4 | ) | | (1.2 | ) | (5.5% | ) |
| | | | | | | | | | | |
Provision for income taxes | | 131.0 | | | 125.5 | | | 5.5 | | 4.4% | |
| | | | | | | | | | | |
Net Income | $ | 239.1 | | $ | 230.9 | | $ | 8.2 | | 3.5% | |
Net Sales
Net sales for the first nine months of 2005 were $3.648 billion, an increase of $212.9 million, or 6.2%, compared to the first nine months of 2004. Approximately $33.8 million of the increase was due to the impact of foreign currency exchange rates, primarily as a result of the strengthening of the euro, in our international businesses. Net sales results for our business segments are provided below:
• | Wholesale Apparel net sales increased $33.6 million, or 1.5%, to $2.300 billion as a result of: |
| - | The inclusion of $12.3 million of sales from our acquired C&C CALIFORNIA business; |
| - | A $16.6 million increase resulting from the impact of foreign currency exchange rates in our international businesses; |
| - | The reimbursement of $12.3 million from a customer of improperly collected markdown allowances; and |
| - | A $7.6 million net decrease across our other Wholesale Apparel businesses, primarily reflecting a 19.1% year-over-year decrease in our domestic LIZ CLAIBORNE business (resulting from lower unit volume and, to a lesser extent, lower unit pricing), decreases in our ELLEN TRACY (due to lower unit volume and increased retailer support), CRAZY HORSE women’s (due to lower demand), ENYCE (due to lower unit volume in Specialty Retail stores partially offset by increased unit volume in department stores), and the discontinuation of our KENNETH COLE womenswear license, partially offset by the continued growth of our JUICY COUTURE business (due to increased customer demand mostly reflected in higher unit volume), and increases in our MEXX Europe, licensed DKNY® JEANS (due to the addition of new retail customers), LUCKY BRAND DUNGAREES (due to increased customer demand and an increase in department store locations), moderate and mid-tier department store (due to higher unit volume) and LIZ CLAIBORNE Canada businesses. |
• | Wholesale Non-Apparel net sales increased by $67.4 million, or 16.5%, to $476.5 million. The increase was primarily due to increases in our Cosmetics business (due to the launch of our LIZ fragrance and continued growth of our REALITIES and LUCKY fragrances), our JUICY COUTURE and LUCKY BRAND Fashion Accessories businesses, our moderate and mid-tier, JUICY COUTURE, LUCKY BRAND, SIGRID OLSEN and LIZ CLAIBORNE Handbags businesses, and our MONET, LIZ CLAIBORNE, LUCKY BRAND, licensed KENNETH COLE and SIGRID OLSEN Jewelry businesses, as well as the addition of our FIRST ISSUE Handbags, AXCESS Jewelry and Fashion Accessories and TINT Jewelry businesses. The impact of foreign currency exchange rates in our international businesses was not material in this segment. |
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• | Retail net sales increased $106.8 million, or 14.6%, to $839.8 million as a result of: |
| - | A $16.7 million increase resulting from the impact of foreign currency exchange rates in our international businesses; and |
| - | A $90.1 million net increase primarily driven by higher comparable store sales in our Specialty Retail business (including a 25.7% comparable store sales increase in our LUCKY BRAND DUNGAREES business) and the net store openings mentioned above. |
| |
| Comparable store sales in our Company-operated stores increased by 1.2% overall, driven by a 10.6% increase in our Specialty Retail business, partially offset by a 5.5% decrease in our Outlet business as a result of reduced levels of customer traffic. |
| |
• | Corporate net sales, consisting of licensing revenue, increased $5.1 million to $31.7 million as a result of revenues from new licenses and growth from our existing license portfolio, primarily growth in LIZ CLAIBORNE branded items. |
Viewed on a geographic basis, Domestic net sales increased by $99.2 million, or 3.8%, to $2.713 billion, reflecting the continued growth in our JUICY COUTURE apparel and accessories, LUCKY BRAND DUNGAREES and DKNY® Jeans businesses, partially offset by declines in our LIZ CLAIBORNE business. International net sales increased $113.7 million, or 13.8%, to $935.2 million. The international increase principally reflected the results of our MEXX Europe and Canadian businesses; approximately $33.8 million of this increase was due to the impact of currency exchange rates.
Gross Profit
Gross profit increased $138.1 million, or 8.7%, to $1.722 billion in the first nine months of 2005 over the first nine months of 2004, partially reflecting a $19.2 million increase due to the impact of foreign currency exchange rates, primarily as a result of the strengthening of the euro, in our international businesses in addition to the reimbursement of $12.3 million from a customer of improperly collected markdown allowances. Gross profit as a percent of net sales increased to 47.2% in 2005 from 46.1% in 2004. The increased gross profit rate reflected the positive impact of lower sourcing costs and a change in the mix of product offerings within our portfolio, primarily reflecting an increased proportion of sales from our MEXX Europe, Canadian retail and domestic Specialty Retail businesses, which run at higher gross profit rates than the Company average, as well as a decreased proportion of sales from our domestic LIZ CLAIBORNE Wholesale Apparel business, which runs at a lower gross profit rate than the Company average, partially offset by additional liquidation of excess inventory.
Selling, General & Administrative Expenses
SG&A increased $123.3 million, or 10.2%, to $1.327 billion in the first nine months of 2005 over the first nine months of 2004 as a result of:
• | An $9.3 million increase from the recent acquisition of C&C CALIFORNIA business and the start-up of internally developed businesses; |
• | A $17.1 million increase resulting from the impact of foreign currency exchange rates, primarily as a result of the strengthening of the euro, in our international businesses; |
• | The inclusion of an additional $9.3 million of expense resulting from the adoption of SFAS No. 123(R) and the shift in our equity-based management compensation plan; |
• | The inclusion of $5.7 million of expenses associated with reductions and repositioning of our workforces, primarily in our wholesale apparel brands reflecting efforts necessary to maximize the efficiency of our overhead cost structure; |
• | The inclusion of $3.2 million of costs associated with office and distribution center real estate consolidation and the closure of our LIZ CLAIBORNE retail store in London; and |
• | A $78.7 million net increase primarily resulting from the expansion of our domestic and international retail businesses. |
The SG&A rate in the first nine months of 2005 as a percent of net sales increased year over year to 36.4% from 35.0%. The increased rate primarily reflected the impact of expenses described above, in addition to the increased proportion of expenses related to our domestic Specialty Retail and MEXX Europe businesses, which run at higher SG&A rates than the Company average, as described above, in addition to reduced expense leverage resulting from the decreased proportion of expenses related to our domestic LIZ CLAIBORNE Wholesale Apparel business, which runs at a lower SG&A rate than the Company average, partially offset by Company-wide expense control initiatives.
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Restructuring (Gain)
In the first nine months of 2005 and 2004, we recorded pretax restructuring gains of $221,000 ($143,000 after tax) and $105,000 ($68,000 after tax), respectively. The 2005 gain representing the reversal of the portion of the $9.8 million pretax ($6.5 million after tax) 2004 restructuring reserve (established to cover the costs associated with restructuring of our European business and the closure of our Secaucus, NJ distribution center) that was no longer required due to the completion of the activities associated with the reserve. The 2004 gain represents the reversal of the portion of the $7.1 million pretax ($4.5 million after tax) 2002 restructuring reserve (established to cover the costs associated with the closure of all 22 domestic Specialty Retail stores operating under the LIZ CLAIBORNE brand name) that was no longer required due to the completion of the activities associated with the reserve.
Operating Income
Operating income in the first nine months of 2005 was $395.2 million, an increase of $15.0 million, or 3.9%, over 2004. The increase in operating income primarily resulted from higher sales, lower sourcing costs, the reimbursement of $12.3 million from a customer of improperly collected markdown allowances and a $2.0 million increase due to the impact of foreign currency exchange rates, primarily as a result of the strengthening of the euro, in our international businesses, partially offset by the inclusion of $8.9 million of expenses primarily related to workforce reductions and office and distribution center real estate consolidations and the inclusion of $9.3 million of expenses resulting from the adoption of SFAS No. 123 (R) and the shift in our equity-based management compensation plan. Operating income as a percent of net sales decreased to 10.8% in the first nine months of 2005 compared to 11.1% in 2004. The decrease in operating income as a percent of sales primarily resulted from continued investment in the expansion of our domestic and international retail businesses and the additional liquidation of excess inventory. Operating income by business segment is provided below:
• | Wholesale Apparel operating income was $270.7 million (11.8% of net sales), an increase of $0.4 million in the first nine months of 2005, compared to $270.3 million (11.9% of net sales) in 2004, principally reflecting increased profits in our MEXX Europe, JUICY COUTURE, moderate and mid-tier department store, and licensed DKNY® JEANS businesses, as well as the favorable impact of the discontinuation of our KENNETH COLE womenswear license, mostly offset by reduced profits in our LIZ CLAIBORNE business, as a result of the lower sales discussed above, and in our ELLEN TRACY, CRAZY HORSE women’s, CLAIBORNE men’s, ENYCE and SIGRID OLSEN businesses; |
• | Wholesale Non-Apparel operating income increased by $18.5 million to $75.7 million (15.9% of net sales) in the first nine months of 2005 compared to $57.2 million (14.0% of net sales) in 2004, principally due to increased profits in our Cosmetics, JUICY COUTURE and LUCKY BRAND Fashion Accessories businesses, moderate and mid-tier, LUCKY BRAND and LIZ CLAIBORNE Handbags businesses and SIGRID OLSEN, MONET, LUCKY BRAND and licensed KENNETH COLE Jewelry businesses, as well as the addition of our TINT jewelry and AXCESS Jewelry and Fashion Accessories businesses, partially offset by reduced profits in our LIZ CLAIBORNE Fashion Accessories and Jewelry businesses; |
• | Retail operating income was $24.4 million (2.9% of net sales) in 2005 compared to $31.8 million (4.3% of net sales) in 2004, principally reflecting reduced profits in our Outlet, MEXX Europe and LIZ CLAIBORNE Europe businesses, in addition to increased costs associated with building a multi-brand platform in Europe, partially offset by increased profits in our LUCKY BRAND DUNGAREES and MEXX Canada businesses; and |
• | Corporate operating income, primarily consisting of licensing operating income, increased $3.4 million to $24.4 million in 2005 compared to $21.0 million in 2004. |
Viewed on a geographic basis, Domestic operating profit increased by $2.7 million, or 0.9%, to $321.3 million, predominantly reflecting increased profits in our Cosmetics business, LUCKY BRAND DUNGAREES Retail businesses, as well as our moderate and mid-tier department store businesses, partially offset by reduced profits in our LIZ CLAIBORNE business. International operating profit increased $12.2 million, or 19.8% to $73.9 million; the international increase reflected increased profitability at our European wholesale apparel and Canadian retail businesses.
Other Expense - net
In 2005, other expense - net was primarily comprised of $1.4 million of minority interest expense. In 2004, other expense - net was comprised of $2.6 million of minority interest expense, partially offset by other non-operating income. (See “Commitments and Capital Expenditures” for discussion of the purchase of the remaining Lucky Brand minority interest.)
Interest Expense - net
Interest expense - net in the first nine months of 2005 was $23.6 million, compared to $22.4 million in the first nine months of 2004, both of which were principally related to borrowings incurred to finance our strategic initiatives,
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including acquisitions. Net interest includes $2.1 million and $0.8 million of interest income in 2005 and 2004, respectively.
Provision for Income Taxes
The income tax rate was 35.4% in the first nine months of 2005 and 35.2% in the prior year.
Net Income
Net income in the first nine months of 2005 increased to $239.1 million, or 6.6% of net sales, from $230.9 million, or 6.7% of net sales, in the first nine months of 2004. Diluted EPS increased 4.8% to $2.20 in 2005, from $2.10 in 2004.
Average diluted shares outstanding decreased by 1.4 million shares to 108.6 million in the first nine months of 2005 on a year-to-year basis as a result of the impact of share repurchases, partially offset by the exercise of stock options and the effect of dilutive securities.
FORWARD OUTLOOK
These forward-looking statements are qualified in their entirety by reference to the risks and uncertainties set forth under the heading “STATEMENT REGARDING FORWARD-LOOKING DISCLOSURE” below. All of these forward-looking statements exclude the impact of any future acquisitions or additional stock repurchases.
Fourth Quarter 2005
For the fourth quarter of 2005, we are forecasting flat sales, an operating margin in the range of 10.5-10.9% and EPS in the range of $0.70-$0.74, including the impact, which we estimate will be approximately $0.04 per share, resulting from the adoption of SFAS No. 123(R) and the shift in the composition of our equity-based management compensation toward restricted stock and away from stock options. This shift toward restricted stock should ultimately reduce dilution and enhance shareholder value, as we expect that fewer shares will be used for equity-based compensation purposes than in prior years. Foreign currency exchange rates are expected to negatively impact fourth quarter sales growth by approximately 2% and fourth quarter EPS by $0.01.
• | In our Wholesale Apparel segment, we expect fourth quarter 2005 net sales to decrease in the range of 4-6%, primarily reflecting an approximate 25% decrease in our domestic LIZ CLAIBORNE business, decreases in our ELLEN TRACY, SIGRID OLSEN, CLAIBORNE, CRAZY HORSE and VILLAGER businesses and the impact of the discontinuation of our licensed KENNETH COLE womenswear business, partially offset by the acquisition of C&C California as well as increases in our MEXX Europe, J.H. COLLECTIBLES, DANA BUCHMAN, AXCESS men’s, EMMA JAMES, LUCKY BRAND and FIRST ISSUE businesses, as well as the addition of our TINT, METROCONCEPTS, BELONGINGS and TAPEMEASURE businesses. |
• | In our Wholesale Non-Apparel segment, we expect fourth quarter 2005 net sales to increase in the range of 2-4%, driven by increases across all product categories. |
• | In our Retail segment, we expect fourth quarter 2005 net sales to increase in the range of 10-12%, primarily driven by increases in our MEXX Europe, LUCKY BRAND, SIGRID OLSEN and LIZ CLAIBORNE Canada businesses. |
• | We expect fourth quarter 2005 licensing revenue to be up 10% compared to 2004. |
Fiscal 2005
For fiscal 2005, we are adjusting our sales guidance to an increase of 4.5%, our operating margin guidance to a range of 10.7-10.9% and our EPS guidance to a range of $2.90-$2.94, reflecting the challenging retail environment. This includes the impact, which we estimate will be approximately $0.10 per share, resulting from the adoption of SFAS No. 123(R) and the shift in our equity-based management compensation plan. We do not expect foreign currency exchange rates in our international businesses to have a material impact on full year 2005 results. We are estimating that our capital and in-store expenditures will approximate $160 million in 2005.
Fiscal 2006
As suggested earlier, factors in the macroeconomic environment combined with the uncertain impact of retailer consolidations in the United States work to restrict our visibility for the coming year. At this time, we can see a low single digit sales increase and 2006 EPS in a broad range between $2.90 and $3.05. This includes the impact, which we estimate will be approximately $0.20 per share, resulting from the adoption of SFAS No. 123(R) and the shift in our equity-based management compensation plan. Foreign currency exchange rates are expected to negatively impact 2006 sales growth by approximately 1%. We expect that our capital and in-store expenditures will be in the $165-$175 million range, which includes opening approximately 100-125 new stores. Our projections also include a
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sales decrease of about $50 million, which results in a decrease in earnings per share of approximately $0.07-$0.08, associated with the 82 department store locations currently identified by Federated Department Stores for closure.
As these macroeconomic issues play out over the next several months, and as there is greater clarity around the implications of retailer consolidation and their shifting strategies, we would expect to be able to refine our financial estimates for 2006. This outlook assumes no change in our business relationship with Lord & Taylor and Sears.
FINANCIAL POSITION, CAPITAL RESOURCES AND LIQUIDITY
Cash Requirements. Our primary ongoing cash requirements are to fund growth in working capital (primarily accounts receivable and inventory) to support projected sales increases, investment in the technological upgrading of our distribution centers and information systems, and other expenditures related to retail store expansion, in-store merchandise shops and normal maintenance activities. We also require cash to fund our acquisition program. In addition, the Company will require cash to fund any repurchase of Company stock under its previously announced share repurchase program. On May 19, 2005, the Company’s Board of Directors authorized the Company to purchase up to an additional $250 million of its common stock for cash in open market purchases and privately negotiated transactions. As of November 2, 2005, the Company had $218.0 million remaining in buyback authorization under the program.
Sources of Cash. Our historical sources of liquidity to fund ongoing cash requirements include cash flows from operations, cash and cash equivalents and securities on hand, as well as borrowings through our commercial paper program and bank lines of credit (which include revolving and trade letter of credit facilities); in 2001, we issued euro-denominated bonds (the “Eurobonds”) to fund the initial payment in connection with our acquisition of MEXX Europe. Our Eurobonds are scheduled to mature in August 2006 and we have the intention and ability to refinance the debt in 2006. These bonds are designated as a hedge of our net investment in MEXX (see Note 2 of Notes to Condensed Consolidated Financial Statements). We anticipate that cash flows from operations, our commercial paper program and bank and letter of credit facilities will be sufficient to fund our next twelve months’ liquidity requirements and that we will be able to adjust the amounts available under these facilities if necessary (see “Commitments and Capital Expenditures” for more information on future requirements). Such sufficiency and availability may be adversely affected by a variety of factors, including, without limitation, retailer and consumer acceptance of our products, which may impact our financial performance, maintenance of our investment-grade credit rating, as well as interest rate and exchange rate fluctuations.
2005 vs. 2004
Cash and Debt Balances. We ended the first nine months of 2005 with $150.4 million in cash and marketable securities, compared to $134.4 million at October 2, 2004 and $393.4 million at January 1, 2005, and with $538.9 million of debt outstanding compared to $596.3 million at October 2, 2004 and $540.6 million at January 1, 2005. The $74.1 million decrease in our net debt position on a year-over-year basis is primarily attributable to cash flow from operations for the year of $414.9 million and the effect of foreign currency translation on our Eurobond, which reduced our debt balance by $12.5 million, partially offset by $155.5 million for capital and in-store expenditures, $105.2 million in share repurchases, the 45.3 million Canadian dollars (or $37.1 million based on the exchange rate on such date) required final contingent payment to complete the purchase of MEXX Canada, the $35 million payment to Lucky Brand shareholders to purchase an additional 8.25% interest in Lucky Brand, and the $29.3 million payment made related to the acquisition of C&C. We ended the third quarter of 2005 with $2.004 billion in stockholders’ equity, giving us a total debt to total capital ratio of 21.2% compared to $1.745 billion in stockholders’ equity last year with a debt to total capital ratio of 25.5% and $1.812 billion in stockholders’ equity at year-end with a debt to total capital ratio of 23.0%.
Accounts Receivable was essentially unchanged at the end of the third quarter of 2005 compared to the end of the third quarter of 2004. The impact of foreign currency exchange rates in our international businesses was not material. Accounts receivable increased $252.4 million, or 58.4%, at October 1, 2005 compared to January 1, 2005 due primarily to the timing of shipments in our domestic operations, partially offset by the impact of foreign currency exchange rates in our international businesses.
Inventories increased $15.2 million, or 2.5%, at the end of first nine months 2005 compared to the end of first nine months 2004. New business initiatives added $16.2 million to our inventory levels. The continuing expansion of our Specialty Retail business added $21.1 million to our inventory levels. The impact of currency exchange rates in our international businesses was not material.
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Inventories increased by $95.6 million, or 17.7%, compared to January 1, 2005, primarily due to the impact of the continuing expansion of our Specialty Retail business and new businesses, partially offset by a shift in timing of our current season and in-transit inventories within our wholesale businesses and the impact of foreign currency exchange rates in our European businesses.
Our average inventory turnover rate was 4.4 times for the twelve-month period ended October 1, 2005 and 4.5 for the twelve-month periods ended October 2, 2004 and January 1, 2005.
Borrowings under our revolving credit facility and other credit facilities peaked at $149.7 million during the nine months of 2005; at the end of the nine months of 2005, our borrowings under these facilities were $110.8 million.
Net cash used in operating activities was $2.2 million in the nine months of 2005, compared to $40.2 million provided in the nine months of 2004. This $42.4 million decrease in cash flow was primarily due to a $356.1 million use of cash for working capital in 2005 compared to a $297.1 million use of cash for working capital in 2004, driven primarily by changes in accounts payable due to timing of payments and accrued expenses due to the payment of certain employment-related obligations, partially offset by changes in our accounts receivable and inventory balances.
Net cash used in investing activities was $203.4 million in the nine months of 2005 compared to $294.1 million in 2004. Net cash used in the first nine months of 2005 primarily reflected payments of $105.1 million for capital and in-store expenditures, $37.1 million to complete the acquisition of MEXX Canada, $35.0 million for the acquisition of additional Lucky Brand shares and payments of $29.3 for the acquisition of C&C. Net cash used in the nine months of 2004 was primarily attributable to the $192.4 million (160 million euro) required final contingent payment to complete the purchase of MEXX Europe and $96.0 million for capital and in-store expenditures.
Net cash used in financing activities was $38.0 million in the first nine months of 2005, compared to $43.3 million provided in the first nine months of 2004. The $81.3 million decrease primarily reflected a reduction in commercial paper borrowings, partially offset by an increase in short-term borrowings.
Commitments and Capital Expenditures
We may be required to make additional payments in connection with our acquisitions. If paid in cash, these payments will be funded with net cash provided by operating activities, our revolving credit and other credit facilities and/or the issuance of debt:
• | On January 28, 2005, we entered into an agreement to acquire the remaining 15% of Lucky Brand shares that were owned by the sellers of Lucky Brand for aggregate consideration of $65.0 million, plus a contingent payment for the final 2.25% based upon a multiple of Lucky Brand’s 2007 earnings. On January 28, 2005, we paid $35.0 million for 8.25% of the equity interest of Lucky Brand. The excess of the amount paid over the related amount of minority interest has been recorded to goodwill. In January 2006, 2007 and 2008, we will acquire 1.9%, 1.5% and 1.1% of the equity interest of Lucky Brand for payments of $10.0 million each. We have recorded the present value of fixed amounts owed ($28.2 million) as an increase in Other Current and Other Non-Current Liabilities. The excess of the liability recorded over the related amount of minority interest has been recorded as goodwill. In June 2008, we will acquire the remaining 2.25% minority share for an amount based on a multiple of Lucky Brand’s 2007 earnings, which we estimate will be in the range of $20-24 million. |
• | Under the Segrets acquisition agreement, we may elect, or be required, to purchase the minority interest shares in Segrets. We estimate that if the eligible payment for Segrets is triggered in 2005, it would fall in the range of $2-4 million, and the payment will be made in either cash or shares of our common stock at the option of either the Company or the seller. |
• | The Juicy Couture acquisition agreement provides for a contingent payment to be determined as a multiple of Juicy Couture’s earnings for one of the years ended 2005, 2006 or 2007. We estimate that if the 2005 measurement year were selected, the Juicy Couture contingent payment in 2006 would be in the range of $106-109 million. This payment will be made in either cash or shares of our common stock at the option of the Company. In March of 2005, the contingent payment agreement was amended to include an advance option for the sellers. If the 2005 measurement year is not selected, the sellers may elect to receive up to 75% of the estimated contingent payment based upon 2005 results. If the 2005 and 2006 measurement years are not selected, the sellers are eligible to elect to receive up to 85% of the estimated contingent payment based on the 2006 measurement year net of any 2005 advances. |
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• | The C&C acquisition agreement provides for contingent payments based upon a multiple of C&C’s earnings in fiscal years 2007, 2008 and 2009. Contingent payments in aggregate are estimated by the Company to be in the range of approximately $20-25 million. The contingent payments will be accounted for as additional purchase price. |
• | We are estimating that our capital and in-store expenditures will approximate $160 million in 2005. |
Financing Arrangements
On August 7, 2001, we issued 350 million euro (or $307.2 million based on the exchange rate in effect on such date) of 6.625% notes due on August 7, 2006 (the “Eurobonds”). The Eurobonds are listed on the Luxembourg Stock Exchange and received a credit rating of BBB from Standard & Poor’s and Baa2 from Moody’s Investor Services. Interest on the Eurobonds is being paid on an annual basis until maturity. These bonds are designated as a hedge of our net investment in Mexx (see Note 2 of Notes to Condensed Consolidated Financial Statements). Our Eurobonds are scheduled to mature in August 2006 and we have the intention and ability to refinance the debt in 2006.
On October 17, 2003, we entered into a $375 million, 364-day unsecured financing commitment under a bank revolving credit facility, replacing the existing $375 million, 364-day unsecured credit facility scheduled to mature in October 2003, and on October 21, 2002, we received a $375 million, three-year bank revolving credit facility. The aforementioned bank facilities replaced an existing $750 million bank facility which was scheduled to mature in November 2003. The three-year facility included a $75 million multi-currency revolving credit line, which permitted the Company to borrow in U.S. dollars, Canadian dollars and euro. At October 2, 2004, the Company had $126.0 million of borrowings outstanding under the Agreement at an average interest rate of 2.0%. The carrying amount of borrowings under the commercial paper program approximates fair value because the interest rates are based on floating rates, which are determined by prevailing market rates.
On October 13, 2004, we entered into a $750 million, five-year revolving credit agreement (the “Agreement”), replacing the $375 million, 364-day unsecured credit facility scheduled to mature in October 2004 and the existing $375 million bank revolving credit facility which was scheduled to mature in October 2005. A portion of the funds available under the Agreement not in excess of $250 million is available for the issuance of letters of credit. Additionally, at our request, the amount of funds available under the Agreement may be increased at any time or from time to time by an aggregate principal amount of up to $250 million with only the consent of the lenders (which may include new lenders) participating in such increase. The Agreement includes a $150 million multi-currency revolving credit line, which permits us to borrow in U.S. dollars, Canadian dollars and euro. The Agreement has two borrowing options, an “Alternative Base Rate” option, as defined in the Agreement, and a Eurocurrency rate option with a spread based on our long-term credit rating. The Agreement contains certain customary covenants, including financial covenants requiring us to maintain specified debt leverage and fixed charge coverage ratios, and covenants restricting our ability to, among other things, incur indebtedness, grant liens, make investments and acquisitions, and sell assets. We believe we are in compliance with such covenants. The funds available under the Agreement may be used to refinance existing debt, to provide working capital and for general corporate purposes of the Company, including, without limitation, the repurchase of capital stock and the support of our $750 million commercial paper program. Our ability to obtain funding through our commercial paper program is subject to, among other things, the Company maintaining an investment-grade credit rating. At October 1, 2005, we had $27.9 million debt outstanding under the Agreement.
As of October 1, 2005, January 1, 2005 and October 2, 2004, we had lines of credit aggregating $569 million, $551 million and $568 million, respectively, which were primarily available to cover trade letters of credit. At October 1, 2005, January 1, 2005 and October 2, 2004, we had outstanding trade letters of credit of $245 million, $310 million and $322 million, respectively. These letters of credit, which have terms ranging from one to ten months, primarily collateralize our obligations to third parties for the purchase of inventory. The fair value of these letters of credit approximates contract values.
Our Canadian and European subsidiaries have unsecured lines of credit totaling approximately $151.7 million (based on the exchange rates as of October 1, 2005), which is included in the aforementioned $569 million available lines of credit. As of October 1, 2005, a total of $110.8 million of borrowings denominated in foreign currencies was outstanding at an average interest rate of 2.8%. These lines of credit bear interest at rates based on indices specified in the contracts plus a margin. The lines of credit are in effect for less than one year and mature at various dates in 2005 and 2006. These lines are guaranteed by the Company. Most of our debt will mature in less than one year and will be refinanced under existing credit lines. The capital lease obligations in Europe expire in 2007 and 2008.
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Off-Balance Sheet Arrangements
On May 22, 2001, we entered into an off-balance sheet financing arrangement (commonly referred to as a “synthetic lease”) to acquire various land and equipment and construct buildings and real property improvements associated with warehouse and distribution facilities in Ohio and Rhode Island. The leases expire on November 22, 2006, with renewal subject to the consent of the lessor. The lessor under the operating lease arrangements is an independent third-party limited liability company, wholly owned by a publicly traded corporation. That public corporation consolidates the financial statements of the lessor in its financial statements. The lessor has other leasing activities and has contributed equity of 5.75% of the $63.7 million project costs. The leases include guarantees by us for a substantial portion of the financing and options to purchase the facilities at original cost; the maximum guarantee is approximately $56 million. The guarantee becomes effective if we decline to purchase the facilities at the end of the lease and the lessor is unable to sell the property at a price equal to or greater than the original cost. We selected this financing arrangement to take advantage of the favorable financing rates such an arrangement afforded as opposed to the rates available under alternative real estate financing options. The lessor financed the acquisition of the facilities through funding provided by third-party financial institutions. The lessor has no affiliation or relationship with us or any of our employees, directors or affiliates, and our transactions with the lessor are limited to the operating lease agreements and the associated rent expense that will be included in SG&A expense in the Consolidated Statements of Income.
In December 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46R”), which amends the same titled FIN 46 that was issued in January 2003. FIN 46R addresses how to identify variable interest entities and the criteria that requires the consolidation of such entities. The third-party lessor does not meet the definition of a variable interest entity under FIN 46R, and therefore consolidation by the Company is not required.
Hedging Activities
At October 1, 2005, we had various euro currency collars outstanding with a notional amount of $17 million, maturing through December 2005 and with values ranging between 1.20 and 1.38 U.S. dollar per euro, and various Canadian currency collars outstanding with a notional amount of $18 million, maturing through April 2006 and with values ranging between 1.13 and 1.25 Canadian dollar per U.S. dollar, and various euro currency collars outstanding with a notional amount of 217 million Hong Kong dollars, maturing through December 2006 and with values ranging between 9.10 and 10.09 Hong Kong dollar per euro. We had $10 million in euro currency collars at October 2, 2004, and $53 million in euro currency collars and $27 million in Canadian currency collars at year-end 2004. At the end of the third quarter of 2005, we also had forward contracts maturing through September 2006 to sell 16 million euro for $19.0 million, to sell 29 million Canadian dollars for $24.4 million, to sell 5.0 million Pounds Sterling for 7.3 million euro, to sell 20.0 million Canadian dollars for 132.9 million Hong Kong dollars and to sell 10 million euro for 93 million Hong Kong dollars. Unrealized gains (losses) for outstanding foreign exchange forward contracts and currency options were mostly offset at the end of the third quarter of 2005 compared to ($6.2) million at year-end 2004 and approximately ($2.8) million at the end of the third quarter of 2004. The ineffective portion of these trades is recognized currently in earnings and was $0.2 million for the nine months ended October 1, 2005. Approximately $0.6 million of income relating to cash flow hedges in Accumulated other comprehensive income (loss) will be reclassified into earnings in the next twelve months as the inventory is sold.
In connection with the variable rate financing under the synthetic lease agreement, we have entered into two interest rate swap agreements with an aggregate notional amount of $40.0 million that began in January 2003 and will terminate in May 2006, in order to fix the interest component of rent expense at a rate of 5.56%. We have entered into these arrangements to hedge against potential future interest rate increases. The change in fair value of the effective portion of the interest rate swap is recorded as a component of Accumulated other comprehensive income (loss) since these swaps are designated as cash flow hedges. The ineffective portion of these swaps is recognized currently in earnings and was not material for the nine months ended October 1, 2005. Approximately $0.2 million of expense relating to cash flow hedges in Accumulated other comprehensive income (loss) will be reclassified into earnings in the next twelve months.
We hedge our net investment position in euro functional subsidiaries by designating the 350 million Eurobonds as a hedge of net investments. The change in the Eurobonds due to changes in currency rates is recorded to Cumulative translation adjustment, a component of Accumulated other comprehensive income (loss). The unrealized gain (loss) recorded to Cumulative translation adjustment was $1.5 million for the quarter ended October 1, 2005 and $4.0 million for the quarter ended October 2, 2004. The unrealized gain recorded to Cumulative translation adjustment
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was $53.0 million and $6.6 million of income for the nine months ended October 1, 2005 and October 2, 2004, respectively.
On February 11, 2004, we entered into interest rate swap agreements for the notional amount of 175 million euro in connection with our 350 million Eurobonds, both maturing August 7, 2006. This converted a portion of the fixed rate Eurobonds interest expense to floating rate at a spread over six month EURIBOR. This is designated as a fair value hedge. The first interest rate setting was August 7, 2004 and will be reset each six-month period thereafter until maturity. We received $1.7 million in the quarter ended October 1, 2005 and $0.8 million in the quarter ended October 2, 2004 as an annual settlement for our interest rate swap.
USE OF ESTIMATES AND CRITICAL ACCOUNTING POLICIES
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the condensed consolidated financial statements and revenues and expenses during the period. Significant accounting policies employed by us, including the use of estimates, are presented in the Notes to Consolidated Financial Statements in our 2004 Annual Report on Form 10-K.
Use of Estimates
Estimates by their nature are based on judgments and available information. The estimates that we make are based upon historical factors, current circumstances and the experience and judgment of our management. We evaluate our assumptions and estimates on an ongoing basis and may employ outside experts to assist in our evaluations. Therefore, actual results could materially differ from those estimates under different assumptions and conditions.
Critical accounting policies are those that are most important to the portrayal of our financial condition and the results of operations and require management’s most difficult, subjective and complex judgments as a result of the need to make estimates about the effect of matters that are inherently uncertain. Our most critical accounting policies, discussed below, pertain to revenue recognition, income taxes, accounts receivable – trade, net, inventories, net, the valuation of goodwill and intangible assets with indefinite lives, accrued expenses, derivative instruments and share-based compensation. In applying such policies, management must use some amounts that are based upon its informed judgments and best estimates. Because of the uncertainty inherent in these estimates, actual results could differ from estimates used in applying the critical accounting policies. Changes in such estimates, based on more accurate future information, may affect amounts reported in future periods.
For accounts receivable, we estimate the net collectibility, considering both historical and anticipated trends as well as an evaluation of economic conditions and the financial positions of our customers. For inventory, we review the aging and salability of our inventory and estimate the amount of inventory that we will not be able to sell in the normal course of business. This distressed inventory is written down to the expected recovery value to be realized through off-price channels. If we incorrectly anticipate these trends or unexpected events occur, our results of operations could be materially affected. We use independent third-party appraisals to estimate the fair values of both our goodwill and intangible assets with indefinite lives. These appraisals are based on projected cash flows, interest rates and other competitive market data. Should any of the assumptions used in these projections differ significantly from actual results, material impairment losses could result where the estimated fair values of these assets become less than their carrying amounts. For accrued expenses related to items such as employee insurance, workers’ compensation and similar items, accruals are assessed based on outstanding obligations, claims experience and statistical trends; should these trends change significantly, actual results would likely be impacted. Derivative instruments in the form of forward contracts and options are used to hedge the exposure to variability in probable future cash flows associated with inventory purchases and sales collections primarily associated with our European and Canadian entities. If fluctuations in the relative value of the currencies involved in the hedging activities were to move dramatically, such movement could have a significant impact on our results. Changes in such estimates, based on more accurate information, may affect amounts reported in future periods. We are not aware of any reasonably likely events or circumstances, which would result in different amounts being reported that would materially affect our financial condition or results of operations.
Revenue Recognition
Revenue within our wholesale operations is recognized at the time title passes and risk of loss is transferred to customers. Wholesale revenue is recorded net of returns, discounts and allowances. Returns and allowances require pre-approval from management. Discounts are based on trade terms. Estimates for end-of-season allowances are based on historic trends, seasonal results, an evaluation of current economic conditions and retailer performance. We review and refine these estimates on a monthly basis based on current experience, trends and retailer performance.
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Our historical estimates of these costs have not differed materially from actual results. Retail store revenues are recognized net of estimated returns at the time of sale to consumers. Licensing revenues are recorded based upon contractually guaranteed minimum levels and adjusted as actual sales data is received from licensees.
Income Taxes
Income taxes are accounted for under SFAS No. 109, “Accounting for Income Taxes.” In accordance with SFAS No. 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as measured by enacted tax rates that are expected to be in effect in the periods when the deferred tax assets and liabilities are expected to be settled or realized. Significant judgment is required in determining the worldwide provisions for income taxes. In the ordinary course of a global business, there are many transactions for which the ultimate tax outcome is uncertain. It is our policy to establish provisions for taxes that may become payable in future years as a result of an examination by tax authorities. We establish the provisions based upon management’s assessment of exposure associated with permanent tax differences, tax credits and interest expense applied to temporary difference adjustments. The tax provisions are analyzed periodically (at least annually) and adjustments are made as events occur that warrant adjustments to those provisions.
Accounts Receivable - Trade, Net
In the normal course of business, we extend credit to customers that satisfy pre-defined credit criteria. Accounts receivable - trade, net, as shown on the Condensed Consolidated Balance Sheets, is net of allowances and anticipated discounts. An allowance for doubtful accounts is determined through analysis of the aging of accounts receivable at the date of the financial statements, assessments of collectibility based on an evaluation of historic and anticipated trends, the financial condition of our customers, and an evaluation of the impact of economic conditions. An allowance for discounts is based on those discounts relating to open invoices where trade discounts have been extended to customers. Costs associated with potential returns of products as well as allowable customer markdowns and operational charge backs, net of expected recoveries, are included as a reduction to net sales and are part of the provision for allowances included in Accounts receivable - trade, net. These provisions result from seasonal negotiations with our customers as well as historic deduction trends (net of expected recoveries) and the evaluation of current market conditions. Should circumstances change or economic or distribution channel conditions deteriorate significantly, we may need to increase our provisions. Our historical estimates of these costs have not differed materially from actual results.
Inventories, Net
Inventories are stated at lower of cost (using the first-in, first-out method) or market. We continually evaluate the composition of our inventories assessing slow-turning, ongoing product as well as prior seasons’ fashion product. Market value of distressed inventory is valued based on historical sales trends for the category of inventory of our individual product lines, the impact of market trends and economic conditions, and the value of current orders in-house relating to the future sales of this type of inventory. Estimates may differ from actual results due to quantity, quality and mix of products in inventory, consumer and retailer preferences and market conditions. We review our inventory position on a monthly basis and adjust our estimates based on revised projections and current market conditions. If economic conditions worsen, we incorrectly anticipate trends or unexpected events occur, our estimates could be proven overly optimistic, and required adjustments could materially adversely affect future results of operations. Our historical estimates of these costs and our provisions have not differed materially from actual results.
Goodwill and Other Intangibles
SFAS No. 142, “Goodwill and Other Intangible Assets,” requires that goodwill and intangible assets with indefinite lives no longer be amortized, but rather be tested at least annually for impairment. This pronouncement also requires that intangible assets with finite lives be amortized over their respective lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”
A two-step impairment test is performed on goodwill. In the first step, we compare the fair value of each reporting unit to its carrying value. Our reporting units are consistent with the reportable segments identified in Note 13 of Notes to Condensed Consolidated Financial Statements. We determine the fair value of our reporting units using the market approach as is typically used for companies providing products where the value of such a company is more dependent on the ability to generate earnings than the value of the assets used in the production process. Under this approach we estimate the fair value based on market multiples of revenues and earnings for comparable companies. If the fair value of the reporting unit exceeds the carrying value of the net assets assigned to that unit, goodwill is not impaired and we are not required to perform further testing. If the carrying value of the net assets assigned to the
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reporting unit exceeds the fair value of the reporting unit, then we must perform the second step in order to determine the implied fair value of the reporting unit’s goodwill and compare it to the carrying value of the reporting unit’s goodwill. The activities in the second step include valuing the tangible and intangible assets of the impaired reporting unit, determining the fair value of the impaired reporting unit’s goodwill based upon the residual of the summed identified tangible and intangible assets and the fair value of the enterprise as determined in the first step, and determining the magnitude of the goodwill impairment based upon a comparison of the fair value residual goodwill and the carrying value of goodwill of the reporting unit. If the carrying value of the reporting unit’s goodwill exceeds the implied fair value, then we must record an impairment loss equal to the difference.
SFAS No. 142 also requires that the fair value of the purchased intangible assets, primarily trademarks and trade names, with indefinite lives be estimated and compared to the carrying value. We estimate the fair value of these intangible assets using independent third parties who apply the income approach using the relief-from-royalty method, based on the assumption that, in lieu of ownership, a firm would be willing to pay a royalty in order to exploit the related benefits of these types of assets. This approach is dependent on a number of factors including estimates of future growth and trends, estimated royalty rates in the category of intellectual property, discounted rates and other variables. We base our fair value estimates on assumptions we believe to be reasonable, but which are unpredictable and inherently uncertain. Actual future results may differ from those estimates. We recognize an impairment loss when the estimated fair value of the intangible asset is less than the carrying value.
Owned trademarks that have been determined to have indefinite lives are not subject to amortization and are reviewed at least annually for potential value impairment as mentioned above. Trademarks having definite lives are amortized over their estimated useful lives. An independent third party values acquired trademarks using the relief-from-royalty method. Trademarks that are licensed by the Company from third parties are amortized over the individual terms of the respective license agreements, which range from 5 to 15 years. Intangible merchandising rights are amortized over a period of four years. Customer relationships are amortized assuming gradual attrition over time. Existing relationships are being amortized over periods ranging from 9 to 25 years.
The recoverability of the carrying values of all long-lived assets with definite lives is reevaluated when changes in circumstances indicate the assets’ value may be impaired. Impairment testing is based on a review of forecasted operating cash flows and the profitability of the related business. For the nine months ended October 1, 2005, there were no material adjustments to the carrying values of any long-lived assets resulting from these evaluations.
Accrued Expenses
Accrued expenses for employee insurance, workers’ compensation, profit sharing, contracted advertising, professional fees, and other outstanding Company obligations are assessed based on claims experience and statistical trends, open contractual obligations, and estimates based on projections and current requirements. If these trends change significantly, then actual results would likely be impacted. Our historical estimates of these costs and our provisions have not differed materially from actual results.
Derivative Instruments
SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended and interpreted, requires that each derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheet as either an asset or liability and measured at its fair value. The statement also requires that changes in the derivative’s fair value be recognized currently in earnings in either income (loss) from continuing operations or Accumulated other comprehensive income (loss), depending on whether the derivative qualifies for hedge accounting treatment.
We use foreign currency forward contracts and options for the purpose of hedging the specific exposure to variability in forecasted cash flows associated primarily with inventory purchases mainly with our European and Canadian entities and other specific activities and the swapping of variable interest rate debt for fixed rate debt in connection with the synthetic lease. These instruments are designated as cash flow hedges and, in accordance with SFAS No. 133, to the extent the hedges are highly effective, the effective portion of the changes in fair value are included in Accumulated other comprehensive income (loss), net of related tax effects, with the corresponding asset or liability recorded in the balance sheet. The ineffective portion of the cash flow hedge, if any, is recognized primarily as a component of Cost of goods sold in current-period earnings or, in the case of the swaps, in connection with the synthetic lease, if any, to SG&A. Amounts recorded in Accumulated other comprehensive income (loss) are reflected in current-period earnings when the hedged transaction affects earnings. If fluctuations in the relative value of the currencies involved in the hedging activities were to move dramatically, such movement could have a significant impact on our results of operations. We are not aware of any reasonably likely events or circumstances,
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which would result in different amounts being reported that would materially affect its financial condition or results of operations.
Hedge accounting requires that at the beginning of each hedge period, we justify an expectation that the hedge will be highly effective. This effectiveness assessment involves an estimation of the probability of the occurrence of transactions for cash flow hedges. The use of different assumptions and changing market conditions may impact the results of the effectiveness assessment and ultimately the timing of when changes in derivative fair values and underlying hedged items are recorded in earnings.
We hedge our net investment position in euro-functional subsidiaries by borrowing directly in foreign currency and designating a portion of foreign currency debt as a hedge of net investments. The change in the borrowings due to changes in currency rates is recorded to Cumulative translation adjustment; a component of Accumulated other comprehensive income (loss). We use a derivative instrument to hedge the changes in the fair value of the debt due to interest rates, and the change in fair value is recognized currently in interest expense together with the change in fair value of the hedged item due to interest rates.
Occasionally, we purchase short-term foreign currency contracts and options outside of the cash flow hedging program to neutralize quarter-end balance sheet and other expected exposures. These derivative instruments do not qualify as cash flow hedges under SFAS No. 133 and are recorded at fair value with all gains or losses, which have not been significant, recognized as a component of SG&A expenses in current period earnings immediately.
Share-Based Compensation
SFAS No. 123(R) “Share-Based Payment” requires the recognition of compensation expense in the Condensed Consolidated Statements of Income related to the fair value of employee share-based options. Determining the fair value of share-based awards at the grant date requires judgment, including estimating the expected term that stock options will be outstanding prior to exercise, the associated volatility and the expected dividends. Judgment is also required in estimating the amount of share-based awards expected to be forfeited prior to vesting. If actual forfeitures differ significantly from these estimates, share-based compensation expense could be materially impacted. Prior to adopting SFAS No. 123(R), the Company applied APB Opinion No. 25, and related Interpretations, in accounting for its stock-based compensation plans. All employee stock options were granted at or above the grant date market price. Accordingly, no compensation cost was recognized for fixed stock option grants in prior periods.
RECENT ACCOUNTING PRONOUNCEMENTS
In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections – a replacement of APB Opinion No. 20 and FASB Statement No. 3.” This Statement changes the requirements for the accounting for and reporting of a change in accounting principle. Previously, most voluntary changes in accounting principles required recognition through a cumulative adjustment within net income of the period of the change. The new standard requires retrospective application to prior periods’ financial statements, unless it is impracticable to determine the period-specific effects or the cumulative effect of the change. SFAS No. 154 does not change the transition provisions of any existing pronouncements. We do not believe that the adoption of SFAS No. 154 will have a significant impact on our consolidated financial condition, results of operations or cash flows.
On October 6, 2005 the FASB issued FASB Staff Position (“FSP”) FAS No. 13-1 “Accounting for Rental Costs Incurred during a Construction Period.” The FASB has concluded that rental costs incurred during and after a construction period are for the right to control the use of a leased asset and must be recognized as rental expense. Such costs were previously capitalizable as construction costs if the company had a policy to do so. The FSP is effective for reporting periods beginning after December 15, 2005. We do not expect that the implementation of FSP FAS No. 13-1 will have a material effect on the results of operations or financial position.
STATEMENT REGARDING FORWARD-LOOKING DISCLOSURE
Statements contained herein and in future filings by the Company with the Securities and Exchange Commission (the “SEC”), in the Company’s press releases, and in oral statements made by, or with the approval of, authorized personnel that relate to the Company’s future performance, including, without limitation, statements with respect to the Company’s anticipated results of operations or level of business for fiscal 2005, any fiscal quarter of 2005 or any other future period, including those herein under the heading “Forward Outlook” or otherwise, are forward-looking
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statements within the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Such statements, which are indicated by words or phrases such as “intend,” “anticipate,” “plan,” “estimate,” “project,” “management expects,” “the Company believes,” “we are optimistic that we can,” “current visibility indicates that we forecast” or “currently envisions” and similar phrases are based on current expectations only, and are subject to certain risks, uncertainties and assumptions. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those anticipated, estimated or projected. Included among the factors that could cause actual results to materially differ are risks with respect to the following:
Risks Associated with Competition and the Marketplace
The apparel and related product markets are highly competitive, both within the United States and abroad. The Company’s ability to compete successfully within the marketplace depends on a variety of factors, including:
• | The continuing challenging retail and macroeconomic environment, including the levels of consumer confidence and discretionary spending, and levels of customer traffic within department stores, malls and other shopping and selling environments, and a continuation of the deflationary trend for apparel products; |
• | Risks associated with the Company’s dependence on sales to a limited number of large United States department store customers, including risks related to the Company’s ability to respond effectively to: |
| - | these customers’ buying patterns, including their purchase and retail floor space commitments for apparel in general (compared with other product categories they sell), and our products specifically (compared with products offered by our competitors, including with respect to customer and consumer acceptance, pricing, and new product introductions); |
| - | these customers’ strategic and operational initiatives, including their continued focus on further development of their “private label” initiatives; |
| - | these customers’ desire to have us provide them with exclusive and/or differentiated designs and product mixes; |
| - | these customers’ requirements for vendor margin support; |
| - | any credit risks presented by these customers, especially given the significant proportion of our accounts receivable they represent; and |
| - | the effect that consolidation, and the uncertainty resulting therefrom, among our larger customers, such as the recent merger between Federated Department Stores, Inc. and The May Department Store Company, might have on the foregoing and/or other risks; |
• | The Company’s ability to effectively anticipate, gauge and respond to changing consumer demands and tastes, across multiple product lines, shopping channels and geographies; |
• | The Company’s ability to translate market trends into appropriate, saleable product offerings relatively far in |
| advance, while minimizing excess inventory positions, including the Company’s ability to correctly balance the level of its fabric and/or merchandise commitments with actual customer orders; |
• | Consumer and customer demand for, and acceptance and support of, Company products (especially by the Company’s largest customers) which are in turn dependent, among other things, on product design, quality, value and service; |
• | The ability of the Company, especially through its sourcing, logistics and technology functions, to operate within substantial production and delivery constraints, including risks associated with the possible failure of the Company’s unaffiliated manufacturers to manufacture and deliver products in a timely manner, to meet quality standards or to comply with the Company’s policies regarding labor practices or applicable laws or regulations; |
• | The Company’s ability to adapt to and compete effectively in the new quota environment, including changes in sourcing patterns resulting from the elimination of quota on apparel products, as well as lowered barrier to entry; |
• | Risks associated with maintaining and enhancing favorable brand recognition, which may be affected by consumer attitudes towards the desirability of fashion products bearing a “mega brand” label and which are widely available at a broad range of retail stores; and |
• | Risks associated with the Company’s operation and expansion of retail business, including the ability to successfully find appropriate sites, negotiate favorable leases, design and create appealing merchandise, appropriately manage inventory levels, install and operate effective retail systems, apply appropriate pricing strategies, and integrate such stores into the Company’s overall business mix. |
Management and Employee Risks
• | Risks associated with the Company’s providing for the succession of senior management; |
• | The Company’s ability to attract and retain talented, highly qualified executives and other key personnel in design, merchandising, sales, marketing, production, systems and other functions; |
• | The Company’s ability to hire and train qualified retail management and associates; and |
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• | Risks associated with any significant disruptions in the Company’s relationship with its employees, including union employees, and any work stoppages by the Company’s employees, including union employees. |
Economic, Social and Political Factors
Also impacting the Company and its operations are a variety of economic, social and political factors, including the following:
• | Risks associated with war, the threat of war, and terrorist activities, including reduced shopping activity as a result of public safety concerns and disruption in the receipt and delivery of merchandise; |
• | Changes in national and global microeconomic and macroeconomic conditions in the markets where the Company sells or sources its products, including the levels of consumer confidence and discretionary spending, consumer income growth, personal debt levels, rising energy costs and energy shortages, and fluctuations in foreign currency exchange rates, interest rates and stock market volatility, and currency revaluations in countries in which we source product; |
• | Changes in social, political, legal and other conditions affecting foreign operations; |
• | Risks of increased sourcing costs, including costs for materials and labor, including as a result of the elimination of quota on apparel products; |
• | Any significant disruption in the Company’s relationships with its suppliers, manufacturers as well as work stoppages by any of the Company’s suppliers or service providers; |
• | The enactment of new legislation or the administration of current international trade regulations, or executive action affecting international textile agreements, including the United States’ reevaluation of the trading status of certain countries, and/or retaliatory duties, quotas or other trade sanctions, which, if enacted, would increase the cost of products purchased from suppliers in such countries, and the January 1, 2005 elimination of quota, which may significantly impact sourcing patterns; and |
• | Risks related to the Company’s ability to establish, defend and protect its trademarks and other proprietary rights and other risks relating to managing intellectual property issues. |
Risks Associated with Acquisitions and New Product Lines and Markets
The Company, as part of its growth strategy, from time to time acquires new product lines and/or enters new markets, including through licensing arrangements. These activities (which also include the development and launch of new product categories and product lines), are accompanied by a variety of risks inherent in any such new business venture, including the following:
• | Ability to identify appropriate acquisition candidates and negotiate favorable financial and other terms, against the background of increasing market competition (from both strategic and financial buyers) for the types of acquisitions the Company have been making; |
• | Risks that the new product lines or market activities may require methods of operations and marketing and financial strategies different from those employed in the Company’s other businesses, including risks associated with acquisitions with significant foreign operations. In addition, these businesses may involve buyers, store customers and/or competitors different from the Company’s historical buyers, store customers and competitors; |
• | Possible difficulties, delays and/or unanticipated costs in integrating the business, operations, personnel, and/or systems of an acquired business; |
• | Risks that projected or satisfactory level of sales, profits and/or return on investment for a new business will not be generated; |
• | Risks involving the Company’s ability to retain and appropriately motivate key personnel of an acquired business; |
• | Risks that expenditures required for capital items or working capital will be higher than anticipated; |
• | Risks associated with unanticipated events and unknown or uncertain liabilities; |
• | Uncertainties relating to the Company’s ability to successfully integrate an acquisition, maintain product licenses, or successfully launch new products and lines; |
• | Certain new businesses may be lower margin businesses and may require the Company to achieve significant cost efficiencies; and |
• | With respect to businesses where the Company acts as licensee, the risks inherent in such transactions, including compliance with terms set forth in the applicable license agreements, including among other things the maintenance of certain levels of sales, and the public perception and/or acceptance of the licensor’s brands or other product lines, which are not within the Company’s control. |
The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We have exposure to interest rate volatility relating to interest rate changes applicable to our revolving credit facility, other credit facilities and our 175 million euro fixed rate to floating rate swap associated with our 350 million Eurobonds. These loans and swaps bear interest at rates which vary with changes in prevailing market rates.
We do not speculate on the future direction of interest rates. As of October 1, 2005, January 1, 2005 and October 2, 2004 our exposure to changing market rates was as follows:
Dollars in millions | October 1, 2005 | January 1, 2005 | October 2, 2004 |
Variable rate debt | $110.8 | $56.1 | $154.6 |
Average interest rate | 2.8% | 2.7% | 2.1% |
| | | |
Notional amount of interest rate swap | $210.7 | $237.2 | $216.9 |
Current implied interest rate | 5.74% | 5.68% | 5.74% |
A ten percent change in the average rate would have resulted in a $1.2 million change in interest expense during the nine months of 2005.
We finance our capital needs through available cash and marketable securities, operating cash flows, letters of credit, synthetic lease and bank revolving credit facilities, other credit facilities and commercial paper issuances. Our floating rate bank revolving credit facility, bank lines, euro interest rate swap and commercial paper program expose us to market risk for changes in interest rates. As of October 1, 2005, we have not employed interest rate hedging to mitigate such risks with respect to our floating rate facilities. We believe that our Eurobond offering, which is a fixed rate obligation, partially mitigates the risks with respect to our variable rate financing.
Growth in our European and Canadian businesses, which transacts business in multiple currencies, has increased our exposure to exchange rate fluctuations. We mitigate the risks associated with changes in foreign currency rates through foreign exchange forward contracts and collars to hedge transactions denominated in foreign currencies for periods of generally less than one year and to hedge expected payment of intercompany transactions with our non-U.S. subsidiaries. Gains and losses on contracts, which hedge specific foreign currency denominated commitments, are recognized in the period in which the transaction is completed.
At October 1, 2005, January 1, 2005 and October 2, 2004, we had outstanding foreign currency collars with notional amounts aggregating to $63 million, $80 million and $10 million, respectively. We had forward contracts aggregating to $81.3 million at October 1, 2005, $45 million at January 1, 2005 and $60 million at October 2, 2004. Unrealized gains (losses) for outstanding foreign exchange forward contracts and currency options were mostly offset at October 1, 2005, ($6.2) million at January 1, 2005 and approximately ($2.8) million at October 2, 2004. A sensitivity analysis to changes in the foreign currencies when measured against the U.S. dollar indicates if the U.S. dollar uniformly weakened by 10% against all of the hedged currency exposures, the fair value of instruments would decrease by $12.2 million. Conversely, if the U.S. dollar uniformly strengthened by 10% against all of the hedged currency exposures, the fair value of these instruments would increase by $9.7 million. Any resulting changes in the fair value would be offset by changes in the underlying balance sheet positions. The sensitivity analysis assumes a parallel shift in foreign currency exchange rates. The assumption that exchange rates change in a parallel fashion may overstate the impact of changing exchange rates on assets and liabilities denominated in foreign currency. We do not hedge all transactions denominated in foreign currency.
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The table below presents the amount of contracts outstanding, the contract rate and unrealized gain or (loss), as of October 1, 2005:
Currency in thousands | U.S. Dollar
Amount | Euro
Amount | Hong Kong
Dollar Amount | Contract
Rate | Unrealized
Gain (Loss) |
Forward Contracts: | | | | | | | | | | | | |
Euro | $ | 19,000 | | | | | | 1.2010 to 1.2755 | | $ | 9 | |
Euro | | | | | | 93,000 | | 0.1037 to 0.1049 | | | 182 | |
Canadian Dollars | | 24,371 | | | | | | 0.8183 to 0.8592 | | | (690 | ) |
Canadian Dollars | | | | | | 132,926 | | 0.1500 to 0.1508 | | | (150 | ) |
Pounds Sterling | | | | 7,313 | | | | 0.6778 to 0.6932 | | | (13 | ) |
| | | | | | | | | | | | |
Foreign Exchange Collar Contracts: | | | | | | | | | | | | |
Euro | $ | 17,000 | | | | | | 1.2000 to 1.3753 | | $ | 542 | |
Euro | | | | | | 217,000 | | 0.0991 to 0.1099 | | | 155 | |
Canadian Dollars | | 18,016 | | | | | | 0.8000 to 0.8850 | | | (79 | ) |
The table below presents the amount of contracts outstanding, the contract rate and unrealized gain or (loss), as of January 1, 2005:
Currency in thousands | U.S. Dollar
Amount | Contract
Rate | Unrealized
Gain (Loss) |
Forward Contracts: | | | | | | | | |
Euro | $ | 43,000 | | 1.2197 to 1.3234 | | $ | (3,758 | ) |
Canadian Dollars | | 1,664 | | 0.8310 to 0.8314 | | | 2 | |
| | | | | | | | |
Foreign Exchange Collar Contracts: | | | | | | | | |
Euro | $ | 53,000 | | 1.2000 to 1.3753 | | $ | (2,123 | ) |
Canadian Dollars | | 26,625 | | 0.8000 to 0.8484 | | | (337 | ) |
The table below presents the amount of contracts outstanding, the contract rate and unrealized gain or (loss), as of October 2, 2004:
Currency in thousands | U.S. Dollar
Amount | Euro
Amount | Contract
Rate | Unrealized
Gain (Loss) |
Forward Contracts: | | | | | | | | | | |
Euro | $ | 56,000 | | | | 1.0665 to 1.2650 | | $ | (2,852 | ) |
Pounds Sterling | | | | 2,958 | | 0.6771 to 0.6799 | | | 5 | |
| | | | | | | | | | |
Foreign Exchange Collar Contracts: | | | | | | | | | | |
Euro | $ | 10,000 | | | | 1.1900 to 1.2800 | | $ | 7 | |
ITEM 4. CONTROLS AND PROCEDURES
The Company’s management, under the supervision and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the Company’s disclosure controls and procedures as of October 1, 2005, and has concluded that the Company’s disclosure controls and procedures are effective in ensuring that all material information required to be filed in this quarterly report has been made known to them in a timely fashion. There was no change in the Company’s internal control over financial reporting during the third quarter of fiscal 2005 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
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PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Various legal actions are pending against the Company. Certain of the legal actions include claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages. The Company contests liability and/or the amount of damages in each pending matter. Although the outcome of any such actions cannot be determined with certainty, management is of the opinion that the final outcome of any of these actions should not have a material adverse effect on the Company’s consolidated results of operations or financial position. Please refer to Note 11 and Note 25 of Notes to Consolidated Financial Statements in our 2004 Annual Report on Form 10-K.
During 2004, our Augusta, Georgia facility, which is no longer operational, became listed on the State of Georgia’s Hazardous Site Inventory of environmentally impacted sites due to the detection of certain chemicals at the site. To date, we have not been required to take any action regarding this matter, however we are continuing to monitor this situation.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
The following table summarizes information about purchases by the Company during the quarter ended October 1, 2005 of equity securities that are registered by the Company pursuant to Section 12 of the Exchange Act:
Period | (a) Total
Number of
Shares
Purchased
(in thousands) | (b) Average
Price Paid Per
Share | (c) Total Number of
Shares Purchased as
Part of Publicly
Announced Plans or
Programs
(in thousands) | (d) Maximum
Approximate Dollar
Value of Shares that
May Yet Be
Purchased Under the
Plans or Programs
(in thousands) (2) |
January 2, 2005 - January 29, 2005 | -- | | $ | -- | | N/A | | $ | 101,516 | |
January 30, 2005 - March 5, 2005 | -- | | $ | -- | | N/A | | $ | 101,516 | |
March 6, 2005 - April 2, 2005 | 7.5 | (1) | $ | 40.79 | | N/A | | $ | 101,516 | |
April 3, 2005 - April 30, 2005 | 139.0 | | $ | 35.06 | | 139.0 | | $ | 96,642 | |
May 1, 2005 - June 4, 2005 | 2,689.5 | | $ | 37.29 | | 2,689.5 | | $ | 246,351 | (3) |
June 5, 2005 - July 2, 2005 | -- | | $ | -- | | N/A | | $ | 246,351 | |
July 3, 2005 - July 30, 2005 | -- | | $ | -- | | N/A | | $ | 246,351 | |
July 31, 2005 - September 3, 2005 | -- | | $ | -- | | N/A | | $ | 246,351 | |
September 4, 2005 - October 1, 2005 | -- | | $ | -- | | N/A | | $ | 246,351 | |
| | | | | | | | | | |
Total nine months | 2,836.0 | | $ | 37.19 | | 2,828.5 | | $ | 246,351 | |
(1) | Represents shares withheld to cover tax-withholding requirements relating to the vesting of restricted stock issued to employees pursuant to the Company’s shareholder-approved stock incentive plans. |
(2) | The Company initially announced the authorization of a share buyback program in December 1989. Since its inception, the Company’s Board of Directors has authorized the purchase under the program of an aggregate of $1.925 billion. As of October 1, 2005, the Company had $246.4 million remaining in buyback authorization under its program. |
(3) | On May 19, 2005, the Company’s Board of Directors authorized the Company to purchase up to an additional $250 million of its Common Stock for cash in open market purchases and privately negotiated transactions. |
ITEM 5. OTHER INFORMATION
None.
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ITEM 6. EXHIBITS
10 | Form of Section 162(m) Long Term Performance Plan Agreement. |
| |
31(a) | Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| |
31(b) | Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| |
32(a)* | Certification of Chief Executive Officer Pursuant to Section 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| |
32(b)* | Certification of Chief Financial Officer Pursuant to Section 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
* | A signed original of the written statement required by Section 906 has been provided to the Company and will be retained by the Company and forwarded to the SEC or its staff upon request. |
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SIGNATURES
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED THEREUNTO DULY AUTHORIZED.
| LIZ CLAIBORNE, INC. | | LIZ CLAIBORNE, INC. |
| | | | | |
| | | | | |
| | | | | |
| By: | /s/ Michael Scarpa | | By: | /s/ Elaine H. Goodell |
| | MICHAEL SCARPA | | | ELAINE H. GOODELL |
| | Senior Vice President, Finance &
Distribution and Chief Financial Officer
(Principal financial officer) | | | Vice President - Corporate Controller and
Chief Accounting Officer
(Principal accounting officer) |
