SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 Form 10-Q Quarterly Report Pursuant to Section 13 or 15(d) of The Securities Exchange Act of 1934 For the quarterly period ended April 3, 1999 Commission File Number 1-13430 Converse Inc. (Exact name of registrant as specified in its charter) Delaware 43-1419731 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) One Fordham Road 01864 North Reading, Massachusetts (Zip Code) (Address of principal executive offices) Registrant's telephone number, including area code: (978) 664-1100 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 Act of 1934 during the preceding 12 months (or for such shorter period that registrant was required to file such reports); and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [_] Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practical date. As of April 3, 1999, 17,345,728 shares of common stock were outstanding. TABLE OF CONTENTS PAGE PART I: FINANCIAL INFORMATION Item 1. Consolidated Financial Statements A. Consolidated Balance Sheet 1 B. Consolidated Statement of Operations 2 C. Consolidated Statement of Cash Flows 3 D. Notes to Consolidated Financial Statements 4 Item 2. Management's Discussion and Analysis of 9 Financial Condition and Results of Operations PART II: OTHER INFORMATION Item 1. Legal Proceedings 15 Item 2. Changes in Securities 15 Item 3. Defaults Upon Senior Securities 15 Item 4. Submission of Matters to a Vote of Security Holders 15 Item 5. Other Information 15 Item 6. Exhibits and Reports on Form 8-K 15 SIGNATURE 16 PART I - FINANCIAL INFORMATION Item 1. FINANCIAL STATEMENTS CONVERSE INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEET (Dollars in thousands, except per share amounts) (Unaudited) January 2, 1999 April 3, 1999 ---------------- ----------------- Assets Current assets: Cash and cash equivalents.............................. $ 3,274 $ 2,565 Receivables, less allowances of $2,086 and $1,846, respectively.......................................... 57,826 62,986 Inventories (Note 3)................................... 71,292 70,243 Prepaid expense and other current assets............... 8,962 7,458 -------- -------- Total current assets................................ 141,354 143,252 Net property, plant and equipment........................ 20,838 20,327 Other assets............................................. 32,814 32,287 -------- -------- $195,006 $195,866 ======== ======== Liabilities and Stockholders' Equity (Deficiency) Current liabilities: Short-term debt........................................ $ 9,557 $ 14,586 Credit facility (Note 4)............................... 73,833 74,310 Accounts payable....................................... 37,184 34,651 Accrued expenses....................................... 10,861 12,655 Income taxes payable................................... 2,861 2,940 -------- -------- Total current liabilities........................... 134,296 139,142 Long-term debt (Note 4).................................. 101,799 101,961 Current assets in excess of reorganization value......... 28,221 27,702 Stockholders' equity (deficiency): Common stock, $1.00 stated value, 50,000,000 shares authorized, 17,319,556 and 17,345,728 shares issued and outstanding at January 2, 1999 and April 3, 1999, respectively.................................. 17,320 17,346 Preferred stock, no par value, 10,000,000 shares authorized none issued and outstanding....... -- -- Additional paid-in capital............................. 3,695 4,664 Unearned compensation.................................. (758) (1,598) Retained earnings (deficit)............................ (88,129) (91,368) Accumulated other comprehensive income................. (1,438) (1,983) -------- -------- Total stockholders' equity (deficiency)............. (69,310) (72,939) $195,006 $195,866 ======== ======== See accompanying notes to condensed consolidated financial statements. -1- CONVERSE INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS (Dollars in thousands, except per share amounts) (Unaudited) Three Months Ended ------------------------------ April 4, 1998 April 3, 1999 -------------- -------------- Net sales.............................................................. $95,240 $70,079 Cost of sales.......................................................... 67,425 51,338 ------- ------- Gross profit........................................................... 27,815 18,741 Selling, general and administrative expenses........................... 29,716 21,651 Royalty income......................................................... 5,028 4,842 ------- ------- Earnings from operations............................................... 3,127 1,932 Interest expense, net.................................................. 4,193 5,030 Other (income) expense, net............................................ (132) (787) ------- ------- Loss before income tax................................................. (934) (2,311) Income tax expense..................................................... 229 928 ------- ------- Net loss............................................................... $(1,163) $(3,239) ======= ======= Net basic and diluted loss per share (Note 2).......................... $ (0.07) $ (0.19) ======= ======= Weighted average number of common shares outstanding (Note 2).......... 17,319 17,329 ======= ======= See accompanying notes to condensed consolidated financial statements. -2- CONVERSE INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS (Dollars in thousands) (Unaudited) Three Months Ended ------------------------------ April 4, 1998 April 3, 1999 -------------- -------------- Cash flows from operating activities: Net loss................................................................ $(1,163) $(3,239) Adjustments to reconcile net loss to net cash required for operating activities: Depreciation of property, plant and equipment........................ 916 1,089 Amortization of intangible assets.................................... 117 50 Amortization of current assets in excess of reorganization value............................................................... (520) (519) Amortization of note discount/warrants............................... -- 162 Amortization of deferred compensation................................ -- 82 Deferred tax benefit................................................. 305 123 Changes in assets and liabilities: Receivables.......................................................... (9,527) (5,160) Inventories.......................................................... 11,955 1,049 Prepaid expenses and other current assets............................ (263) 1,483 Accounts payable and accrued expenses................................ (6,105) (739) Income taxes payable................................................. (478) 79 Other long-term assets and liabilities............................... 74 (170) ------- ------- Net cash required for operating activities......................... (4,689) (5,710) ------- ------- Cash flows from investing activities: Additions to property, plant and equipment.............................. (681) (578) ------- ------- Net cash used by investing activities.............................. (681) (578) ------- ------- Cash flows from financing activities: Net proceeds from exercise of stock options............................. 11 -- Net proceeds from sale of common stock (Note 6)......................... -- 73 Net proceeds from short-term debt....................................... 8,146 5,029 Net proceeds from (payment of) credit facility.......................... (4,350) 477 ------- ------- Net cash provided by financing activities.......................... 3,807 5,579 Net decrease in cash and cash equivalents................................ (1,563) (709) Cash and cash equivalents at beginning of period......................... 5,738 3,274 ------- ------- Cash and cash equivalents at end of period............................... $ 4,175 $ 2,565 ======= ======= See accompanying notes to condensed consolidated financial statements. -3- CONVERSE INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands) 1. Summary of Significant Accounting Policies Basis of presentation: In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation. This interim financial information and notes thereto should be read in conjunction with the Company's annual report on Form 10-K for the year ended January 2, 1999. The Company's consolidated results of operations for the three months ended April 3, 1999 are not necessarily indicative of the results to be expected for any other interim period or the entire fiscal year. 2. Net Earnings (Loss) per Common Share Net earnings (loss) per common share is computed based on the weighted average number of common shares and common equivalent shares, if dilutive, assumed outstanding for the applicable period. 3. Inventories Inventories are summarized as follows: January 2, 1999 April 3, 1999 --------------- ------------- Retail merchandise................. $ 4,535 $ 4,781 Finished products.................. 57,365 56,647 Work in process.................... 5,009 5,206 Raw materials...................... 4,383 3,609 ------- ------- $71,292 $70,243 ======= ======= 4. Debt As more fully described in Note 8 to the Consolidated Financial Statements for the year ended January 2, 1999 included within the Company's annual report on Form 10-K, in May 1997 the Company issued $80,000 of 7% Convertible Subordinated Notes due June 1, 2004 (the "Convertible Notes"). The Convertible Notes are convertible at any time prior to maturity, unless previously redeemed into common stock of the Company, at the option of the holder, at a price of $21.83 per share, subject to adjustment in certain events. In addition, the Convertible Notes may be redeemed, in whole or in part, at the option of the Company, at any time on or after June 5, 2000 at redemption prices set forth therein plus accrued interest to the date of redemption. -4- Interest is payable semi-annually on June 1 and December 1. Proceeds from the Convertible Notes were used to repay indebtedness under the Company's then existing credit facility (the "Old Credit Facility"). Simultaneously with the issuance of the Convertible Notes in May 1997, the Company entered into a new $150,000 secured credit agreement (the "Credit Facility") with BT Commercial Corporation ("BTCC") for revolving loans, letters of credit, foreign exchange contracts and banker acceptances and repaid the Old Credit Facility. In July 1997 BTCC, as agent, syndicated the Credit Facility to a group of participating lenders (the "Banks"). The amount of credit available to the Company at any time is limited by a borrowing base formula, as defined in the Credit Facility, consisting primarily of U.S. accounts receivable and inventory. The aggregate letters of credit, foreign exchange contracts and banker acceptances may not exceed $80,000 at any time; revolving loans are limited only by the Credit Facility's maximum availability less any amounts outstanding for letters of credit, foreign exchange contracts or banker acceptances. The Credit Facility is for a five-year term and, accordingly, has an expiration date of May 21, 2002. However, the total revolving loans and banker acceptances outstanding under the Credit Facility of $74,310 are classified as current due to the Company's lockbox arrangement (whereby payments made by the Company's customers are deposited in a lockbox controlled by the Banks) and certain clauses contained in the Credit Facility regarding mandatory repayment that involve subjective judgments by the Banks. This classification is required by Emerging Issues Task Force 95-22, "Balance Sheet Classification of Borrowings Outstanding under a Revolving Credit Agreement that Includes both a Subjective Acceleration Clause and a Lockbox Arrangement". In September 1998, the Company's Credit Facility was amended to permit the issuance of the Secured Notes as discussed below. The amendment decreases the commitment under the Credit Facility from $150,000 to $120,000 and changes a financial performance covenant. As of April 3, 1999 the Company's borrowing base was $80,511. Utilization under the Credit Facility amounted to $75,204 consisting of revolving loans of $71,753, banker acceptances of $2,557 and outstanding letters of credit of $894. Accordingly, $5,307 of the maximum available borrowing base remained unutilized as of April 3, 1999. Revolving loans under the Credit Facility bear interest either at the Prime Lending Rate (as defined therein) plus one percent (1.00%) per annum or at the Adjusted LIBOR Rate (as defined therein) plus a margin of two and one-half percent (2.50%) per annum. The foregoing LIBOR margin is subject to reduction based upon the Company achieving certain interest coverage ratios specified in the Credit Facility. At April 3, 1999, revolving loans outstanding under the Credit Facility bore interest of 7.61% based upon the weighted average of the Prime Lending Rate and Adjusted LIBOR Rate, as defined. Obligations outstanding under the Credit Facility are secured by first priority liens on substantially all of the Company's U.S. and Canadian assets. The Credit Facility requires compliance with customary affirmative and negative covenants, including certain financial covenants. At April 3, 1999, the Company was in compliance with all covenants contained in the Credit Facility, as amended. -5- In September 1998, the Company issued $28,643 aggregate principal amount of 15% Senior Secured Notes (the "Secured Notes") due September 16, 2000 (the "Initial Maturity Date"). Interest on the Secured Notes is payable quarterly in arrears. The Initial Maturity Date may be extended an additional 12 months at the Company's option upon written notification of its election to extend and payment of a fee equal to 3% of the then outstanding principal amount of the Secured Notes (the "First Extended Maturity Date"). The First Extended Maturity Date may be extended to May 21, 2002 at the Company's option upon written notification of its election to extend and payment of an additional fee equal to 3% of the then outstanding principal amount of the Secured Notes. The Secured Notes were issued in two series: Series A in the aggregate principal amount of $24,858 (the "Series A Secured Notes") and Series B in the aggregate principal amount of $3,785 (the "Series B Secured Notes"). The Secured Notes are redeemable at any time at face amount plus accrued interest. The Secured Notes require compliance with customary affirmative and negative covenants, including certain financial covenants, substantially the same as the requirements contained in the Credit Facility. Upon issuance of the Series A Secured Notes, the Company received gross proceeds of $24,000 after discount from the face amount. In connection with the issuance of the Series A Secured Notes, the Company issued warrants to purchase 360,000 shares of the Company's common stock to the purchasers and paid funding fees to certain purchasers amounting to $350. The warrants were valued at $1.22 per share, vest immediately and expire on March 16, 2003. The Company paid a placement fee of 4% of the gross proceeds, or $960, with respect to the Series A Secured Notes. The Series A Secured Notes carry a second priority perfected lien on all real and personal, tangible and intangible assets of the Company. The Series B Secured Notes were issued in exchange for the surrender of $5,735 face amount of Convertible Notes, which were subsequently cancelled by the Company. In connection with the issuance of the Series B Secured Notes, the Company paid a placement fee of 2% of the face amount, or $76. The Series B Secured Notes carry a third priority perfected lien on all real and personal, tangible and intangible assets of the Company. Subsidiaries of the Company maintain asset-based financing arrangements in certain European countries with various lenders. In general, these financing arrangements allow for borrowings based upon eligible accounts receivable and inventory at varying advance rates and varying interest rates. As of April 3, 1999, total short-term borrowings outstanding under these financing arrangements totaled $14,586. These obligations are secured by first priority liens on the respective foreign assets being financed. In addition, Converse Inc. provided guarantees with respect to the outstanding borrowings for certain of the financing arrangements. 5. Comprehensive Income For the three months ended April 4, 1998 and April 3, 1999, comprehensive income items included in stockholders' equity consisted of cumulative translation adjustments of $(288) and $(545), respectively. Total comprehensive income (loss) for the first quarter of 1998 was $(1,451) compared to comprehensive income (loss) of $(3,784) for the first quarter of 1999. -6- 6. Stock Option Plans In February 1999, 250,000 shares of restricted stock were granted to certain employees, resulting in $922 of unearned compensation. All restricted stock grants are subject to restrictions as to continuous employment. The restricted stock vests 100% on the third anniversary of the grant date. As there is no exercise payment associated with the restricted stock awards, the cost of the awards, determined as the fair market value of the shares on the date of grant, is charged to expense ratably over the three year vesting period. In February 1999, 26,172 shares of common stock were issued under the Company's Employee Stock Purchase Plan. Proceeds of $73 were recorded in conjunction with this purchase. 7. Commitments and Contingencies Converse is or may become a defendant in a number of pending or threatened legal proceedings in the ordinary course of its business. Converse believes that the ultimate outcome of any such proceedings will not have a material adverse effect on its financial position or results of operations. 8. Recently Issued Accounting Standards On June 15, 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" (FAS 133). FAS 133 is effective for all fiscal years beginning after June 15, 1999 (January 2, 2000 for the Company). FAS 133 requires that all derivative instruments be recorded on the balance sheet at their fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and, if it is, the type of hedge transaction. Management of the Company anticipates that, due to its limited use of derivative instruments, the adoption of FAS 133 will not have a significant effect on the Company's results of operations or its financial position. 9. Subsequent Events On April 9, 1999, Converse entered into a long-term agreement with a third party company for the exclusive distribution and license rights in Canada for Converse footwear, apparel, hats and bags. This new licensee agreement will have the impact of reducing the Company's global backlog and will lower future net sales and expenses while increasing royalty income. The agreement also provides for the sale of all of Converse's Canadian assets and operations to this new third party distributor. -7- 10. Business Segment Information As more fully described in Note 17 to the Consolidated Financial Statements for the year ended January 2, 1999 included within the Company's annual report on Form 10-K, the Company has adopted Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information". Summarized financial information concerning the Company's reportable business segments is shown in the following table: Europe, Americas Middle East, (excluding United States Africa Asia Pacific United States) Eliminations Consolidated -------------- ------------ ------------ ------------- ------------- ------------- Three months ending April 3, 1999: Net sales to customer.............. $ 35,096 $22,016 $ 9,797 $3,170 $ -- $ 70,079 Intersegment net sales............. 8,699 -- -- -- (8,699) -- Segment pretax profit (loss)....... (4,237) 1,332 1,336 (742) -- (2,311) Segment total assets at April 3, 1999..................... 145,196 40,863 2,990 6,817 -- 195,866 Three months ending April 4, 1998: Net sales to customer............. $ 53,616 $25,582 $11,213 $2,829 $ -- $ 95,240 Intersegment net sales............ 16,688 -- -- -- (16,688) -- Segment pretax profit (loss)...... (6,491) 1,317 4,730 (490) -- (934) Segment total assets at January 2, 1999................... 153,107 33,066 4,834 3,999 -- 195,006 -8- Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table sets forth certain items relating to the Company's operating results as a percentage of net sales for the three months ended April 4, 1998 ("First Quarter 1998") and for the three months ended April 3, 1999 ("First Quarter 1999"). Three Months Ended ---------------------------------------------- April 4, 1998 % April 3, 1999 % ---------------------- --------------------- Net sales....................................... $95,240 100.0 $70,079 100.0 Gross profit.................................... 27,815 29.2 18,741 26.7 Selling, general and administrative expenses...................................... 29,716 31.2 21,651 30.9 Royalty income.................................. 5,028 5.3 4,842 6.9 Earnings from operations........................ 3,127 3.3 1,932 2.8 Other (income) expense.......................... (132) (0.1) (787) (1.1) Interest expense, net........................... 4,193 4.4 5,030 7.2 Net loss........................................ (1,163) (1.2) (3,239) (4.6) Net basic and diluted loss per share..................................... $(0.07) -- $(0.19) -- Net Sales Net sales for First Quarter 1999 decreased to $70.1 million from $95.2 million for First Quarter 1998, a 26.4% decrease. The $25.1 million reduction in net sales was attributable to decreases of 13.2%, 39.8%, 42.4% and 55.7% for First Quarter 1999 in the categories of athletic originals, basketball, children's and cross training, respectively, as compared to First Quarter 1998. The reduction in net sales was partially offset by a $1.9 million increase in the Company's action sports category, which was introduced in 1998. Net sales in the United States decreased 34.5% to $35.1 million in First Quarter 1999 from $53.6 million in First Quarter 1998. Net sales decreased 15.9% internationally to $35.0 million for First Quarter 1999 from $41.6 million for First Quarter 1998. First Quarter 1999 net sales decreased 12.6% and 20.2% in the Asia Pacific and Europe, Middle East and Africa ("EMEA") regions, respectively. First Quarter 1999 Latin America region sales increased to $1.3 million from $0.8 million for First Quarter 1998, or 62.5%. Over the past two years, the athletic footwear market has suffered a downturn following an over expansion of retail capacity in the industry, an oversupply of product in the market and a shift in fashion trends away from athletic footwear and apparel. The effect of the industry downturn is most evident by the decreases realized in the Company's basketball and cross training categories, as well as the children's category which, in large part, is comprised of "takedowns" -9- from these categories. Coupled with the economic downturn in Asia, these factors led to order cancellations, which resulted in excess inventory and put pressure on margins and earnings. Also contributing to the sales decline internationally was the conversion of two wholly-owned operating units in Spain and Portugal to new licensee agreements which lowered net sales to be offset by increased royalty income. Gross Profit Gross profit decreased to $18.7 million for First Quarter 1999 from $27.8 million for First Quarter 1998, a 32.7% reduction. The weak athletic market and related volume decreases accounted for the majority of the gross profit reduction over the period. The Company's gross profit margin fell to 26.7% of net sales for First Quarter 1999 compared to 29.2% of net sales for First Quarter 1998. The decline was caused by continued heavy promotional activity and price reductions to control inventory levels as well as reduced demand for the Company's performance categories due to the change in consumer preference away from branded athletic footwear. Selling, General and Administrative Expense Selling, general and administrative expenses decreased 26.9% to $21.7 million for First Quarter 1999 from $29.7 million for First Quarter 1998. The decrease in selling, general and administrative expenses of $8.0 million was primarily attributable to the Company's aggressive efforts to reduce operating expenses to address the effect of the industry downturn. As a percentage of net sales, selling, general and administrative expenses decreased to 30.9% for First Quarter 1999 from 31.2% for First Quarter 1998. Royalty Income Royalty income decreased by 4.0% to $4.8 million for First Quarter 1999 from $5.0 million for First Quarter 1998. The reduction was primarily attributable to a decrease of 38.1% in the Latin America region. This decline was partially offset by a 2.0% improvement in the Pacific region. As a percentage of net sales, royalty income was 6.9% for First Quarter 1999 compared to 5.3% for First Quarter 1998. Earnings from Operations Primarily as a result of the factors described above, the Company recorded earnings form operations of $1.9 million for First Quarter 1999 compared to $3.1 million for First Quarter 1998, a 38.7% decline. As a percentage of net sales, earnings from operations were 2.8% and 3.3% for First Quarter 1999 and First Quarter 1998, respectively. -10- Other (Income) Expense First Quarter 1999 other income of $0.8 million was primarily related to foreign exchange gains associated with the foreign currency exchange contracts and currency options the Company had entered into as part of its hedging strategy to reduce exposure to foreign currency fluctuations. Interest Expense Interest expense for First Quarter 1999 increased to $5.0 million from $4.2 million for First Quarter 1998, a 19.0% increase. The increase reflects higher borrowing costs related to the Senior Secured Notes issued in September 1998. Net Loss Primarily as a result of the factors discussed above, the Company recorded a net loss for First Quarter 1999 of $3.2 million compared to a net loss of $1.2 million in First Quarter 1998. The net loss for First Quarter 1999 and First Quarter 1998 included non-operating charges to increase the deferred tax valuation reserve of $1.8 million and $0.5 million, respectively. Excluding these non-operating charges, the net loss for First Quarter 1999 was $1.4 million compared to $0.7 million for First Quarter 1998. Loss Per Share Basic and diluted loss for First Quarter 1999 was $0.19 per share as compared to basic and diluted loss of $0.07 per share for First Quarter 1998. The loss for First Quarter 1999 and First Quarter 1998 included the non- operating charges discussed above of $0.11 per share and $0.03 per share, respectively. Excluding these non-operating charges, the net loss for First Quarter 1999 was $0.08 per share compared to $0.04 per share for First Quarter 1998. Liquidity and Capital Resources As of April 3, 1999 the Company's working capital (net of cash) position decreased to $1.5 million from $3.8 million at January 2, 1999. Accounts receivable increased $5.2 million as a result of shipments in First Quarter 1999 exceeding those in the previous quarter. This increase and a $2.5 million reduction in accounts payable was financed by a $1.1 million reduction in inventories, a $1.5 million reduction in prepaid expenses and other current assets as well as increases of $0.1 million and $1.8 million in income taxes payable and accrued expenses, respectively. The remainder of the needed financing was achieved through seasonal borrowing increases of $5.5 million. Total borrowings under the Company's Credit Facility and asset based financing arrangements increased to $88.9 million at April 3, 1999 from $83.4 million at January 2, 1999, reflecting the working capital changes discussed above (see Note 4 of Notes to Condensed Consolidated Financial Statements contained herein). -11- For First Quarter 1999 and First Quarter 1998, net cash required for operating activities was $5.7 million and $4.7 million, respectively. During these periods cash was primarily used to fund the Company's working capital requirements. Net cash used by investing activities was $0.6 million and $0.7 million for First Quarter 1999 and First Quarter 1998, respectively. Cash invested was for additions to property, plant and equipment. Net cash provided by financing activities was $5.5 million and $3.8 million for First Quarter 1999 and First Quarter 1998, respectively. Cash provided by financing activities consisted almost entirely of net proceeds from the Company's seasonal borrowing. Backlog At the end of First Quarter 1999, the Company's global order backlog was $92.7 million, compared to $127.1 million at the end of First Quarter 1998, a decrease of 27.1%. The Company's four major categories of basketball, children's, cross training and athletic originals recorded declines of 10.3%, 22.9%, 33.8% and 32.4%, respectively. The United States order backlog decreased 22.8% while the international backlog decreased 31.8%. The amount of backlog at any particular time is affected by a number of factors, including the scheduling of the introduction of new products and the timing of the manufacture and shipment of the Company's products. In addition, the backlog position is not necessarily indicative of future sales because the ratio of future orders to "at once" shipments and sales by the Company owned retail stores may vary from year to year. Also, the Company has recently converted two of its wholly-owned operating units to new licensee agreements, which had the impact of reducing the Company's global backlog and will lower future net sales while increasing royalty income. Accordingly a comparison of backlog as of two different dates is not necessarily meaningful. The Year 2000 Background The "Year 2000 Problem" is the result of many existing computer programs and embedded chip technology containing programming code in which calendar year data is abbreviated by using only two digits rather than four to refer to a year. As a result of this, some of these programs may fail to operate or may not properly recognize a year that begins with "20" instead of "19." This may cause such software to recognize a date using "00" as the year 1900 rather than the year 2000. Even systems and equipment that are not typically thought of as computer- related often contain embedded hardware or software that may improperly interpret dates beginning with the year 2000. The Company's Year 2000 Project Converse began working on Year 2000 compliance issues in 1996 when it established a Company-wide Year 2000 project team (the "Year 2000 Project Team") to identify all potential non-compliant software, hardware and embedded chip technology and determine to what extent modification or replacement was necessary to mitigate the Year 2000 Problem. The first task of the Year 2000 Project Team was to conduct an assessment of all internal hardware, software and -12- embedded chip technology to determine Year 2000 compliance and to assess the risks associated with non-compliance by the Company's vendors, suppliers and customers. The Year 2000 Project Team divided the action steps necessary to minimize any Year 2000 non-compliance into two distinct categories: internal compliance of software, hardware and embedded chip technology, and external non- compliance by the Company's vendors, suppliers and customers. Internal Year 2000 Compliance. The Company began the process of executing ----------------------------- the necessary code changes and upgrading existing systems in 1996. As a result, most of the Company's software, hardware and embedded chip technology are already Year 2000 compliant. The Year 2000 Project Team developed an ongoing program designed to bring the remaining software, hardware and embedded chip technology at all of its domestic and international locations into Year 2000 compliance in time to minimize any significant detrimental affects on the Company's business and operations. In many cases these upgrades were already planned as part of ongoing business process improvements. Currently, the Company has completed approximately 95% of the work believed to be required to bring all internal systems into compliance. Converse's current target is to complete all remaining work by the end of the third quarter of 1999. External Year 2000 Compliance. The Year 2000 Project Team reviewed all ----------------------------- material relationships between Converse and each of its vendors and suppliers and determined which ones were critical to Converse's business and operations. The Company addressed each category as follows: "Critical" Suppliers. Converse deemed 165 of its vendors and suppliers ------------------- to be "critical" to the Company's business and operations. Converse has sent each of its critical suppliers a detailed Year 2000 readiness questionnaire and checklist, followed in some cases by formal communication and/or site visits. Response rate to date is 97%, with 93% of the respondents indicating all systems have been or will be verified Year 2000 compliant. For those critical suppliers that do not respond or that do not have adequate compliance plans, Converse is developing contingency plans that assume an estimated level of noncompliance. These plans will likely consist of early purchase of materials, components, work-in-process or finished goods. Even so, these contingency plans are subject to much uncertainty and may not be sufficient to mitigate any business interruption. Thus, some material adverse impact to Converse may result from one or more third parties regardless of Converse's defensive contingency plans. "Non-Critical" Suppliers. The Company sent letters to 2,193 suppliers ----------------------- and vendors deemed to be "non-critical" advising them of the Year 2000 Problem and requesting that they address compliance. Non-compliance by such suppliers would not have a material adverse affect on the Company. -13- Costs Associated with Year 2000 Compliance. - Through the first quarter of 1999 the Company spent approximately $2.1 million on incremental costs associated with the Year 2000 Problem. These costs consisted of new hardware and software as well as the cost of contracted programmers and the salaries and fringe benefits of employees dedicated to addressing the Year 2000 Problem. These costs have been funded through operating cash flows. Approximately $0.8 million of this amount relates to hardware and software which the Company has capitalized and the remainder has been expensed as incurred. The Company estimates that an additional $0.4 million will be incurred during the remainder of 1999 to complete this process. These additional expenditures will be comprised of some additional new hardware and software, as well as the cost of contracted programmers and the salaries and benefits of employees dedicated to addressing the Year 2000 Problem. These estimates are based on currently available information and may change in the event of unforeseen future developments. Risks Associated with the Year 2000 Problem. The failure to correct a material Year 2000 Problem could result in the interruption in, or failure of, certain normal business activities or operations of the Company. Such failures could materially and adversely affect the Company's results of operations, liquidity and financial condition. Due to the general uncertainty inherent in the Year 2000 Problem, resulting primarily from uncertainty of the Year 2000 readiness of third-party vendors and suppliers, the Company is unable at this time to determine whether the consequences of any Year 2000 failures will have a material impact on the Company. As discussed above, Converse is dependent on a large number of vendors and suppliers in most of the locations in which the Company operates to deliver a wide range of goods and services. These vendors and suppliers, in turn, rely on many sub-tier vendors and suppliers. Converse believes that this extended supply chain presents the area of greatest risk of Year 2000 noncompliance, due to Converse's limited ability to influence actions of some of these third parties and because of Converse's inability to accurately estimate the level and impact of noncompliance of third parties throughout the extended supply chain. Forward-looking statements Any statements set forth above which are not historical facts, including the statements concerning the outlook for sales, earnings and anticipated cost savings, and the product and industry developments for 1999 and 2000 are forward looking statements that involve certain risks and uncertainties that could cause actual results to differ materially from those in the forward looking statements. Potential risks and uncertainties include such factors as the financial strength of the Company, the competitive pricing environment and inventory levels within the footwear and apparel industries, consumer demand for athletic footwear, market acceptance of the Company's products, the strength of the U.S. dollar and the success of planned advertising, marketing and promotional campaigns and other risks identified in documents filed by the Company with the Securities and Exchange Commission. -14- PART II. OTHER INFORMATION Item 1. Legal Proceedings. There have been no material changes from the information previously reported under Item 3 of the Company's annual report on Form 10-K for the fiscal year ended January 2, 1999. Item 2. Changes in Securities. Not Applicable Item 3. Defaults Upon Senior Securities. Not Applicable Item 4. Submission of Matters to a Vote of Security-Holders. Not Applicable. Item 5. Other Information. Not Applicable Item 6. Exhibits and Reports on Form 8-K (a) Exhibits. The following exhibits are contained in this report: 10 Amendment No. 1 to Employment Agreement between Converse and Glenn N. Rupp. 27 Financial Data Statement (b) Reports on Form 8-K. There were no reports on Form 8-K filed during the quarter ended April 3, 1999. -15- SIGNATURE 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. Dated: May 17, 1999 Converse Inc. By: /s/ Donald J. Camacho -------------------------- Donald J. Camacho Senior Vice President and Chief Financial Officer -16- EXHIBIT INDEX Exhibit No. Description - ----------- ----------- 10 Amendment No. 1 to Employment Agreement between Converse and Glenn N. Rupp. 27 Financial Data Statement