UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
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| For the quarterly period ended September 30, 2006 |
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| Or |
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o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission files number 1-8681
RUSS BERRIE AND COMPANY, INC.
(Exact name of registrant as specified in its charter)
New Jersey |
| 22-1815337 |
(State of or other jurisdiction of |
| (I.R.S. Employer Identification Number) |
111 Bauer Drive, Oakland, New Jersey |
| 07436 |
(Address of principal executive offices) |
| (Zip Code) |
(201) 337-9000
(Registrant’s Telephone Number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer o Accelerated filer x Non-accelerated filero
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
The number of shares outstanding of each of the registrant’s classes of common stock, as of October 27, 2006 was as follows:
CLASS |
| OUTSTANDING |
Common Stock, $0.10 stated value |
| 20,913,072 |
2
PART 1 - FINANCIAL INFORMATION
RUSS BERRIE AND COMPANY, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in Thousands, except per share data)
(UNAUDITED)
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| September 30, |
| December 31, |
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Assets |
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Current assets |
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Cash and cash equivalents |
| $ | 11,182 |
| $ | 28,667 |
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Accounts receivable, trade, less allowances of $1,734 in 2006 and $1,943 in 2005 |
| 56,803 |
| 53,189 |
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Inventories, net |
| 45,140 |
| 55,871 |
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Prepaid expenses and other current assets |
| 14,701 |
| 11,651 |
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Income tax receivable |
| 2,090 |
| 2,979 |
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Deferred income taxes |
| 2,132 |
| 2,274 |
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Total current assets |
| 132,048 |
| 154,631 |
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Property, plant and equipment, net |
| 13,547 |
| 17,856 |
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Goodwill |
| 89,242 |
| 89,242 |
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Intangible assets |
| 61,610 |
| 61,599 |
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Restricted cash |
| 768 |
| 750 |
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Other assets |
| 5,102 |
| 4,883 |
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Total assets |
| $ | 302,317 |
| $ | 328,961 |
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Liabilities and Shareholders’ Equity |
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Current liabilities |
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Current portion of long-term debt |
| $ | 9,000 |
| $ | 2,600 |
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Short-term debt |
| 6,506 |
| 31,924 |
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Accounts payable |
| 11,882 |
| 17,764 |
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Accrued expenses |
| 27,690 |
| 26,629 |
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Accrued income taxes |
| 2,420 |
| 4,203 |
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Total current liabilities |
| 57,498 |
| 83,120 |
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Deferred income taxes |
| 9,340 |
| 6,358 |
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Long-term debt, excluding current portion |
| 45,750 |
| 41,993 |
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Other long-term liabilities |
| 3,488 |
| 3,636 |
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Total liabilities |
| 116,076 |
| 135,107 |
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Commitments and contingencies |
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Shareholders’ equity |
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Common stock: $0.10 per share stated value; authorized 50,000,000 shares; issued 26,549,356 shares at September 30, 2006 and 26,472,256 at December 31, 2005 |
| 2,655 |
| 2,649 |
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Additional paid in capital |
| 89,802 |
| 88,751 |
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Retained earnings |
| 190,046 |
| 200,756 |
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Accumulated other comprehensive income |
| 13,888 |
| 11,848 |
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Treasury stock, at cost, 5,636,284 shares at September 30, 2006 and December 31, 2005 |
| (110,150 | ) | (110,150 | ) | ||
Total shareholders’ equity |
| 186,241 |
| 193,854 |
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Total liabilities and shareholders’ equity |
| $ | 302,317 |
| $ | 328,961 |
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The accompanying notes are an integral part of the unaudited consolidated financial statements.
3
RUSS BERRIE AND COMPANY, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in Thousands, Except Per Share Data)
(UNAUDITED)
|
| Three Months Ended September 30, |
| Nine Months Ended September 30, |
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| 2006 |
| 2005 |
| 2006 |
| 2005 |
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Net sales |
| $ | 78,144 |
| $ | 83,237 |
| $ | 221,193 |
| $ | 215,996 |
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Cost of sales |
| 48,838 |
| 48,643 |
| 134,191 |
| 124,985 |
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Gross profit |
| 29,306 |
| 34,594 |
| 87,002 |
| 91,011 |
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Selling, general and administrative expenses |
| 25,775 |
| 29,936 |
| 84,804 |
| 89,831 |
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Operating income |
| 3,531 |
| 4,658 |
| 2,198 |
| 1,180 |
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Other (expense) income: |
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Interest expense, including amortization and write-off of deferred financing costs |
| (1,650 | ) | (1,424 | ) | (9,059 | ) | (13,143 | ) | ||||
Interest and investment income |
| 93 |
| 116 |
| 305 |
| 761 |
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Other, net |
| (141 | ) | (132 | ) | 165 |
| (654 | ) | ||||
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| (1,698 | ) | (1,440 | ) | (8,589 | ) | (13,036 | ) | ||||
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Income (loss) before income tax expense |
| 1,833 |
| 3,218 |
| (6,391 | ) | (11,856 | ) | ||||
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Income tax expense |
| 1,577 |
| 11,824 |
| 4,319 |
| 4,637 |
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Net income (loss) |
| $ | 256 |
| $ | (8,606 | ) | $ | (10,710 | ) | $ | (16,493 | ) |
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Net income (loss) per share: |
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Basic |
| $ | 0.01 |
| $ | (0.41 | ) | $ | (0.51 | ) | $ | (0.79 | ) |
Diluted |
| $ | 0.01 |
| $ | (0.41 | ) | $ | (0.51 | ) | $ | (0.79 | ) |
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Weighted average shares: |
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Basic |
| 20,864 |
| 20,824 |
| 20,847 |
| 20,824 |
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Diluted |
| 20,882 |
| 20,824 |
| 20,847 |
| 20,824 |
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The accompanying notes are an integral part of the unaudited consolidated financial statements.
4
RUSS BERRIE AND COMPANY, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in Thousands)
(UNAUDITED)
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| Nine Months Ended September 30, |
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| 2006 |
| 2005 |
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Cash flows from operating activities: |
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Net loss |
| $ | (10,710 | ) | $ | (16,493 | ) |
Adjustments to reconcile net loss to net cash (used in) provided by operating activities: |
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Depreciation and amortization |
| 4,060 |
| 4,971 |
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Amortization and write-off of deferred financing costs |
| 3,009 |
| 5,855 |
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Provision for accounts receivable |
| 894 |
| 371 |
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Provision for inventory reserve |
| 2,728 |
| 667 |
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Deferred income taxes |
| 3,016 |
| 5,013 |
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Write off on disposal of fixed assets |
| 2,988 |
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Other |
| (274 | ) | 405 |
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Change in assets and liabilities: |
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Restricted cash |
| (18 | ) | 14,848 |
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Accounts receivable |
| (4,507 | ) | 947 |
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Income tax receivable |
| 889 |
| — |
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Inventories |
| 8,003 |
| (9,958 | ) | ||
Prepaid expenses and other current assets |
| (3,017 | ) | (252 | ) | ||
Other assets |
| 43 |
| 62 |
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Accounts payable |
| (5,883 | ) | 8,983 |
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Accrued expenses |
| 499 |
| (6,333 | ) | ||
Accrued income taxes |
| (1,783 | ) | 7,486 |
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Net cash (used in) provided by operating activities |
| (63 | ) | 16,572 |
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Cash flows from investing activities: |
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Proceeds from sale of property, plant and equipment |
| 90 |
| 8,961 |
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Capital expenditures |
| (2,840 | ) | (950 | ) | ||
Net cash (used in)/provided by investing activities |
| (2,750 | ) | 8,011 |
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Cash flows from financing activities: |
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Proceeds from issuance of common stock |
| 1,057 |
| — |
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Dividends paid to shareholders |
| — |
| (2,082 | ) | ||
Issuance of long-term debt |
| 59,250 |
| 81,983 |
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Repayment of long-term debt |
| (81,017 | ) | (142,004 | ) | ||
Net borrowings on revolving credit facility |
| 6,506 |
| — |
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Payment of deferred financing costs |
| (2,508 | ) | (3,513 | ) | ||
Net cash used in financing activities |
| (16,712 | ) | (65,616 | ) | ||
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Effect of exchange rate changes on cash and cash equivalents |
| 2,040 |
| (2,515 | ) | ||
Net decrease in cash and cash equivalents |
| (17,485 | ) | (43,548 | ) | ||
Cash and cash equivalents at beginning of period |
| 28,667 |
| 48,099 |
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Cash and cash equivalents at end of period |
| $ | 11,182 |
| $ | 4,551 |
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Cash paid during the year for: |
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Interest expense |
| $ | 4,270 |
| $ | 7,437 |
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Income taxes |
| $ | 2,557 |
| $ | 1,831 |
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The accompanying notes are an integral part of the unaudited consolidated financial statements
5
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 1 - INTERIM CONSOLIDATED FINANCIAL STATEMENTS
The accompanying unaudited interim consolidated financial statements have been prepared by Russ Berrie and Company, Inc. and its subsidiaries (the “Company”) in accordance with accounting principles generally accepted in the United States of America for interim financial reporting and the instructions to the Quarterly Report on Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in financial statements prepared under generally accepted accounting principles have been condensed or omitted pursuant to such principles and regulations. The information furnished reflects all adjustments, which are, in the opinion of management, of a normal recurring nature and necessary for a fair presentation of the Company’s consolidated financial position, results of operations and cash flows for the interim periods presented. Results for interim periods are not necessarily an indication of results to be expected for the year.
The Company operates in two segments: (i) the Company’s gift business and (ii) the Company’s infant and juvenile business, which is comprised of Sassy, Inc. and Kids Line, LLC. This segmentation of the Company’s operations reflects how management currently views the results of operations. Corporate assets and overhead expenses are included in the gift segment. The Company has entered into separate credit facilities with respect to each of its segments (see Note 5). As provided for under the Company’s credit facilities, during the nine months ended September 30, 2006, the infant and juvenile segment paid the gift segment $1.5 million as reimbursement of corporate expenses. These payments are subject to restrictions as provided under the credit facility and are eliminated in consolidation.
The Company’s gift business designs, manufactures through third parties and markets a wide variety of gift products to retail stores throughout the United States and throughout the world via the Company’s international wholly-owned subsidiaries and independent distributors. The Company’s infant and juvenile businesses design and market products in a number of baby categories including, among others, infant bedding and accessories, bath toys and accessories, developmental toys, feeding items and baby comforting products. These products are sold to consumers, primarily in the United States, through mass merchandisers, toy specialty, food, drug and independent retailers, apparel stores and military post exchanges.
Certain prior year amounts have been reclassified to conform to the 2006 presentation.
This Quarterly Report on Form 10-Q should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2005, as amended on April 20, 2006 and May 1, 2006 (the “2005 10-K”) and the Company’s Quarterly Reports on Form 10-Q for the first and second quarters of 2006.
NOTE 2 - ACCOUNTING FOR STOCK COMPENSATION
The Company currently maintains the 2004 Stock Option, Restricted and Non-Restricted Stock Plan (the “2004 Option Plan”) and the Amended and Restated 2004 Employee Stock Purchase Plan (collectively, the “2004 Stock Plans”). As of September 30, 2006, there were 1,688,263 shares of common stock reserved for issuance under the 2004 Stock Plans, net of shares previously issued under the 2004 Stock Plans. The Company also continues to have options outstanding under its 1999 and 1994 Stock Option and Restricted Stock Plans, its 1999 and 1994 Stock Option Plans and its 1999 and 1994 Stock Option Plans for Outside Directors, (collectively, the “Predecessor Plans”). No awards could be made after December 31, 2003 with respect to the 1999 Predecessor Plans and after December 31, 1998 with respect to the 1994 Predecessor Plans. (Refer to Item 12, “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters - Equity Compensation Plan Information”, and Note 19, “Stock Plans”, of the 2005 10-K for further details with respect to option plans).
6
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Stock Option Plans
The exercise price for options issued under the 2004 Option Plan and the Predecessor Plans is generally equal to the closing price of the Company’s common stock as of the date the option is granted. Generally, stock options under the 2004 Option Plan and the Predecessor Plans vest between one and five years from the grant date unless otherwise stated by the specific grant. Options generally expire 10 years from the date of grant.
Prior to January 1, 2006, the Company accounted for stock-based compensation under the recognition and measurement principles of Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), and related interpretations. Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock Based Compensation” (“SFAS 123”), established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation plans. As permitted by SFAS 123, the Company elected to continue to apply the intrinsic-value-based method of APB 25 described above, and adopted the disclosure only requirements of SFAS 123, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.”
In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123(R), “Share-Based Payment” (“SFAS 123(R)”), which establishes standards for transactions in which an entity exchanges its equity instruments for goods or services. This statement is a replacement of SFAS 123 and supersedes APB 25. SFAS 123(R) requires companies to recognize an expense for compensation cost related to share-based payment arrangements, including stock options and employee stock purchase plans, based on the grant-date fair value of the award. This standard applies to all awards unvested or granted as of the required effective date and to awards modified, repurchased or cancelled after that date.
The Company adopted the provisions of SFAS 123(R) on January 1, 2006 using the “modified prospective” transition method. The “modified prospective” transition method requires compensation cost to be recognized beginning with the effective date (a) based on the requirements of SFAS 123(R) for all share-based payments granted after the effective date and (b) based on the requirements of SFAS 123 for all awards granted to employees prior to the effective date of SFAS 123(R) that remain unvested on the effective date. In accordance with this method, prior periods were not restated to reflect the impact of adopting the new standard.
Effective December 28, 2005, the Company amended all outstanding stock option agreements that pertained to options with exercise prices in excess of the market price for the Company’s common stock at the close of business on December 28, 2005 (“Underwater Options”) which at that time had remaining vesting requirements. As a result of these amendments, all Underwater Options, which represented all outstanding options (to purchase approximately 1.5 million shares of the Company’s common stock) that had not yet fully-vested, became fully vested and immediately exercisable at the close of business on December 28, 2005. Of the options accelerated, approximately 90,000 options were held by non-employee directors, approximately 678,000 were held by officers of the Company and the balance were held by other employees of the Company as of September 30, 2006. Because these options were priced above the then current market price on December 28, 2005, the acceleration of vesting of these options did not result in any expense being recognized in the Company’s Consolidated Statements of Operations. The purpose of the accelerated vesting of stock options was to enable the Company to avoid recognizing compensation expense associated with these options in future periods as required by SFAS 123(R), estimated at the date of acceleration to be $1.6 million (pre-tax) in 2006 and in subsequent years through 2010 of approximately $3.7 million (pre-tax).
As noted above, prior to January 1, 2006, in accordance with APB 25, no compensation cost had been recognized for options granted by the Company with an initial exercise price equal to the fair value of the common stock. Had compensation cost for the Company’s stock grants been determined based upon the
7
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
fair value recognition provisions of SFAS 123 at the grant date, the Company’s pro-forma net loss and net loss per share for the three and nine months ended September 30, 2005 would have been as follows (in thousands, except per share data):
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| Three Months Ended |
| Nine Months Ended |
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| September 30, 2005 |
| September 30, 2005 |
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Net loss-as reported |
| $ | (8,606 | ) | $ | (16,493 | ) |
Deduction for stock-based compensation expense determined under fair value method net of tax-pro forma |
| 319 |
| 676 |
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Net loss-pro forma |
| $ | (8,925 | ) | $ | (17,169 | ) |
Loss per share (basic) — as reported |
| $ | (0.41 | ) | $ | (0.79 | ) |
Loss per share (basic) — pro forma |
| $ | (0.43 | ) | $ | (0.82 | ) |
Loss per share (diluted) — as reported |
| $ | (0.41 | ) | $ | (0.79 | ) |
Loss per share (diluted) — pro forma |
| $ | (0.43 | ) | $ | (0.82 | ) |
The fair value of each option granted by the Company was estimated on the grant date using the Black-Scholes option-pricing model with the following assumptions used for the grants:
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| Three Months Ended |
| Nine Months Ended |
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|
| September 30, 2005 |
| September 30, 2005 |
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Dividend yield |
| 1.50 | % | 1.50 | % | ||
Risk-free interest rate |
| 4.12 | % | 4.96 | % | ||
Volatility |
| 36.50 | % | 35.45 | % | ||
Expected life (years) |
| 3.7 |
| 3.7 |
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Weighted average fair value of options granted during the year |
| $ | 5.48 |
| $ | 5.68 |
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The following table summarizes stock option activity for the nine months ended September 30, 2006:
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| Weighted |
| Weighted |
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| Average |
| Average |
| Aggregate |
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| Exercise |
| Remaining |
| Intrinsic |
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| Options |
| Price |
| Life (in years) |
| Value |
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Outstanding and vested at December 31, 2005 |
| 1,769,238 |
| $ | 17.16 |
| 8.49 |
| — |
| |
Exercised |
| (77,100 | ) | $ | 12.37 |
| — |
| — |
| |
Cancelled |
| (181,517 | ) | $ | 14.27 |
| — |
| — |
| |
Outstanding and vested at September 30, 2006 |
| 1,510,621 |
| $ | 17.75 |
| 8.00 |
| $ | 1,845,750 |
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During the nine months ended September 30, 2006, no options were granted. The aggregate intrinsic value in the table above represents the total pretax value of the in-the-money options, which value is determined by aggregating the “spread” of each of the in-the-money options (with the “spread” being the difference between the fair market value at September 30, 2006 and the exercise price of each option) assuming that all shareholders exercised their options on September 30, 2006. This amount will change based on the fair market value of the Company’s stock. The Company’s policy is to issue shares from authorized shares reserved for such issuance to fulfill stock option exercises.
During the nine months ended September 30, 2006, no compensation expense was recorded because the Company did not grant any options during such period and all of the options outstanding at the date of adoption of SFAS 123(R) were fully vested. Compensation expense for future share-based payment arrangements will be recorded as required by SFAS 123 (R).
Employee Stock Purchase Plan
Under the Amended and Restated 2004 Employee Stock Purchase Plan (the “ESPP”), eligible employees are provided the opportunity to purchase the Company’s common stock at a discount. Pursuant to the
8
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
ESPP, options are granted to participants as of the first trading day of each plan year, which is the calendar year, and may be exercised as of the last trading day of each plan year, to purchase from the Company the number of shares of common stock that may be purchased at the relevant purchase price with the aggregate amount contributed by each participant. In each plan year, an eligible employee may elect to participate in the ESPP by filing a payroll deduction authorization form for up to 10% (in whole percentages) of his or her compensation. No employee shall have the right to purchase Company common stock under the ESPP that has a fair market value in excess of $25,000 in any plan year. The purchase price is the lesser of 85% of the closing market price of the Company’s common stock on either the first trading day or the last trading day of the plan year. If an employee does not elect to exercise his or her option, the total amount credited to his or her account during that plan year is returned to such employee without interest, and his or her option expires. As of September 30, 2006, the ESPP had 131,722 shares reserved for future issuance. At the ESPP’s last year end, December 31, 2005, there were 158 participants in the ESPP. The impact of SFAS 123(R) on the ESPP for the nine months ended September 30, 2006 was approximately $67,000.
The fair value of each option granted under the ESPP is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:
| Three Months Ended |
| Nine Months Ended |
| |||||
|
| September 30, |
| September 30, |
| ||||
|
| 2006 |
| 2005 |
| 2006 |
| 2005 |
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Dividend yield |
| — |
| 1.33 | % | — |
| 1.33 | % |
Risk-free interest rate |
| 4.38 | % | 2.79 | % | 4.38 | % | 2.79 | % |
Volatility |
| 50.40 | % | 41.70 | % | 50.40 | % | 41.70 | % |
Expected life (years) |
| 1 |
| 1 |
| 1 |
| 1 |
|
The Company estimates expected stock price volatility based on actual historical changes in the market value of the Company’s stock. The risk-free interest rate is based on the U.S. Treasury yield with a term that is consistent with the expected life of the stock options. The expected life of stock options under the ESPP is one year, or the equivalent of the annual plan year.
NOTE 3 — WEIGHTED AVERAGE COMMON SHARES
The weighted average common shares outstanding included in the computation of basic and diluted net income / loss per share is set forth below (in thousands):
|
| Three Months Ended September 30, |
| Nine Months Ended September 30, |
| ||||
|
| 2006 |
| 2005 |
| 2006 |
| 2005 |
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Weighted average common shares outstanding: |
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Basic |
| 20,864 |
| 20,824 |
| 20,847 |
| 20,824 |
|
Employee stock options and other |
| 18 |
| — |
| — |
| — |
|
Diluted |
| 20,882 |
| 20,824 |
| 20,847 |
| 20,824 |
|
The computation of diluted net income (loss) per common share for the three and nine months ended September 30, 2006 did not include options to purchase approximately 1.3 million and 1.5 million shares of common stock, respectively, as the effect of their inclusion would have been anti-dilutive to income (loss) per share. For the three and nine months ended September 30, 2005, 0.8 million stock options were not included in the computation of diluted net income (loss) per common share as the effect of their inclusion would have been anti-dilutive.
9
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 4 — CONTINGENCY
As previously disclosed in the 2005 10-K, in December 2004, the Company purchased all of the outstanding equity interests and warrants in Kids Line, LLC (the “Purchase”), in accordance with the terms and provisions of a Membership Interest Purchase Agreement (the “Purchase Agreement”). At closing, the Company paid approximately $130.5 million, which represented the portion of the purchase price due at closing plus various transaction costs, which was subsequently adjusted to $130.6 million. The aggregate purchase price under the Purchase Agreement includes the potential payment of contingent consideration (the “Earnout Consideration”). The Earnout Consideration shall equal 11.724% of the Agreed Enterprise Value (described below) of Kids Line as of the last day of the Measurement Period (the three year period ending November 30, 2007), and shall be paid at the times described in the Purchase Agreement (approximately the third anniversary of the closing date). The Agreed Enterprise Value shall be the product of (i) Kids Line’s EBITDA during the twelve (12) months ending on the last day of the Measurement Period and (ii) the applicable multiple (ranging from zero to eight) as set forth in the Purchase Agreement. The Company cannot currently determine the amount of the Earnout Consideration that will be required to be paid pursuant to the Purchase Agreement. However, based on current projections, the Company currently anticipates that the Earnout Consideration will be approximately $30 million, although the amount could be more or less depending on the actual performance of Kids Line for the remaining portion of the Measurement Period. The amount of the Earnout Consideration will be charged to goodwill. The Company currently anticipates that cash flow from operations and anticipated availability under the Infantline Credit Agreement will be sufficient to fund the payment of the Earnout Consideration (and that such payment will be permitted under the Infantline Credit Agreement), however there can be no assurance that unforeseen events or changes in the Company’s business would not have a material adverse impact on our ability to pay the Earnout Consideration and therefore on the Company’s liquidity. As described in Note 5 (Section 1.A and 1.E) below, the Infantline Borrowers (defined below) have agreed, on a joint and several basis, to assume sole responsibility to pay the Earnout Consideration in place of the Company.
NOTE 5 — DEBT
In connection with the purchase of Kids Line in December 2004, the Company and certain of its subsidiaries entered into a financing agreement (the “Financing Agreement”). The Financing Agreement consisted of a term loan in the original principal amount of $125.0 million which was scheduled to mature on November 14, 2007 (the “2004 Term Loan”). The Company used the proceeds of the 2004 Term Loan to substantially finance the Purchase and pay fees and expenses related thereto. The 2004 Term Loan was repaid in full and the Financing Agreement was terminated in connection with the execution of the 2005 Credit Agreement, discussed below, as of June 28, 2005. There were no fees paid as a result of the early termination of the Financing Agreement. However, in conjunction therewith, the Company wrote off the remaining unamortized balance of approximately $4.8 million in deferred financing costs.
In order to reduce overall interest expense and gain increased flexibility with respect to the financial covenant structure of the Company’s senior financing, on March 14, 2006, the 2005 Credit Agreement (defined below) was terminated and the obligations thereunder were refinanced (the “LaSalle Refinancing”). In connection with the LaSalle Refinancing, all outstanding obligations under the 2005 Credit Agreement (approximately $76.5 million) were repaid using proceeds from the Infantline Credit Agreement, defined below, which is part of the LaSalle Refinancing. The Company paid a fee of approximately $1.3 million in connection with the early termination of the 2005 Credit Agreement. In addition, the Company wrote off, in the first quarter of 2006, approximately $2.5 million in deferred financing costs in connection with the LaSalle Refinancing.
As part of the LaSalle Refinancing, the Company formed a wholly-owned Delaware subsidiary, Russ Berrie U.S. Gift, Inc. (“Newco”), to which it assigned (the “Assignment”) substantially all of its assets and liabilities which pertain primarily to its domestic gift business, such that separate loan facilities could be made directly available to each of the Company’s domestic gift business and infant and juvenile business, respectively. The Assignment transaction reinforces the operation of the Company as two separate segments, and the credit facilities that have been extended to each segment are separate and distinct. There are no cross-default provisions between the Infantline Credit Agreement and Giftline Credit Agreement, which are described below.
Long-term debt at September 30, 2006 and December 31, 2005 consists of the following (in thousands):
10
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
|
| September 30, 2006 |
| December 31, 2005 |
| ||
Term Loan A (2005 Credit Agreement) |
| $ | — |
| $ | 4,593 |
|
Term Loan B (2005 Credit Agreement) |
| — |
| 40,000 |
| ||
Term Loan (2006 Infantline Credit Agreement) |
| 54,750 |
| — |
| ||
|
| 54,750 |
| 44,593 |
| ||
Less current portion |
| 9,000 |
| 2,600 |
| ||
Long-term debt |
| $ | 45,750 |
| $ | 41,993 |
|
1. The LaSalle Refinancing – Effective March 14, 2006
A. The Infantline Credit Agreement
On March 14, 2006 (the “Closing Date”), Kids Line, LLC (“KL”) and Sassy, Inc. (“Sassy”, and together with KL, the “Infantline Borrowers”) entered into a credit agreement as borrowers, on a joint and several basis, with LaSalle Bank National Association as administrative agent and arranger (the “Agent”), the lenders from time to time party thereto, the Company as loan party representative, Sovereign Bank as syndication agent, and Bank of America, N.A. as documentation agent (the “Infantline Credit Agreement”). Unless otherwise specified herein, capitalized terms used but undefined in this Note 5 Section 1.A shall have the meanings ascribed to them in the Infantline Credit Agreement.
The commitments under the Infantline Credit Agreement (the “Infantline Commitments”) consist of (a) a $35.0 million revolving credit facility (the “Revolving Loan”), with a subfacility for letters of credit in an amount not to exceed $5.0 million, and (b) a $60.0 million term loan facility (the “Term Loan”). The Infantline Borrowers drew down approximately $79.7 million on the Infantline Credit Agreement on the Closing Date, including the full amount of the Term Loan, which reflects the payoff of all amounts outstanding under the 2005 Credit Agreement and certain fees and expenses associated with the LaSalle Refinancing. As of September 30, 2006, the outstanding balance on the Revolving Loan was $0.75 million and the outstanding balance on the Term Loan was $54.75 million.
The principal of the Term Loan will be repaid in installments as follows: (a) $0.75 million on the last day of each calendar month for the period commencing March 2006 through and including February 2008, (b) $1.0 million on the last day of each calendar month for the period commencing March 2008 through and including February 2009 and (c) $1.25 million on the last day of each calendar month for the period commencing March 2009 through and including February 2011. A final installment in the aggregate amount of the unpaid principal balance of the Term Loan (in addition to all outstanding amounts under the Revolving Loan) is due and payable on March 14, 2011, in each case subject to customary early termination provisions in accordance with the terms of the Infantline Credit Agreement.
The Infantline Loans bear interest at a rate per annum equal to the Base Rate (for Base Rate Loans) or the LIBOR Rate (for LIBOR Loans), at the Company’s option, plus an applicable margin, in accordance with a pricing grid based on the most recent quarter-end Total Debt to EBITDA Ratio, which applicable margin shall range from 1.75% - 2.50% for LIBOR Loans and from 0.25% - 1.00% for Base Rate Loans. The applicable interest rate margins as of September 30, 2006 were: 2.0% for LIBOR loans and 0.5% for Base Rate Loans. The weighted average interest rates for the outstanding loans as of September 30, 2006 were as follows:
| At September 30, 2006 |
| |||
|
| LIBOR Loans |
| Base Rate Loans |
|
Infantline Revolver |
| n/a |
| 8.75 | % |
Infantline Term Loan |
| 7.43 | % | 8.75 | % |
Interest is due and payable (i) with respect to Base Rate Loans, monthly in arrears on the last day of each calendar month, upon a prepayment and at maturity and (ii) with respect to LIBOR Loans, on the last day
11
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
of each Interest Period, upon a prepayment (and if the Interest Period is in excess of three months, on the three-month anniversary of the first day of such Interest Period), and at maturity.
In connection with the execution of the Infantline Credit Agreement, the Infantline Borrowers paid aggregate closing fees of $1.4 million and an aggregate agency fee of $25,000. An aggregate agency fee of $25,000 will be payable on each anniversary of the Closing Date. The Revolving Loan is subject to an annual non-use fee (payable monthly, in arrears, and upon termination of the relevant obligations) of 0.50% for unused amounts under the Revolving Loan, an annual letter of credit fee (payable monthly, in arrears, and upon termination of the relevant obligations) for undrawn amounts with respect to each letter of credit based on the most recent quarter-end Total Debt to EBITDA Ratio ranging from 1.75% - 2.50% and other customary letter of credit administration fees. In addition, if the credit facility is terminated for any reason prior to the first anniversary of the Closing Date, the Infantline Borrowers shall pay an aggregate early termination fee of approximately $1.0 million.
The Infantline Borrowers are required to make prepayments of the Term Loan upon the occurrence of certain transactions, including most asset sales or debt or equity issuances. Additionally, commencing in early 2008 with respect to fiscal year 2007, annual mandatory prepayments of the Term Loan shall be required in an amount equal to 50% of Excess Cash Flow for each fiscal year unless the Total Debt to EBITDA Ratio for such fiscal year was equal to or less than 2.00:1.00.
The Infantline Credit Agreement contains customary affirmative and negative covenants, as well as the following financial covenants (the “Infantline Financial Covenants”): (i) a minimum EBITDA test, (ii) a minimum Fixed Charge Coverage Ratio, (iii) a maximum Total Debt to EBITDA Ratio and (iv) an annual capital expenditure limitation. As of September 30, 2006, the Company was in compliance with the financial covenants contained in the Infantline Credit Agreement.
The Infantline Credit Agreement contains significant limitations on the ability of the Infantline Borrowers to distribute cash to Russ Berrie and Company, Inc. (“RB”), which became a corporate holding company by virtue of the Assignment, for the purpose of paying dividends to the shareholders of the Company or for the purpose of paying RB’s corporate overhead expenses, including a cap (subject to certain exceptions) of $2.0 million per year on the amount that can be provided to RB to pay corporate overhead expenses.
As a result of the LaSalle Refinancing, the obligation to pay the Earnout Consideration pursuant to the Kids Line acquisition (see Note 4) is no longer the obligation of RB, but the joint and several obligation of the Infantline Borrowers. With respect to the Earnout Consideration, the Infantline Borrowers will be permitted to pay all or a portion of the Earnout Consideration to the extent that, before and after giving effect to such payment, (i) Excess Revolving Loan Availability will equal or exceed $3.0 million and (ii) no violation of the Infantline Financial Covenants would then exist, or would, on a pro forma basis, result therefrom.
In order to secure the obligations of the Infantline Borrowers, (i) the Infantline Borrowers have pledged and have granted security interests to the Agent in substantially all of their existing and future personal property, (ii) each Infantline Borrower has guaranteed the performance of the other Infantline Borrower, (iii) Sassy granted a mortgage for the benefit of the Agent and the lenders on its real property located at 2305 Breton Industrial Park Drive, S.E., Kentwood, Michigan and (iv) the Company pledged 100% of the equity interests of each of the Infantline Borrowers to the Agent (the “Infantline Pledge Agreement”). Pursuant to the Infantline Pledge Agreement, RB has agreed that it will function solely as a holding company and will not, without the prior written consent of the Agent, engage in any business or activity except for specified activities, including those relating to its investments in its subsidiaries existing on the Closing Date, the maintenance of its existence and compliance with law, the performance of obligations under specified contracts and other specified ordinary course activities.
B. The Giftline Credit Agreement
On March 14, 2006 as amended on April 11, 2006 (to clarify the application of a financial covenant) and August 8, 2006, Russ Berrie U.S. Gift, Inc. (“Newco”) and other specified wholly-owned domestic subsidiaries of the Company (collectively, the “Giftline Borrowers”), entered into a credit agreement as borrowers, on a joint and several basis, with LaSalle Bank National Association, as issuing bank (the “Issuing Bank”), LaSalle Business Credit, LLC as administrative agent (the “Administrative Agent”), the
12
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
lenders from time to time party thereto, and the Company, as loan party representative (as amended, the “Giftline Credit Agreement” and, together with the Infantline Credit Agreement, the “2006 Credit Agreements”). Unless otherwise specified herein, capitalized terms used but undefined in this Note 5 Section 1.B shall have the meanings ascribed to them in the Giftline Credit Agreement.
The Giftline Credit Agreement contemplates the potential inclusion of additional lenders subsequent to the initial closing, which as of September 30, 2006 has not occurred, and a simultaneous increase in the commitment. The facility consists of a revolving credit loan commitment (a) before such commitment is increased, if at all, in an amount equal to the Borrowing Base minus amounts outstanding under the Canadian Credit Agreement (as defined below) and (b) after such commitment is increased, if at all, in an amount equal to the lesser of (i) $25.0 million and (ii) the then-current Borrowing Base, in each case minus amounts outstanding under the Canadian Credit Agreement (the “Giftline Revolver”), with a subfacility for letters of credit to be issued by the Issuing Bank in an amount not to exceed $8.0 million. The Borrowing Base is primarily a function of a percentage of eligible accounts receivable and eligible inventory and, as of September 30, 2006, the Borrowing Base, inclusive of the Borrowing Base provided under the Canadian Credit Agreement, was approximately $7.9 million. As of September 30, 2006, the outstanding balance on the Giftline Revolver was $4.6 million and the balance on the Canadian Revolving Loan (see Section 1.C below) was $1.1 million.
All outstanding amounts under the Giftline Revolver are due and payable on March 14, 2011, subject to earlier termination in accordance with the terms of the Giftline Credit Agreement.
The Giftline Revolver bears interest at a rate per annum equal to the sum of the Base Rate (for Base Rate Loans) or the LIBOR Rate (for LIBOR Loans), at the Company’s option, plus a margin of 2.75% for LIBOR Loans and 1.25% for Base Rate Loans. Interest is due and payable in the same manner as with respect to the Infantline Loans. As of September 30, 2006, the interest rate was 9.5% for the one outstanding Base Rate loan and 8.12% for outstanding LIBOR loans.
In connection with the execution of the Giftline Credit Agreement, the Infantline Borrowers paid (on behalf of the Giftline Borrowers) aggregate closing fees of $0.15 million and an aggregate agency fee of $20,000. Aggregate agency fees of $20,000 will be payable by the Giftline Borrowers on each anniversary of the Closing Date. The Giftline Revolver is subject to an annual non-use fee (payable monthly, in arrears, and upon termination of the relevant obligations) of 0.50% for unused amounts under the Giftline Revolver, and other fees as described with respect to the Giftline Revolver. If the commitment under the Giftline Credit Agreement is increased, an additional fee equal to 1.0% of the increase will be required. In addition, if the Termination Date (which includes customary termination events) occurs prior to the first anniversary of the Closing Date, the Giftline Borrowers shall pay a termination fee equal to 1.0% of the highest Maximum Revolving Commitment that had been in effect at any time prior to such termination.
All accounts of the Giftline Borrowers are required to be with the Administrative Agent or its affiliates, and cash in such accounts will be swept on a daily basis to pay down outstanding amounts under the Giftline Revolver.
The Giftline Credit Agreement contains customary affirmative and negative covenants substantially similar to those applicable to the Infantline Credit Agreement. The Giftline Credit Agreement contains the following financial covenants (the “Giftline Financial Covenants”): (i) a minimum EBITDA test, (ii) a minimum Excess Revolving Loan Availability requirement of $5.0 million, (iii) an annual capital expenditure limitation and (iv) a minimum Fixed Charge Coverage Ratio (for quarters commencing with the quarter ended March 31, 2008). In addition, at any time after December 31, 2007 in respect of which the Fixed Charge Coverage Ratio for the Computation Period ending as of the fiscal quarter end most recently preceding such date was less than 1.00:1.00, the aggregate amounts outstanding under the Giftline Credit Agreement and the Canadian Loan Agreement may not exceed $10.0 million. On August 8, 2006, the Giftline Credit Agreement was amended to lower the threshold on the Minimum EBITDA covenant by $1.0 million per fiscal quarter for each of four consecutive fiscal quarters commencing with the fiscal quarter ending September 30, 2006. As of September 30, 2006, the Company was in compliance with the financial covenants contained in the Giftline Credit Agreement.
The Giftline Credit Agreement contains significant limitations on the ability of the Giftline Borrowers to distribute cash to RB for the purpose of paying dividends to the shareholders of the Company or for the
13
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
purpose of paying RB’s corporate overhead expenses, including a cap (subject to certain exceptions) on the amount that can be provided to RB to pay corporate overhead expenses equal to $4.5 million per year for each of fiscal years 2006 and 2007, and $5.0 million for each fiscal year thereafter.
In order to secure the obligations of the Giftline Borrowers, the Giftline Borrowers pledged and have granted security interests to the Administrative Agent in substantially all of their existing and future personal property, and each Giftline Borrower guaranteed the performance of the other Giftline Borrowers under the Giftline Credit Agreement. In addition, RB provided a limited recourse guaranty of the obligations of the Giftline Borrowers under the Giftline Credit Agreement. This guarantee is secured by a lien on the assets intended to be assigned to Newco pursuant to the Assignment. RB also pledged 100% of the equity interests of each of the Giftline Borrowers and 65% of its equity interests in certain of its First Tier Foreign Subsidiaries to the Administrative Agent (the “Giftline Pledge Agreement”). The Giftline Pledge Agreement contains substantially similar limitations on the activities of RB as is set forth in the Infantline Pledge Agreement.
The Company’s ability to maintain compliance with the financial covenants under the 2006 Credit Agreements is dependent, particularly in the case of the Giftline Credit Agreement, upon the successful implementation of the Company’s Profit Improvement Plan (described in Note 8 herein) and current operational plans. Based on these plans and management’s current projections, management believes that the Company will remain in compliance with the financial covenants in the 2006 Credit Agreements at least through September 30, 2007. However, in the event that the Company is unable to successfully implement the key elements of the Profit Improvement Plan and current operational plans, there can be no assurance that the Company will remain in compliance with the financial covenants in the 2006 Credit Agreements.
C. Canadian Credit Agreement
As contemplated by the 2005 Credit Agreement on June 28, 2005, the Company’s Canadian subsidiary, Amram’s Distributing Ltd. (“Amrams”), executed a separate Credit Agreement (acknowledged by the Company) with the financial institutions party thereto and LaSalle Business Credit, a division of ABN AMRO Bank, N.V., Canada Branch, a Canadian branch of a Netherlands bank, as issuing bank and administrative agent (the “Canadian Credit Agreement”), and related loan documents with respect to a maximum U.S. $10.0 million revolving loan (the “Canadian Revolving Loan”). RB executed an unsecured Guarantee (the “Canadian Guarantee”) to guarantee the obligations of Amrams under the Canadian Credit Agreement. In connection with the LaSalle Refinancing, the Canadian Credit Agreement was amended to (i) replace references to the LaSalle Credit Agreement with the Giftline Credit Agreement (such that, among other conforming changes, a default under the Giftline Credit Agreement will be a default under the Canadian Credit Agreement), (ii) release RB from the Canadian Guaranty and (iii) provide for a maximum U.S. $5.0 million revolving loan. In connection with the release of the Company from the Canadian Guaranty, Newco executed an unsecured Guarantee (the “Newco Guarantee”) to guarantee the obligations of Amrams under the Canadian Credit Agreement. A default under the Infantline Credit Agreement will not constitute a default under the Canadian Credit Agreement. The outstanding balance under the Canadian Revolving Loan as of September 30, 2006 was U.S. $1.12 million which reduces availability under the Giftline Credit Agreement by a corresponding amount.
The Commitments under the Candian Credit Agreement bear interest at a rate per annum equal to the sum of the Base Rate (for Base Rate Loans) or the LIBOR Rate (for LIBOR Loans) plus an applicable margin. As of September 30, 2006, the interest rate for the outstanding Base Rate loan was 8.25%, and there were no Libor Loans outstanding.
D. Economic Development Authority (“EDA”) Loan Agreement
Since 1983, the Company had been a guarantor of the EDA Loan Agreement, pursuant to which the EDA issued the EDA Bonds in the principal amount of $7.0 million to finance the construction of the South Brunswick, New Jersey facility now leased by the Company from the Estate of Mr. Russell Berrie. Mr. Berrie (and after his death, his Estate) was the primary obligor with respect to the EDA Bonds. In connection therewith, the Company, in 1983, caused the issuance of a letter of credit in an amount of
14
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
approximately $7.4 million to secure the payment obligations with respect to the EDA Bonds and had granted a security interest on accounts receivable and inventory of the Company up to $2.0 million to secure its obligations under its guarantee and the Amended and Restated Letter of Credit Reimbursement Agreement (“L/C RA”) executed in connection therewith.
On April 3, 2006, the Estate (with funds provided by Ms. Berrie) redeemed the EDA Bonds. As a result, the Company’s obligations under the guarantee discussed above (as well as the L/C RA, all letters of credit and related security interests) have been terminated.
E. Earnout Security Documents
All capitalized terms used but undefined in this Note 5, Section 1.E “Earnout Security Documents” section shall have the meanings ascribed to them in the “Giftline Credit Agreement”.
As has been previously reported, the Company was obligated to pay the Earnout Consideration under the Kids Line Purchase Agreement. Pursuant to the Letter Agreement between the Infantline Borrowers and California KL Holdings, Inc., and the other parties thereto (the “Letter Agreement”), the Infantline Borrowers have agreed, on a joint and several basis, to assume sole responsibility to pay the Earnout Consideration in the place of the Company. In connection therewith, the Earnout Security Documents have been amended to effect the partial release of the Company as obligor and the full release of the security interests granted thereunder by any Giftline Borrowers. To secure the obligations of the Infantline Borrowers to pay the Earnout Consideration, the Infantline Borrowers have granted a subordinated lien on substantially all of their assets, on a joint and several basis, and RB has granted a subordinated lien on the equity interests of each of the Infantline Borrowers to the Earnout Sellers Agent. All such security interests and liens are subordinated to the senior indebtedness of the Infantline Borrowers arising under the Infantline Credit Agreement. The Earnout Consideration is not secured by the Giftline Borrowers or their assets or equity interests. However, based on current projections, the Company currently anticipates that the Earnout Consideration will be approximately $30 million, although the amount could be more or less depending on the actual performance of Kids Line for the remaining portion of the Measurement Period. The Company currently anticipates that cash flow from operations and anticipated availability under the Infantline Credit Agreement will be sufficient to fund the obligation to pay the Earnout Consideration. The amount of the Earnout Consideration will be charged to goodwill.
2. 2005 Credit Agreement – Effective June 28, 2005 through March 13, 2006
The Company and certain of its domestic wholly-owned subsidiaries party thereto (the “Specified Subsidiaries”), entered into a $105.0 million credit agreement dated as of June 28, 2005, and amended as of August 4 and October 11, 2005 (the “2005 Credit Agreement”), with LaSalle Bank National Association and other lenders. Unless otherwise specified herein, capitalized terms used but undefined herein shall have the meanings ascribed to them in the 2005 Credit Agreement.
The obligations under the 2005 Credit Agreement (the “Commitments”) consisted of Facility A Obligations and Facility B Obligations. The Facility A Obligations were comprised of: (a) a $52.0 million revolving credit facility (the “Revolving Loan”), with a sub-facility for letters of credit to be issued by the Issuing Bank in an amount not to exceed $10.0 million; and (b) a $13.0 million term loan facility (“Term Loan A”). The Facility B Obligations consisted of a $40.0 million term loan facility (“Term Loan B”). As of December 31, 2005, the Company had $31.9 million outstanding under the Revolving Loan.
The principal of Term Loan A was due in equal monthly installments of approximately $0.2 million (subject to reduction by prepayments), to be made on the last day of each month (commencing July 31, 2005). As of December 31, 2005, the interest rate on the base rate loan was 7.5% and the LIBOR Loan was 5.98%.
In connection with the execution of the 2005 Credit Agreement and the Canadian Credit Agreement, the Company recorded approximately $2.3 million of deferred financing costs which were included in “other assets” at December 31, 2005 and were being amortized over the five-year period of the Commitments. The unamortized balance of these deferred financing costs was written off in the first quarter of 2006 as a result of the LaSalle Refinancing in March 2006.
The 2005 Credit Agreement contained certain financial covenants and certain restrictions on the payment of dividends and the Earnout Consideration. As of December 31, 2005, the Company was not in compliance with the “Total Debt to EBITDA Ratio” covenant in the 2005 Credit Agreement. However,
15
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
because the Company completed the LaSalle Refinancing on March 14, 2006, the long-term debt at December 31, 2005 was classified as long-term.
As contemplated by the 2005 Credit Agreement, the Company’s Canadian subsidiary, Amram’s Distributing Ltd. (“Amrams”), entered into on June 30, 2005, as of June 28, 2005, and amended as of August 4 and October 11, 2005, a separate credit agreement with the financial institutions party thereto and LaSalle Business Credit, a division of ABN AMRO Bank, N.V., Canada Branch, a Canadian branch of a Netherlands bank (the “Canadian Credit Agreement”) with respect to a maximum U.S. $10.0 million revolving loan (the “Canadian Revolving Loan”), with a sub-facility for letters of credit in an amount not to exceed U.S. $2.0 million. All outstanding amounts under the Canadian Revolving Loan were to be due and payable on June 28, 2010, subject to earlier termination in accordance with the terms of the Canadian Credit Agreement.
The Canadian Revolving Loan would bear interest at a rate per annum equal to the sum of (x)(i) the Base Rate or the Canadian Base Rate (as defined in the Canadian Credit Agreement), at the option of Amrams (for Base Rate Loans) or (ii) the LIBOR Rate (for LIBOR Loans) plus (y) an applicable margin, in accordance with a pricing grid based on the most recent quarter-end Total Debt to EBITDA Ratio. The interest rate as of December 31, 2005 was 7.25%. The Canadian Credit Agreement is described in further detail in the Quarterly Report on Form 10-Q for the period ended June 30, 2005. The Canadian Credit Agreement was amended in connection with the execution of the 2006 Credit Agreements, as described above.
In order to secure its obligations under the Canadian Credit Agreement, Amrams has granted security interests to the administrative agent thereunder in substantially all of its real and personal property. In addition, the Company has executed an unsecured Guarantee (the “Canadian Guaranty”) to guarantee the obligations of Amrams under the Canadian Credit Agreement, which guaranty was released in connection with the 2006 Credit Agreements. All amounts outstanding under the 2005 Credit Agreement were paid in full in connection with the LaSalle Refinancing.
See the 2005 10-K for additional detail regarding the 2005 Credit Agreement and a predecessor facility.
NOTE 6 — GOODWILL AND INTANGIBLE ASSETS
Intangible assets consist of the following (in thousands):
|
| Weighted |
| September 30, |
| December 31, |
| ||
MAM distribution agreement and relationship |
| Indefinite life |
| $ | 10,400 |
| $ | 10,400 |
|
Sassy trade name |
| Indefinite life |
| 7,100 |
| 7,100 |
| ||
Applause trade name |
| Indefinite life |
| 7,646 |
| 7,646 |
| ||
Kids Line customer relationships |
| Indefinite life |
| 31,100 |
| 31,100 |
| ||
Kids Line trade name |
| Indefinite life |
| 5,300 |
| 5,300 |
| ||
Other intangible assets |
| 4.7 years |
| 64 |
| 53 |
| ||
|
|
|
| $ | 61,610 |
| $ | 61,599 |
|
Other intangible assets as of September 30, 2006 and December 31, 2005 include Kids Line and Sassy non-compete agreements, which are being amortized over four and five years, respectively, and a patent. Amortization expense was $19,000 and $288,000 for the first nine months of 2006 and 2005, respectively.
All of the Company’s goodwill and indefinite life intangibles, except for the Applause tradename, are in the infant and juvenile segment, and resulted from the 2002 and 2004 acquisitions of Sassy, Inc. and Kids Line LLC, respectively. There were no changes to the carrying amount of goodwill during the nine months ended September 30, 2006.
16
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 7 — DIVIDENDS
No cash dividends were paid during the three and nine months ended September 30, 2006. No cash dividends were paid during the three months ended September 30, 2005 and $2.1 million of dividends were paid during the nine months ended September 30, 2005. See Note 5 for a discussion of dividend restrictions imposed by the Company’s senior bank facilities.
NOTE 8 — RESTRUCTURING AND RELATED COSTS
In November 2005, the Company continued restructuring efforts with respect to its domestic gift business to reduce expenses, right-size the infrastructure consistent with current business levels and re-align domestic gift operations to better meet the needs of different distribution channels. During the first nine months of 2006, in accordance with its November 2005 restructuring plan, the Company recorded a $0.7 million restructuring charge related to severance costs of employees at its Petaluma, California distribution center, which closed in the second quarter of 2006, and the reduction of additional sales staff and operational support positions in the U.S. Gift business. In addition, in connection with the PIP implementation (discussed in detail in Item 2 below), the Company recorded a restructuring charge of an aggregate of approximately $3.4 million in the nine months ended September 30, 2006 attributable to the downsizing of its operations under its PIP, which was comprised primarily of employee severance costs. The Company also incurred a one time charge of $1.3 million during the three months ended September 30, 2006, in connection with the relocation of its distribution facility in the United Kingdom, primarily related to the write-off of fixed assets and moving costs. See “Item 2, Management’s Discussion and Analysis of Financial Condition and Results or Operations — Overview.”
The Company reassesses the reserve requirements under the restructuring efforts at the end of each reporting period. A rollforward of the restructuring accrual is set forth below (in thousands):
| Employee |
| Facility |
|
|
| ||||
|
| Separation |
| Exit Costs |
| Total |
| |||
Balance @ 12/31/05 |
| $ | 1,731 |
| $ | 131 |
| $ | 1,862 |
|
2006 Provision |
| 4,087 |
| — |
| 4,087 |
| |||
Less Payments |
| 4,419 |
| 41 |
| 4,460 |
| |||
Balance @ 9/30/06 |
| $ | 1,399 |
| $ | 90 |
| $ | 1,489 |
|
NOTE 9 — SEGMENTS OF THE COMPANY AND RELATED INFORMATION
The Company operates in two segments: (i) the Company’s gift business and (ii) the Company’s infant and juvenile business, which includes Sassy, Inc. and Kids Line, LLC. This segmentation of the Company’s operations reflects how management currently views the results of operations. There are no inter-segment revenues to eliminate. Corporate assets and overhead expenses are included in the gift segment.
The Company’s gift business designs, manufactures through third parties and markets a wide variety of gift products to retail stores throughout the United States and throughout the world via the Company’s international wholly-owned subsidiaries and independent distributors. The Company’s infant and juvenile businesses design and market products in a number of baby categories including, among others, infant bedding and accessories, bath toys and accessories, developmental toys, feeding items and baby comforting products. These products are sold to consumers, primarily in the United States, through mass merchandisers, toy, specialty, food, drug and independent retailers, apparel stores and military post exchanges.
17
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
|
| Three Months Ended |
| Nine Months Ended |
| ||||||||
(Dollars in thousands) |
| 2006 |
| 2005 |
| 2006 |
| 2005 |
| ||||
Gift: |
|
|
|
|
|
|
|
|
| ||||
Net sales |
| $ | 43,412 |
| $ | 50,303 |
| $ | 112,603 |
| $ | 116,977 |
|
Selling, general and administrative expenses (a) (b) |
| 19,240 |
| 25,432 |
| 68,676 |
| 76,029 |
| ||||
Operating loss (c) |
| (3,932 | ) | (4,269 | ) | (26,345 | ) | (24,587 | ) | ||||
Other income |
| 3 |
| 12 |
| 135 |
| 147 |
| ||||
Depreciation and amortization |
| 1,114 |
| 1,270 |
| 3,435 |
| 4,317 |
| ||||
Loss before income tax expense |
| $ | (3,929 | ) | $ | (4,257 | ) | $ | (26,210 | ) | $ | (24,440 | ) |
|
|
|
|
|
|
|
|
|
| ||||
Infant and juvenile: |
|
|
|
|
|
|
|
|
| ||||
Net sales |
| $ | 34,732 |
| $ | 32,934 |
| $ | 108,590 |
| $ | 99,019 |
|
Selling,general and administrative expenses (b) |
| 6,535 |
| 4,504 |
| 16,128 |
| 13,802 |
| ||||
Operating income |
| 7,463 |
| 8,927 |
| 28,543 |
| 25,767 |
| ||||
Other expense |
| 1,701 |
| 1,452 |
| 8,724 |
| 13,183 |
| ||||
Depreciation and amortization |
| 200 |
| 209 |
| 624 |
| 696 |
| ||||
Income before income tax expense |
| $ | 5,762 |
| $ | 7,475 |
| $ | 19,819 |
| $ | 12,584 |
|
|
|
|
|
|
|
|
|
|
| ||||
Consolidated: |
|
|
|
|
|
|
|
|
| ||||
Net sales |
| $ | 78,144 |
| $ | 83,237 |
| $ | 221,193 |
| $ | 215,996 |
|
Selling, general and administrative expenses |
| 25,775 |
| 29,936 |
| 84,804 |
| 89,831 |
| ||||
Operating income |
| 3,531 |
| 4,658 |
| 2,198 |
| 1,180 |
| ||||
Other expense |
| 1,698 |
| 1,440 |
| 8,589 |
| 13,036 |
| ||||
Depreciation and amortization |
| 1,314 |
| 1,479 |
| 4,059 |
| 5,013 |
| ||||
Income (loss) before income tax expense |
| $ | 1,833 |
| $ | 3,218 |
| $ | (6,391 | ) | $ | (11,856 | ) |
(a) Selling, general and administrative expense for the gift segment includes: (i) for the three months ended September 30, 2006 and 2005, $0.5 million and $0.9 million, respectively, of restructuring costs (ii) for the nine months ended September 30, 2006 and 2005, $4.1 million and $1.3 million, respectively, of restructuring costs and (iii) for the three and nine months ended September 2006, $1.3 million and $3.8 million, respectively of other special charges incurred in connection with the development of the 2006 PIP.
(b) Selling, general and administrative expenses for the three and nine months ended September 30, 2006 for the gift segment were reduced by a $1.5 million infant and juvenile segment reimbursement for corporate overhead costs. This offset to the gift segment expenses is eliminated in consolidation with the corresponding $1.5 million charge to selling, general & administrative expenses of the infant and juvenile segment.
(c) Operating loss for the gift segment is impacted by charges recorded in cost of sales, including: (i) for the three months ended September 30, 2006 and 2005, $2.4 million and $0.2 million, respectively, and (ii) for the nine months ended September 30, 2006 and 2005, $3.0 million and $0.3 million.
18
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Total assets of each segment were as follows :
(Dollars in thousands) |
| September 30, |
| December 31, |
| ||
Gift |
| $ | 107,062 |
| $ | 129,721 |
|
Infant and juvenile |
| 195,255 |
| 199,240 |
| ||
Total |
| $ | 302,317 |
| $ | 328,961 |
|
Concentration of Risk
As disclosed in the 2005 10-K, approximately 89% of the Company’s purchases are attributable to manufacturers in the People’s Republic of China. The supplier accounting for the greatest dollar volume of purchases accounted for approximately 16% and the five largest suppliers accounted for approximately 40% in the aggregate. The Company utilizes approximately 130 manufacturers in Eastern Asia and believes that there are many alternative manufacturers and sources of raw materials for the Company’s products. As a result, the Company does not believe there is a concentration of risk associated with any significant manufacturing relationship. See Item 1A, “Risk Factors”, of the 2005 10-K.
With respect to customers, Toys “R” Us, Inc. and Babies “R” Us, Inc., in the aggregate, accounted for 19.3% and 23.1%, respectively, of the Company’s consolidated net sales during the three and nine month periods ended September 30, 2006, and 18.1% and 21.6%, respectively, during the three and nine months periods ended September 30, 2005.
NOTE 10 — FOREIGN CURRENCY FORWARD EXCHANGE CONTRACTS
Certain of the Company’s subsidiaries periodically enter into foreign currency forward exchange contracts to hedge inventory purchases, both anticipated and firm commitments, denominated in the United States dollar. These contracts reduce foreign currency risk caused by changes in exchange rates and are used to offset the currency impact of these inventory purchases, generally for periods up to 13 months. At September 30, 2006, the Company’s forward contracts have expiration dates which range from one to six months.
The Company accounts for its forward exchange contracts as an economic hedge, with subsequent changes in fair value recorded in the Consolidated Statements of Operations. As of September 30, 2006, net unrealized gains of $15,000 relating to forward contracts are included in other current assets and as of December 31, 2005, unrealized losses of $0.16 million are included in accrued expenses in the Consolidated Balance Sheets.
The Company has forward contracts to exchange British pounds sterling, Canadian dollars and Australian dollars for United States dollars with notional amounts of $5.1 million and $3.3 million as of September 30, 2006 and December 31, 2005, respectively. The Company has forward contracts to exchange United States dollars to Euros with notional amounts of $2.3 million and $6.4 million as of September 30, 2006 and December 31, 2005, respectively. The Company does not anticipate any material adverse impact on its results of operations or financial position from these contracts.
NOTE 11 — COMPREHENSIVE INCOME / (LOSS)
Comprehensive Income / (Loss), representing all changes in Shareholders’ Equity during the period other than changes resulting from the issuance or repurchase of the Company’s common stock and payment of dividends, is reconciled to net income (loss) for the three and nine months ended September 30, 2006 and 2005 as follows:
19
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
|
| Three Months Ended |
| Nine Months Ended |
| ||||||||
(Dollars in thousands) |
| 2006 |
| 2005 |
| 2006 |
| 2005 |
| ||||
Net income (loss) |
| $ | 256 |
| $ | (8,606 | ) | $ | (10,710 | ) | $ | (16,493 | ) |
Other comprehensive income (loss), net of tax: |
|
|
|
|
|
|
|
|
| ||||
Foreign currency translation adjustments |
| 808 |
| 233 |
| 2,040 |
| (3,113 | ) | ||||
Net unrealized gain on foreign currency forward exchange contracts and other |
| — |
| (57 | ) | — |
| 358 |
| ||||
Other comprehensive income (loss) |
| 808 |
| 176 |
| 2,040 |
| (2,755 | ) | ||||
Comprehensive income (loss) |
| $ | 1,064 |
| $ | (8,430 | ) | $ | (8,670 | ) | $ | (19,248 | ) |
NOTE 12 — CONTINGENCIES AND COMMITMENTS
In the ordinary course of its business, the Company is party to various copyright, patent and trademark infringement, unfair competition, breach of contract, customs, employment and other legal actions incidental to its business, as plaintiff or defendant. In the opinion of management, the amount of ultimate liability with respect to such actions that are currently pending will not materially adversely affect the consolidated results of operations, financial condition or cash flows of the Company.
In connection with the Company’s purchase of Kids Line LLC, the aggregate purchase price includes a payment of Earnout Consideration as more fully described in Note 4. The Company cannot currently determine the amount of the Earnout Consideration that will be required to be paid pursuant to the Purchase Agreement. However, based on current projections, the Company currently anticipates that the Earnout Consideration will be approximately $30 million, although the amount could be more or less depending on the actual performance of Kids Line for the remaining portion of the Measurement Period.
The Company enters into various license agreements relating to trademarks, copyrights, designs, and products which enable the Company to market items compatible with its product line. All license agreements other than the agreement with MAM Babyartikel GmbH (which has a remaining term of five years), are for three year terms with extensions agreed to by both parties. Several of these license agreements require prepayments of certain minimum guaranteed royalty amounts. The amount of minimum guaranteed royalty payments with respect to all license agreements aggregates $6.6 million, of which $1.7 million remained unpaid at September 30, 2006, substantially all of which is due prior to December 31, 2007. During 2005, the Company recorded a charge to cost of sales of $2.3 million against these royalty prepayments for amounts that management believes will not be realized, and during the three months ended September 30, 2006, the Company recorded an additional $750,000 charge associated with these minimum guaranteed royalties.
During 2002, Russ Berrie (UK) Limited entered into a lease with a related party for warehousing space with a 20 year term. During August 2006, Russ Berrie (UK) entered into an agreement, which closed on October 31, 2006, whereby Russ Berrie (UK) agreed to vacate and cancel its lease prior to the expiration of the stated term. Russ Berrie (UK) subsequently entered into a new third party lease for appropriately smaller space with a term of 10 years. In connection with these transactions, the Company recorded a charge of $1.3 million primarily related to the write off of fixed assets and moving costs.
20
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 13 — RECENTLY ISSUED ACCOUNTING STANDARDS
In July 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48), effective for fiscal years beginning after December 15, 2006. FIN 48 requires a two-step approach to determine how to recognize tax benefits in the financial statements where recognition and measurement of a tax benefit must be evaluated separately. A tax benefit will be recognized only if it meets a “more-likely-than-not” recognition threshold. For tax positions that meet this threshold, the tax benefit recognized is based on the largest amount of tax benefit that is greater than 50 percent likely of being realized upon ultimate settlement with the taxing authority. We are currently evaluating the impact of adopting FIN 48, and have not yet determined the significance of this new rule to our overall results of operations, cash flows or financial position.
In September 2006, the SEC staff issued Staff Accounting Bulletin (SAB) Topic 1N (SAB 108), “Financial Statements — Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” which is effective for calendar year companies as of December 31, 2006. SAB 108 provides guidance on how prior year misstatements should be taken into consideration when quantifying misstatements in current year financial statements for purposes of determining whether the financial statements are materially misstated. Under this guidance, companies should take into account both the effect of a misstatement on the current year balance sheet as well as the impact upon the current year income statement in assessing the materiality of a current year misstatement. Once a current year misstatement has been quantified, the guidance in SAB Topic 1M, “Financial Statements — Materiality,” (SAB 99) should be applied to determine whether the misstatement is material. The Company is currently assessing the potential impact, if any, on the implementation of SAB 108 on the Company’s financial statement.
21
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The financial and business analysis below provides information that the Company believes is relevant to an assessment and understanding of the Company’s consolidated financial condition, changes in financial condition and results of operations. This financial and business analysis should be read in conjunction with the Company’s consolidated financial statements and accompanying Notes to Unaudited Consolidated Financial Statements set forth in Part I, Financial Information, Item 1, “Financial Statements” of this Quarterly Report on Form 10-Q and the Company’s Annual Report on Form 10-K for the year ended December 31, 2005, as amended (the “2005 10-K”), as well as the Company’s Quarterly Report on Form 10-Q for each of the periods ended March 31, 2006 and June 30, 2006.
OVERVIEW
The Company is a leader in the gift and infant and juvenile industries. The Company’s gift business designs, manufactures through third parties and markets a wide variety of gift products to retail stores throughout the world. The Company’s infant and juvenile businesses design, manufacture through third parties and market products in a number of baby categories, including infant bedding and accessories, bath toys and accessories, developmental toys, feeding items and baby comforting products. These products are sold to consumers, primarily in the United States, through mass merchandisers, toy, specialty, food, drug and independent retailers, apparel stores, military post exchanges and other venues.
The Company’s revenues are primarily derived from sales of its products in its gift and infant and juvenile business segments. For the three and nine month periods ended September 30, 2006, gift segment sales accounted for 55.6% and 50.9%, respectively, and infant and juvenile segment sales accounted for 44.4% and 49.1%, respectively, of the Company’s consolidated net sales.
Sales and operating profits in the Company’s gift segment began to decline during 2003 as a result of several factors including: (i) retailer consolidation and a declining number of independent retail outlets, which in turn had a negative impact on sales from such outlets; (ii) increased competition from other entities, both wholesalers and retailers, which offered lower pricing and achieved greater customer acceptance of their products; and (iii) changing buying habits of consumers, marked by a shift from independent retailers to mass market retailers. Commencing in the third quarter of 2003, the Company began to implement a multi-pronged approach to address these trends, which consists of: (i) focusing on categorizing and rationalizing its product range; (ii) segmenting its selling efforts to address customer requirements and shifting channels of distribution; (iii) increasing its focus on national accounts, in order to build and strengthen the Company’s presence in the mass market through the use if its APPLAUSE® trademark as the mass market brand platform; (iv) focusing on growing its international business and infant and juvenile segments; (v) selectively increasing its use of licensing to differentiate its products from its competitors; (vi) implementing a three-tiered “good”, “better”, “best” branding strategy within its gift segment to differentiate products sold into the mass market, the Company’s traditional specialty retail market and the upscale department store market; and (vii) ”right-sizing” its operations in order to reduce overhead expenses through headcount reductions and the closure of certain domestic showrooms and warehouses.
Despite significant cost reductions achieved by this multi-pronged approach, through much of 2005, the Company had achieved only limited success in reversing the challenges facing its gift business and the industry in general. As a result, in November 2005, the Company commenced the implementation of a restructuring of its domestic gift business designed to “right size” the infrastructure consistent with existing business levels and re-align domestic gift operations to better meet the needs of different distribution channels. The November 2005 restructuring included the elimination of approximately 90 positions, a reduction in the number of gift products sold by the Company, and the closure of the Company’s distribution center in Petaluma, California. These actions resulted in (i) a pre-tax restructuring charge in 2005 of approximately $1.4 million, (ii) an inventory write-down of $4.2 million charged to cost of sales in the fourth quarter of 2005 and (iii) $0.7 million of restructuring charges during the first half of 2006 related to severance costs. Severance payments to employees impacted by the November 2005 restructuring will
22
continue through the end of 2006, although such payments will not impact the Company’s results of operations, as they were reflected in the restructuring charges noted above.
As an expansion of its November 2005 restructuring and ongoing analysis, in 2006, the Company commenced the development and phased implementation of a Profit Improvement Program (“PIP”) with respect to its global gift business. The PIP involves the analysis and re-evaluation of key operational aspects of the Company’s gift business and has been designed to help enable the Company to return its gift business to a sustainable level of profitability. The PIP’s focus is the reengineering of the manner in which the gift segment operates and reduction of the size of the gift business by focusing on the most profitable products, customers and territories as a means of providing a platform for potential profitable growth in the future. The scope of the PIP is broad and significant and may cause losses to our business that we cannot predict, including a loss of gift segment sales. Implementation of the PIP has and may continue to result in the recognition of certain restructuring charges and the incurrence of related severance obligations. The Company may also be required to make certain investments to generate the efficiencies and focus on profitable operations that the PIP is designed to achieve. See Item 1A, “Risk Factors”, and “Liquidity and Capital Resources” in the Company’s 2005 10-K for further information regarding the PIP.
The Company had retained the services of an independent advisor to assist in the development of the PIP. During the first half of 2006, the Company incurred consulting expense of approximately $2.5 million in connection with services provided by such advisor, which relationship was concluded at the end of June 2006.
As part of the PIP, the Company has (i) terminated its direct sales and distribution operations in France, Germany, Belgium and Holland, (ii) restructured certain of its sales and related operations in the U.K., (iii) relocated its distribution facility in the U.K. to a lower cost alternative and (iv) eliminated certain executive positions in its domestic gift segment. As a result of these actions, the Company reduced headcount by an aggregate of 55 positions and recorded a restructuring charge of an aggregate of approximately $3.4 million in the nine months ended September 30, 2006, primarily related to employee severance costs. The Company also incurred a one-time charge of $1.3 million during the three months ended September 30, 2006 in connection with the aforementioned relocation of its United Kingdom distribution facility, primarily related to the write-off of fixed assets and moving costs. The Company anticipates that it will establish alternative means of reaching certain customers in the countries where it has terminated direct sales and distribution efforts, including through the use of independent sales representatives or distributors. However, the Company anticipates that its aggregate sales from France, Germany, Belgium and Holland may be reduced by approximately $6.0 million on an annualized basis as a result of these actions, at least for the near term.
As a result of the November 2005 restructuring and the 2006 PIP, management believes that future expenses will be reduced by approximately $22 million on an annualized basis, the full year effect of which is expected to be recognized in fiscal 2007. Although initial implementation of the PIP has been largely completed, there are certain additional initiatives that have been identified by management but which have not commenced pending a final determination by management of whether their implementation would be appropriate or desirable. As a result, a description of further courses of action, the estimated completion date of the PIP’s implementation and estimates of the range of additional charges to be incurred or other expenditures required in connection therewith cannot be determined at this time.
SEGMENTS
The Company currently operates in two segments: (i) its gift business and (ii) its infant and juvenile business.
RESULTS OF OPERATIONS—THREE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005
The Company’s consolidated net sales for the three months ended September 30, 2006 decreased 6.1% to $78.1 million compared to $83.2 million for the three months ended September 30, 2005 as a result of a decrease in its gift business, partially offset by growth in its infant and juvenile segment.
23
The Company’s gift segment net sales for the three months ended September 30, 2006 decreased 13.7% to $43.4 million compared to $50.3 million for the three months ended September 30, 2005, primarily as a result of significant reductions in sales force personnel and product line rationalizations resulting from implementation of portions of the PIP. Net sales in the Company’s gift segment were favorably impacted by foreign exchange rates by approximately $0.9 million for the three months ended September 30, 2006. The Company’s infant and juvenile segment net sales for the three months ended September 30, 2006 increased 5.5% to $34.7 million compared to $32.9 million for the three months ended September 30, 2005. This increase is primarily attributable to sales growth in the Company’s Kids Line subsidiary.
Consolidated gross profit was 37.5% of consolidated net sales for the three months ended September 30, 2006 as compared to 41.6% of consolidated net sales for the three months ended September 30, 2005. Gross profit for the Company’s gift segment was 35.3% of net sales for such segment for the three months ended September 30, 2006, as compared to 42.1% of net sales for the three months ended September 30, 2005. The decline in the consolidated gross profit percentage is primarily due to close-out sales related to the elimination of certain gift segment product lines in connection with the implementation of the PIP, as well as competitive pricing pressure and sales channel mix. In addition, the Company recorded an inventory write-down of $1.2 million in connection with its PIP, which write-down was charged to the gift segment cost of sales. Gross profit for the Company’s infant and juvenile segment was relatively flat at 40.3% of net sales for the three months ended September 30, 2006, as compared to 40.8% of net sales for the three months ended September 30, 2005.
Consolidated selling, general and administrative expense was $25.8 million, or 33.0% of consolidated net sales, for the three months ended September 30, 2006, compared to $29.9 million, or 36.0% of consolidated net sales, for the three months ended September 30, 2005. Selling, general and administrative expense in the Company’s gift segment decreased by approximately $6.2 million to $19.2 million in the third quarter of 2006 from $25.4 million in the prior year period. This decrease is primarily the result of ongoing expense reductions in the gift segment due to 2005 and 2006 restructuring activities. These decreases were partially offset by charges of $0.5 million associated with the restructuring activities in Europe and $1.3 million in connection with the relocation of the Company’s distribution facility in the U.K in the gift segment, as well as an increase of $2.0 million in the Company’s infant and juvenile segment. Selling, general and administrative expenses in the 2006 period for the gift segment include a contribution toward corporate overhead from the infant and juvenile segment of $1.5 million, which amount was charged to the infant and juvenile segment and credited to the gift segment.
Consolidated other expense was $1.7 million for the three months ended September 30, 2006 compared to $1.4 million for the three months ended September 30, 2005. This $0.3 million increase is primarily the result of higher financing costs in the infant and juvenile segment in 2006.
Income tax expense for the three months ended September 30, 2006 was $1.6 million compared to $11.8 million for the three months ended September 30, 2005. The Company recorded a domestic income tax expense of approximately $1.0 million for the three months ended September 30, 2006 and 2005 primarily related to the deferred tax liability associated with tax amortization of intangible assets relating to the Kids Line, Sassy, and Applause acquisitions. These deferred tax liabilities are indefinite in nature for accounting purposes, and therefore cannot be offset against the Company’s deferred tax assets. The Company has recorded full valuation allowances against these deferred tax assets as management believes it is more likely than not that these net deferred tax assets will not be realized. The Company recorded approximately $0.6 million of foreign tax expense related to profitable operations in Canada, Hong Kong, and Australia for the three months ended September 30, 2006. For the three months ended September 30, 2005, income tax expense was $11.8 million primarily related to the reversal of income tax benefits recorded in the first six months of 2005, and a decision to record significant valuation allowances against the Company’s deferred tax assets associated with domestic and foreign NOL’s, contribution carryforwards, and foreign tax credit carryforwards, as management believed it was more likely than not that these deferred tax assets would not be realized.
As a result of the foregoing, consolidated net income for the three months ended September 30, 2006 was $0.3 million, or $0.01 per diluted share, compared to consolidated net loss of $8.6 million, or $0.41 per diluted share, for the three months ended September 30, 2005.
24
RESULTS OF OPERATIONS— NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005
The Company’s consolidated net sales for the nine months ended September 30, 2006 increased 2.4% to $221.2 million compared to $216.0 million for the nine months ended September 30, 2005 as a result of sales growth in its infant and juvenile segment.
The Company’s gift segment net sales decreased 3.7% for the nine months ended September 30, 2006 to $112.6 million compared to $117.0 million for the nine months ended September 30, 2005, primarily as a result of significant reductions in sales force personnel and product line rationalizations as provided in the PIP. Net sales in the Company’s gift segment were favorably impacted by foreign exchange rates by approximately $0.4 million for the nine months ended September 30, 2006. The Company’s infant and juvenile segment net sales for the nine months ended September 30, 2006 increased 9.7% to $108.6 million compared to $99.0 million for the nine months ended September 30, 2005. This increase is primarily attributable to sales growth in the Company’s Kids Line subsidiary.
Consolidated gross profit was 39.3% of consolidated net sales for the nine months ended September 30, 2006 as compared to 42.1% of consolidated net sales for the nine months ended September 30, 2005. Gross profit for the Company’s gift segment was 37.6% of net sales for such segment for the nine months ended September 30, 2006 as compared to 44.0% of net sales for the nine months ended September 30, 2005. The decline in the consolidated gross profit percentage is primarily due to close-out sales related to the elimination of certain product lines in connection with the implementation of the PIP, as well as competitive pricing pressure and sales channel mix in the gift segment. In addition, in the third quarter of 2006, the Company recorded an inventory write-down of $1.2 million in connection with its PIP. Gross profit for the Company’s infant and juvenile segment was 41.1% of net sales for such segment for the nine months ended September 30, 2006, as compared to 40.0% of net sales for the nine months ended September 30, 2005.
Consolidated selling, general and administrative expense was $84.8 million, or 38.3% of consolidated net sales, for the nine months ended September 30, 2006 compared to $89.8 million, or 41.6% of consolidated net sales, for the nine months ended September 30, 2005. Selling, general and administrative expense in the Company’s gift segment decreased by $7.4 million to $68.7 million in the first nine months of 2006 from $76.0 million in the prior year period. Included in the gift segment selling, general and administrative expense in the first nine months of 2006 was $4.1 million in charges associated with the restructuring activities in the U.S. and European gift divisions, $1.3 million in costs associated with the relocation of the Company’s distribution facility in the U.K. and $2.5 million of consulting costs incurred in connection with the development of the PIP. These charges were offset by ongoing expense reductions in the gift segment as a result of 2005 and 2006 restructuring activities.
Consolidated other expense was $8.6 million for the nine months ended September 30, 2006 compared to $13.0 million for the nine months ended September 30, 2005, a decrease of $4.4 million. The decrease in 2006 is primarily attributable to lower interest expense as a result of the LaSalle Refinancing as well as lower overall borrowings. Additionally, during the nine months ended September 30, 2006, the Company wrote off $2.5 million of deferred financing costs and paid a $1.3 million early termination fee related to its refinancing of the 2005 Credit Agreement as compared to $4.8 million written off during the nine months ended September 30, 2005 which resulted from the termination of the Financing Agreement.
Income tax expense for the nine months ended September 30, 2006 was $4.3 million compared to $4.6 million for the nine months ended September 30, 2005. The Company recorded a domestic income tax expense of approximately $3.2 million for the nine months ended September 30, 2006 and 2005 primarily related to the deferred tax liability associated with the tax amortization of intangible assets relating to the Kids Line, Sassy, and Applause acquisitions. These deferred tax liabilities are indefinite in nature for accounting purposes, and therefore can not be offset by the Company’s deferred tax assets. The Company has recorded full valuation allowances against these deferred tax assets as management believes it is more likely than not that these net deferred tax assets will not be realized. The Company recorded approximately $1.1 million of foreign tax expense related to profitable operations in Canada, Hong Kong, and Australia for the nine months ended September 30, 2006 versus $0.9 million for the nine months ended September 30, 2005.
25
As a result of the foregoing, consolidated net loss for the nine months ended September 30, 2006 was $10.7 million, or $0.51 per diluted share, compared to consolidated net loss of $16.5 million, or $0.79 per diluted share, for the nine months ended September 30, 2005.
Liquidity and Capital Resources
The Company’s principal sources of liquidity are cash and cash equivalents, funds from operations, and availability under its bank facilities. The Company believes that it will able to fund its capital requirements for 2007 from such sources. In addition, subject to the discussion below under “Kids Line and Related Financing” with respect to the Earnout Consideration and the Company’s continued compliance with the financial covenants included in its 2006 Credit Agreements (defined below), the Company believes that cash flows from operations and future borrowings will be sufficient to fund its operating needs for at least the next 12 months.
As of September 30, 2006, the Company had cash and cash equivalents of $11.2 million, compared to $28.7 million at December 31, 2005. This reduction of approximately $17.5 million was primarily related to the repayment of debt and a decrease in accounts payable, partially offset by a reduction in inventory. As of September 30, 2006 and December 31, 2005, working capital was $74.6 million and $71.5 million, respectively.
Cash and cash equivalents decreased by approximately $17.5 million during the nine months ended September 30, 2006, compared to a decrease of $43.5 million during the nine months ended September 30, 2005. The decrease during the nine months ended September 30, 2006 was primarily a result of the factors described in the preceding paragraph. The decrease during the nine months ended September 30, 2005 was primarily due to the payment of debt related to the termination of the Financing Agreement partially offset by proceeds from the 2005 Credit Agreement, proceeds from the sale of assets in the UK and Hong Kong during the first quarter of 2005, the previously recorded US Federal tax refund received in the second quarter of 2005, and collections of accounts receivable. Net cash provided by operating activities was approximately $2.0 million during the nine months ended September 30, 2006, compared to net cash provided by operating activities of approximately $16.6 million during the nine months ended September 30, 2005. The decrease of $14.6 million was due primarily to the 2006 payment of debt of approximately $15.3 million, the release of restricted cash in the 2005 period that was used toward repayment of the 2004 term loan, partially offset by amortization of the deferred gain on the sale and leaseback of the Canadian facility in 2006. Net cash used in investing activities was approximately $2.8 million for the nine months ended September 30, 2006, compared to net cash provided by investing activities of approximately $8.0 million for the nine months ended September 30, 2005. The reduction of $10.8 million was due primarily to proceeds from the sale of assets in the first quarter of 2005. Net cash provided by financing activities was approximately $16.7 million for the nine months ended September 30, 2006, compared to net cash provided by financing activities of $65.6 million for the nine months ended September 30, 2005. The reduction of $48.9 million was due primarily to higher debt repayment in the first quarter of 2005, which included required prepayments of the 2004 term loan in the amount of $20.0 million as well as the Company’s ability to sustain lower borrowings in 2006.
Kids Line and Related Financing
On March 14, 2006, as amended on April 11, 2006 (to clarify the application of a financial covenant) and August 8, 2006, the Company refinanced its credit facility and entered into separate Credit Agreements for each of its operating segments. All of the prior debt outstanding on March 14, 2006, together with fees and expenses associated with the transaction, was refinanced by drawing down approximately $79.7 million under the Infantline Credit Agreement (described below), including the full amount of the $60.0 million Term Loan and $19.7 million of the Infantline Revolver. At September 30, 2006, the Company had $55.5 million outstanding under the Infantline Credit Agreement, reflecting repayments of the Infantline Revolver and the Term Loan in the amounts of $18.9 million and $5.3 million, respectively. As of September 30, 2006, the outstanding balance on the Giftline Revolver was $4.6 million and the balance on the outstanding Canadian Revolver (see Section 1.C below) was $1.1 million.
Background. The Company purchased all of the outstanding equity interests and warrants in Kids Line (the “Purchase”) in accordance with the terms and provisions of a Membership Interest Purchase Agreement
26
(the “Purchase Agreement”) executed as of December 15, 2004. At closing, the Company paid approximately $130.5 million, which represented the portion of the purchase price due at closing plus various transaction costs. The aggregate purchase price under the Purchase Agreement, however, also includes the potential payment of the Earnout Consideration, which is defined as 11.724% of the Agreed Enterprise Value of Kids Line as of the last day of the three year period ending November 30, 2007 (the “Measurement Period”). The Earnout Consideration shall be paid as provided in the Purchase Agreement (approximately the third anniversary of the Closing Date). The “Agreed Enterprise Value” shall be the product of (i) Kids Line’s EBITDA during the twelve (12) months ending on the last day of the Measurement Period and (ii) the applicable multiple (ranging from zero to eight) as set forth in the Purchase Agreement. The Company cannot currently determine the amount of the Earnout Consideration that will be required to be paid pursuant to the Purchase Agreement. However, based on current projections, the Company currently anticipates that the Earnout Consideration will be approximately $30 million, although the amount could be more or less depending on the actual performance of Kids Line for the remaining portion of the Measurement Period. The amount of the Earnout Consideration will be charged to goodwill if and when it is earned. The Company currently anticipates that cash flow from operations and anticipated availability under the Infantline Credit Agreement will be sufficient to fund the payment of the Earnout Consideration (and that such payment will be permitted under the Infantline Credit Agreement), however there can be no assurance that unforeseen events or changes in our business would not have a material adverse impact on our ability to pay the Earnout Consideration and therefore on our liquidity.
The Kids Line acquisition was financed with the proceeds of a term loan under a financing agreement (the “Financing Agreement”), which is described in further detail in the Current Report on Form 8-K filed by the Company with the SEC on December 22, 2004. The Financing Agreement was subsequently replaced by the 2005 Credit Agreement and the 2005 Canadian Credit Agreement (as defined below), which are described in further detail in Note 5 above and in the Current Report on Form 8-K filed by the Company with the SEC on July 5, 2005.
In order to reduce overall interest expense and gain increased flexibility with respect to the financial covenant structure of the Company’s senior bank financing, on March 14, 2006, the 2005 Credit Agreement was terminated and the obligations thereunder were refinanced (the “LaSalle Refinancing”). For a detailed description of the 2006 Credit Agreements, which are defined and summarized below, see Note 5 above and the Company’s Current Report on Form 8-K filed with the SEC on March 17, 2006. On March 14, 2006, in connection with the LaSalle Refinancing, all outstanding obligations under the 2005 Credit Agreement (approximately $76.5 million) were repaid using proceeds from the Infantline Credit Agreement (defined below). The Company paid a fee of approximately $1.3 million in connection with the early termination of the 2005 Credit Agreement, which had been scheduled to mature on June 28, 2010. In addition, the Company wrote-off, in the first quarter of 2006, approximately $2.5 million in deferred financing costs in connection with the LaSalle Refinancing.
As part of the LaSalle Refinancing, the Company formed a wholly-owned Delaware subsidiary, Russ Berrie U.S. Gift, Inc. (“Newco”), to which it assigned (the “Assignment”) substantially all of its assets and liabilities which pertain primarily to its domestic gift business, such that separate loan facilities could be made directly available to each of the Company’s domestic gift business and infant and juvenile business, respectively. The Assignment transaction reinforces the operation of the Company as two separate segments, and the credit facilities that have been extended to each segment are separate and distinct. There are no cross-default provisions between the Infantline Credit Agreement and Giftline Credit Agreement (described below).
Infantline Credit Agreement. On March 14, 2006, Kids Line and Sassy (the “Infantline Borrowers”), entered into a credit agreement as borrowers, on a joint and several basis, with LaSalle Bank National Association as administrative agent and arranger (the “Agent”), the lenders from time to time party thereto, the Company as loan party representative, Sovereign Bank as syndication agent, and Bank of America, N.A. as documentation agent (the “Infantline Credit Agreement”). Unless otherwise specified herein, capitalized terms used but undefined in Note 5 Section 1.A this section shall have the meanings ascribed to them in the Infantline Credit Agreement.
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The commitments under the Infantline Credit Agreement consist of (a) a $35.0 million revolving credit facility (the “Revolving Loan”), with a subfacility for letters of credit in an amount not to exceed $5.0 million, and (b) a $60.0 million term loan facility (the “Term Loan”). The Infantline Borrowers drew down approximately $79.7 million under the Infantline Credit Agreement on the Closing Date, including the full amount of the Term Loan, which reflects the payoff of all amounts outstanding under the 2005 Credit Agreement and certain fees and expenses associated with the LaSalle Refinancing. As of September 30, 2006, the outstanding balance on the Revolving Loan was $0.75 million and the outstanding balance on the Term Loan was $54.8 million. The Infantline loans bear interest at a rate per annum equal to the Base Rate (for Base Rate Loans) or the LIBOR Rate (for LIBOR Loans), at the Company’s option, plus an applicable margin, in accordance with a pricing grid based on the most recent quarter-end Total Debt to EBITDA Ratio, which applicable margin ranges from 1.75% - 2.50% for LIBOR Loans and from 0.25% - 1.00% for Base Rate Loans.
The principal of the Term Loan under the Infantline Credit Agreement must be repaid in installments as follows: (a) $0.75 million on the last day of each calendar month for the period commencing March 2006 through and including February 2008, (b) $1.0 million on the last day of each calendar month for the period commencing March 2008 through and including February 2009, (c) $1.25 million on the last day of each calendar month for the period commencing March 2009 through and including February 2011. A final installment in the aggregate amount of the unpaid principal balance of the Term Loan (in addition to all outstanding amounts under the Revolving Loan) is due and payable on March 14, 2011, in each case subject to earlier termination in accordance with the terms of the Infantline Credit Agreement.
The Infantline Credit Agreement contains customary affirmative and negative covenants, as well as the following financial covenants: (i) a minimum EBITDA test, (ii) a minimum Fixed Charge Coverage Ratio, (iii) a maximum Total Debt to EBITDA Ratio and (iv) an annual capital expenditure limitation. As of September 30, 2006, the Company was in compliance with the financial covenants contained in the Infantline Credit Agreement.
Giftline Credit Agreement. Also on March 14, 2006 as amended on April 11, 2006 (to clarify the application of a financial covenant) and August 8, 2006, Newco and other specified wholly-owned domestic subsidiaries of the Company (collectively, the (discussed below) “Giftline Borrowers”), entered into a credit agreement as borrowers, on a joint and several basis, with LaSalle Bank National Association, as issuing bank (the “Issuing Bank”), LaSalle Business Credit, LLC as administrative agent (the “Administrative Agent”), the lenders from time to time party thereto, and the Company, as loan party representative (as amended, the “Giftline Credit Agreement” and, together with the Infantline Credit Agreement, the “2006 Credit Agreements”). Unless otherwise specified herein, capitalized terms used but undefined in this section shall have the meanings ascribed to them in the Giftline Credit Agreement.
The Giftline Credit Agreement contemplates the potential inclusion of additional lenders subsequent to the initial closing, which as of September 30, 2006 has not occurred, and a simultaneous increase in the commitment, and the facility consists of a revolving credit loan commitment (a) before such commitment is increased, if at all, in an amount equal to the Borrowing Base minus amounts outstanding under the Canadian Credit Agreement (as defined below) and (b) after such commitment is increased, if at all, in an amount equal to the lesser of (i) $25.0 million and (ii) the then-current Borrowing Base, in each case minus amounts outstanding under the Canadian Credit Agreement (the “Giftline Revolver”), with a subfacility for letters of credit to be issued by the Issuing Bank in an amount not to exceed $8.0 million. The Borrowing Base is primarily a function of a percentage of eligible accounts receivable and eligible inventory and, as of September 30, 2006, the Borrowing Base, inclusive of the Borrowing Base provided under the Canadian Credit Agreement, was approximately $7.9 million. The Giftline Borrowers did not draw down on the Giftline Revolver on the Closing Date. All outstanding amounts under the Giftline Revolver are due and payable on March 14, 2011, subject to earlier termination in accordance with the terms of the Giftline Credit Agreement. The balance of the Giftline Revolver was $4.6 million at September 30, 2006. The Giftline Revolver bears interest at a rate per annum equal to the sum of the Base Rate (for Base Rate Loans) or the LIBOR Rate (for LIBOR Loans), at the Company’s option, plus a margin of 2.75% for LIBOR Loans and 1.25% for Base Rate Loans. Interest is due and payable in the same manner as with respect to the Infantline Loans.
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The Giftline Credit Agreement contains customary affirmative and negative covenants substantially similar to those applicable to the Infantline Credit Agreement. The Giftline Credit Agreement contains the following financial covenants: (i) a minimum EBITDA test, (ii) a minimum Excess Revolving Loan Availability requirement of $5.0 million, (iii) an annual capital expenditure limitation and (iv) a minimum Fixed Charge Coverage Ratio (for quarters commencing with the quarter ending March 31, 2008). In addition, at any time after December 31, 2007 in respect of which the Fixed Charge Coverage Ratio for the Computation Period ending as of the Fiscal Quarter end most recently preceding such date was less than 1.00:1.00, the aggregate amounts outstanding under the Giftline Credit Agreement and the Canadian Loan Agreement may not exceed $10.0 million. As of September 30, 2006, the Company was in compliance with the financial covenants contained in the Giftline Credit Agreement. On August 8, 2006, the Giftline Credit Agreement was amended to lower the threshold on the Minimum EBITDA covenant by $1.0 million per fiscal quarter for each of four consecutive fiscal quarters commencing with the fiscal quarter ended September 30, 2006.
As contemplated by the 2005 Credit Agreement, on June 28, 2005, the Company’s Canadian subsidiary, Amram’s Distributing Ltd. (“Amrams”), executed a separate Credit Agreement (acknowledged by the Company) with the financial institutions party thereto and LaSalle Business Credit, a division of ABN AMRO Bank, N.V., Canada Branch, a Canadian branch of a Netherlands bank, as issuing bank and administrative agent (the “Canadian Credit Agreement”), and related loan documents with respect to a maximum U.S. $10.0 million revolving loan (the “Canadian Revolving Loan”). Russ Berrie and Company, Inc. (“RB”), a corporate holding company, executed an unsecured Guarantee (the “Canadian Guarantee”) to guarantee the obligations of Amrams under the Canadian Credit Agreement. In connection with the LaSalle Refinancing, on March 14, 2006, the Canadian Credit Agreement was amended to (i) replace references to the 2005 Credit Agreement with the Giftline Credit Agreement (such that, among other conforming changes, a default under the Giftline Credit Agreement will be a default under the Canadian Credit Agreement), (ii) release the Company from the Canadian Guaranty and (iii) provide for a maximum U.S. $5.0 million revolving loan. In connection with the release of the Company from the Canadian Guaranty, Newco executed an unsecured Guarantee (the “Newco Guarantee”) to guarantee the obligations of Amrams under the Canadian Credit Agreement. A default under the Infantline Credit Agreement will not constitute a default under the Canadian Credit Agreement. The outstanding balance under the Canadian Revolving Loan as of September 30, 2006 was $1.12 million which reduces availability under the Giftline Credit Agreement by a corresponding amount.
The Company believes that the lower interest rates that were extended to the Company’s subsidiaries in connection with the LaSalle Refinancing will enable the Company to reduce its aggregate interest expense, on a comparable basis, by approximately $2.0 million per year. However, because the 2006 Credit Agreements are extended directly to RB’s domestic subsidiaries, RB is dependent upon its operating subsidiaries to provide the cash necessary to enable the Company to fund its corporate overhead and other expenses.
The 2006 Credit Agreements restrict the ability of the Company’s domestic subsidiaries to distribute cash to RB for the purpose of paying dividends to the shareholders of the Company or for the purpose of satisfying the Company’s corporate overhead expenses. Subject to certain exceptions, the aggregate maximum amount that can be distributed by the Company’s domestic subsidiaries to RB to enable RB to pay corporate overhead expenses is $6.5 million for each of 2006 and 2007, and $7.0 million annually thereafter, with only $2.0 million of this amount permitted to be distributed by the Infantline Borrowers on an annualized basis. The Company believes that the amounts permitted to be distributed to it by its subsidiaries will be sufficient to fund its corporate overhead expenses, although there can be no assurance that such expenses will not exceed current estimates. See the Company’s Current Report on Form 8-K filed on March 17, 2006. There are no restrictions in the 2006 Credit Agreements on the ability of the Company’s foreign subsidiaries to distribute cash to the Company.
As a result of the LaSalle Refinancing, the obligation to pay the Earnout Consideration pursuant to the Kids Line acquisition is no longer the obligation of RB, but the joint and several obligations of the Infantline Borrowers. With respect to the Earnout Consideration, the Infantline Borrowers will be permitted to pay all or a portion of the Earnout Consideration to the extent that, before and after giving effect to such
29
payment, (i) Excess Revolving Loan Availability will equal or exceed $3.0 million and (ii) no violation of the Infantline Financial Covenants would then exist, or would, on a pro forma basis, result therefrom.
The Company’s ability to maintain compliance with the financial covenants under the 2006 Credit Agreements is dependent, particularly in the case of the Giftline Credit Agreement, upon the successful implementation of the PIP described under “Overview” above and current operational plans. Based on these plans and management’s current projections, management believes that the Company will remain in compliance with the financial covenants in the 2006 Credit Agreements at least through September 30, 2007. However, in the event that the Company is unable to successfully implement the key elements of the PIP and current operational plans, there can be no assurance that the Company will remain in compliance with such financial covenants, particularly the financial covenants in the Giftline Credit Agreement.
Other Events and Circumstances Pertaining to Liquidity
In the event that additional initiatives related to the PIP are determined to be implemented, certain significant restructuring charges may be recognized and related severance obligations incurred. As the determination to implement any or all such initiatives has not yet been made, estimates of the range of any additional charges or other related expenditures cannot be determined at this time. In addition to the $15.0 million anticipated cost savings as a result of the November 2005 restructuring, the PIP initiatives that have been implemented to date are expected to result in additional savings of approximately $7.0 million annually. See “Overview” above for a more detailed description of the PIP and the restructuring activities undertaken in 2005 and 2006.
The Company enters into foreign currency forward exchange contracts, principally to manage the economic currency risks associated with the purchase of inventory by its European, Canadian and Australian subsidiaries in the gift segment and by Sassy Inc. in the infant and juvenile segment.
The Company is dependent upon information technology systems in many aspects of its business. In 2002, the Company commenced a global implementation of an Enterprise Resource Planning (“ERP”) system for its gift businesses. During 2003 and continuing into 2004, certain of the Company’s international gift subsidiaries began to phase-in aspects of the new ERP system. In late 2005, the Company began to explore alternative global information technology systems for its gift business that could provide greater efficiencies, lower costs and greater reporting capabilities than those provided by the current ERP system. As a result of this review, all remaining international implementations were placed on hold pending a decision on whether or not to replace the current ERP system. The Company expects to make a decision on whether to replace its current ERP system during fiscal 2007.
Effective December 28, 2005, the Company amended all outstanding stock option agreements such that all options with exercise prices in excess of the market price for the Company’s common stock at the close of business on December 28, 2005 became fully vested and immediately exercisable at the close of business on December 28, 2005. Because these options were priced above the then current market price on December 28, 2005, the acceleration of vesting of these options did not result in the recognition of any compensation expense, although such action enabled the Company to avoid future compensation expense which would have been required by SFAS 123(R) (described in Note 2 of Notes to Unaudited Consolidated Financial Statements) of approximately $1.6 million (pre-tax) in 2006 and $3.7 million (pre-tax) in subsequent years through 2010.
In March 1990, the Board of Directors authorized the Company to repurchase an aggregate of up to 7.0 million shares of common stock. As of December 31, 2005, 5.6 million shares have been repurchased since the beginning of the Company’s stock repurchase program. The Company did not repurchase any shares pursuant to this program or otherwise during fiscal 2005 or through the first nine months of 2006. The 2006 Credit Agreements impose certain limitations on the ability of the Company to repurchase shares.
The Company is subject to legal proceedings and claims arising in the ordinary course of its business that the Company believes will not have a material adverse impact on the Company’s consolidated financial condition, results of operations or cash flows.
Consistent with its past practices and in the normal course of its business, the Company regularly reviews acquisition opportunities of varying sizes. The Company may consider the use of debt or equity financing
30
to fund potential acquisitions. The 2006 Credit Agreements impose restrictions on the Company that could limit its ability to respond to market conditions or to take advantage of acquisitions or other business opportunities.
Contractual Obligations
The following table summarizes the Company’s significant known contractual obligations as of September 30, 2006 and the future periods in which such obligations are expected to be settled in cash (dollars in thousands):
|
| Total |
| 2006 |
| 2007 |
| 2008 |
| 2009 |
| 2010 |
| Thereafter |
| |||||||
Operating Lease Obligations |
| $ | 42,107 |
| $ | 1,723 |
| $ | 6,550 |
| $ | 5,946 |
| $ | 5,381 |
| $ | 4,678 |
| $ | 17,829 |
|
Purchase Obligations(1) |
| $ | 39,570 |
| $ | 39,570 |
| $ | — |
| $ | — |
| $ | — |
| $ | — |
| $ | — |
|
Debt Repayment Obligations(2) |
| $ | 61,256 |
| $ | 8,756 |
| $ | 9,000 |
| $ | 11,500 |
| $ | 14,500 |
| $ | 15,000 |
| $ | 2,500 |
|
Royalty Obligations |
| $ | 1,678 |
| $ | 313 |
| $ | 1,295 |
| $ | 70 |
| $ | — |
| $ | — |
| $ | — |
|
Total Contractual Obligations |
| $ | 144,611 |
| $ | 50,362 |
| $ | 16,845 |
| $ | 17,516 |
| $ | 19,881 |
| $ | 19,678 |
| $ | 20,329 |
|
(1) The Company’s purchase obligations consist of purchase orders for inventory.
(2) Reflects repayment obligations under the 2006 Credit Agreements. See Note 5 of Notes to Unaudited Consolidated Financial Statements for a description of the 2006 Credit Agreements, including provisions that create, increase and/or accelerate obligations thereunder.
Off Balance Sheet Arrangements
As of September 30, 2006, there have been no material changes in the information provided under the caption “Off Balance Sheet Arrangements” of Item 7 of the 2005 10-K, other than the termination if the EDA Obligations described in Note 5 to Notes to Unaudited Consolidated Financial Statements.
CRITICAL ACCOUNTING POLICIES
The SEC has issued disclosure advice regarding “critical accounting policies”, defined as accounting policies that management believes are both most important to the portrayal of the Company’s financial condition and results and require application of management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effects of matters that are inherently uncertain.
Management is required to make certain estimates and assumptions during the preparation of its consolidated financial statements that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Estimates and assumptions are reviewed periodically, and revisions made as determined to be necessary by management. There have been no material changes to the Company’s significant accounting estimates and assumptions or the judgments affecting the application of such estimates and assumptions during the period covered by this report from those described in the Company’s 2005 10-K, except as described below.
Historically, the Company accounted for stock-based compensation under the recognition and measurement principles of APB 25 and related interpretations. Accordingly, no compensation expense was reflected in the Company’s Consolidated Statements of Operations as all options granted had an exercise price equal to the fair market value of the underlying common stock on the date of grant. In accordance with the disclosure provisions of SFAS 123, previously issued financial statements included pro forma disclosures of the effect on net income and net income per share as if the Company had applied the fair value recognition provisions of SFAS 123, “Accounting for Stock-Based Compensation”, to share-based compensation.
The Company adopted the provisions of SFAS 123(R) on January 1, 2006 using the “modified prospective” transition method. The “modified prospective” transition method requires compensation cost to be
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recognized beginning with the effective date (a) based on the requirements of SFAS 123(R) for all share-based payments granted after the effective date and (b) based on the requirements of SFAS 123 for all awards granted to employees prior to the effective date of SFAS 123(R) that remain unvested on the effective date. In accordance with this method, prior periods were not restated to reflect the impact of adopting the new standard.
See Note 2 of Notes to Unaudited Consolidated Financial Statements for further discussion of the impact of the Company’s adoption of SFAS 123(R), as well as the valuation methodology and assumptions utilized.
Also see Note 2 of Notes to Consolidated Financial Statements of the 2005 10-K for a summary of the significant accounting policies used in the preparation of the Company’s consolidated financial statements.
Recently Issued Accounting Standards
In July 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48), effective for fiscal years beginning after December 15, 2006. FIN 48 requires a two-step approach to determine how to recognize tax benefits in the financial statements where recognition and measurement of a tax benefit must be evaluated separately. A tax benefit will be recognized only if it meets a “more-likely-than-not” recognition threshold. For tax positions that meet this threshold, the tax benefit recognized is based on the largest amount of tax benefit that is greater than 50 percent likely of being realized upon ultimate settlement with the taxing authority. We are currently evaluating the impact of adopting FIN 48, and have not yet determined the significance of this new rule to our overall results of operations, cash flows or financial position.
In September 2006, the SEC staff issued Staff Accounting Bulletin (SAB) Topic 1N (SAB 108), “Financial Statements — Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” which is effective for calendar year companies as of December 31, 2006. SAB 108 provides guidance on how prior year misstatements should be taken into consideration when quantifying misstatements in current year financial statements for purposes of determining whether the financial statements are materially misstated. Under this guidance, companies should take into account both the effect of a misstatement on the current year balance sheet as well as the impact upon the current year income statement in assessing the materiality of a current year misstatement. Once a current year misstatement has been quantified, the guidance in SAB Topic 1M, “Financial Statements — Materiality,” (SAB 99) should be applied to determine whether the misstatement is material. The Company is currently assessing the potential impact, if any on the implementation of SAB 108 on the Company’s financial statements.
Forward-Looking Statements
This Quarterly Report on Form 10-Q contains certain forward-looking statements. Additional written and oral forward-looking statements may be made by the Company from time to time in Securities and Exchange Commission (SEC) filings and otherwise. The Private Securities Litigation Reform Act of 1995 provides a safe-harbor for forward-looking statements. These statements may be identified by the use of forward-looking words or phrases including, but not limited to, “anticipate”, “project”, “believe”, “expect”, “intend”, “may”, “planned”, “potential”, “should”, “will” or “would”. The Company cautions readers that results predicted by forward-looking statements, including, without limitation, those relating to the Company’s future business prospects, revenues, operating results, working capital, liquidity, capital needs, interest costs and income are subject to certain risks and uncertainties that could cause actual results to differ materially from those indicated in the forward-looking statements. Specific risks and uncertainties include, but are not limited to, those set forth under Item 1A, “Risk Factors”, of the 2005 10-K. The Company undertakes no obligation to publicly update any forward-looking statement, whether as a result of new information, future events or otherwise.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
As of September 30, 2006, there have been no material changes in the Company’s market risks associated with marketable securities and foreign currency exchange rates, as described in Item 7A of the 2005 10-K. The market risk associated with long-term debt has changed as a result of the termination of the 2005 Credit Agreement and the execution of the 2006 Credit Agreements, as is more fully described in Note 5 of Notes to Unaudited Consolidated Financial Statements. The interest applicable to the 2006 Credit Agreements is based upon (i) the LIBOR Rate and (ii) the Base Rate (each as defined in the 2006 Credit Agreements), plus an applicable margin. At September 30, 2006, a sensitivity analysis to measure potential changes in applicable interest rates indicates that a one percentage point increase in interest rates would increase the Company’s interest expense by approximately $0.6 million annually, based upon the level of debt at September 30, 2006. See Note 5 of Notes to Unaudited Consolidated Financial Statements for a description of the interest rates applicable to the loans under the 2006 Credit Agreements.
ITEM 4. CONTROLS AND PROCEDURES
We maintain disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) or 15d-15(e)) that are designed to ensure that information required to be disclosed in our reports filed or submitted pursuant to the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that information required to be disclosed in our Exchange Act reports is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.
Under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, we carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Paragraph (b) of Exchange Act Rules 13a-15 and 15d-15 as of September 30, 2006. Based upon our evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective as of September 30, 2006.
As previously reported in our Annual Report on Form 10-K for the year ended December 31, 2005 and subsequent Forms 10-Q, the Company did not maintain sufficient personnel resources with the requisite technical accounting and financial reporting expertise to: affect a timely financial closing process; sufficiently address non- routine and or complex accounting issues that arise from time to time in the course of the Company’s operations; and effectively prepare timely account reconciliations and analysis. This lack of sufficient personnel resources with the requisite technical accounting and financial reporting expertise resulted in: material errors in the classification of long-term debt and income tax expense; errors in equity accounts, inter-company accounts, depreciation expense, inventory, and foreign currency transactions; and material omissions of disclosures in the Company’s preliminary 2005 consolidated financial statements. The foregoing led management to conclude as of December 31, 2005 that the Company’s disclosure controls and procedures were not effective and resulted in management concluding that a material weakness existed. The Company’s management, which includes the Chief Executive Officer and the Chief Financial Officer, have dedicated resources to assess the issues that gave rise to the aforementioned material weakness. As of the date of this filing, the remediation initiatives management has implemented include:
· Reorganizing the reporting structure and responsibilities of the employees within the Finance Department;
· Hiring additional qualified staff members including a senior level individual with the required technical and financial reporting expertise;
· Implementing changes in the senior level management of the Finance Department;
· Implementing time lines and strengthen internal reviews of reporting packages from the Company’s operating units; and
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· Improving the timeliness of reporting to management and in meeting external reporting requirements in a timely manner.
As of the date of this filing, the remediation of this material weakness has been completed. We have implemented all the remediation initiatives outlined above, which we believe are sufficient to eliminate the material weakness in internal control over financial reporting as discussed above.
Changes in Internal Control Over Financial Reporting
Except as discussed above, there were no changes in our internal controls over financial reporting identified in connection with the evaluation required by paragraph (d) of Exchange Act Rules 13a-15 or 15d-15 that occurred during the fiscal quarter ended September 30, 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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There have been no material changes to the risk factors set forth in Part I, Item 1A, “Risk Factors”, of the Company’s 2005 10-K.
| Exhibits to this Quarterly Report on Form 10-Q. | |||
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| 3.2 (q) |
| Amended and Restated By-Laws of the Company adopted October 5, 2006. |
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| 10.104 |
| Investor Rights Agreement, dated as of August 10, 2006, among the Company and the investors listed on the signature pages thereto. (incorporated by reference to the Current Report on Form 8-K filed August 14, 2006.) |
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| 10.105 |
| Lease Agreement, dated August 8, 2006, between Erachange Limited and Russ Berrie (UK) Limited. |
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|
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| 10.106 |
| Agreement For the Sale and Purchase of Liberty House Bulls Copse Road Hounsdown Business Park Totton Southampton, SO40 9RB dated October 31, 2006, between Hounsdown, Inc., Russ Berrie (UK) Limited and Garmin (Europe) Limited. |
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| 31.1 |
| Certification of CEO required by Section 302 of the Sarbanes Oxley Act of 2002. |
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|
|
|
|
|
| 31.2 |
| Certification of CFO required by Section 302 of the Sarbanes Oxley Act of 2002. |
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|
|
|
|
|
| 32.1 |
| Certification of CEO required by Section 906 of the Sarbanes Oxley Act of 2002. |
|
|
|
|
|
|
| 32.2 |
| Certification of CFO required by Section 906 of the Sarbanes Oxley Act of 2002. |
Items 1, 2, 3, 4 and 5 are not applicable and have been omitted.
35
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.
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| RUSS BERRIE AND COMPANY, INC. | ||
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| (Registrant) | |
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| By | /s/ JAMES J. O’REARDON, JR. |
Date: November 9, 2006 |
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| James J. O’Reardon, Jr. |
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| Vice President and Chief Financial Officer |
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36
EXHIBIT INDEX
3.2 (q) | Amended and Restated By-Laws of the Company adopted October 5, 2006 |
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|
10.104 | Investor Rights Agreement, dated as of August 10, 2006, among the Company and the investors listed on the signature pages thereto. (Incorporated by reference to the Current Report on Form 8-K filed August 14, 2006.) |
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|
10.105 | Lease Agreement, dated August 8, 2006, between Erachange Limited and Russ Berrie (UK) Limited. |
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|
10.106 | Agreement For the Sale and Purchase of Liberty House Bulls Copse Road Hounsdown Business Park Totton Southampton, SO40 9RB dated October 31, 2006, between Hounsdown, Inc., Russ Berrie (UK) Limited and Garmin (Europe) Limited. |
|
|
31.1 | Certification of CEO required by Section 302 of the Sarbanes Oxley Act of 2002. |
|
|
31.2 | Certification of CFO required by Section 302 of the Sarbanes Oxley Act of 2002. |
|
|
32.1 | Certification of CEO required by Section 906 of the Sarbanes Oxley Act of 2002. |
|
|
32.2 | Certification of CFO required by Section 906 of the Sarbanes Oxley Act of 2002. |
37