[LETTERHEAD OF STUBBS, ALDERTON & MARKILES, LLP]
John J. McIlvery
Partner
Direct 818.444.4502
Voice
Direct Fax 818.444.6302
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E-Mail jmcilvery@biztechlaw.com
January 25, 2008
VIA FEDERAL EXPRESS
Securities and Exchange Commission
Division of Corporation Finance
100 F Street, N.E.
Washington, D.C. 20549
Attn: Christopher Owings
Mail Stop 3561
Re: Talon International, Inc.
Responses to Staff Comments of November 21, 2007
with respect to:
Registration Statement on Form S-3
File August 10, 2007
File No. 333-145344
Form 10-K for fiscal year ended December 31, 2006
Filed April 13, 2007, as amended
Form 10-Q for Quarterly Period Ended June 30, 2007
Filed August 14, 2007
Form 10-Q for Quarterly Period Ended September 30, 2007
Filed November 19, 2007
File No. 1-13669
Ladies and Gentlemen:
On behalf of Talon International Inc. (the "Company"), we have enclosed
as Attachment B one copy of the Company's proposed Amendment No. 2 to Annual
Report on Form 10-K for the fiscal year ended December 31, 2006 (the "10-K
Amendment"). We have also enclosed as Attachment C a marked copy of the 10-K
Amendment that shows new changes to the affected items of the original Annual
Report on Form 10-K filed on April 13, 2007, as amended by Amendment No. 1 to
Annual Report on Form 10-K filed on April 30, 2007 (as previously amended, the
"Original Form 10-K"), made in connection with the responses in this letter. The
10-K Amendment includes the additional and amended disclosure the Company
proposes to make to the Original Form 10-K in response to the Staff's comment
letter, dated November 21, 2007 (the "Comment Letter").
Additionally, we have set below the Company's responses to the Comment
Letter. The factual information provided herein relating to the Company has been
made available to us by the Company. Paragraph numbering used for each
supplemental response set forth below corresponds to the numbering used in the
Comment Letter.
Securities and Exchange Commission
January 25, 2008
Page 2
Upon resolution of the issues raised by the Staff in the Comment
Letter, the Company will file the 10-K Amendment and response letter via EDGAR,
as well as a pre-effective amendment to the Corporation's Registration Statement
on Form S-3 (File No. 333-145344) (the "S-3 Amendment").
The Company's detailed response to the individual comments follows.
FORM 10-K FOR FISCAL YEAR ENDED DECEMBER 31, 2006
1. We reviewed the proposed amendment submitted under your letters dated
October 30, 2007 and November 9, 2007 in response to our letter dated
September 6, 2007. Please note that we will be unable to clear the
annual report of comments until you address the comments below and file
the amendment. Also, please address the comments below in the amendment
as applicable.
The Company acknowledges the Staff's comments. Upon resolution of the
issues raised by the Staff in the Comment Letter, the Company will file the 10-K
Amendment and response letter via EDGAR, as well as the S-3 Amendment.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS, PAGE 20
OVERVIEW, PAGE 20
2. We reviewed your response to comment two in our letter dated September
6, 2007. It appears that your response is inconsistent with your
present disclosure that you now operate with fewer employees and will
have lower associated operating and distribution expenses. Considering
your present disclosure, we still believe that you should include a
discussion of the expected effects from fewer employees and other cost
reductions resulting from your 2005 restructuring on future earnings
and cash flows as discussed in the fifth paragraph of the interpretive
response to the question in SAB Topic 5:P:4. This additional analysis
should:
o Quantify the expected effects of the restructuring and
disclose the initial period in which those effects are
expected to be realized;
o Discuss whether the cost savings are expected to be offset by
anticipated increases in other expenses or reduced revenues;
o Clearly identify the income statement line items to be
impacted (for example, cost of goods sold, selling expenses,
general and administrative expenses, etc.); and
o Discuss whether actual savings anticipated by the
restructuring are being achieved as expected and, if not, the
reasons for an outcome different from your initial
expectations and the likely effects of the different outcome
on future operating results and liquidity.
Securities and Exchange Commission
January 25, 2008
Page 3
The Company acknowledges the Staff's comments with respect to
disclosures in accordance with Statement 146 and SAB Topic 5 and accordingly,
the Company has further modified the relevant disclosure in the 10-K Amendment
to address these areas to its best ability given the nature of the restructuring
and the actions involved. The Company respectfully assets that these disclosures
now fully comply with Statement 146 and SAB Topic 5and fairly present these
actions to the investor.
APPLICATION OF CRITICAL ACCOUNTING POLICIES AND ESTIMATES, PAGE 29
3. We considered your response to comment six in our letter dated
September 6, 2007 and we note the proposed revisions to your disclosure
regarding bad debt and inventory reserves. We agree that your financial
statements and discussion of financial condition and results of
operations contain disclosures regarding the restructuring plan,
accounts and notes receivable, assets held for sale, idle and impaired
and inventory reserves and the impact of these items on your operating
performance. However, the disclosure in this section should provide
greater insight into the quality and variability of information
regarding financial condition and operating performance. To achieve
this objective, the discussion should describe the material
implications of uncertainties associated with the methods, assumptions
and estimates underlying your critical accounting measurements that
have had or that you reasonably expect will have a material impact on
financial condition and operating performance and on the comparability
of reported information among periods. Also, the discussion should
address, to the extent material such factors as how accurate the
estimates/assumptions have been in the past, how much the
estimates/assumptions have changed in the past and whether the
estimates/assumptions are reasonably likely to change in the future.
Therefore, we would expect you to provide quantitative as well as
qualitative disclosure when quantitative information is reasonably
available for each of the critical accounting estimates you identify in
order to achieve the disclosure objective. Also, since critical
accounting estimates and assumptions are based on matters that are
highly uncertain, you should analyze and disclose their specific
sensitivity to change, based on other outcomes that are reasonably
likely to occur and would have a material effect. For example, if a
reasonably likely change in the assumptions used in estimating cash
flows expected to result from the use and eventual disposition of
long-lived assets would have a material effect on your financial
condition or operating performance, the impact that could result given
the range of reasonably likely outcomes should be disclosed and
quantified. Please refer to Item 303(a)(3)(ii) of Regulation S-K as
well as the Commission's Guidance Regarding Management's Discussion and
Analysis of Financial Condition and Results of Operations, SEC Release
No. 33-8350, issued December 19, 2003 and available on our website at
www.sec.gov.
Securities and Exchange Commission
January 25, 2008
Page 4
The Company acknowledges the Staff's comments with respect to
disclosures in the Application of Critical Accounting Policies and accordingly
the Company has further modified the disclosure in this section of the 10-K
Amendment to address these comments.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA, PAGE 33
CONSOLIDATED STATEMENTS OF OPERATIONS, PAGE 37
4. We reviewed your response to comment eight in our letter dated
September 6, 2007 and the proposed revisions to disclosure regarding
your allowance for doubtful accounts. Given the materiality of bad debt
expense to fiscal 2004 and 2005 operating results, it appears that you
should separately disclose bad debt expense for each of the years
presented on the face of the statements of operations. Refer to
paragraph (b)5 of Rule 5-03 of Regulation S-X, Please revise or advise
as appropriate.
The Company acknowledges the Staff's comments with respect to the
separate disclosure of bad debt expense on the face of its consolidated
statements of operations for 2004 and 2005 and accordingly the Company has
further modified the10-K Amendment to address this disclosure.
5. We reviewed your response to comment nine in our letter dated September
6, 2007 and the proposed revisions to your disclosure. You state that
the disclosures in the proposed amendment have been updated to reflect
the reclassification of amortized discounts and deferred financing
costs. Although we note the revision to your income statement, it does
not appear you disclosed the reclassification in the notes to the
financial statements. Please do so.
The disclosure regarding the reclassification was inadvertently omitted
in the draft Form 10-K amendment previously provided to the Staff. The Company
has further modified the 10-K Amendment to include this disclosure.
CONSOLIDATED STATEMENTS OF CASH FLOWS, PAGE 39
6. We note your response to comment 10 in our letter dated September 6,
2007 and your proposed revision to the non-cash increase in the
inventory valuation reserve for 2004. We also reviewed the proposed
revisions to Schedule II in response to comments three and 24 in our
letter dated September 6, 2007. It is still unclear to us why it is
appropriate to offset deductions in your allowance for doubtful
accounts and reserve for obsolescence resulting from recoveries and
write-offs in the "increase (decrease) in allowance for doubtful
accounts" and "increase (decrease) in inventory valuation reserve" line
items since these line items should represent non-cash charges and
credits reflected in operating results. Please advise.
Securities and Exchange Commission
January 25, 2008
Page 5
The Company records only non-cash entries into these valuation reserves
and believes that the reporting of the net change in these reserves are
appropriate adjustments within the Consolidated Statement of Cash Flows to
reconcile net income to the changes in cash.
Provisions for doubtful accounts recorded in the accounts receivable
valuation reserve are specific valuation reserves associated with individual
accounts. The specific accounts are maintained within the Company's accounts
receivable records at their gross amounts until all efforts to collect these
amounts have been exhausted or the accounts have been collected in whole or in
part. At this determination, the uncollected amount of the account is
written-off and charged to bad debt expense. Simultaneously, the valuation
reserve established for this account is reversed and credited to bad debt
expense in the period. Please consider the hypothetical example (not actual
transactions) noted below:
2006
Period 4: Specific reserve of $150,000 is established for an account
with a balance outstanding of $600,000.
The statement of cash flow reflects an item reconciling net
income to net cash flows of $150,000 as the "increase in
allowance for doubtful accounts."
2007
Period 3: The customer settles the account for $500,000. The uncollected
account balance is written-off and $100,000 is charged to bad
debt ($600,000 less $500,000 collected). Simultaneously, the
specific provision previously recorded for $150,000 is
reversed and a net credit in bad debt expense of $50,000
results within the period.
The statement of cash flow reflects an item reconciling net
income to net cash flow of a "(decrease) in the allowance for
doubtful accounts" of $150,000 - representing the non-cash
increase in net income for the period resulting from the
reserve reversal.
The statement of cash flow also reflects a change in the gross
amount of accounts receivable of $100,000 - representing the
cash impact of the difference in the account and the amount
collected.
The Company respectfully asserts that the foregoing accounting provides
the investor with a full presentation of the cash contributions from operating
earnings as well as the direct changes occurring within the operating assets.
Similarly, all changes in the reserve for inventory obsolescence are
non-cash transactions. Inventory valuation provisions are substantially all
obsolescence provisions as opposed to lower of cost or market provisions, and
are maintained by specific inventory items
Securities and Exchange Commission
January 25, 2008
Page 6
within the Company's accounts. As these inventory components are sold or
disposed of, the cash transaction is initially recorded in the Company's records
at the gross inventory amounts before the obsolescence provision. Accordingly,
cost of sales is charged with the initial inventory cash value upon its sale or
disposal. Concurrently, the specific reserve associated with this item is
credited to cost of sales and the valuation reserve reduced for the amount
previously recorded.
Paragraph 29 of Statement 95 requires reporting all major classes of
items reconciling net income to net cash flow "... including at a minimum
changes during the period in receivables pertaining to operating activities, in
inventory, and in payables pertaining to operating activities, shall be
separately reported. Enterprises are encouraged to provide further breakdowns of
those categories that they consider meaningful." Footnote 17 of paragraph 115,
Appendix B of Statement 95 discussing the methods of determining the amounts of
operating cash receipts notes "For the resulting operating cash receipts and
payments to be accurate, the effects of all noncash entries to accounts
receivable and payable, inventory and other balance sheet accounts used in the
calculation must be eliminated. For example, the change in accounts receivable
would have to be determined exclusive of any bad debt write-offs and other
noncash charges and credits to customer accounts during the period." While these
comments more specifically pertain to the direct method of reporting cash
flows,and the Company (like most organizations) utilizes the indirect method,
the FASB nevertheless encourages companies to make more detailed disclosures
where possible.
Accordingly, the Company believes that while the net change in the
balance sheet presentation for these accounts is appropriate, the net change in
these operating accounts is best disclosed in the statements of cash flows with
a full presentation of the impact of the valuation reserves on the net income,
and the cash change in the operating accounts. The Company believes this is
particularly true where such valuation reserves have been a significant portion
of the net account activity as has been the case for the Company in 2004 and
2005.
7. We note your response to comment 29 in our letter September 6, 2007 and
the proposed revision to disclose the conversion of trade accounts
payable and accrued legal costs to notes payable in the supplemental
disclosure of non-cash financing activities. Please tell us how you
classify principal payments on the related notes payable in the
statements and why your classification complies with the provisions in
SFAS 95. It appears that principal payments should be classified in
cash flows from operating activities. Refer to paragraph 23.a, of SFAS
95. Also, refer to the comment below regarding the correction in the
classification of note receivable collections.
With respect to the reporting of principal payments on notes payable
arising from the conversion of accounts payable and accrued legal costs, these
payments were included in the statement of cash flow as items from financing
activities. The Company acknowledges the
Securities and Exchange Commission
January 25, 2008
Page 7
Staff's comments with respect to reporting the note payments as items from
operating activities and accordingly the Company has further modified the 10-K
Amendment to appropriately reclassify these amounts in the statements of cash
flows. Please refer to the 10-K Amendment and to the supplemental analysis of
the reclassifications to the statements of cash flows for the specific
adjustments enclosed as Attachment A, as well as the response to Comment 8
below.
8. We note your response to comment 11 in our letter dated September 6,
2007 and the correction of the classification of note receivable
collections as cash flows from operating activities as opposed to
financing activities. It is unclear to us why the correction in the
classification of cash flows is not treated as a correction of an error
in accordance with SFAS 154. Please provide us with your materiality
assessment of the quantitative and qualitative factors that support
your determination that a restatement is not required. Refer to SAB
Topics 1:M and 1:N. If you determine that you should restate cash flows
in response to our comments, please address the following items:
o Compliance with Item 4.02(a) of Form 8-K;
o Compliance with the disclosure requirements of SFAS 154 and
staff practice requiring that restated amounts be clearly
labeled as restated;
o Inclusion of an explanatory paragraph in the reissued audit
opinion;
o Updated disclosures throughout the document, including Items 7
and 9A; and
o Updated certifications.
Included in Attachment A for your review is a supplemental analysis of
the reclassifications required to the statement of cash flows to properly
reflect the collections of notes receivable and the payments of notes payable
(arising from the conversion of accounts receivable and accrued legal expenses),
as cash flows from operating activities rather than as cash flow from financing
activities as originally reported. The Company agrees that these represent
presentation errors within the statements of cash flows, but respectfully
asserts that these errors rise to the level of materiality that require a
restatement of the financial statements in accordance with SFAS 154, or SAB
Topics 1:M and 1:N.
In support of this conclusion, Attachment A includes specific comments
and considerations in the determination of our materiality assessments, as well
as the impact on investment measures and considerations typically made by
investors.
The Company has concluded that the reclassifications resulting from
these items are both quantitatively and qualitatively immaterial and when
considered individually and in the context of the financial statements taken as
a whole, these items would not affect the analysis or conclusions of an investor
in the consideration of an investment in the shares of the Company.
Consequently, the Company has determined that a restatement of the 2006
financial statements in accordance with SFAS 154 is not required and that a
reclassification of these amounts in an amendment to the 2006 Form 10-K,
together with an explanation of
Securities and Exchange Commission
January 25, 2008
Page 8
the reclassification is appropriate. The Company also takes the position that
these adjustments are not material to the quarterly reports on Form 10-Q and the
Company therefore respectfully asserts that the interim reports do not require
amendment and that the errors be prospectively corrected in future filings.
Please see the modifications the Company has made to the 10-K Amendment
to appropriately reclassify these amounts in the statements of cash flows
together with the explanation of the reclassification in the amended financial
statements.
9. Reference is made to the above comment and the proposed revision to
your disclosure in the operating activities section under the liquidity
and capital resources heading in management's discussion and analysis
that note receivable collections do not reflect cash flows from current
operating activity and your disclosure of cash provided from operations
without the cash inflow from note receivable collections. Given that
cash inflows from the note receivable are included in operating cash
flows, please tell us the purpose of this disclosure. Also, please note
that disclosure of cash provided by operations without cash inflows
from note receivable collections is a non-GAAP financial measure and
that you are required to comply with the disclosure requirements of
Item 10(e) of Regulation S-K. Please disclose the reasons why
management believes the presentation of the non-GAAP financial measure
provides useful information to investors and the additional purposes,
if any, for which management uses the measure.
The Company believes that the collections from note receivable, while
correctly representing cash flows from operating activities in accordance with
GAAP, are not a normal and recurring portion of the company's typical business
activities, and that investors must be cautious in considering the cash flows
from operating activities and not necessarily assume that such historical cash
flows would be representative of future cash flows. The Company's disclosure was
intended to ensure this understanding by the Company's investors, and not to be
inconsistent with, or present any non-GAAP disclosures.
The Company has included revised disclosure in the 10-K Amendment in
response the Staff's comments, in an attempt to more clearly explain this risk
to the Company's investors and to ensure that the Company's disclosures are
consistent with GAAP.
NOTE 13 - COMMITMENTS AND CONTINGENCIES, PAGE 62
10. We note your response to comment 20 in our letter dated September 6,
2007. You indicate that you will disclose in the amended filing that an
estimate of the possible loss or range of loss cannot be made with
respect to the Mexican federal tax authority claim. Yet, there is no
disclosure in the draft of the amendment provided with your response.
Please revise.
Securities and Exchange Commission
January 25, 2008
Page 9
The disclosure was inadvertently omitted in the modified draft of the
Form 10-K amendment previously provided to the Staff. The Company has further
modified the 10-K Amendment to include the relevant disclosure.
NOTE 14 - GEOGRAPHIC INFORMATION, PAGE 65
11. We note your response to comment 21 in our letter dated September 6,
2007 and the proposed revision to your disclosure. Please include a
discussion and analysis of revenue from each product class and related
trends in management's discussion and analysis of financial condition
and results of operations.
The additional discussion regarding the analysis of revenue by each
product class has been added to the 10-K Amendment in response to the Staff's
comments.
NOTE 17 - QUARTERLY RESULTS, PAGE 67
12. We note your response to comment 22 in our letter dated September 6,
2007 and the proposed revision to your disclosure. Please revise your
footnote disclosure to describe unusual or infrequently occurring items
recognized in each quarter as well as the aggregate effect and nature
of year-end or other adjustments which are material to the results of
the fourth quarter of each year. Refer to Item 302(a)(3) of regulation
S-X.
The Company has included additional disclosure in the 10-K Amendment to
include the appropriate discussion regarding year-end and other adjustments
material to the results of the fourth quarter.
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES, PAGE 72
13. We reviewed the proposed revisions to Schedule II as presented in your
responses to comments three and 24 in our letter dated September 6,
2007. Please disclose direct write-offs of inventory not reflected in
the additions to the reserve for obsolescence in note (1) for each year
presented. Also, please explain to us why reversals of prior period
provisions, as disclosed in note (2), are reflected in the deduction
column as opposed to the additions column which should represent
amounts charged to income.
The Company has modified the 10-K Amendment to include the direct
write-offs of inventory in Schedule II as noted. The transactions included in
the valuation reserves are all non-cash adjustments as explained in the response
to Comment 6 above. Prior period provisions within the same year are included in
the additions column and are a component of the amounts charged to income. The
net additions column plus the direct write-offs, represents the amounts charged
to income for the period. The deductions column is used to distinguish the
application of prior year provisions. There are no reversals of prior year
Securities and Exchange Commission
January 25, 2008
Page 10
provisions included, but only the application of these provisions to accounts
collected or written-off.
FORM 10-Q FOR QUARTERLY PERIOD ENDED JUNE 30, 2007
14. Please address the comments above as applicable.
Comments previously addressed that are not applicable to the Form 10-Q
for the period ended June 30, 2007 are Items 1, 2, 4, 5, 9, 12, and 13.
Comment 3: The Company did not change the methods it uses to determine
its critical accounting estimates since the filing of its Form 10-K for the year
ended December 31, 2006. The Company will modify the Form 10-Q disclosures on a
prospective basis to ensure full compliance with SEC Release 33-8350.
Comment 6: The response to Comment 6 is applicable to the Company's
quarterly filings as well, and the Company respectfully asserts that further
explanation for the Form 10-Q is not necessary.
Comment 7: The Company will modify its Forms 10-Q on a prospective
basis as noted in Item 7 above.
Comment 8: The Company's assessment of materiality for the 2006 annual
periods and for the quarterly periods affected is included in the response to
Comment 8.
Comment 10: The Company will modify its Forms 10-Q disclosure on a
prospective basis as noted in Comment 10 above.
Comment 11: The Company will modify its Forms 10-Q disclosure on a
prospective basis as noted in Comment 11 above.
ITEM 1. FINANCIAL STATEMENTS, PAGE 3
CONSOLIDATED STATEMENT OF CASH FLOWS, PAGE 5
15. We reviewed your response to comment 28 in our letter dated September
6, 2007. Given the information in your response regarding the nature of
the restricted cash deposit, it is unclear to us how you conclude that
the investment account could have been reported as a cash equivalent
and the basis in GAAP that supports a classification other than
restricted cash. Refer to paragraph 6 of Section A, Chapter 3 of ARB 43
and Rule 5-02.1 of Regulation S-X. Please cite the authoritative
literature that supports your position. Otherwise, we believe that the
deposit should not be included in cash and cash equivalents in the
statements of cash flows and that you should restate your statements of
cash flows accordingly. If you determine that
Securities and Exchange Commission
January 25, 2008
Page 11
you should restate cash flows in response to our comment, tell us your
basis for the classification of restricted cash as either an investing
or operating activity.
The Company believes that the classification of restricted cash in its
third quarter report dated June 30, 2007 is consistent with paragraph 6 of
Section A, Chapter 3 of ARB 43. The pronouncement indicates that cash restricted
for long-term debts would be excluded from current assets. The cash reported as
restricted at June 30, 2007 was restricted for the liquidation of the secured
convertible promissory notes which are included in current liabilities at June
30, 2007. Disclosures regarding the restriction on cash at the period end were
included in footnote 9 to the financial statements in accordance with Rule
5-02.1 of Regulation S-X.
FASB Statement 95 paragraph 5 denotes that "the information provided in
a statement of cash flows ...should help investors, creditors, and others to
....(b) assess the enterprise's ability to meet its obligations..." The Company
believes that the inclusion of the cash in the restricted escrow account as a
cash equivalent is an important disclosure to aide investors in their
understanding that the secured convertible debt obligations reported on the
balance sheet have been provided for to the extent of this cash. The
presentation reflects the results of the Company's restructuring of its debt
arrangements and of the total funds secured in this effort for the liquidation
of its current liabilities.
Additionally, paragraph 8 of FASB 95 defines cash equivalents as
"short-term, highly liquid investments that are both: a. Readily convertible to
known amounts of cash, and b. So near their maturity that they present
insignificant risk of changes in value because of changes in interest rates."
The respectfully asserts that the cash escrow account established for the
temporary settlement of the debt transactions at June 30, 2007 met both of these
conditions, from a practical as well as contractual standpoint. The liquidity of
this account and elimination of the restriction was further evidenced by the
settlement of the transaction in less than 30 days, and at the filing of the
financial statements the cash restriction had been fully resolved and the
associated debt paid as was disclosed in footnote 10 (Subsequent Events).
The Company believes that the FASB guidance noted above and the nature
of the restricted cash give the authoritative support for the Company's
presentation of these transactions within the financial statements at June 30,
2007. The Company believes that its current presentation, together with the
footnote disclosures, provide greater clarity for understanding the transactions
to investors than alternate disclosures would that present this cash within the
statement of cash flows as a cash outflow for investing or operating purposes.
Cash outflows from investing activities are defined in FASB 95,
paragraph 17 c. as "payments ...to acquire ..other productive assets." The
escrow account was specifically, contractually established to exclude the
possibility of any gain or loss on the escrow funds,
Securities and Exchange Commission
January 25, 2008
Page 12
and accordingly the Company does not believe that the cash represents an outflow
for investing purposes.
Cash flows from operating activities are defined as all transactions
not defined as investing or financing activities and "are generally the cash
effects of transactions and other events that enter into the determination of
net income." The Company similarly does not believe that the transaction
qualifies as a cash outflow for operating activities.
The Company respectfully asserts that its presentation of the
restricted cash in the balance sheet at June 30, 2007 and the treatment of this
cash as a cash equivalent for the purposes of the Statement of Cash Flows,
together with the disclosures made in the footnotes to the financial statements,
presents a complete and clear understanding of the transactions involved for
investors, and is supported by the intent and specifics of the appropriate
accounting guidance for similar transactions. Accordingly, the Company
respectfully asserts that the financial statements for the period ended June 30,
2007 do not require modification or restatement.
ITEM 4. CONTROL PROCEDURES, PAGE 30
16. In your response to comment 31 in our letter dated September 6, 2007
you reference significant changes (emphasis added) in your internal
controls over financial reporting. Please confirm to us, if true, that
there were no changes (emphasis added) in internal controls that
occurred during the quarters ended March 31, 2007 and June 30, 2007
that have materially affected or are reasonable likely to materially
affect, your internal control over financial reporting. In future
filings, please disclose any change (emphasis added) in internal
control that occurred during the last fiscal quarter that has
materially affected, or is reasonably likely to affect, your internal
control over financial reporting. Refer to Item 308(c) of Regulation
S-K.
The Company confirms that it has not made changes in its internal
controls over financial reporting during 2007 that have materially affected or
are reasonable likely to materially affect, your internal control over financial
reporting. The Company will include as appropriate disclosures about significant
changes in its internal control structure in future filings.
FORM 10-Q FOR QUARTERLY PERIOD ENDED SEPTEMBER 30, 2007
17. Please address the comments above as applicable.
Comments previously addressed that are not applicable to the Form 10-Q
for the period ended September 30, 2007 are Comments 1, 2, 4, 5, and 9 through
16.
Securities and Exchange Commission
January 25, 2008
Page 13
Comment 3: The Company did not change the methods it uses to determine
its critical accounting estimates since the filing of its Form 10-K for the year
ended December 31, 2006. The Company will modify its Form 10-Q disclosures on a
prospective basis to ensure full compliance with SEC Release 33-8350.
Comment 6: The response to Comment 6 is applicable to the Company's
quarterly filings as well, and the Company respectfully asserts that further
explanation for the Form 10-Q is not necessary.
Comment 7: The Company will modify its Forms 10-Q on a prospective
basis as noted in Comment 7 above.
Comment 8: The Company's assessment of materiality for the 2006 annual
periods and for the quarterly periods affected is included in the response to
Comment 8 above.
ITEM I. FINANCIAL STATEMENTS, PAGE 3 NOTE 7. DEBT FACILITY, PAGE 12
18. Please tell us why the warrants issued in connection with the revolving
credit and term loan agreement are properly classified as equity
instruments. Please address the requirements of paragraphs 12-32 of
EITF 00-19 in your response. In addition, in future filings, please
disclose whether the warrants contain any provision that could require
net-cash settlement.
The Company has determined that the warrants issued in connection with
the June 2007 revolving credit and term loan agreement met all of the
requirements of EITF 00-19 for classification as equity instruments. In
particular:
o The warrants are not cash settled, but equity settled;
o The warrants may be settled in unregistered shares;
o The Company has sufficient share capital to meet all of the
obligations;
o The shares that may be acquired are either fixed or adjustment
is within the Company's control;
o The contract does not include cash settlements in the event
SEC filings are not timely made, but includes a penalty
representing damages that is consistent with market penalties
and is capped;
o There are no "top-off" or "make whole" provisions;
o The warrants do not require net cash settlements;
Securities and Exchange Commission
January 25, 2008
Page 14
o There are no rights afforded the warrant holders to suggest
that their position in the Company is higher than that of a
common stock holder; and
o No collateral was posted or required.
The Company will include the disclosure that no cash settlements are
required in future filings.
NOTE 13. SUBSEQUENT EVENTS, PAGE 18
19. Please tell us why you believe the equity instruments issued and
re-priced in connection with the modification of the debt facility are
within the scope of SFAS 123(R), and why it is appropriate to charge
the fair value of the common stock and the difference in the fair value
of the warrants to expense. Please also tell us what consideration you
gave to the guidance in EITF 96-19 in determining your accounting
treatment. In addition, please tell us how you intend to account for
the equity instruments to be issued and re-priced if you complete an
equity offering and the basis in GAAP for your expected accounting
treatment.
The Company believes that the overriding guidance for the fair
valuation of options and warrants generally falls under the scope of FAS 123(R)
and intended its reference to be broad. The Company determined that the stock
issued in connection with the waiver and the re-pricing of the warrants
represents a non-substantial change in the debt instrument in accordance with
the specific guidance of EITF 96-19. Accordingly, in its description of the
accounting for the cost of the change the Company's disclosure should have
distinguished that the cost of the waiver would be amortized over the remaining
term of the loan and the legal costs would be expensed in the fourth quarter.
The Company believes that in the event that it completes an equity
offering the offering will be accounted for on its own merits in accordance with
the applicable accounting guidance in effect at that time - most likely EITF
00-19 as outlined above.
The recent amendment to the debt agreement places no requirement on the
completion of an offering, but simply determined in advance the cost of an
additional modification to the loan agreement in the event that the Company
elects to do so. If completed, the Company would evaluate the cost of the
amendment at that time in accordance with EITF 00-19 as above.
* * * * *
Securities and Exchange Commission
January 25, 2008
Page 15
We hope the above has been responsive to the Staff's comments. If you
have any questions or require any additional information or documents, please
telephone me at (818) 444-4502.
Sincerely,
/s/ John J. McIlvery
--------------------
John J. McIlvery
Encl.
cc: Lonnie Schnell, Company CFO
Adam Phippen, SEC Staff Accountant
Anita Karu, SEC Attorney-Adviser
Securities and Exchange Commission
January 25, 2008
Page 16
Attachment A
Materiality assessment of the impact of presentation errors in the
Company's 2006 Annual Report on Form 10-K, and in its
Quarterly reports on Form 10-Q for the periods ended March
31, 2007; June 30, 2007 and September 30, 2007.
Nature of the Accounting Error:
In the Company's 2006 Form 10-K, and the quarterly reports for the
periods ended March 31, 2007 and June 30, 2006, the Company presented
collections from a note receivable as cash flows from Financing
activities. The note receivable arose from a transaction that settled
long outstanding accounts receivable from a prior customer with the
receipt of a Note made by this customer and its affiliate with
scheduled payments and additional collateral. FASB 95 paragraph 22
denotes that cash inflows from Operating activities include "receipts
from collection or sale of accounts and both short-and long-term
receivable from customers arising from those sales." The accompanying
summary of Cash Reclassifications reflects the impact of these
collections as Item (A).
In the Company's 2006 Form 10-K, and the quarterly reports for the
periods ended March 31, 2007, June 30, 2006, and September 30, 2007 the
Company presented payments made on a note payable as cash flows from
Financing activities. The note payable arose from a transaction that
financed outstanding legal bills from the Company's legal counsel
through the issuance of a Note payable to this firm and pledged the
collections on the above note receivable for payment of this note. FASB
95 similarly denotes that cash outflows from Operating activities
include "payments on accounts and both short-and long-term notes
payable to suppliers for those materials or goods." The accompanying
summary of Cash Reclassifications reflects the impact of these payments
as Item (B).
The errors noted above are strictly presentation errors, limited
strictly to the Statement of Cash Flows for the periods noted. There is
no impact on the Balance Sheet presentation or amounts, and no impact
on the Statement of Operations, net earnings or per share amounts.
In the Statement of Cash Flows the net increase (decrease) in the cash
and cash equivalents for the period in not affected and the cash and
cash equivalents at the beginning or end of the periods is not
affected. The amounts of the note collections
Securities and Exchange Commission
January 25, 2008
Page 17
and the note payments are properly determined and there is no
cumulative effect of the errors compounding from the transactions.
The error is limited to the presentation of these amounts as Financing
vs. Operating activities and the respective sub-totals for these
amounts in the Statement of Cash Flows.
Quantitative Analysis:
For fiscal year 2006, correction of the above items would result in a
sub-category of cash flows from financing activities of $1,793,000 as
compared to the reported sub-category of $2,020,000. The sub-total of
cash used by financing activities would be $791,000 as compared to the
reported sub-total of $1,108,000. The variance, in each sub-category,
of $226,758 represents approximately 7.7% of the cash and cash
equivalents held at the period end.
The cash flow comparisons for the three, six and nine month periods for
fiscal year 2007 affected by these items are set out in the summary
below:
Variance
FROM OPERATIONS FROM FINANCING % of cash &
- ------------------------------ ----------------------------- cash
As Reported As Corrected As Reported As Corrected equivalents
- ----------- ------------ ----------- ------------ -----------
March 31, 2007
$ 845,727 $ 783,208 $ (152,108) $ (89,589) 1.9%
June 30, 2007
$ 1,776,085 $ 2,050,754 $ 9,126,318 $ 8,851,649 7.2%
Sept. 30, 2007
$ 1,322,834 $ 1,206,445 $(1,356,501) $(1,240,112) 5.0%
The Company's review of the materiality of the adjustments required
also examined the impact of the changes on various financial
performance ratios and measurements typically used by investor in
evaluating businesses. Attached for consideration is an exhibit to this
supplement of an expanded summary of the Selected Financial Data for
the four years 2003 through 2006 and for the three quarters of 2007.
The information
Securities and Exchange Commission
January 25, 2008
Page 18
normally required in the Selected Financial Data summary is not
impacted by the revisions and would be unchanged.
In this expanded version the Company has added the sub-categories from
the statement of cash flows as well as several cash flow related ratios
on both a reported and as adjusted basis to consider the possible
impact on the analyses an independent investor may consider.
As previously noted, there is no impact of the above adjustments on the
balance sheet or income statement. The majority of financial ratios
used by industry and investors stem from these two primary financial
statements, and accordingly none of the typical investor ratios are
impacted by the adjustments.
The Company's evaluation considered the key financial amounts typically
reviewed: Revenues - No Impact; Income from operations - no impact; net
income - no impact; net income per share - no impact; cash - no impact;
current assets - no impact; total assets - no impact; net equity - no
impact; net cash flow - no impact. The Company's review also considered
typical ratios and benchmarks: Working Capital - no impact; Working
Capital Ratio - no impact; Quick ratio - no impact; % net income to
Total Assets - no impact; % net income to Equity - no impact.
Additionally, less common ratios that may be affected were also
reviewed. The table below sets out the differences that result in these
ratios.
1st Qtr 2nd Qtr 3rd Qtr
2003 2004 2005 2006 2007 2007 2007
REPORTED
% Cash from
Operations to
Current
Liabilities -10.8% -101.9% 7.5% 9.0% 3.2% 7.3% 15.4%
CORRECTED
% Cash from
Operations to
Current
Liabilities -10.8% -101.9% 7.5% 8.0% 3.0% 8.4% 14.0%
REPORTED
% Cash from
Operations to
Debt -9.8% -43.4% 3.8% 8.4% 3.0% 5.2% 6.3%
CORRECTED
% Cash from
Operations to
Debt -9.8% -43.4% 3.8% 7.5% 2.8% 6.0% 5.8%
Securities and Exchange Commission
January 25, 2008
Page 19
Qualitative Analysis:
As documented in the SAB Topic 1 and FASB literature, and as defined by
courts (as quoted in SAB), an item is material if there is ...
"..a substantial likelihood that the ...fact would have been viewed by
the reasonable investor as having significantly altered the "total mix"
of information made available."
Given that the errors are isolated to the presentation of the
information between two sub-categories within the statement of cash
flows, and that the preponderance of financial benchmarks, ratios, and
performance measures are not affected by the adjustments; that the
misstatement does not mask a change or trend in performance; does not
hide a performance shortfall; does not affect a compliance or
contractual matter; and does not evidence or hide a pattern of
transactions or events, the Company has determined that the "total mix"
of information would not be materially different to an investor,
financial institution or reader of the Company's financial reports as a
consequence of these errors and accordingly it is the Company's
position that these errors are immaterial to the financial reports of
the Company.
Securities and Exchange Commission
January 25, 2008
Page 20
SUMMARY OF CHANGES IN STATEMENT OF CASH FLOW
CORRECTION OF ERROR IN REPORTING NOTE COLLECTIONS AND PAYMENTS
2 0 0 6
------------------------------------------------------------
FROM INVESTING FINANCING NET
OPERATIONS ACTIVITIES ACTIVITIES CASH
------------ ------------ ------------ ------------
FISCAL YEAR
As Filed ........................... $ 2,019,911 $ (344,688) $ (1,017,947) $ 657,276
Note receivable collections ... (A) 640,539 -- (640,539) --
Note payable payments ......... (B) (867,297) -- 867,297 --
------------ ------------ ------------ ------------
As Corrected ............. $ 1,793,153 $ (344,688) $ (791,189) $ 657,276
============ ============ ============ ============
$ Variance within each category $ (226,758) $ -- $ 226,758 $ --
2 0 0 7
------------------------------------------------------------
FROM INVESTING FINANCING NET
OPERATIONS ACTIVITIES ACTIVITIES CASH
------------ ------------ ------------ ------------
THREE MONTHS ENDING MARCH 31,
As Filed ........................... $ 845,727 $ (356,195) $ (152,108) $ 337,424
Note receivable collections ... (A) 331,656 -- (331,656) --
Note payable payments ......... (B) (394,175) -- 394,175 --
------------ ------------ ------------ ------------
As Corrected ............. $ 783,208 $ (356,195) $ (89,589) $ 337,424
============ ============ ============ ============
$ Variance within each category $ (62,519) $ -- $ 62,519 $ --
SIX MONTHS ENDING JUNE 30,
As Filed ........................... $ 1,776,085 $ (514,812) $ 9,126,318 $ 10,387,591
Note receivable collections ... (A) 671,808 -- (671,808) --
Note payable payments ......... (B) (397,139) -- 397,139 --
------------ ------------ ------------ ------------
As Corrected ............. $ 2,050,754 $ (514,812) $ 8,851,649 $ 10,387,591
============ ============ ============ ============
$ Variance within each category $ 274,669 $ -- $ (274,669) $ --
NINE MONTHS ENDING SEPTEMBER 30,
As Filed ........................... $ 1,322,834 $ (585,470) $ (1,356,501) $ (619,137)
Note receivable collections ... (A) -- -- -- --
Note payable payments ......... (B) (116,389) -- 116,389 --
------------ ------------ ------------ ------------
As Corrected ............. $ 1,206,445 $ (585,470) $ (1,240,112) $ (619,137)
============ ============ ============ ============
$ Variance within each category $ (116,389) $ -- $ 116,389 $ --
Securities and Exchange Commission
January 25, 2008
Page 21
SELECTED FINANCIAL DATA
(amounts in thousands, except per share amounts)
Year Ended December 31, 2007
-------------------------------------------- --------------------------------
2003 2004 2005 2006 1st Qtr 2nd Qtr 3rd Qtr
-------------------------------------------- --------------------------------
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Total revenue ............................... $ 64,443 $ 55,109 $ 47,331 $ 48,825 $ 9,090 $ 13,567 $ 9,013
Income (loss) from operations ............... $ (5,881) $(14,527) $(27,409) $ 1,021 (648) 835 (3,055)
% of revenue ........................... -9.1% -26.4% -57.9% 2.1% -7.1% 6.2% -33.9%
Net income (loss) ........................... $ (4,745) $(17,609) $(29,538) $ 309 (795) $ 490 (3,682)
% of revenue ........................... -7.4% -32.0% -62.4% 0.6% -8.7% 3.6% -40.9%
Net income (loss) per share - Diluted ....... $ (0.46) $ (1.02) $ (1.62) $ (0.02) $ (0.04) $ 0.03 $ (0.18)
Net income (loss) per share - basic ......... $ (0.46) $ (1.02) $ (1.62) $ (0.02) $ (0.04) $ 0.02 $ (0.18)
Weighted Average shares outstanding - basic . 10,651 17,316 18,226 18,377 18,533 18,591 20,041
Weighted Average shares outstanding - basic . 10,651 17,316 18,226 18,956 18,533 20,059 20,041
CONSOLIDATED BALANCE SHEET DATA:
Cash and cash equivalents ................... $ 14,443 $ 5,461 $ 2,277 $ 2,935 $ 3,272 $ 3,822 $ 2,319
Restricted cash ............................. -- -- -- -- -- 9,500 --
Current Assets .............................. 55,726 40,483 14,784 12,570 15,922 25,224 9,345
Total Assets ................................ 67,770 56,448 30,321 25,694 28,760 37,858 21,030
Current Liabilities ......................... 19,260 11,175 14,851 22,471 26,312 24,323 8,599
Capital lease obligations, line of credit
& notes payable ........................ 11,759 18,792 16,001 16,214 1,695 9,849 12,354
Convertible redeemable preferred stock ...... 2,895 -- -- -- 12,481 12,488 --
Total Liabilities ........................... 21,312 26,253 29,409 24,007 28,007 34,172 20,953
Stockholders' equity ........................ 43,564 30,195 912 1,686 753 3,686 77
Total Liabilities and stockholders' equity .. $ 67,770 $ 56,448 $ 30,321 $ 25,694 $ 28,760 $ 37,828 $ 21,030
Working Capital ............................. $ 36,466 $ 29,308 $ (67) $ (9,901) $(10,390) $ 901 $ 746
Working Capital Ratio ....................... 2.89 3.62 1.00 0.56 0.61 1.04 1.09
% net income to Total Assets ................ -7.0% -31.2% -97.4% 1.2% -2.8% 1.3% -17.5%
% net income to Stockholders' equity ........ -10.9% -58.3% -3238.8% 18.3% -105.6% 13.3% -4781.8%
PER SHARE DATA:
Net book value per common share ............. $ 3.79 $ 1.66 $ 0.05 $ 0.09 $ 0.04 $ 0.18 $ 0.00
Common shares outstanding ................... 11,508 18,171 18,241 18,466 18,541 20,041 20,041
CONSOLIDATED CASH FLOW DATA: 3 mos 6 mos 9 mos
--------------------------------
Net Cash Flow ............................... 14,157 (8,982) (3,183) 657 337 10,388 (619)
Cash flow from operations ................... (2,086) (11,382) 1,112 2,020 845 1,776 1,323
Cash flow from investing activities ......... (2,516) (3,616) (1,453) (345) (356) (514) (585)
Cash flow from financing activities ......... $ 18,759 $ 6,016 $ (2,842) $ (1,018) $ (152) $ 9,126 $ (1,357)
Quick Ratio (Cash & A/R / current liablities) 114.1% 209.0% 53.4% 33.8% 30.9% 40.6% 71.9%
% cash from Operations to current liabilities -10.8% -101.9% 7.5% 9.0% 3.2% 7.3% 15.4%
% cash from Operations to Debt .............. -9.8% -43.4% 3.8% 8.4% 3.0% 5.2% 6.3%
CONSOLIDATED CASH FLOW DATA (AS CORRECTED):
Net Cash Flow ............................... 14,157 (8,982) (3,183) 657 337 10,388 (619)
Cash flow from operations ................... (2,086) (11,382) 1,112 1,793 783 2,050 1,206
Cash flow from investing activities ......... (2,516) (3,616) (1,453) (345) (356) (514) (585)
Cash flow from financing activities ......... $ 18,759 $ 6,016 $ (2,842) $ (791) $ (90) $ 8,852 $ (1,240)
Quick Ratio (Cash & A/R / current liablities) 114.1% 209.0% 53.4% 33.8% 30.9% 40.6% 71.9%
% cash from Operations to current liabilities -10.8% -101.9% 7.5% 8.0% 3.0% 8.4% 14.0%
% cash from Operations to Debt .............. -9.8% -43.4% 3.8% 7.5% 2.8% 6.0% 5.8%
ATTACHMENT B
TALON INTERNATIONAL, INC.
ANNUAL REPORT ON FORM 10-K/A
================================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K/A
(AMENDMENT NO. 2)
[X] Annual Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2006
[_] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
Commission file number 1-13669
TAG-IT PACIFIC, INC.
(Exact Name of Registrant as Specified in Its Charter)
DELAWARE 95-4654481
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
21900 BURBANK BLVD., SUITE 270
WOODLAND HILLS, CALIFORNIA 91367
(Address of Principal Executive Offices) (Zip Code)
(818) 444-4100
(Registrant's Telephone Number, Including Area Code)
Securities registered pursuant to Section 12(b) of the Act:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
------------------- -----------------------------------------
COMMON STOCK, $.001 PAR VALUE AMERICAN STOCK EXCHANGE
Securities registered pursuant to Section 12(g) of the Act:
NONE
Indicate by check mark if the registrant is a well-known seasoned issuer, as
defined in Rule 405 of the Securities Act.
Yes [_] No [X]
Indicate by check mark if the registration is not required to file reports
pursuant to Section 13 or Section 15(d) of the Act. Yes [_] No [X]
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 past 90 days.
Yes [X] No [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K [_]
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer or a non-accelerated filer (as defined in Rule 12b-2 of the
Exchange Act).
Large accelerated filer [_] Accelerated filer [_] Non-accelerated filer [X]
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Act). Yes [_] No [X]
At June 30, 2006 the aggregate market value of the voting and non-voting common
stock held by non-affiliates of the registrant was $12,147,000. At April 10,
2007 the issuer had 18,466,433 shares of Common Stock, $.001 par value, issued
and outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
None.
================================================================================
EXPLANATORY NOTE
This Amendment No. 2 to Form 10-K on Form 10-K/A (this "Amendment")
amends Talon International, Inc.'s (formerly, Tag-It Pacific, Inc.) (the
"Company") Annual Report on Form 10-K for the fiscal year ended December 31,
2006, originally filed on April 12, 2007, and amended by Amendment No. 1 to Form
10-K on Form 10-K/A filed on April 30, 2007 (as amended, the "Original Filing").
The Company is filing this Amendment to amend the disclosure contained in Item
3, Item 6, Item 7, Item 8, Item 9A and Item 15 of the Original Filing.
Except as described above, no other changes have been made to the
Original Filing. This Amendment continues to speak as of the date of the
Original Filing, and the Company has not updated the disclosures contained
therein to reflect any events which occurred at a date subsequent to the filing
of the Original Filing. In this Amendment, unless the context indicates
otherwise, the terms "Company," "we," "us," and "our" refer to Talon
International, Inc. and its subsidiaries.
1
ITEM 3. LEGAL PROCEEDINGS
On October 12, 2005, a shareholder class action complaint-- HUBERMAN V.
TAG-IT PACIFIC, INC., ET AL., Case No. CV05-7352 R(Ex)--was filed against us and
certain of our current and former officers and directors in the United States
District Court for the Central District of California alleging claims under
Section 10(b) and Section 20 of the Securities Exchange Act of 1934, as amended,
and Rule 10b-5 promulgated thereunder. The action is brought on behalf of all
purchasers of our publicly-traded securities during the period from November 14,
2003 to August 12, 2005. On January 23, 2006 the court heard competing motions
for appointment of lead plaintiff/counsel and appointed Seth Huberman as lead
plaintiff. The lead plaintiff thereafter filed an amended complaint on March 13,
2006. The amended complaint alleges that defendants made false and misleading
statements about the company's financial situation and its relationship with
certain of its large customers during a purported class period between November
13, 2003 and August 12, 2005. It purports to state claims under Section
10(b)/Rule 10b-5 and Section 20(a) of the Securities Exchange Act of 1934. The
Company filed a motion to dismiss the amended complaint, which motion was denied
by the court on July 17, 2006. On December 21, 2006 the court established a
trial date of May 1, 2007 and ordered completion of discovery by March 19, 2007.
On February 20, 2007 the court denied class certification. Plaintiff has moved
the court to reconsider the ruling, and also to intervene a new plaintiff to
pursue class certification. Both of those motions were denied on April 2, 2007.
In addition, the same day, the Court granted Defendants' motion for summary
judgment, and it is anticipated that the Court will enter a judgment in favor of
all Defendants shortly. It is possible that Plaintiff will appeal the summary
judgment and class certification rulings. We believe that this matter will be
resolved in trial or in settlement within the limits of our insurance coverage,
however the outcomes of this action or an estimate of the potential losses, if
any, related to the lawsuit cannot be reasonably predicted, and an adverse
resolution of the lawsuit could potentially have a material adverse effect on
our financial position and results of operations.
On April 16, 2004 we filed suit against Pro-Fit Holdings, Limited
("Pro-Fit") in the U.S. District Court for the Central District of California --
TAG-IT PACIFIC, INC. V. PRO-FIT HOLDINGS, LIMITED, CV 04-2694 LGB (RCx) --
asserting various contractual and tort claims relating to our exclusive license
and intellectual property agreement with Pro-Fit, seeking declaratory relief,
injunctive relief and damages. It is our position that the agreement with
Pro-Fit gives us the exclusive rights in certain geographic areas to Pro-Fit's
stretch and rigid waistband technology. On September 17, 2004, Pro-Fit filed an
answer denying the material allegations of the complaint and filed counterclaims
alleging various contractual and tort claims seeking injunctive relief and
damages. We filed a reply denying the material allegations of Pro-Fit's
pleading. Pro-Fit has since purported to terminate the exclusive license and
intellectual property agreement based on the same alleged breaches of the
agreement that are the subject of the parties' existing litigation, as well as
on an additional basis. On February 9, 2005, and again on June 16, 2005, we
amended our pleadings in the litigation to assert additional breaches by Pro-Fit
of its obligations under the agreement and under certain additional letter
agreements, and for a declaratory judgment that Pro-Fit's patent No. 5,987,721
is invalid and not infringed by us. Thereafter, Pro-Fit filed an amended answer
and counterclaims denying the material allegations of the amended complaint and
alleging various contractual and tort claims seeking injunctive relief and
damages. Pro-Fit further asserted that we infringed its United States Patent
Nos. 5,987,721 and 6,566,285. We filed a reply denying the substantive
allegations of the amended counterclaims. On June 5, 2006 the Court denied our
motion for partial summary judgment holding that summary adjudication that we
did not breach our agreement with Pro-Fit by engaging in certain activities in
Columbia was not appropriate. The Court also held that Pro-Fit was not
"unwilling or unable" to fulfill orders by refusing to fill orders with goods
produced in the United States. The Court did not find that we breached our
agreement with Pro-Fit and a trial is required to determine issues concerning
our activities in Columbia and whether other actions by Pro-Fit constituted an
unwillingness or inability to fill orders. As a result of a change in the law,
we dismissed our antitrust claims against Pro-Fit. The court has not yet set a
date for trial of this matter. We have derived a significant amount of revenue
from the sale of products incorporating the stretch waistband technology, and
our business, results of operations and financial condition could be materially
adversely affected if the dispute with Pro-Fit is not resolved in a manner
favorable to us. Additionally, we have incurred significant legal fees in this
2
litigation, and unless the case is settled, we will continue to incur additional
legal fees in increasing amounts as the case accelerates to trial.
We have agreements with our foreign subsidiaries that provide for
royalty payments to the U.S. parent company for the sales of products carrying
the TALON(R) brand name, and that also provide for a cost sharing arrangement
associated with various corporate administrative and operations support costs.
These agreements may give rise to inquiries and possible disputes by the foreign
taxing authority, resulting in the possible disallowance of some of these costs
and potentially resulting in higher foreign income taxes than has been provided.
We believe that our basis of charging these royalties and its allocation of
costs to foreign subsidiaries is appropriate under the various taxing agency
laws, and that any disagreement or disallowance regarding such costs will not
have a material affect on the financial statements of the Company. A subsidiary,
Tag-It de Mexico, S.A. de C.V., has operated under the Mexican government's
Maquiladora Program, which entitles Tag-It de Mexico to certain favorable
treatment as respects taxes and duties regarding certain imports. In July of
2005, the Mexican Federal Tax Authority asserted a claim against Tag-It de
Mexico alleging that certain taxes had not been paid on imported products during
the years 2000, 2001, 2002 and 2003. In October of 2005, we filed a procedural
opposition to the claim and submitted documents to the Mexican Tax Authority in
opposition to this claim, supporting our position that the claim was without
merit. The Mexican Federal Tax Authority failed to respond to the opposition
filed, and the required response period by the Tax Authority has lapsed. In
addition, a controlled entity incorporated in Mexico (Logistica en Avios, S.A.
de C.V.) through which we conducted our operations in 2005, may be subjected to
a claim or claims from the Mexican Tax Authority, as identified directly above,
and additionally to other tax issues, including those arising from employment
taxes. We believe that any such claim is defective on both procedural and
documentary grounds and is without merit. An estimate of the possible loss or
range of loss if any associated with these matters cannot be made at this time.
We do not believe these matters will have a material adverse affect on us.
We currently have pending a number of other claims, suits and
complaints that arise in the ordinary course of our business. We believe that we
have meritorious defenses to these claims and that the claims are either covered
by insurance or, after taking into account the insurance in place, would not
have a material effect on our consolidated financial condition if adversely
determined against us.
3
PART II
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data is not necessarily indicative of
our future financial position or results of future operations, and should be
read in conjunction with Item 7, "Management's Discussion and Analysis of
Financial Condition and Results of Operations" and the Consolidated Financial
Statements and Notes thereto included in Item 8, "Financial Statements and
Supplementary Data" of this Report on Form 10-K.
YEARS ENDED DECEMBER 31,
(In thousands except per share data)
2002 2003(1) 2004(1,2) 2005(1) 2006
------------ ---------- ----------- ----------- --------------
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Total revenue...................................... $ 60,073 $ 64,443 $ 55,109 $ 47,331 $ 48,825
Income (loss) from operations...................... $ 3,044 $ (5,881) $ (14,482) $ (27,098) $ 1,332
Net income (loss).................................. $ 1,496 $ (4,745) $ (17,609) $ (29,538) $ 309
Net income (loss) per share - basic................ $ 0.14 $ (0.46) $ (1.02) $ (1.62) $ 0.02
Net income (loss) per share - diluted.............. $ 0.14 $ (0.46) $ (1.02) $ (1.62) $ 0.02
Weighted average shares outstanding - basic........ 9,232 10,651 17,316 18,226 18,377
Weighted average shares outstanding - diluted...... 9,531 10,651 17,316 18,226 18,956
CONSOLIDATED BALANCE SHEET DATA:
Cash and cash equivalents.......................... $ 285 $ 14,443 $ 5,461 $ 2,277 $ 2,935
Total assets....................................... $ 54,055 $ 67,770 $ 56,448 $ 30,321 $ 25,694
Capital lease obligations, line of credit and notes
payable ........................................ $ 21,263 $ 11,759 $ 18,792 $ 16,001 $ 16,214
Convertible redeemable preferred stock............. $ 2,895 $ 2,895 $ - $ - $ -
Stockholders' equity............................... $ 18,467 $ 43,564 $ 30,195 $ 912 $ 1,686
Total liabilities and stockholders' equity......... $ 54,055 $ 67,770 $ 56,448 $ 30,321 $ 25,694
PER SHARE DATA:
Net book value per common share.................... $ 1.98 $ 3.79 $ 1.66 $ 0.05 $ 0.09
Common shares outstanding.......................... 9,320 11,508 18,171 18,241 18,466
- ----------------------
(1) We incurred restructuring costs of $6.4 million, $.4 million, and $7.7
million during the years ended December 31, 2005, 2004 and 2003, respectively.
(2) We incurred net charges of $4.3 million from the write-off of obligations
due from a former major customer and other fourth quarter adjustments totaling
$9.5 million during the year ended December 31, 2004.
4
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
The following management's discussion and analysis is intended to
assist the reader in understanding our consolidated financial statements. This
discussion is provided as a supplement to, and should be read in conjunction
with, our consolidated financial statements and accompanying notes.
Tag-It Pacific, Inc. designs, sells, manufactures and distributes
apparel zippers, specialty waistbands and various apparel trim products to
manufacturers of fashion apparel, specialty retailers and mass merchandisers. We
sell and market these products under various branded names including TALON and
TEKFIT. We operate the business globally under three product groups.
We plan to increase our global expansion of TALON zippers through the
establishment of a network of Talon owned sales, distribution and manufacturing
locations, distribution relationships and joint ventures. The network of these
distributors and manufacturing joint ventures, in combination with TALON owned
and affiliated facilities under the TALON brand, is expected to improve our
time-to-market by eliminating the typical setup and build-out phase for new
manufacturing capacity throughout the world, and by sourcing, finishing and
distributing to apparel manufacturers in their local markets.
We have structured our trim business to focus as an outsourced product
development, sourcing and sampling department for the most demanding brands and
retailers. We believe that trim design differentiation among brands and
retailers has become a critical marketing tool for our customers. By assisting
our customers in the design, development, sampling and sourcing of trim, we
expect to achieve higher margins for our trim products, create long-term
relationships with our customers, grow our sales to a particular customer by
supplying trim for a larger proportion of their brands, and better differentiate
our trim sales and services from those of our competitors. We plan to
aggressively expand our trim business globally, so we may better serve our
apparel factory customers in the field, in addition to our brand and retail
customer. We believe we can lead the industry in trim sourcing by having both an
intimate relationship with our brand and retail customers, and having a
distributed service organization to serve our factory customers (those that
manufacture for the apparel brand and retailers) globally.
Our TEKFIT services provide manufacturers with the patented technology,
manufacturing know-how and materials required to produce pants incorporating an
expandable waistband. These products were previously produced by several
manufacturers for one single brand. In October 2006 our exclusive supply
contract with this brand expired. With the expiration of this exclusive contract
we now have broader access to other customers and we intend to actively expand
this product offering to other brands. Orders have already been placed by a new
brand customer in October 2006 as a result of these efforts. However sales to
the previous brand are expected to decline significantly in 2007 and orders from
new brands are not expected to fully offset these declines in the near term.
Consequently, we expect sales and earnings contributions from this product line
to decline significantly for at least the first half of 2007; though we believe
our sales of this product will grow subsequently as we market our products to
new customers throughout the year.
Our efforts to expand this product offering to other customers have
also been limited by a licensing dispute. As described more fully in this report
under Item 3. "Legal Proceedings", we are presently in litigation with Pro-Fit
Holdings Limited related to our exclusively licensed rights to sell or
sublicense stretch waistbands manufactured under Pro-Fit's patented technology.
The revenues we derive from the sale of products incorporating the
stretch waistband technology, represented approximately 19% of our consolidated
revenues for the years ended December 31, 2006 and 2005, and 25% in 2004;
accordingly the results of operations and financial condition could be
materially adversely affected if our dispute with Pro-Fit is not resolved in a
manner favorable to us, or if we are unsuccessful in securing new customers to
replace the revenues previously generated by the single brand.
5
In an effort to better align our organizational and cost structures
with its future growth opportunities, in August 2005 our Board of Directors
adopted a restructuring plan that was substantially completed by December 31,
2005. The plan included restructuring our global operations by eliminating
redundancies in our Hong Kong operation, closing our facilities in Mexico, and
closing our North Carolina manufacturing facility. We have also refocused our
sales efforts on higher margin products, which may result in lower net sales
initially as we focus on acquiring high quality customers, and decrease our
customer concentration. As a result of this restructuring, we now operate with
fewer employees and will have lower associated operating and distribution
expenses.
During 2005, we recorded charges in connection with this restructuring
plan in accordance with SFAS No. 146 (as amended), "Accounting for Costs
Associated with Exit or Disposal Activities." In addition, the restructuring
plan resulted in the carrying value of certain long-lived assets, primarily
equipment, being impaired. Accordingly, in 2005 we recorded a charge to
recognize the impairment of these assets in accordance with SFAS No. 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets."
Our North Carolina manufacturing facility has been classified as "Fixed
assets held for sale" in our consolidated financial statements. Management has
committed to sell the asset and has listed the property for sale with a
commercial real estate agent. We believe the sale of the asset is probable and
that the sale is expected to be completed within one year. The major components
of manufacturing equipment used in this plant to manufacture zippers are not
classified as assets held for sale since management intends to re-deploy this
equipment in the manufacture of TALON zippers through investment or sale of this
equipment to distributors of TALON zippers. This equipment is separately
identified as idle equipment as a component of "Property and Equipment". See
"Notes to consolidated financial statements," Note 1.
Restructuring costs recorded in the third quarter of 2005 were $6.2
million. Additional restructuring costs of $0.2 million were incurred in the
fourth quarter of 2005. Total restructuring costs in 2005 were $6.4 million.
These costs include $3.4 million of inventory write-downs charged to cost of
goods sold; $2.2 million for the impairment of long-lived assets (primarily
machinery and equipment), $0.2 million of one-time employee termination benefits
and other costs of $0.2 million which were charged to operating expenses. In
addition, an impairment charge to goodwill of $0.4 million was recorded. This
goodwill was associated with an acquisition made to benefit our Central and
South American operations. Since these operations were closed during 2005, the
goodwill was impaired and written off. As a result of the restructuring, the
Company expected to reduce general and administrative operating costs by
approximately 25% to 30%, or $5.0 to $6.0 million on an annualized basis.
Initial savings anticipated during the fourth quarter of 2005 were expected to
be approximately $1.0 million offset by $0.8 million in costs to implement the
restructuring including a $0.4 million write-off of goodwill. During fiscal year
2006 general and administrative expense savings, principally as a result of the
restructuring, were approximately $4.4 million. The initial savings were
slightly less than anticipated in the restructuring plan due to necessary
outside consulting and temporary employee costs occurring due to the staff
reductions. During the first quarter of 2004, we incurred and recorded residual
restructuring charges of $0.4 million from a restructuring plan implemented in
2003.
In 2004, following negotiations with Tarrant Apparel Group, a former
customer, we determined that a significant portion of the obligations due from
this customer were uncollectible. Accordingly, included in general and
administrative expenses for 2004 are charges of $4.3 million related primarily
to the write-down of this receivable and leaving a remaining balance receivable
from this customer of $4.5 million. An affiliate of the customer repaid the $4.5
million receivable balance over the period from May through December 2005. In
addition to this $4.3 million write-down in 2004, we also recorded an accounts
receivable reserve of $5.0 million (or 9.1% of net sales) in the fourth quarter
of 2004 based on management's estimate of the collectibility of accounts
receivable primarily related to two other customers.
Our bad debt expense for the year ended December 31, 2005 includes
reserves of $3.6 million recorded in the second quarter of 2005 based on
management's estimate at the time of the collectibility of accounts receivable
from one customer. The fourth quarter of 2005 includes charges of $0.6 million
6
representing the present value discount of a subsequent note received in 2006 in
exchange for that same customer's accounts receivable. Bad debt expense also
includes a write-off in the third quarter of $1.8 million principally associated
with a single customer.
In connection with our 2005 restructuring plan, we recorded an
inventory write-down of $3.4 million in the third quarter of 2005. During the
fourth quarter of 2004, we recorded inventory write-downs totaling $2.5 million
based on management's estimate of the net realizable value of certain
inventories.
In 2004, we incurred net operating losses and increased our valuation
allowance for deferred tax assets to reduce our net deferred tax asset from $2.8
million to $1.0 million. The decrease in the net deferred tax asset resulted in
a charge of $1.8 million against the provision for income taxes in the fourth
quarter of 2004. In 2005, we further reduced the net carrying value of the
deferred tax asset to zero, resulting in an addition to the provision for income
taxes of $1.0 million for the year ended December 31, 2005.
RESULTS OF OPERATIONS
NET SALES
For the years ended December 31, 2006, 2005, and 2004, total sales by
geographic region based on customer delivery locations were as follows (amounts
in thousands):
2006 CHANGE 2005 CHANGE 2004
------- ------- ------- ------- -------
United States ............ $ 5,287 (41)% $ 8,903 85% $ 4,823
Asia ..................... 28,975 45 20,005 57 12,786
Mexico ................... 2,476 (71) 8,526 (60) 21,453
Dominican Republic ....... 9,138 54 5,915 (39) 9,678
Other .................... 2,949 (26) 3,982 (38) 6,369
------- ------- ------- ------- -------
Total ................ $48,825 3% $47,331 (14)% $55,109
======= ======= ======= ======= =======
The net revenues for the three primary product groups is as follows:
Year Ended December 31,
-------------------------------------------
2006 2005 2004
----------- ----------- -----------
Product Group Net Revenue:
Talon zipper .............. $17,005,203 $13,593,479 $12,712,689
Trim ...................... 22,502,947 24,788,397 28,805,347
Tekfit .................... 9,316,852 8,949,300 13,591,445
----------- ----------- -----------
$48,825,002 $47,331,176 $55,109,481
=========== =========== ===========
Sales are influenced by a number of factors, including demand, pricing
strategies, foreign exchange effects, new product launches and indications,
competitive products, product supply, and acquisitions. See Item 1 "Business"
for a discussion of our principal products.
Sales in 2006 increased modestly from 2005 as a net result of a
substantial decline within selected markets offset by large increases in other
geographical markets. Sales, principally of Trim products, to customers in
Mexico declined sharply in 2006 from 2005 ($6.0 million) as the industry shift
of apparel production from Latin America to Asia continued from 2005, from the
discontinuance of approximately $4.0 million in sales of products from 2005, and
as we completed the closure of our assembly and distribution operations within
Mexico. Total Trim product sales declined by approximately $2.3 million in 2006
as compared to 2005 as a consequence of the reductions from Mexico and the U.S.
described above offset by increased sales in Asia and the Dominican Republic
resulting mainly from the shift in industry trends. Sales of TALON products to
7
customers within the U.S. also declined significantly (approximately $3.6
million) as a result of the industry shift of apparel production and as a result
of our closure of our manufacturing facility in North Carolina during the third
quarter of 2005. The decline of Talon product sales from the North and Central
American regions was substantially offset by the shifting of this production to
manufacturers within Asia, and our expansion of operations with customers in
this region, resulting in a net increase in Talon product sales for 2006 over
2005 of approximately $3.4 million. Additionally, expanded demand by our
exclusive customer for the TEKFIT waistband also resulted in an increase of
approximately $0.4 million in 2006 over 2005 in our sales to the Dominican
Republic, where the principal manufacturers of this product are located, and
sales of Trim products into this region increased as key customer sales shifted
out of the Mexico marketplace to this region. Sales within Other geographical
regions also reflect the worldwide shifting of apparel production to Asia.
The net decrease of sales in 2005 was primarily due to a decrease in
sales to our customers in Mexico of Trim products and, to a lesser extent, TALON
zippers, resulting from the industry shift of apparel production from Latin
America to Asia, and due to the restructuring in the third quarter of 2005 which
disrupted sales in the Mexico regions as we prepared for a shift of operations
to Asia. Sales in Asia of our Trim products and Talon zippers increased
significantly during 2005 partially offsetting the declines from the Mexico and
the Latin American regions for the Trim products and resulting in a net gain in
Talon product sales overall. We responded to these market changes in 2005 with
the implementation of a restructuring plan that included reducing our operations
in Mexico and focusing our efforts on the market in Asia. Sales of our TEKFIT
waistband decreased in 2005 because of lower demand from our exclusive customer
for this product. During 2005, we continued our plan to decrease reliance on two
significant customers in Mexico. These two customers contributed approximately
$7.7 million or 16.3% of revenues for the year ended December 31, 2005.
COST OF GOODS SOLD AND SELECTED OPERATING EXPENSES
The following table summarizes cost of goods sold and selected
operating expenses for the years ended December 31, 2006, 2005, and 2004
(amounts in thousands):
2006 CHANGE 2005 CHANGE 2004
-------- -------- -------- -------- --------
Sales ............................ $ 48,825 3% $ 47,331 (14)% $ 55,109
-------- -------- -------- -------- --------
Cost of goods sold ............... 34,356 (27)% 47,070 5% 44,814
% of sales ................... 70% -- 99% -- 81%
-------- -------- -------- -------- --------
Selling expenses ................. 2,778 (5)% 2,929 1% 2,899
% of sales ................... 6% -- 6% -- 5%
-------- -------- -------- -------- --------
General and administrative expense 10,873 (32)% 16,098 23% 13,047
% of sales ................... 22% -- 34% -- 24%
-------- -------- -------- -------- --------
Bad debt expense (recoveries) .... (513) (109)% 5,858 (30)% 8,416
-------- -------- -------- -------- --------
1% -- 12% -- 15%
-------- -------- -------- -------- --------
Restructuring charges ............ 0 (100)% 2,474 496% 415
% of sales ................... 0% -- 5% -- 1%
-------- -------- -------- -------- --------
COST OF GOODS SOLD
Cost of goods sold for the year ended December 31, 2006 declined 27%
from 2005 as the result of a number of the actions we implemented in connection
with our 2005 restructuring plan, and as a result of our focus on higher margin
product sales and continued efforts to reduce costs worldwide. Cost of goods
sold in 2006 declined by approximately $4.8 million (10.3%) from 2005 as a
result of higher direct margins on products sold; by approximately $1.9 million
(4.0%) from lower freight & duty charges as a result of relocating our
operations closer to our customers in Asia; by a reduction in inventory
adjustments and obsolescence of $1.6 million (3.5%) due primarily to inventories
8
located at our Mexico production operations; by the elimination of $3.4 million
(7.3%) in restructuring charges incurred in 2005; and by approximately $1.8
million (3.8%) from reductions in manufacturing and overhead charges as a result
of reduced employee related costs and operating expenses of our North Carolina
and Mexico operations; offset by increases of approximately $0.8 million (1.8%)
on higher sales volumes.
Cost of goods sold increased 5% for the year ended December 31, 2005
primarily due to a $3.4 million (7.7%) write-down of inventory in connection
with the 2005 restructuring plan, and an increase in our inventory obsolescence
reserve of $2.1 million (4.7%), including $0.5 million in the fourth quarter of
2005. Cost of sales also increased as a percentage of sales due to unabsorbed
overhead costs incurred in our North Carolina manufacturing facility and charges
of approximately $0.2 million (0.5%) associated with unrealized charge-backs
recorded in the second quarter of 2005 and $0.6 million (1.3%) in credits issued
to customers during the first quarter for defective products received from a
major supplier. Cost of goods sold declined by approximately $4.1 million (9.1%)
as a result of the decline in revenue from 2004 to 2005.
Cost of goods sold for the year ended December 31, 2004, included
inventory write-downs totaling $2.7 million (5% of net sales) recorded in the
fourth quarter of 2004 based on management's estimate of the net realizable
value of certain inventory.
SELLING EXPENSES
Selling expense for the year ended December 31, 2006 decreased $0.2
million (5.0%) from 2005 as a result of lower travel and entertainment costs of
$0.3 million; lower legal costs of $0.3 million; and other employee benefit and
administrative cost reductions of approximately $0.1 million; offset by
increases in sales commissions of approximately $0.3 million and increased
spending for sales and marketing programs of $0.2 million. Selling expenses
increased 1.0% for the year ended December 31, 2005 because we were unable to
reduce expenses in direct proportion to the decrease in sales. In 2004, selling
expenses represented 5% of net sales, and included $0.4 million in royalty
expense related to the intellectual property rights agreement with Pro-Fit.
GENERAL AND ADMINISTRATIVE EXPENSES
General and administrative expenses for the year ended December 31,
2006 decreased $5.2 million or 32% from 2005. $0.5 million of the reduction from
2005 was the result of the write-off of goodwill primarily associated with
closed operations;, reductions in legal costs by $1.9 million principally as a
reduction of our costs associated with the ProFit litigation; lower employee and
benefit costs by $1.9 million from reduced employment levels; reduced facility
costs of $0.6 million; and reductions in other administrative and travel costs
of $1.4 million; offset by approximately $0.7 million in increased professional
and audit fees as we changed auditors and utilized more professional consultants
in lieu of full time regular employees; and stock based compensation expense of
$0.4 million associated with the implementation of FAS 123(R).
General and administrative expenses increased approximately $3.0
million (23%) in 2005 compared to 2004. This increase in general and
administrative expenses resulted from higher legal expenses of approximately
$3.5 million related primarily to the Pro-Fit litigation, and an impairment
charge to goodwill of $0.5 million incurred in connection with the 2005
restructuring plan; offset by reductions of approximately $1.0 million
associated with lower employment levels and related costs in connection with the
restructuring plan.
Included in general and administrative expenses for the year ended
December 31, 2004 are charges of $4.3 million related primarily to the
write-down of receivables due from one customer. We also recorded an accounts
receivable reserve of $5.0 million (or 9% of net sales) in the fourth quarter of
2004 based on management's estimate of the collectibility of accounts receivable
primarily related to two other customers. In the first quarter of 2004, we
incurred additional restructuring charges of $0.4 million related to the final
residual costs associated with our restructuring plan implemented in the fourth
quarter of 2003.
9
BAD DEBT EXPENSE
Bad debt expenses for the year ended December 31, 2006 reflected a net
recovery of $0.5 million as compared to bad debt expenses of $5.9 million for
the year ended December 31, 2005. The bad debt recoveries in 2006 represent
collections of accounts written-off in prior years as uncollectible, and the
2005 expense is primarily related to outstanding unsettled receivables from a
former customer. Bad debt expense in 2004 were $8.4 million, and include charges
of $4.3 million related primarily to the write-down of receivables due from one
customer; recovery of approximately $1.4 associated with a customer account
written-off in 2003 and settled in 2004; and provisions of $5.5 million ($5.0
million, or 9% of net sales, recorded in the fourth quarter of 2004 based on
management's estimate of the collectability of accounts receivable primarily
related to two other customers).
RESTRUCTURING CHARGES
Restructuring costs in 2005 were the result of the adoption of our 2005
restructuring plan. Restructuring costs recorded in the third quarter of 2005
were $6.2 million. Additional costs of $0.2 million were incurred in the fourth
quarter of 2005. Total restructuring costs of $6.4 million were recorded in the
Consolidated Statement of Operations for the year ended December 31, 2005 as
follows (in millions):
Cost of goods sold ........................ $ 3.4
Operating expenses:
General & administrative expenses ...... 0.5
Restructuring charges .................. 2.5
------
Total restructuring costs ................. $ 6.4
======
During the first quarter of 2004, we incurred restructuring charges of
$0.4 million for final residual costs associated with our 2003 restructuring
plan.
INTEREST EXPENSE AND INTEREST INCOME
Interest expense of $1,357,000 for the year ended December 31, 2006
decreased approximately $89,000 from $1,446,000 during 2005 as a result of lower
average debt levels in 2006 compared to 2005. For both years ended December 31,
2006 and 2005, interest expenses included $311,000 in amortized deferred
financing charges related primarily to the secured convertible notes payable.
Interest income for the year ended December 31, 2006 of $368,000 increased
approximately $302,000 from $66,000 during 2005 related primarily to the note
receivable discussed in Note 2 to the consolidated financial statements.
Interest expense increased for the year ended December 31, 2005
approximately $594,000 (or 64%) to $1,446,000 from $882,000 for 2004. The
increase in interest expense was primarily due to higher debt levels associated
with the $12.5 million 6% secured convertible notes payable dated November 2004,
the $0.8 million 6.5% mortgage note payable to First National Bank dated June
2004, and the $0.9 million 6.5% equipment note payable to First National Bank
dated November 2004 which were outstanding for the entire year in 2005 compared
to a partial year in 2004; partially offset by the repayment of a remaining $1.4
million due pursuant to a note payable and a reduction in amounts due to factor
in 2005. Included in interest expense for the years ended December 31, 2005 and
2004 was $311,000 and $45,000, respectively, in amortized deferred financing
charges related primarily to the secured convertible notes payable. Interest
income for the years ended December 31, 2005 and 2004 was $66,000 and $32,000,
respectively.
INCOME TAXES
Income tax provisions for the year ended December 31, 2006 principally
include a royalty tax from the Inland Revenue Department in Hong Kong applicable
to 2005, net of an estimated tax benefit for 2006 foreign losses and minimum
federal and state filing fees.
10
The provision for income taxes for the year ended December 31, 2005
principally reflects the elimination of the net deferred tax asset in 2005 of
$1.0 million, and estimated foreign taxes. Based on the Company's net operating
losses, there is not sufficient evidence to determine that it is more likely
than not that the Company will be able to utilize its net operating loss carry
forwards to offset future taxable income.
The provision for income taxes was $2.3 million for the year ended
December 31, 2004 .The income tax provision primarily reflects a charge of $1.8
million as a result of a decrease in the value of net deferred tax assets, and
foreign income taxes of $0.5 million on foreign earnings.
LIQUIDITY AND CAPITAL RESOURCES
The following table summarizes selected financial data (amounts in
thousands):
DECEMBER 31, DECEMBER 31,
2006 2005
------------ ------------
Cash and cash equivalents ........................ $ 2,935 $ 2,277
Total assets ..................................... 25,694 30,321
Current debt ..................................... 22,471 14,851
Non-current debt ................................. 1,536 14,558
Stockholders' equity ............................. 1,686 912
CASH AND CASH EQUIVALENTS
Our cash is held with financial institutions. Substantially all of the
balances at December 31, 2006 and 2005 are in excess of federally insured
limits. As of December 31, 2006 and 2005 we had restricted cash balances of
$50,000 related to cash collateral for a letter of credit with Wells Fargo Bank.
FINANCING ARRANGEMENTS
The Company currently does not have an active financing arrangement to
provide for working capital requirements and cash provided by operating
activities is our only recurring source of funds. We financed building, land and
equipment purchases through notes payable and capital lease obligations expiring
through June 2011. These obligations bear interest at rates of 6.5% and 6.6% per
annum, and under these obligations, we are required to make monthly payments of
principal and interest. In June 2006 we entered into a note payable with our
legal counsel in exchange for legal fees outstanding to this firm related to our
Pro-Fit litigation. The note agreement provides for monthly payments against the
note in amounts equal to payments we receive from our note receivable until such
time as the note is paid in full. The note receivable is fully pledged as
collateral against this note payable.
A factoring agreement for the purchase of eligible receivables from our
Hong Kong subsidiary exists with East Asia Heller, wherein the factor purchases
our eligible accounts receivable and may assume the credit risk with respect to
those accounts for which the factor has given its prior approval. If the factor
does not assume the credit risk for a receivable, the collection risk associated
with the receivable remains with us. The agreement provides for us to pay a
fixed commission rate and for us to borrow up to 80% of eligible accounts
receivable. Interest is charged at 1.5% over the Hong Kong Dollar prime rate.
However, during 2005 and 2006 the factor declined to advance funds to us under
this agreement. Accordingly, no outstanding advances as of December 31, 2006 and
2005 existed.
In 2005, we entered into a letter of credit with Wells Fargo Bank. This
letter of credit provides for a maximum of $50,000, expires in June 2007 and is
secured by cash on hand managed by Wells Fargo Bank. At December 31, 2006,
outstanding letters of credit under the Wells Fargo facility were $50,000. This
letter is pledged as collateral for a bond posted in connection with our
litigation with Todo Textile, S. A. in which a settlement agreement was reached
11
in 2006. Upon release of the bond held by the court in this matter, the letter
of credit will be released and the settlement amount of $40,000 paid from the
proceeds.
The outstanding balance of our demand notes payable to related parties
at December 31, 2006 and 2005 was $665,000. Included is a $500,000 convertible
secured promissory note payable with interest at 11% payable quarterly. The note
is due on demand and is convertible into common stock at the election of the
holder at a rate of $4.50 per share. The remaining demand notes totaling
$165,000 bear interest at 0%-10%, have no scheduled monthly payments, and are
due within fifteen days from demand.
CASH FLOWS
The following table summarizes our cash flow activity for the years
ended December 31, 2006, 2005, and 2004 (amounts in thousands):
2006 2005 2004
-------- -------- --------
Net cash provided by (used in) operating activities $ 1,794 $ 1,112 $(11,382)
Net cash used in investing activities .............. (345) (1,454) (3,616)
Net cash provided by (used in) financing activities (791) (2,841) 6,016
Net increase (decrease) in cash and cash equivalents 657 (3,183) (8,982)
OPERATING ACTIVITIES
Cash and cash equivalents for the year ended December 31, 2006
increased by $0.7 million from December 31, 2005 principally arising from cash
generated by operating activities, net of payments on notes payable and capital
leases.
Cash provided by operating activities is our only recurring source of
funds and was $1.8 million for the year ended December 31, 2006. The cash
generated by operating activities during 2006 resulted primarily from net
earnings (before non-cash expenses) of approximately $2.3 million; reductions in
inventory net of applied reserves of $2.5 million; $1.0 million in reductions in
accounts receivable net of reserves applied, and approximately $0.6 million in
collections on the note receivable; net of reductions in accounts payable of
$2.6 million; repayments on notes payable of $0.9 million and reductions in
other liabilities, net of approximately $1.2 million. The note receivable
collections are associated with unsettled accounts receivable from a former
customer converted into a note receivable in early 2006. The repayments on the
notes payable are principally associated with previously accrued legal expenses
converted into a note payable in May of 2006. Payments on the note payable are
made from collections received from the note receivable which is pledged to the
note payable. These notes are non-recurring settlements associated primarily
with sales and expenses from 2005 and prior transactions. See notes to
consolidated financial statements, Note 2 - "Accounts and Note Receivable" and
Note 6 - "Notes Payable."
The net decrease in inventory of $2.5 million reflects the Company's
efforts to dispose of and lower slower-moving and obsolete inventory components.
The cost of net inventories eliminated during the year was $8.6 million, and
reserves applicable to this inventory of $6.1 million were applied to these
dispositions. Accounts receivable for the year ended December 31, 2006 declined
by $2.1 million primarily as a result of improved collections and faster turns
of accounts receivable, and by approximately $0.7 million in accounts
written-off. Accounts receivable reserves declined by $1.1 million from the
write-off of uncollectible accounts and by approximately $0.4 million from the
collection of accounts reserved for in prior years. In addition, during 2006
collections of accounts written-off in prior years was $0.5 million.
The increase in cash provided by operating activities during the year
ended December 31, 2005 resulted from, among other changes, a $10.6 million
decrease in accounts receivable, including the collection of a $4.5 million
12
receivable from one customer; a $3 million increase in accounts payable; a $2.8
million decrease in inventories; a $2.1 million increase in accrued legal costs;
substantially offset by a net loss of $29.5 million.
At December 31, 2005, accounts receivable from Azteca Productions
International ("Azteca"), a significant customer, was approximately $10,968,000
less a reserve of $7,528,000, totaling $3,440,000, net. In February 2006, the
Company accepted a note agreement from Azteca which provides for total payments
including principal and interest of $4.0 million in exchange for the net
outstanding accounts receivable balance. The balance of the note receivable at
December 31, 2005 of $3,440,000 reflects a $560,000 charge to discount the note,
using a 10.5% discount rate, to its net present value. The Azteca accounts
receivable, net at December 31, 2005 was reclassified on the accompanying
consolidated balance sheets to note receivable to reflect this subsequent
settlement.
The decrease in cash provided by operations for 2004 resulted primarily
from a net loss of $17.6 million together with a net increase of $7.6 million in
accounts receivable due primarily to slower customer collections of receivables
during the year. This decrease was partially offset by a $4 million net increase
in the allowance for doubtful accounts and a $7.8 million decrease in
inventories.
INVESTING ACTIVITIES
Net cash used in investing activities for the year ended December 31,
2006 and 2005 consisted of capital expenditures of $0.3 million and $1.5
million, respectively for leasehold improvements and equipment purchases.
Net cash used in investing activities for the year ended December 31,
2004 consisted of capital expenditures of $3.6 million for computer equipment,
the purchase of additional TALON zipper equipment and building, land and
leasehold improvements related to the TALON manufacturing facility in North
Carolina. The building and land purchase of the TALON manufacturing facility was
reported as a non-cash financing transaction.
FINANCING ACTIVITIES
Net cash used in financing activities for the years ended December 31,
2006 and 2005 reflects the repayment of notes payable and capital lease
obligations. In 2005 cash used in financing activities also included, the
repayment of borrowings under a bank line of credit partially offset by proceeds
from the exercise of stock options and warrants.
Net cash provided by financing activities for the year ended December
31, 2004 primarily reflects funds raised from secured convertible promissory
notes of $12.5 million, the exercise of stock options and warrants, proceeds
from notes payable and a capital lease obligation, offset by the repayment of
borrowings under our credit facility and notes payable.
We currently satisfy our working capital requirements primarily through
cash flows generated from operations. As the major apparel industry brands
continue to outsource apparel manufacturing to offshore locations, our foreign
customers, though backed by U.S. brands and retailers, will continue to
increase. This makes traditional financing arrangements with U.S. banks and
financial institutions difficult and accordingly we continue to evaluate
non-traditional financing of our foreign assets.
We believe that our existing cash and cash equivalents and anticipated
cash flows from our operating activities and available financing will be
sufficient to fund our minimum working capital and capital expenditure needs for
at least the next twelve months. This conclusion is based on the belief and
expectation that we have successfully completed the restructuring plan adopted
in 2005 and that our strategic plan and the company's current structure will
allow for continued profitability; that we will collect our note and accounts
receivable in accordance to existing terms; and that we will complete a
refinancing of the convertible notes payable by their maturity date in November
2007. We have discussed the refinancing of these notes with the current note
13
holders and with various financial and investment institutions. We believe that
we will be successful in completing a modification or replacement of these notes
prior to their maturity.
If we are unable to successfully complete the refinancing of the
convertible notes or to collect our note and accounts receivable, or experience
greater than anticipated reductions in sales, we may need to raise additional
capital, or obtain alternate financing to repay the convertible notes, or
further reduce the scope of our business in order to fully satisfy our future
short-term liquidity requirements. If we cannot raise additional capital or
arrange for alternate financing or reduce the scope of our business in response
to a substantial decline in sales, we may default on the payment of the
convertible notes payable. The event of a default on the payment of these notes
will materially affect the business operations in the long-term, however the
on-going operations for 2007 are nevertheless anticipated to substantially
continue throughout the 2007 year-end as operations from assets not pledged to
these notes continues.
The extent of our future long-term capital requirements will depend on
many factors, including our results of operations, future demand for our
products, the size and timing of future acquisitions, and our expansion into
foreign markets. Our need for additional long-term financing includes the
integration and expansion of our operations to exploit our rights under our
TALON trade name, the expansion of our operations in Asia and other markets and
the further development of our waistband technology. If our cash from operations
is less than anticipated or our working capital requirements and capital
expenditures are greater than we expect, we may need to raise additional debt or
equity financing in order to provide for our operations. We are continually
evaluating various financing strategies to be used to expand our business and
fund future growth or acquisitions. There can be no assurance that additional
debt or equity financing will be available on acceptable terms or at all. If we
are unable to secure additional financing, we may not be able to execute our
plans for expansion, including expansion into foreign markets to promote our
TALON brand trade name, and we may need to implement additional cost savings
initiatives.
CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS
The following summarizes our contractual obligations at December 31,
2006 and the effects such obligations are expected to have on liquidity and cash
flow in future periods:
Payments Due by Period
-------------------------------------------------------------------
Less than 1-3 4-5 After
Contractual Obligations Total 1 Year Years Years 5 Years
- ------------------------- ----------- ----------- ----------- ----------- -----------
Demand notes payable
to related parties (1) $ 1,181,000 $ 1,181,000 $ -- $ -- $ --
Capital lease obligations $ 1,027,000 $ 506,000 $ 521,000 $ -- $ --
Operating leases ........ $ 1,421,000 $ 437,000 $ 754,000 $ 229,000 $ 1,000
Notes payable ........... $ 2,426,000 $ 1,193,000 $ 604,000 $ 629,000 $ --
Convertible notes payable $13,143,000 $13,143,000 $ -- $ -- $ --
----------- ----------- ----------- ----------- -----------
Total Obligations .. $19,198,000 $16,460,000 $ 1,879,000 $ 858,000 $ 1,000
=========== =========== =========== =========== ===========
(1) The majority of notes payable to related parties are due on demand with
the remainder due and payable on the fifteenth day following the date
of delivery of written demand for payment, and include accrued interest
payable through December 31, 2006.
At December 31, 2006 and 2005, we did not have any relationships with
unconsolidated entities or financial partnerships, such as entities often
referred to as structured finance or special purpose entities, which would have
been established for the purpose of facilitating off-balance sheet arrangements
or other contractually narrow or limited purposes. As such, we are not exposed
to any financing, liquidity, market or credit risk that could arise if we had
engaged in such relationships.
14
RELATED PARTY TRANSACTIONS
For a description of transactions to which we were or will be a party,
and in which any director, executive officer, or shareholder of more than 5% of
our common stock or any member of their immediate family had or will have a
direct or indirect material interest, see Note 16 of the Notes to the
consolidated financial statements included in Item 8 of this Report.
APPLICATION OF CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions for the reporting period and as of
the financial statement date. We base our estimates on historical experience and
on various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. These estimates and assumptions affect the reported amounts of
assets and liabilities, the disclosure of contingent liabilities and the
reported amounts of revenue and expense. Actual results could differ from those
estimates.
Critical accounting policies are those that are important to the
portrayal of our financial condition and results, and which require us to make
difficult, subjective and/or complex judgments. Critical accounting policies
cover accounting matters that are inherently uncertain because the future
resolution of such matters is unknown. We believe the following critical
accounting policies affect our more significant judgments and estimates used in
the preparation of our consolidated financial statements:
o Accounts receivable balances are evaluated on a continual
basis and allowances are provided for potentially
uncollectible accounts based on management's estimate of the
collectibility of customer accounts. If the financial
condition of a customer were to deteriorate, resulting in an
impairment of its ability to make payments, an additional
allowance may be required. Allowance adjustments are charged
to operations in the period in which the facts that give rise
to the adjustments become known. During the year ended
December 31, 2006, net recoveries were $0.5 million (with
provisions of $0.2 million), and bad debt expense for the
years ended December 31, 2005 and 2004 were $5.9 million and
$8.4 million, respectively. The bad debt expense in 2004 and
2005 was primarily associated with specific receivables from a
former customer that were settled in early 2006 with the
acceptance of a note receivable at a substantial discount and
with the full write-off of customer accounts (one customer
primarily) where most all collection efforts had failed.
During 2006 accounts receivable delinquencies were
substantially eliminated lowering the risk for additional
material write-offs. The note receivable accepted from the
former customer in early 2006 represents a continuing risk of
collection and its performance is evaluated each quarter.
o Inventories are stated at the lower of cost, determined using
the first-in, first-out basis, or market value and are all
substantially finished goods. The costs of inventory include
the purchase price, inbound freight and duties, conversion
costs and certain allocated production overhead costs.
Inventory is evaluated on a continual basis and reserve
adjustments are made based on management's estimate of future
sales value, if any, of specific inventory items. Inventory
reserves are recorded for damaged, obsolete, excess and
slow-moving inventory. We use estimates to record these
reserves. Slow-moving inventory is reviewed by category and
may be partially or fully reserved for depending on the type
of product and the length of time the product has been
included in inventory. Reserve adjustments are made for the
difference between the cost of the inventory and the estimated
market value, if lower, and charged to operations in the
period in which the facts that give rise to these adjustments
become known. Market value of inventory is estimated based on
the impact of market trends, an evaluation of economic
conditions and the value of current orders relating to the
15
future sales of this type of inventory. Provisions for
reserves for inventory valuation for the years ended December
31, 2006, 2005 and 2004, were $0.6 million, $2.5 million and
$1.0 million, respectively. The increase in the provision
during 2005 was primarily related to the remaining inventory
we owned at our operations in Mexico. The closure of our
manufacturing operations and from the exit of operations in
Mexico as part of the 2005 restructuring plan substantially
eliminates our acquisition or production of inventory that is
not directly associated with a customer's order. Accordingly,
the risk of future inventory obsolescence adjustments is
substantially reduced in 2006. The provisions recorded in
prior years are considered adequate to dispose of the
remaining inventories without further adjustment.
o We record deferred tax assets arising from temporary timing
differences between recorded net income and taxable net income
when and if we believe that future earnings will be sufficient
to realize the tax benefit. For those jurisdictions where the
expiration date of tax benefit carry-forwards or the projected
taxable earnings indicate that realization is not likely, a
valuation allowance is provided. If we determine that we may
not realize all of our deferred tax assets in the future, we
will make an adjustment to the carrying value of the deferred
tax asset, which would be reflected as an income tax expense.
Conversely, if we determine that we will realize a deferred
tax asset, which currently has a valuation allowance, we would
be required to reverse the valuation allowance, which would be
reflected as an income tax benefit. We believe that our
estimate of deferred tax assets and determination to record a
valuation allowance against such assets are critical
accounting estimates because they are subject to, among other
things, an estimate of future taxable income, which is
susceptible to change and dependent upon events that may or
may not occur, and because the impact of recording a valuation
allowance may be material to the assets reported on the
balance sheet and results of operations. See Notes to
consolidated financial statements, Note 12, "Income Taxes". As
of December 31, 2005 the deferred tax assets were fully
reserved.
o We record impairment charges when the carrying amounts of
long-lived assets are determined not to be recoverable.
Impairment is measured by assessing the usefulness of an asset
or by comparing the carrying value of an asset to its fair
value. Fair value is typically determined using quoted market
prices, if available, or an estimate of undiscounted future
cash flows expected to result from the use of the asset and
its eventual disposition. The amount of impairment loss is
calculated as the excess of the carrying value over the fair
value. Changes in market conditions and management strategy
have historically caused us to reassess the carrying amount of
our long-lived assets. Long-lived assets are evaluated on a
continual basis and impairment adjustments are made based upon
management's valuations. As part of our 2005 restructuring
plan, certain long-lived assets, primarily machinery and
equipment, were impaired and their values adjusted
accordingly. The long-lived assets are planned to be
re-deployed through manufacturing arrangements with our
principal suppliers in Asia. The fair value of these assets
will be affected by our ability to secure appropriate
manufacturing arrangements and to utilize the equipment to
meet future production requirements. If we are unable to
secure favorable arrangements or to secure sufficient
production through these operations the fair value of this
equipment may be impaired.
o Sales are recognized when persuasive evidence of an
arrangement exists, product delivery has occurred, pricing is
fixed or determinable, and collection is reasonably assured.
Sales resulting from customer buy-back agreements, or
associated inventory storage arrangements are recognized upon
delivery of the products to the customer, the customer's
designated manufacturer, or upon notice from the customer to
destroy or dispose of the goods. Sales, provisions for
estimated sales returns, and the cost of products sold are
recorded at the time title transfers to customers. Actual
product returns are charged against estimated sales return
allowances.
16
o Upon approval of a restructuring plan by management, we record
restructuring reserves for certain costs associated with
facility closures and business reorganization activities as
they are incurred or when they become probable and estimable.
Such costs are recorded as a current liability. We record
restructuring reserves in compliance with SFAS 146 "Accounting
for Costs Associated with Exit or Disposal Activities",
resulting in the recognition of employee severance and related
termination benefits for recurring arrangements when they
became probable and estimable and on the accrual basis for
one-time benefit arrangements. We record other costs
associated with exit activities as they are incurred. Employee
severance and termination benefits are estimates based on
agreements with the relevant union representatives or plans
adopted by us that are applicable to employees not affiliated
with unions. These costs are not associated with nor do they
benefit continuing activities. Inherent in the estimation of
these costs are assessments related to the most likely
expected outcome of the significant actions to accomplish the
restructuring. Changing business conditions may affect the
assumptions related to the timing and extent of facility
closure activities. We review the status of restructuring
activities on a quarterly basis and, if appropriate, records
changes based on updated estimates. See Note 11, "2005
Restructuring Costs".
o We are currently involved in various lawsuits, claims and
inquiries, most of which are routine to the nature of the
business, and in accordance with SFAS No. 5, "Accounting for
Contingencies." We accrue estimates of the probable and
estimable losses for the resolution of these claims. The
ultimate resolution of these claims could affect our future
results of operations for any particular quarterly or annual
period should our exposure be materially different from our
earlier estimates or should liabilities be incurred that were
not previously accrued.
NEW ACCOUNTING PRONOUNCEMENTS
In September 2006, the FASB issued SFAS No. 157, "Fair Value
Measurements", ("SFAS No. 157"). SFAS No. 157 defines fair value, establishes a
framework for measuring fair value in generally accepted accounting principles
(GAAP), and expands disclosures about fair value measurements. This Statement
applies under other accounting pronouncements that require or permit fair value
measurements, and does not require any new fair value measurements. The
application of SFAS No. 157, however, may change current practice within an
organization. SFAS No. 157 is effective for all fiscal years beginning after
November 15, 2007, with earlier application encouraged. We do not believe that
SFAS No. 157 will have a material impact on our financial position, results of
operations or cash flows.
In September 2006, the SEC issued Staff Accounting Bulletin No. 108,
CONSIDERING THE EFFECTS OF PRIOR YEAR MISSTATEMENTS WHEN QUANTIFYING
MISSTATEMENTS IN CURRENT YEAR FINANCIAL STATEMENTS ("SAB 108"), to address
diversity in practice in quantifying financial statement misstatements. SAB 108
requires the quantification of misstatements based on their impact on both the
balance sheet and the income statement to determine materiality. The guidance
provides for a one-time cumulative effect adjustment to correct for
misstatements that were not deemed material under a company's prior approach but
are material under the SAB 108 approach. SAB 108 is effective for fiscal years
ending after November 15, 2006. The implementation of SAB 108 did not have a
material impact on our financial position, results of operations or cash flows.
In June 2006, the Financial Accounting Standards Board ("FASB") issued
Interpretation No. 48, ACCOUNTING FOR UNCERTAINTY IN INCOME TAXES -- AN
INTERPRETATION OF FASB STATEMENT NO. 109, (FIN 48). FIN 48 clarifies the
accounting for uncertainty in income taxes recognized in an enterprise's
financial statements in accordance with FASB Statement No. 109, ACCOUNTING FOR
INCOME TAXES. FIN 48 also prescribes a recognition threshold and measurement
attribute for the financial statement recognition and measurement of a tax
position taken or expected to be taken in a tax return that results in a tax
benefit. Additionally, FIN 48 provides guidance on de-recognition, income
statement classification of interest and penalties, accounting in interim
periods, disclosure, and transition. This interpretation is effective for fiscal
years beginning after December 15, 2006. We are currently evaluating the effect
that the application of FIN 48 will have on its results of operations and
financial condition.
17
In February 2006, the FASB issued Statement of Financial Accounting
Standards No. 155, "Accounting for Certain Hybrid Financial Instruments" ("SFAS
155"), which amends SFAS No. 133, "Accounting for Derivatives Instruments and
Hedging Activities" ("SFAS 133") and SFAS No. 140, "Accounting for Transfers and
Servicing of Financial Assets and Extinguishment of Liabilities" ("SFAS 140).
SFAS 155 amends SFAS 133 to narrow the scope exception for interest-only and
principal-only strips on debt instruments to include only such strips
representing rights to receive a specified portion of the contractual interest
or principle cash flows. SFAS 155 also amends SFAS 140 to allow qualifying
special-purpose entities to hold a passive derivative financial instrument
pertaining to beneficial interests that itself is a derivative instrument. SFAS
No. 155 is effective for all financial instruments acquired or issued after the
beginning of an entity's first fiscal year that begins after September 15, 2006.
We do not believe that SFAS No. 155 will have a material impact on the Company's
financial position, results of operations or cash flows.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
All of our sales are denominated in United States dollars or the currency of the
country in which our products originate. We are exposed to market risk for
fluctuations in the foreign currency exchange rates for certain product
purchases that are denominated in Hong Kong dollars, Chinese Yuan's and British
Pounds. During 2004, we purchased forward exchange contracts for British Pounds
to hedge the payments of product purchases. We do not intend to purchase
additional contracts to hedge the exchange exposure for future product
purchases. There were no hedging contracts outstanding as of December 31, 2006.
Currency fluctuations can increase the price of our products to foreign
customers which can adversely impact the level of our export sales from time to
time. The majority of our cash equivalents are held in United States dollars in
various bank accounts and we do not believe we have significant market risk
exposure with regard to our investments. At December 31, 2006, none of our
indebtedness was subject to interest rate fluctuations.
18
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
TABLE OF CONTENTS
PAGE
----
Report of Independent Registered Public Accounting Firm................... 34
Report of Independent Registered Public Accounting Firm................... 35
Consolidated Balance Sheets............................................... 36
Consolidated Statements of Operations..................................... 37
Consolidated Statements of Stockholders' Equity and Convertible
Redeemable Preferred Stock............................................. 38
Consolidated Statements of Cash Flows..................................... 39
Notes to Consolidated Financial Statements................................ 40
19
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders
Tag It Pacific Inc.
Woodland Hills, California
We have audited the consolidated balance sheets of Tag It Pacific Inc. and
subsidiaries as of December 31, 2006 and 2005, and the related consolidated
statements of operations, stockholders' equity and convertible redeemable
preferred stock, and cash flows for each of the two years in the period ended
December 31, 2006. Our audits also included the financial statement schedules of
Tag It Pacific Inc., listed in Item 15(a). These financial statements and
financial statement schedules are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provided a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Tag It Pacific Inc.
and subsidiaries as of December 31, 2006 and 2005, and the results of their
operations and their cash flows for each of the two years in the period ended
December 31, 2006, in conformity with U.S. generally accepted accounting
principles. Also, in our opinion, the related financial statement schedules,
when considered in relation to the basic consolidated financial statements,
taken as a whole, present fairly in all material respects the information set
forth therein.
/S/ SINGER LEWAK GREENBAUM & GOLDSTEIN LLP
- ------------------------------------------
Los Angeles, California
April 9, 2007
20
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors
Tag-It Pacific, Inc.
Los Angeles, California
We have audited the accompanying consolidated statements of operations,
stockholders' equity and convertible redeemable preferred stock and cash flows
of Tag-It Pacific, Inc. and subsidiaries for the year ended December 31, 2004.
The financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audit.
We conducted our audit in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. The Company is not
required to have, nor were we engaged to perform, an audit of its internal
control over financial reporting. Our audit included consideration of internal
control over financial reporting as a basis for designing audit procedures that
are appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company's internal control over financial
reporting. Accordingly, we express no such opinion. An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements and assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provided a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the results of operations of Tag-It
Pacific, Inc. and subsidiaries and their cash flows for the year ended December
31, 2004, in conformity with accounting principles generally accepted in the
United States of America.
/s/ BDO Seidman, LLP
Los Angeles, California
March 31, 2005
21
TAG-IT PACIFIC, INC.
CONSOLIDATED BALANCE SHEETS
December 31, December 31,
2006 2005
------------ ------------
Assets
Current Assets:
Cash and cash equivalents ............................. $ 2,934,673 $ 2,277,397
Accounts receivable, net .............................. 4,664,766 5,652,990
Note receivable ...................................... 1,378,491 662,369
Inventories, net ...................................... 3,051,220 5,573,099
Prepaid expenses and other current assets ............. 541,034 618,577
------------ ------------
Total current assets ..................................... 12,570,184 14,784,432
Property and equipment, net .............................. 5,623,040 6,438,096
Fixed assets held for sale ............................... 826,904 826,904
Note receivable, less current portion .................... 1,420,969 2,777,631
Due from related parties ................................. 675,137 655,489
Other intangible assets, net ............................. 4,139,625 4,255,125
Other assets ............................................. 437,569 583,117
------------ ------------
Total assets ............................................. $ 25,693,428 $ 30,320,794
============ ============
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable ....................................... $ 4,006,241 $ 6,719,226
Accrued legal costs .................................... 427,917 2,520,111
Other accrued expenses ................................. 3,359,267 4,168,552
Demand notes payable to related parties ................ 664,970 664,971
Current portion of capital lease obligations ........... 432,728 590,884
Current portion of notes payable ....................... 1,107,207 186,837
Current portion of secured convertible promissory notes 12,472,622 --
------------ ------------
Total current liabilities ................................ 22,470,952 14,850,581
Capital lease obligations, less current portion .......... 474,733 856,495
Notes payable, less current portion ...................... 1,061,514 1,261,018
Secured convertible promissory notes ..................... -- 12,440,623
------------ ------------
Total liabilities ........................................ 24,007,199 29,408,717
------------ ------------
Commitments and contingencies (Note 13)
Stockholders' Equity:
Preferred stock Series A, $0.001 par value; 250,000
shares authorized; no shares issued or outstanding .... -- --
Common stock, $0.001 par value, 100,000,000 shares
authorized; 18,466,433 shares issued and outstanding
at December 31, 2006; 18,241,045 at December 31, 2005 18,466 18,241
Additional paid-in capital ............................. 51,792,502 51,327,878
Accumulated deficit .................................... (50,124,739) (50,434,042)
------------ ------------
Total stockholders' equity ............................... 1,686,229 912,077
------------ ------------
Total liabilities and stockholders' equity ............... $ 25,693,428 $ 30,320,794
============ ============
See accompanying notes.
22
TAG-IT PACIFIC, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2006 2005 2004
------------ ------------ ------------
Net sales ................................. $ 48,825,002 $ 47,331,176 $ 55,109,481
Cost of goods sold ........................ 34,356,034 47,070,381 44,813,736
------------ ------------ ------------
Gross profit .............................. 14,468,968 260,795 10,295,745
Selling expenses .......................... 2,777,772 2,928,659 2,899,329
General and administrative expenses ....... 10,872,887 16,098,363 13,047,215
Bad debt expense (recoveries) ............. (513,347) 5,857,946 8,416,392
Restructuring charges ..................... -- 2,474,281 414,675
------------ ------------ ------------
Total operating expenses .................. 13,137,312 27,359,249 24,777,611
Income (loss) from operations ............. 1,331,656 (27,098,454) (14,481,866)
Interest expense, net ..................... 988,453 1,379,786 849,888
------------ ------------ ------------
Income (loss) before income taxes ......... 343,203 (28,478,230) (15,331,754)
Provision for income taxes ................ 33,900 1,059,479 2,277,214
------------ ------------ ------------
Net income (loss) ......................... 309,303 (29,537,709) (17,608,968)
Less: Preferred stock dividends ........... -- -- (30,505)
------------ ------------ ------------
Net income(loss) to common shareholders .. $ 309,303 $(29,537,709) $(17,639,473)
============ ============ ============
Basic income(loss) per share .............. $ 0.02 $ (1.62) $ (1.02)
============ ============ ============
Diluted income( loss) per share ........... $ 0.02 $ (1.62) $ (1.02)
============ ============ ============
Basic weighted average shares outstanding . 18,377,484 18,225,851 17,316,202
============ ============ ============
Diluted weighted average shares outstanding 18,955,796 18,225,851 17,316,202
============ ============ ============
See accompanying notes.
23
TAG-IT PACIFIC, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND CONVERTIBLE REDEEMABLE PREFERRED STOCK
YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004
Preferred Stock Preferred Stock
Common Stock Series A Series D
--------------------------- --------------------------- ----------------------------
Shares Amount Shares Amount Shares Amount
------------ ------------ ------------ ------------ ------------ ------------
BALANCE, JANUARY 1, 2004 ... 11,508,201 $ 11,510 -- -- 572,818 $ 22,918,693
Conversion of preferred
stock Series C and
accrued dividends ..... 700,144 700 -- -- -- --
Conversion of preferred
stock Series D ........ 5,728,180 5,728 -- -- (572,818) (22,918,693)
Warrants issued in
private placement
transaction ........... -- -- -- -- -- --
Common stock issued upon
exercise of options and
warrants .............. 214,276 214 -- -- -- --
Common stock and warrants
issued for services ... 20,500 21 -- -- -- --
Tax benefit from exercise
of stock options ...... -- -- -- -- -- --
Preferred stock dividends -- -- -- -- -- --
Net loss ................ -- -- -- -- -- --
------------ ------------ ------------ ------------ ------------ ------------
BALANCE, DECEMBER 31, 2004 . 18,171,301 18,173 -- -- -- --
Common stock issued upon
exercise of options and
warrants .............. 69,744 68 -- -- -- --
Net loss ................ -- -- -- -- -- --
------------ ------------ ------------ ------------ ------------ ------------
BALANCE, DECEMBER 31, 2005 . 18,241,045 18,241 -- -- -- --
Common stock issued for
services .............. 225,388 225 -- -- -- --
Stock based compensation -- -- -- -- -- --
Net income .............. -- -- -- -- -- --
------------ ------------ ------------ ------------ ------------ ------------
BALANCE, DECEMBER 31, 2006 . 18,466,433 $ 18,466 -- -- -- --
============ ============ ============ ============ ============ ============
Convertible
Redeemable Preferred Stock
Additional Retained Series C
Paid-In Earnings ----------------------------
Capital (Deficit) Total Shares Amount
------------ -------------- ------------ ------------ ------------
BALANCE, JANUARY 1, 2004 ... $ 23,890,356 $ (3,256,860) $ 43,563,699 759,494 $ 2,895,001
Conversion of preferred
stock Series C and
accrued dividends ..... 3,353,008 -- 3,353,708 (759,494) (2,895,001)
Conversion of preferred
stock Series D ........ 22,912,965 -- -- -- --
Warrants issued in
private placement
transaction ........... 189,815 -- 189,815 -- --
Common stock issued upon
exercise of options and
warrants .............. 557,514 -- 557,728 -- --
Common stock and warrants
issued for services ... 85,710 -- 85,731 -- --
Tax benefit from exercise
of stock options ...... 84,034 -- 84,034 -- --
Preferred stock dividends -- (30,505) (30,505) -- --
Net loss ................ -- (17,608,968) (17,608,968) -- --
------------ -------------- ------------ ------------ ------------
BALANCE, DECEMBER 31, 2004 . 51,073,402 (20,896,333) 30,195,242 -- --
Common stock issued upon
exercise of options and
warrants .............. 254,476 -- 254,544 -- --
Net loss ................ -- (29,537,709) (29,537,709) -- --
------------ -------------- ------------ ------------ ------------
BALANCE, DECEMBER 31, 2005 . 51,327,878 (50,434,042) 912,077 -- --
Common stock issued for
services .............. 102,504 -- 102,729 -- --
Stock based compensation 362,120 -- 362,120 -- --
Net income .............. -- 309,303 309,303 -- --
------------ -------------- ------------ ------------ ------------
BALANCE, DECEMBER 31, 2006 . $ 51,792,502 $ (50,124,739) $ 1,686,229 -- --
============ ============== ============ ============ ============
See accompanying note
24
TAG-IT PACIFIC, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2006 2005 2004
------------ ------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) .......................................... $ 309,303 $(29,537,709) $(17,608,968)
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Depreciation and amortization ............................ 1,523,225 1,931,990 1,547,223
Decrease in deferred income taxes ........................ -- 1,000,000 1,800,000
Common stock and warrants issued for services ............ 32,729 -- 85,731
Stock based compensation ................................. 362,120
Increase(decrease) in allowance for doubtful accounts .... (1,117,500) 2,630,759 4,042,428
Increase(decrease) in inventory valuation reserve ........ (6,064,000) 940,973 (240,000)
Asset impairment due to restructuring .................... -- 2,343,531 --
Impairment of goodwill ................................... -- 450,000 --
Disposal of assets ....................................... 129,179 -- --
Changes in operating assets and liabilities:
Accounts receivable ...................................... 2,086,076 10,666,295 (7,640,984)
Note receivable collections .............................. 640,539 -- --
Inventories .............................................. 8,585,879 2,791,747 7,551,060
Prepaid expenses and other current assets ................ 77,543 1,880,443 13,121
Other assets ............................................. (140,217) 314,998 147,046
Accounts payable ......................................... (2,587,985) 2,986,302 (2,647,692)
Accrued legal costs ...................................... (442,194) 2,113,197 245,796
Other accrued expenses ................................... (733,767) 671,348 831,346
Repayment of notes payable converted from accounts payable (867,297) -- --
Income taxes payable ..................................... (480) (71,589) 12,032
------------ ------------ ------------
Net cash provided by (used in) operating activities ........ 1,794,153 1,112,285 (11,381,861)
------------ ------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from sale of equipment ............................ 2,500 -- --
Acquisition of property and equipment ...................... (347,188) (1,453,848) (3,615,899)
------------ ------------ ------------
Net cash used in investing activities ...................... (344,688) (1,453,848) (3,615,899)
------------ ------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from secured convertible promissory notes ......... -- -- 11,663,685
Proceeds from exercise of stock options and warrants ....... -- 254,544 557,728
(Repayment) of line of credit and due to factor, net ....... -- (614,506) (6,481,007)
Proceeds from capital lease obligation ..................... -- -- 950,000
Payment of capital lease obligations ....................... (604,351) (906,765) (332,583)
Proceeds from notes payable ................................ -- -- 880,000
Repayment of notes payable ................................. (186,838) (1,574,975) (1,222,170)
------------ ------------ ------------
Net cash (used in) provided by financing activities ........ (791,189) (2,841,702) 6,015,653
------------ ------------ ------------
Net increase (decrease) in cash and cash equivalents .......... 657,276 (3,183,265) (8,982,107)
Cash and cash equivalents, beginning of year .................. 2,277,397 5,460,662 14,442,769
------------ ------------ ------------
Cash and cash equivalents, end of year ........................ $ 2,934,673 $ 2,277,397 $ 5,460,662
============ ============ ============
See accompanying notes.
25
TAG-IT PACIFIC, INC.
Consolidated Statements of Cash Flows
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2006 2005 2004
------------ ------------ ------------
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash received (paid) during the year for:
Interest paid ........................................... $ (975,609) $ (1,264,539) $ (693,045)
Interest received ....................................... $ 320,232 $ 42,516 $ 32,340
Income taxes paid ....................................... $ (33,900) $ (64,064) $ (495,345)
Income taxes received ................................... $ -- $ 39,571 $ 17,903
Non-cash financing activity:
Capital lease obligation ................................ $ 64,432 $ 273,376 $ 249,418
Accounts receivable, net converted to notes receivable .. $ -- $ 3,440,000 $ 470,799
Trade payable & accrued legal, converted to notes payable $ 1,775,000 $ -- $ --
Preferred Series D stock converted to common stock ...... $ -- $ -- $ 22,918,693
Preferred Series C stock converted to common stock ...... $ -- $ -- $ 2,895,001
Accrued dividends converted to common stock ............. $ -- $ -- $ 458,707
Mortgage note payable ................................... $ -- $ -- $ 765,000
Warrants issued to placement agent ...................... $ -- $ -- $ 93,815
See accompanying notes.
26
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
NATURE OF BUSINESS
Tag-It Pacific, Inc. (the "Company") is an apparel company that
specializes in the distribution of trim items to manufacturers of fashion
apparel, specialty retailers and mass merchandisers. The Company acts as a full
service outsourced trim management department for manufacturers, a specified
supplier of trim items to owners of specific brands, brand licensees and
retailers, a manufacturer and distributor of zippers under the TALON brand name
and a distributor of stretch waistbands that utilize licensed patented
technology under the TEKFIT brand name.
ORGANIZATION AND BASIS OF PRESENTATION
Tag-It Pacific, Inc. is the parent holding company of Tag-It, Inc., a
California corporation, Tag-It Pacific (HK) Ltd., a BVI corporation, Tag-It de
Mexico, S.A. de C.V., A.G.S. Stationery, Inc., a California corporation
(collectively, the "Subsidiaries"), all of which were consolidated under a
parent limited liability company on October 17, 1997 and became wholly-owned
subsidiaries of the Company immediately prior to the effective date of the
Company's initial public offering in January 1998. Immediately prior to the
initial public offering, the outstanding membership units of Tag-It Pacific LLC
were converted to 2,470,001 shares of Common Stock of the Company. In January
2000, the Company formed Tag-It Pacific Limited, a Hong Kong corporation, and in
April 2000, the Company formed Talon International, Inc., a Delaware
corporation. During 2006 we formed two wholly owned subsidiaries of Tag-It
Pacific, Inc.; Talon Zipper (Shenzhen) Company Ltd. in China, and Talon
International Pvt. Ltd., in India. All newly formed corporations are 100%
wholly-owned Subsidiaries of Tag-It Pacific, Inc. Logistica en Avios, S.A. de
C.V. was an affiliated entity over which the Company exercised control, and as
such, is accounted for in the same manner as a wholly-owned subsidiary.
All significant intercompany accounts and transactions have been
eliminated in consolidation. Assets and liabilities of foreign subsidiaries are
translated at rates of exchange in effect at the close of the period. Revenues
and expenses are translated at the weighted average of exchange rates in effect
during the year. The resulting translation gains and losses are deferred and are
shown as a separate component of stockholders' equity, if material, and
transaction gains and losses, if any, are recorded in the consolidated statement
of income in the period incurred. During 2006, 2005 and 2004, foreign currency
translation and transaction gains and losses were not material. The Company does
not engage in hedging activities with respect to exchange rate risk.
USE OF ESTIMATES
The preparation of consolidated financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the year.
Actual results could differ from those estimates.
CASH AND CASH EQUIVALENTS
The Company considers all highly liquid investments purchased with an
initial maturity of three months or less to be cash equivalents. The Company had
approximately $2.9 million and $2.2 million at financial institutions in excess
of federally insured limits at December 31, 2006 and 2005.
27
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
ALLOWANCE FOR DOUBTFUL ACCOUNTS
We are required to make judgments as to the collectibility of accounts
receivable based on established aging policy, historical experience and future
expectations. The allowances for doubtful accounts represent allowances for
customer trade accounts receivable that are estimated to be partially or
entirely uncollectible. These allowances are used to reduce gross trade
receivables to their net realizable value. We record these allowances based on
estimates related to the following factors: (i) customer specific allowances;
(ii) amounts based upon an aging schedule; and (iii) an estimated amount, based
on our historical experience, for issues not yet identified.
INVENTORIES
Inventories are stated at the lower of cost, determined using the
first-in, first-out basis, or market value and are all substantially finished
goods. The costs of inventory include the purchase price, inbound freight and
duties, conversion costs and certain allocated production overhead costs.
Inventory reserves are recorded for damaged, obsolete, excess and slow-moving
inventory. We use estimates to record these reserves. Slow-moving inventory is
reviewed by category and may be partially or fully reserved for depending on the
type of product and the length of time the product has been included in
inventory. Reserve adjustments are made for the difference between the cost of
the inventory and the estimated market value, if lower, and charged to
operations in the period in which the facts that give rise to these adjustments
become known. Market value of inventory is estimated based on the impact of
market trends, an evaluation of economic conditions and the value of current
orders relating to the future sales of this type of inventory.
Inventories consist of the following:
Year Ended December 31,
--------------------------------
2006 2005
----------- -----------
Finished goods ....................... $ 4,293,220 $12,879,099
Less reserves ........................ 1,242,000 7,306,000
----------- -----------
Total inventories .................... $ 3,051,220 $ 5,573,099
=========== ===========
PROPERTY AND EQUIPMENT AND FIXED ASSETS HELD FOR SALE
Property and equipment are recorded at historical cost. Maintenance and
repairs are expensed as incurred. Upon retirement or other disposition of
property and equipment, the related cost and accumulated depreciation or
amortization are removed from the accounts and any gains or losses are included
in results of operations. During the year ended December 31, 2005 the Company
wrote-off fully depreciated equipment, films, dies and art designs no longer in
service, and changed its estimates of the expected useful lives of the dies and
molds to 3 months or 1 year, depending upon the nature of the tool.
Depreciation of property and equipment is computed using the
straight-line method based on estimated useful lives as follows:
Furniture and fixtures 5 years
Machinery and equipment 5 to 10 years
Computer equipment 5 years
Leasehold improvements Term of the lease or the estimated life of
the related improvements, whichever is
shorter.
Dies, and molds 3 months to 1 years
Idle equipment 5 to 10 years
28
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Property and equipment consist of the following:
Year Ended December 31,
---------------------------
2006 2005
----------- -----------
Furniture and fixtures ......................... $ 582,832 $ 551,623
Machinery and equipment ........................ 1,682,296 3,319,786
Computer equipment ............................. 3,422,058 3,325,997
Leasehold improvements ......................... 214,807 139,803
Dies, and molds ................................ 106,273 106,273
Idle equipment ................................. 4,434,980 2,806,475
----------- -----------
10,443,246 10,249,958
Accumulated depreciation and amortization ...... 4,820,206 3,811,862
----------- -----------
Net property and equipment ..................... $ 5,623,040 $ 6,438,096
=========== ===========
Depreciation expense for the years ended December 31, 2006, 2005 and
2004 was $1,090,000, $1,499,000, and $1,277,000, respectively.
During the year ended December 31, 2005, the Company wrote-off fixed
assets with a net book value of $2,036,000 in connection with the 2005
restructuring plan.
Idle equipment is principally machinery and equipment used for the
production of zipper chain and the assembly of finished zippers. This equipment
was originally associated with the production and assembly facilities in North
Carolina and in Mexico, and was temporarily rendered idle with the closing of
these operations in connection with the 2005 Restructuring Plan. The Company
intends to redeploy this equipment during the next year within production
operations being established in Asia and India. The equipment continues to be
depreciated based upon its estimated useful lives.
Fixed assets held for sale consists of the North Carolina land and
manufacturing facility. Management has the authority and has committed to sell
the asset; the asset is listed for sale with a commercial real estate agent who
is actively marketing the property; the sale of the asset is probable and the
sale is expected to be completed within one year. See Note 11, "2005
Restructuring Plan". This asset held for sale is financed by a mortgage note
with a balance of $712,950 at December 31, 2006 and $734,787 at December 31,
2005.
GOODWILL AND OTHER INTANGIBLE ASSETS
Intangible assets consist of goodwill, tradename, and exclusive license
and intellectual property rights. Goodwill represents the excess of costs over
fair value of assets of businesses acquired. Goodwill and intangible assets
acquired in a purchase business combination and determined to have an indefinite
useful life are not amortized, but instead tested for impairment at least
annually in accordance with the provisions of FASB Statement No. 142, Goodwill
and Other Intangible Assets. Intangible assets with estimable useful lives are
amortized over their respective estimated useful lives, which average 5 years,
to their estimated residual values, and reviewed for impairment in accordance
with FASB Statement No. 144, Accounting for Impairment or Disposal of Long-Lived
Assets.
29
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
At December 31, 2006, the Company evaluated its Other Intangible Assets
and determined that there was no impairment of these assets and made no changes
to the net carrying amount of Tradename for the years ended December 31, 2006
and 2005. At December 31, 2005, the Company evaluated its Goodwill and
determined that an impairment adjustment in the amount of $450,000 related to
goodwill was necessary to reduce the carrying value of goodwill to zero.
Amortization expense related to exclusive license and intellectual property
rights of $115,500 were recorded for each of the years ended December 31, 2006,
2005 and 2004.
Goodwill and other intangible assets as of December 31, 2006 and 2005
are as follows:
Year Ended December 31,
--------------------------
2006 2005
----------- -----------
Goodwill .................................................... $ -- $ 500,000
Accumulated amortization .................................. -- (50,000)
Impairment write-off ...................................... -- (450,000)
----------- -----------
Goodwill, net ............................................. $ -- $ --
=========== ===========
Other Intangible Assets:
Tradename ................................................. $ 4,110,750 $ 4,110,750
Accumulated amortization .................................. -- --
----------- -----------
Tradename, net ........................................ 4,110,750 4,110,750
Exclusive license and intellectual property rights ........ 577,500 577,500
Accumulated amortization .................................. (548,625) (433,125)
----------- -----------
Exclusive license and intellectual property rights, net 28,875 144,375
----------- -----------
Other intangible assets, net .............................. $ 4,139,625 $ 4,255,125
=========== ===========
The estimated amortization expense for these assets for succeeding
years is $28,875 for 2007.
IMPAIRMENT OF LONG-LIVED ASSETS
We record impairment charges when the carrying amounts of long-lived
assets are determined not to be recoverable. Impairment is measured by assessing
the usefulness of an asset or by comparing the carrying value of an asset to its
fair value. Fair value is typically determined using quoted market prices, if
available, or an estimate of undiscounted future cash flows expected to result
from the use of the asset and its eventual disposition. The amount of impairment
loss is calculated as the excess of the carrying value over the fair value.
Changes in market conditions and management strategy have historically caused us
to reassess the carrying amount of our long-lived assets. During the year ended
December 31, 2005, the Company recorded asset impairment charges in connection
with its 2005 Restructuring Plan (See Note 11).
30
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
ACCRUED EXPENSES
Included in the December 31, 2006 accrued expenses is a customer
payment of approximately $1,105,000. The payment is an advance on raw material
inventory purchases for this customer. We recorded these funds as a short term
obligation and not as revenue because the product for this customer's order was
not shipped as of December 31, 2006. The underlying order is expected to ship
within six months.
INCOME TAXES
Income taxes are accounted for under the asset and liability method.
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases and tax benefit carry-forwards. Deferred tax liabilities and assets at the
end of each period are determined using enacted tax rates. The Company records
deferred tax assets arising from temporary timing differences between recorded
net income and taxable net income when and if we believe that future earnings
will be sufficient to realize the tax benefit. For those jurisdictions where the
expiration date of tax benefit carry-forwards or the projected taxable earnings
indicate that realization is not likely, a valuation allowance is provided.
The provisions of SFAS No. 109, "Accounting for Income Taxes," require
the establishment of a valuation allowance when, based on currently available
information and other factors, it is more likely than not that all or a portion
of a deferred tax asset will not be realized. SFAS No. 109 provides that an
important factor in determining whether a deferred tax asset will be realized is
whether there has been sufficient income in recent years and whether sufficient
income is expected in future years in order to utilize the deferred tax asset.
The Company believes that its estimate of deferred tax assets and
determination to record a valuation allowance against such assets are critical
accounting estimates because they are subject to, among other things, an
estimate of future taxable income, which is susceptible to change and dependent
upon events that may or may not occur, and because the impact of recording a
valuation allowance may be material to the assets reported on the balance sheet
and results of operations.
STOCK-BASED COMPENSATION
On January 1, 2006, the Company adopted Statement of Financial
Accounting Standards No. 123 (revised 2004), "Share-Based Payment," ("SFAS
123(R)") which requires the measurement and recognition of compensation expense
for all share-based payment awards made to employees and directors based on
estimated fair values. SFAS 123(R) supersedes the Company's previous accounting
under Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued
to Employees" ("APB 25") for periods beginning in fiscal 2006. In March 2005,
the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107
("SAB 107") relating to SFAS 123(R). The Company has applied the provisions of
SAB 107 in its adoption of SFAS 123(R).
The Company adopted SFAS 123(R) using the modified prospective
transition method, which requires the application of the accounting standard as
of January 1, 2006. The Company's financial statements as of and for the year
ended December 31, 2006 reflect the impact of SFAS 123(R). In accordance with
the modified prospective transition method, the Company's financial statements
for prior periods have not been restated to reflect, and do not include, the
impact of SFAS 123(R). There was no stock-based compensation expense related to
employee or director stock options recognized during the years ended December
31, 2005 or 2004. Options issued to consultants are accounted for in accordance
with the provisions of Emerging Issues Task Force (EITF) No. 96-18, "Accounting
for Equity Instruments That Are Issued to Others Than Employees for Acquiring,
or in Conjunction with Selling, Goods or Services."
31
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
As a result of adopting SFAS 123(R) on January 1, 2006, the Company's
income before income taxes and net income for the year ended December 31, 2006
are $395,000 lower than if it had continued to account for share-based
compensation under APB Opinion 25.
The following table illustrates the effect on net income and loss per
share if the Company had applied the fair value recognition provisions of SFAS
123(R) to stock-based awards granted under the Company's stock option plans in
all periods presented. For purposes of this pro-forma disclosure, the fair value
of the options is estimated using the Black-Scholes-Merton option-pricing
formula ("Black-Scholes model") and amortized to expense generally over the
options' vesting periods.
2005 2004
------------ ------------
Net loss as reported ........................... $(29,537,709) $(17,608,968)
Add: Stock-based employee compensation expense
included in reported net income, net of
related tax effects ....................... -- --
Deduct: Total stock-based employee
compensation expense determined under fair
value method for all awards, net of
related tax effects ....................... (221,167) (55,228)
------------ ------------
Pro forma net loss ............................. $(29,758,876) $(17,664,196)
============ ============
Loss per share:
Basic - as reported ....................... $ (1.62) $ (1.02)
Basic - pro forma ......................... $ (1.63) $ (1.02)
SFAS 123(R) requires companies to estimate the fair value of
share-based payment awards to employees and directors on the date of grant using
an option-pricing model. The value of the portion of the award that is
ultimately expected to vest is recognized as expense over the requisite service
periods in the Company's Statements of Operations. Stock-based compensation
expense recognized in the Statements of Operations for the year ended December
31, 2006 included compensation expense for share-based payment awards granted
prior to, but not yet vested as of January 1, 2006 based on the grant date fair
value estimated in accordance with the pro-forma provisions of SFAS 123 and
compensation expense for the share-based payment awards granted subsequent to
January 1, 2006 based on the grant date fair value estimated in accordance with
the provisions of SFAS 123(R). For stock-based awards issued to employees and
directors, stock-based compensation is attributed to expense using the
straight-line single option method, which is consistent with how the
prior-period pro formas were provided. As stock-based compensation expense
recognized in the Statements of Operations for 2006 is based on awards expected
to vest, SFAS 123(R) requires forfeitures to be estimated at the time of grant
and revised, if necessary, in subsequent periods if actual forfeitures differ
from those estimates. For the year ended December 31, 2006, expected forfeitures
are immaterial and as such the Company is recognizing forfeitures as they occur.
In the pro-forma information provided under SFAS 123 for the periods prior to
2006, the Company accounted for forfeitures as they occurred.
Prior to the adoption of SFAS 123(R), the Company accounted for
stock-based awards to employees and directors using the intrinsic value method
in accordance with APB Opinion 25. Under the intrinsic value method, the Company
recognized share-based compensation equal to the award's intrinsic value at the
time of grant over the requisite service periods using the straight-line method.
Forfeitures were recognized as incurred. During the years ended December, 31,
32
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2005 and 2004, there was no stock-based compensation expense recognized in the
Statements of Operations for awards issued to employees and directors as the
awards had no intrinsic value at the time of grant because their exercise prices
equaled the fair values of the common stock at the time of grant.
The Company's determination of fair value of share-based payment awards
to employees and directors on the date of grant uses the Black-Scholes model,
which is affected by the Company's stock price as well as assumptions regarding
a number of complex and subjective variables. These variables include, but are
not limited to, the expected stock price volatility over the expected term of
the awards, and actual and projected employee stock option exercise behaviors.
The Company estimates expected volatility using historical data. The expected
option term is estimated using the "safe harbor" provisions under SAB 107.
The Company has elected to adopt the detailed method provided in SFAS
123(R) for calculating the beginning balance of the additional paid-in capital
pool ("APIC pool") related to the tax effects of employee stock-based
compensation, and to determine the subsequent impact on the APIC pool and
Statements of Cash Flows of the tax effects of employee stock-based compensation
awards that are outstanding upon adoption of SFAS 123(R).
COMPREHENSIVE INCOME
The Company has adopted Statement of Financial Standard No. 130,
"Reporting Comprehensive Income" ("SFAS 130"), issued by the FASB and effective
for financial statements with fiscal years beginning after December 15, 1997.
SFAS 130 establishes standards for reporting and display of comprehensive income
and its components in a full set of general-purpose financial statements. There
were no material other comprehensive income items for the years ended December
31, 2006, 2005 and 2004.
REVENUE RECOGNITION
Sales are recognized when persuasive evidence of an arrangement exists,
product delivery has occurred, pricing is fixed or determinable, and collection
is reasonably assured. Sales resulting from customer buy-back agreements, or
associated inventory storage arrangements are recognized upon delivery of the
products to the customer, the customer's designated manufacturer, or upon notice
from the customer to destroy or dispose of the goods. Sales, provisions for
estimated sales returns, and the cost of products sold are recorded at the time
title transfers to customers. Actual product returns are charged against
estimated sales return allowances.
Sales rebates and discounts are common practice in the industries in
which the Company operates. Volume, promotional, price, cash and other discounts
and customer incentives are accounted for as a reduction to gross sales. Rebates
and discounts are recorded based upon estimates at the time products are sold.
These estimates are based upon historical experience for similar programs and
products. The Company reviews such rebates and discounts on an ongoing basis and
accruals for rebates and discounts are adjusted, if necessary, as additional
information becomes available.
RECLASSIFICATION
Certain reclassifications have been made to the prior year financial
statements to conform to 2006 presentation. The amortization of deferred
financing costs and discounts are reported as "Interest Expense, net" on the
consolidated statement of operations. These items ($310,771 and $45,000 for 2005
and 2004, respectively) were previously reported as "General and Administrative
Expenses".
33
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
CLASSIFICATION OF EXPENSES
COST OF SALES - Cost of goods sold primarily includes expenses related
to inventory purchases, customs, duty, freight, overhead expenses and reserves
for obsolete inventory. Overhead expenses primarily consist of warehouse and
operations salaries, and other warehouse expenses.
SELLING EXPENSE - Selling expenses primarily include royalty expense,
sales salaries and commissions, travel and entertainment, marketing and other
sales-related costs.
GENERAL AND ADMINISTRATIVE EXPENSES - General and administrative
expenses primarily include administrative salaries, employee benefits,
professional service fees, facility expenses, information technology costs,
investor relations, travel and entertainment, depreciation and amortization, bad
debts, restructuring costs and other general corporate expenses.
INTEREST EXPENSE AND INTEREST INCOME - Interest expense reflects the
cost of borrowing and amortization of deferred financing costs and discounts.
Interest expense for the years ended December 31, 2006, 2005 and 2004 was
$1,357,000, $1,446,000, and $882,000, respectively. Interest income of $368,000,
$66,000 and $32,000 for the years ended December 31, 2006, 2005 and 2004,
respectively, consists of earnings from outstanding amounts due to the Company
under notes and other interest bearing receivables.
SHIPPING AND HANDLING COSTS
In accordance with Emerging Issues Task Force (EITF) 00-10, Accounting
for Shipping and Handling Fees and Costs, the Company records shipping and
handling costs billed to customers as a component of revenue, and shipping and
handling costs incurred by the Company for outbound freight are recorded as a
component of cost of sales. Total shipping and handling costs included as
component of revenue for the years ended December 31, 2006, 2005 and 2004
amounted to $146,000, $98,000 and $194,000. Total shipping and handling costs
included as a component of cost of sales for each of these years amounted to
$691,000, $925,000 and $1,002,000.
RESTRUCTURING CHARGES
The Company records restructuring reserves in compliance with SFAS 146
"Accounting for Costs Associated with Exit or Disposal Activities", resulting in
the recognition of employee severance and related termination benefits for
recurring arrangements as they are incurred and on the accrual basis for
one-time benefit arrangements. The Company records other costs associated with
exit activities as they are incurred. Employee severance and termination
benefits are estimates based on agreements with the relevant union
representatives or plans adopted by the Company that are applicable to employees
not affiliated with unions. These costs are not associated with nor do they
benefit continuing activities. Inherent in the estimation of these costs are
assessments related to the most likely expected outcome of the significant
actions to accomplish the restructuring. Changing business conditions may affect
the assumptions related to the timing and extent of facility closure activities.
The Company reviews the status of restructuring activities on a quarterly basis
and, if appropriate, records changes based on updated estimates. See Note 11,
"2005 Restructuring Plan".
LITIGATION
We are currently involved in various lawsuits, claims and inquiries,
most of which are routine to the nature of the business, and in accordance with
SFAS No. 5, "Accounting for Contingencies," we accrue estimates of the probable
and estimable losses for the resolution of these claims. The ultimate resolution
of these claims could affect our future results of operations for any particular
quarterly or annual period should
34
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
our exposure be materially different from our earlier estimates or should
liabilities be incurred that were not previously accrued.
FAIR VALUE OF FINANCIAL INFORMATION
The following methods and assumptions were used to estimate the fair
value of each class of financial instruments for which it is practicable to
estimate that value. Accounts receivable: Due to the short-term nature of the
receivables, the fair value approximates the carrying value. Due from related
parties and notes payable to related parties: Due to the short-term nature and
current market borrowing rates of the loans and notes, the fair value
approximates the carrying value. Notes payable: Fair value approximates carrying
value based upon current market borrowing rates for loans with similar terms and
maturities.
NEW ACCOUNTING PRONOUNCEMENTS
In September 2006, the FASB issued SFAS No. 157, "Fair Value
Measurements", ("SFAS No. 157"). SFAS No. 157 defines fair value, establishes a
framework for measuring fair value in generally accepted accounting principles
(GAAP), and expands disclosures about fair value measurements. This Statement
applies under other accounting pronouncements that require or permit fair value
measurements, and does not require any new fair value measurements. The
application of SFAS No. 157, however, may change current practice within an
organization. SFAS No. 157 is effective for all fiscal years beginning after
November 15, 2007, with earlier application encouraged. The Company does not
believe that SFAS No. 157 will have a material impact on the Company's financial
position, results of operations or cash flows.
In September 2006, the SEC issued Staff Accounting Bulletin No. 108,
Considering the Effects of Prior Year Misstatements when Quantifying
Misstatements in Current Year Financial Statements ("SAB 108"), to address
diversity in practice in quantifying financial statement misstatements. SAB 108
requires the quantification of misstatements based on their impact on both the
balance sheet and the income statement to determine materiality. The guidance
provides for a one-time cumulative effect adjustment to correct for
misstatements that were not deemed material under a company's prior approach but
are material under the SAB 108 approach. SAB 108 is effective for fiscal years
ending after November 15, 2006. The implementation of SAB 108 did not have a
material impact on the financial position, results of operations or cash flows
of the Company.
In June 2006, the Financial Accounting Standards Board ("FASB") issued
Interpretation No. 48, Accounting for Uncertainty in Income Taxes -- An
Interpretation of FASB Statement No. 109, (FIN 48). FIN 48 clarifies the
accounting for uncertainty in income taxes recognized in an enterprise's
financial statements in accordance with FASB Statement No. 109, Accounting for
Income Taxes. FIN 48 also prescribes a recognition threshold and measurement
attribute for the financial statement recognition and measurement of a tax
position taken or expected to be taken in a tax return that results in a tax
benefit. Additionally, FIN 48 provides guidance on de-recognition, income
statement classification of interest and penalties, accounting in interim
periods, disclosure, and transition. This interpretation is effective for fiscal
years beginning after December 15, 2006. The Company is currently evaluating the
effect that the application of FIN 48 will have on its results of operations and
financial condition.
In February 2006, the FASB issued Statement of Financial Accounting
Standards No. 155, "Accounting for Certain Hybrid Financial Instruments" ("SFAS
155"), which amends SFAS No. 133, "Accounting for Derivatives Instruments and
Hedging Activities" ("SFAS 133") and SFAS No. 140, "Accounting for Transfers and
Servicing of Financial Assets and Extinguishment of Liabilities" ("SFAS 140).
SFAS 155 amends SFAS 133 to narrow the scope exception for interest-only and
principal-only strips on debt instruments to include only such strips
representing rights to receive a specified portion of the contractual interest
or principle cash flows. SFAS 155 also amends SFAS 140 to allow qualifying
special-purpose entities to hold a passive derivative financial instrument
pertaining to beneficial interests that itself is
35
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
a derivative instrument. SFAS No. 155 is effective for all financial instruments
acquired or issued after the beginning of an entity's first fiscal year that
begins after September 15, 2006. The Company does not believe that SFAS No. 155
will have a material impact on the Company's financial position, results of
operations or cash flows.
NOTE 2 - ACCOUNTS AND NOTE RECEIVABLE
At December 31, 2006 a note receivable from Azteca Productions
International ("Azteca") was outstanding in the amount of $2,799,460. The note
is receivable in monthly installments over thirty-one months beginning March 1,
2006. The payments are $50,000 per month for the first 5 months, then range from
$133,000-$267,000 per month until paid in full. At December 31, 2005, accounts
receivable from Azteca, a significant customer in 2005, was approximately
$10,968,000 less a reserve of $7,528,000. In February 2006, the Company accepted
a note agreement from Azteca which provided for total payments including
principal and interest of $4.0 million in exchange for the net outstanding
accounts receivable balance. The value of the note receivable recorded effective
at December 31, 2005 reflected a $560,000 charge to the face value to discount
the note, using a 10.5% discount rate, to its net present value. The Azteca
accounts receivable, net at December 31, 2005 was reclassified on the
accompanying consolidated balance sheets to note receivable to reflect this
subsequent settlement. The following summarizes the future minimum payments of
the note receivable:
Years ending December 31, Amount
-----------
2007 .................................................... $ 1,599,996
2008 .................................................... 1,483,339
-----------
Total payments .......................................... 3,083,335
Less amount representing interest ....................... (283,875)
-----------
Balance at December 31, 2006 ............................ 2,799,460
Less current portion .................................... 1,378,491
-----------
Long-term portion ....................................... $ 1,420,969
===========
Accounts receivable are included on the accompanying consolidated
balance sheet net of an allowance for doubtful accounts. The total allowance for
doubtful accounts at December 31, 2006 was $71,500. The total allowance for
doubtful accounts at December 31, 2005 was $1,188,758, after reclassification of
the net Azteca receivable to note receivable.
In 2004, following negotiations with Tarrant Apparel Group, a former
customer, we determined that a significant portion of the obligations due from
this customer were uncollectible. Accordingly, included in general and
administrative expenses for 2004 are charges of $4.3 million related primarily
to the write-down of this receivable and leaving a remaining balance receivable
from this customer of $4.5 million. An affiliate of the customer repaid the $4.5
million receivable balance over the period from May through December 2005.
NOTE 3 - FACTORING AGREEMENT
The Company entered into a factoring agreement with East Asia Heller in
2004 for the purchase of eligible receivables from its Hong Kong subsidiary,
Tag-It Pacific (HK) Limited. The factor may purchase eligible accounts
receivable and assume the credit risk with respect to those accounts for which
they have given their prior approval. If the factor does not assume the credit
risk for a receivable, the collection risk associated with the receivable
remains with the Company. The Company pays a fixed commission rate and
36
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
may borrow up to 80% of its eligible accounts receivable. Interest is charged at
1.5% over the Hong Kong Dollar prime rate (7.75% and 7.75% at December 31, 2006
and 2005). However, during 2005 and 2006 the factor declined to advance funds to
the Company under this agreement. Accordingly, as of December 31, 2006, and 2005
there were no outstanding advances from the factor.
NOTE 4 - DEMAND NOTES PAYABLE TO RELATED PARTIES
Demand notes payable to related parties consist of the following:
Year Ended December 31,
-------------------------------
2006 2005
-------------- --------------
Two notes payable issued from 1995-1998 to
parties related to or affiliated with
directors of the Company with interest rates
ranging from 0% to 10% per annum, due and
payable on the fifteenth day following
delivery of written demand for payment ...... $ 85,176 $ 85,176
Convertible secured note payable issued in
October 2000 to a director of the Company
bears interest at 11%, payable quarterly, is
due on demand and convertible into common
stock at the election of the holder at a
rate of $4.50 per share, the market value of
the Company's common stock on the date of
approval by the Company's Board of
Directors. The note is secured by
substantially all of the Company's assets ... 500,000 500,000
Unsecured notes payable to a director of the
Company accrue interest at 7% and 8.5% per
annum, principal and interest due on demand
and fifteen days from demand ................ 79,795 79,795
-------------- --------------
$ 664,971 $ 664,971
============== ==============
Interest expense related to the demand notes payable to related parties
for the years ended December 31, 2006, 2005 and 2004 amounted to $67,753,
$67,753, and $81,628. Included in accrued expenses at December 31, 2006 and 2005
was $515,738 and $447,986 of related accrued interest. There was no interest
paid on the demand notes during the years ended December 31, 2006 and 2005.
37
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5 - CAPITAL LEASE OBLIGATIONS
The Company financed equipment purchases through various capital lease
obligations expiring through August 2010. These obligations bear interest at
various rates ranging from 4.6% to 15% per annum. Future minimum annual payments
under these capital lease obligations are as follows:
Years ending December 31, Amount
- ------------------------ -----------
2007 .................................................... $ 505,029
2008 .................................................... 336,970
2009 .................................................... 184,606
2010 .................................................... 430
-----------
Total payments .......................................... 1,027,035
Less amount representing interest ....................... (119,574)
-----------
Balance at December 31, 2006 ............................ 907,461
Less current portion .................................... 432,728
-----------
Long-term portion ....................................... $ 474,733
===========
At December 31, 2006, total property and equipment under capital lease
obligations and related accumulated depreciation was $3,533,154 and $1,178,469,
respectively. At December 31, 2005, total property and equipment under capital
lease obligations and related accumulated depreciation was $3,468,721 and
$661,533, respectively.
NOTE 6 - NOTES PAYABLE
Notes payable consist of the following:
Year Ended December 31,
-------------------------------
2006 2005
-------------- --------------
$765,000 note payable to First National Bank
dated June 3, 2004; interest at 6.5%;
payable in eighty-four monthly payments of
principal and interest of $5,746 beginning
July 2004; twenty-year amortization, all
unpaid principal and interest due June 3,
2011 (seven years); secured by building in
North Carolina .............................. $ 712,950 $ 734,787
$880,000 note payable to First National Bank
dated November 22, 2004; interest at 6.5%;
payable in sixty monthly payments of
principal and interest of $17,254 beginning
December 2004; all unpaid principal and
interest due November 22, 2009; secured by
manufacturing equipment ..................... 548,068 713,068
$1,650,000 note payable to Hennigan, Bennett
& Dorman, LLP dated May 31, 2006; interest
at 3.0%; payable in fourteen monthly
payments of principal and interest beginning
June 2006, of $50,000 for the first two
payments, and $133,333 for the next twelve
months thereafter until July 1, 2007;
secured by the note receivable .............. 907,703 --
-------------- --------------
Notes Payable ......................... 2,168,721 1,447,855
Less Current portion .................. 1,107,207 186,837
-------------- --------------
Notes payable, net of current portion $ 1,061,514 $ 1,261,018
============== ==============
38
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Future minimum annual payments under these notes payable obligations
are as follows:
Years ending December 31, Amount
- ------------------------ ----------
2007 .................................................. $1,107,207
2008 .................................................. 213,030
2009 .................................................. 210,218
2010 .................................................. 28,301
2011 and thereafter ................................... 609,965
----------
Total ................................................. $2,168,721
==========
NOTE 7 - SECURED CONVERTIBLE PROMISSORY NOTES
On November 10, 2004, the Company raised $12.5 million from the sale of
Secured Convertible Promissory Notes (the "Notes") to existing shareholders. The
Notes are convertible into common stock at a price of $3.65 per share, bear
interest at 6% payable quarterly, are due November 9, 2007 and are secured by
the Talon trademarks. The Notes are convertible at the option of the holder at
any time after closing. The Company may repay the Notes at any time after one
year from the closing date with a 15% prepayment penalty. Among other
restrictions, the Notes restrict the Company from declaring or paying a dividend
prior to conversion or payment of the Notes. At maturity, the Company may repay
the Notes in cash or require conversion if certain conditions are met. In
connection with the issuance of the Notes, the Company issued to the Note
holders, warrants to purchase up to 171,235 shares of common stock. The warrants
have a term of five years, an exercise price of $3.65 per share and vested 30
days after closing. The fair value of the warrants was estimated at
approximately $96,000 utilizing the Black-Scholes model and recorded as a
discount against the face value of the Notes. The discount is amortized over the
three-year term of the Notes on a straight-line basis. The Company has
registered the resale by the holders of the shares issuable upon conversion of
the Notes and exercise of the warrants. In connection with this financing, the
Company paid the placement agent $704,000 in cash, and issued the placement
agent a warrant to purchase 215,754 common shares at an exercise price of $3.65
per share. The warrant is exercisable beginning May 10, 2005 through November
10, 2009. The fair value of the warrant was estimated at $93,815 utilizing the
Black-Scholes model and recorded as deferred financing costs which are amortized
over the three- year term of the Notes. The full amount of principal under these
secured convertible promissory notes is due November 7, 2007. (See Item 7.
Management's Discussion and Analysis).
NOTE 8 - STOCKHOLDERS' EQUITY AND CONVERTIBLE REDEEMABLE PREFERRED STOCK
PREFERRED STOCK
STOCKHOLDER'S RIGHTS PLAN
In October 1998, the Company adopted a stockholder's rights plan. Under
the rights plan the Company distributed one preferred share purchase right for
each outstanding share of Common Stock outstanding on November 6, 1998. Upon the
occurrence of certain triggering events related to an unsolicited takeover
attempt of the Company, each purchase right not owned by the party or parties
making the unsolicited takeover attempt will entitle its holder to purchase
shares of the Company's Series A Preferred Stock at a value below the then
market value of the Series A Preferred Stock. The rights of holders of the
Common Stock will be subject to, and may be adversely affected by, the rights of
holders of the share
39
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
purchase rights, the Series A Preferred Stock and any other preferred stock that
may be issued in the future. The issuance of preferred stock, while providing
desirable flexibility in connection with possible acquisitions and other
corporate purposes, could make it more difficult for a third party to acquire a
majority of the Company's outstanding voting stock.
SERIES D PREFERRED STOCK PRIVATE PLACEMENT TRANSACTION
On December 18, 2003, the Company sold an aggregate of 572,818 shares
of non-voting Series D Convertible Preferred Stock, at a price of $44.00 per
share, to institutional investors and individual accredited investors in a
private placement transaction. The Company received net proceeds of $23,083,693
after commissions and other offering expenses. The Series D Convertible
Preferred Stock was convertible after approval at a special meeting of
stockholders at a rate of 10 common shares for each share of Series D
Convertible Preferred Stock. Except as required by law, the Series D Preferred
shares had no voting rights. The Series D Preferred shares accrued dividends,
commencing on June 1, 2004, at an annual rate of 5% of the initial stated value
of $44.00 per share, payable quarterly. In the event of a liquidation,
dissolution or winding-up of the Company, the Series D Preferred shares would
have been entitled to receive, prior to any distribution on the common stock, a
distribution equal to the initial stated value of the shares plus all accrued
and unpaid dividends.
At a special meeting of stockholders held on February 11, 2004, the
stockholders of the Company approved the issuance of 5,728,180 shares of common
stock upon conversion of the Series D Preferred Stock. At the conclusion of the
meeting, all of the shares of the Series D Convertible Preferred Stock
automatically converted into common shares and the Series D Convertible
Preferred Stock was eliminated.
The Company has registered the common shares issued upon conversion of
the Series D Convertible Preferred Stock for resale by the investors. In
conjunction with the private placement transaction the Company issued a warrant
to purchase 572,818 common shares to the placement agent at an exercise price of
$4.74 per share. The warrant is exercisable beginning June 18, 2004 through
December 18, 2008. The fair value of the warrant was estimated at approximately
$165,000 utilizing the Black-Scholes model and was recorded as a reduction of
the proceeds from the placement of the Series D Convertible Preferred Stock. The
Company has determined that this transaction did not result in a beneficial
conversion feature.
SERIES C PREFERRED STOCK PURCHASE AGREEMENT AND CO-MARKETING AND SUPPLY
AGREEMENT
In accordance with the Series C Preferred Stock Purchase Agreement
entered into with Coats North America Consolidated, Inc. ("Coats") on September
20, 2001, the Company issued 759,494 shares of Series C Convertible Redeemable
Preferred Stock to Coats North America Consolidated, Inc. in exchange for an
equity investment from Coats of $3,000,001 cash. The Series C Preferred shares
were convertible at the option of the holder after one year at the rate of the
closing price multiplied by 125% of the ten-day average closing price prior to
closing. The Series C Preferred shares were redeemable at the option of the
holder after four years. If the holders elected to redeem the Series C Preferred
shares, the Company had the option to redeem for cash at the stated value of
$3,000,001 or in the form of the Company's common stock at 85% of the market
price of the Company's common stock on the date of redemption. If the market
price of the Company's common stock on the date of redemption was less than
$2.75 per share, the Company was required to redeem for cash at the stated value
of the Series C Preferred shares. The Company could elect to redeem the Series C
Preferred shares at any time for cash at the stated value. The terms of the
Series C Preferred shares provided for cumulative dividends at a rate of 6% of
the stated value per annum, payable in cash or the Company's common stock. The
dividends were payable at the earlier of the declaration of the Board,
conversion or redemption. Each Series C Preferred share had the right to vote
for each of the Company's common shares that the Series C Preferred shares could
then be converted into on the record date. Total legal and other costs
associated with this transaction of $105,000 were netted against the $3,000,001
proceeds received from Coats.
40
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
In connection with the Series C Preferred Stock Purchase Agreement, the
Company also entered into a 10-year Co-Marketing and Supply Agreement with
Coats. The Co-Marketing and Supply Agreement provides for selected introductions
into Coats' customer base and the Company's trim packages will exclusively offer
thread manufactured by Coats.
On February 25, 2004, the holders of the Series C Preferred Stock
converted all 759,494 shares of Series C Preferred Stock, plus $458,707 of
accrued dividends, into 700,144 shares of common stock. The Series C Preferred
Stock was eliminated in March 2004.
SERIES B PREFERRED STOCK PURCHASE AGREEMENT, DISTRIBUTION AGREEMENT AND
TRADENAME PURCHASE AGREEMENT
On April 3, 2000, the Company entered into a ten-year exclusive license
and distribution agreement with Talon, Inc. and its parent company, Grupo
Industrial Cierres Ideal, S.A. de C.V. ("GICISA"). Under this agreement, Tag-It
Pacific, Inc. was the exclusive sales, marketing, distribution and e-commerce
arm for "Talon" products for all customers in the United States, Mexico-based
maquiladores, Canada and the Pacific Rim and had the exclusive license to market
trim products under the "Talon" brand name. In exchange for these exclusive
distribution rights, the Company issued 850,000 shares of Series B Convertible
Preferred stock to GICISA. After a period of 30 months, the shares were
convertible into the Company's common stock once the average price per share of
the Company's common stock reached or exceeded $8.00 for a 30-day consecutive
period. The preferred stock was automatically convertible into shares of the
Company's common stock based on a rate of one minus the fraction of $2.50 over
the average per share closing price of the Company's common stock for the 30-day
period preceding the conversion.
The Series B Convertible Preferred stock had a liquidation preference
of $.001 per share, and was entitled to receive non-cumulative dividends on an
as converted basis, if and when, such dividends were declared on the Company's
common stock and was redeemable by the Company under certain conditions as
outlined in the agreement.
The estimated fair value of the Series B Convertible Preferred stock on
April 3, 2000 was $1,400,000. The Company recorded the value of the license and
distribution rights as a long-term asset, which was being amortized over the
ten-year period of the agreement. The unamortized balance of the long-term asset
at December 21, 2001 was $1,166,667.
On September 30, 2000, the Company purchased inventory from GICISA in
exchange for an unsecured note payable in the amount of $2,830,024. The note
payable was non-interest bearing and was due April 1, 2002. The Company imputed
interest for the holding period of the note amounting to $272,000. The note was
subordinate to the obligations due under a credit facility with UPS Capital. The
note payable balance at December 21, 2001 was $2,767,182, net of imputed
interest of $62,842.
On December 21, 2001, the Company entered into an Asset Purchase
Agreement with Talon, Inc. and GICISA. Pursuant to the Asset Purchase Agreement,
the Company acquired from Talon, Inc. and GICISA: (1) certain inventory and
equipment, (2) all patent rights held by Talon, Inc. and (3) all of Talon's
rights to its trade names and trademarks bearing the Talon name. In addition,
the Asset Purchase Agreement terminated the exclusive 10-year license and
distribution agreement, dated as of April 3, 2000 by and among the Company,
GICISA and Talon, Inc.
Under the Asset Purchase Agreement, the Company issued to Talon, Inc.
500,000 shares of common stock, par value $0.001 per share, a promissory note in
the amount of $4,900,000 and $100,000 in cash held in escrow. The Asset Purchase
Agreement required Talon, Inc. to place 50,000 shares of the Company's common
stock and $100,000 in escrow for a period of 12 months to satisfy any
indemnification claims the Company may have under the Asset Purchase Agreement.
The common stock was valued at the market value of the Company's stock on the
date of closing. The promissory note was unsecured, and accrued interest at
41
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
prime plus 2%. In connection with the Asset Purchase Agreement, the Company also
entered into a mutual release with Talon, Inc. and GICISA pursuant to which
Talon, Inc. and GICISA released the Company from its obligations under the
unsecured note payable of $2,830,024 dated September 30, 2000 and other current
liabilities under the Exclusive License and Distribution Agreement. Further,
850,000 shares of the Company's series B convertible preferred stock held by
GICISA were canceled at the closing of the Asset Purchase Agreement. The balance
of the unsecured promissory note was $1.4 million at December 31, 2004. The
unsecured promissory note and all outstanding obligations due under the note
payable were paid in full as of June 1, 2005.
The Series B Convertible Preferred Stock was eliminated in February
2004.
COMMON STOCK
2003 PRIVATE PLACEMENT
On May 30, 2003, the Company raised approximately $6,037,500 in a
private placement transaction with five institutional investors. Pursuant to a
securities purchase agreement with these institutional investors, the Company
sold 1,725,000 shares of its common stock at a price per share of $3.50. After
commissions and expenses, the Company received net proceeds of approximately
$5.5 million. The Company has registered the shares issued in the private
placement with the Securities and Exchange Commission for resale by the
investors. In conjunction with the private placement transaction, the Company
issued warrants to purchase 172,500 shares of common stock to the placement
agent. The warrants are exercisable beginning August 30, 2003 through May 30,
2008 and have a per share exercise price of $5.06.
STOCK GRANT AGREEMENT
Pursuant to Stock Grant Agreements between the Company and Herman Roup,
dated December 1, 2001, January 1, 2002 and July 17, 2002, the Company issued to
Mr. Roup an aggregate 20,500 shares of common stock in 2004 for services
provided to the Company valued at $74,825.
EXCLUSIVE LICENSE AND INTELLECTUAL PROPERTY RIGHTS AGREEMENT
On April 2, 2002, the Company entered into an Exclusive License and
Intellectual Property Rights Agreement (the "Agreement") with Pro-Fit Holdings
Limited ("Pro-Fit"). The Agreement gives the Company the exclusive rights to
sell or sublicense waistbands manufactured under patented technology developed
by Pro-Fit for garments manufactured anywhere in the world for the United States
market and all United States brands. In accordance with the Agreement, the
Company issued 150,000 shares of its common stock which were recorded at the
market value of the stock on the date of the Agreement. The shares contain
restrictions related to the transfer of the shares and registration rights. The
Agreement has an indefinite term that extends for the duration of the trade
secrets licensed under the Agreement. The Company has recorded an intangible
asset amounting to $577,500 and is amortizing this asset on a straight-line
basis over its estimated useful life of five years. The Company is currently in
litigation with this supplier (See Notes 1 and 13).
NOTE 9 - STOCK OPTION INCENTIVE PLAN AND WARRANTS
STOCK OPTION INCENTIVE PLAN
On October 1, 1997, the Company adopted the 1997 Stock Incentive Plan
(the "1997 Plan"), which authorized the granting of a variety of stock-based
incentive awards. The Board of Directors, who determines the recipients and
terms of the awards granted, administers the 1997 Plan. On July 31, 2006 at the
42
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Company's annual meeting of stockholder's two amendments to the 1997 Stock Plan
were approved which (1) increased the maximum number of shares of common stock
that may be issued pursuant to awards granted under the 1997 Plan from 3,077,500
shares to 6,000,000 shares, and (2) increased the number of shares of common
stock that may be issued pursuant to awards granted to any individual under the
plan in a single year to 50% of the total number of shares available under the
plan.
The Company believes that such awards better align the interests of
its employees with those of its shareholders. Option awards are generally
granted with an exercise price equal to the market price of the Company's stock
on the date of the grant for years prior to 2006, and for the year ended
December 31, 2006, the average market price of the Company's stock for the five
trading days prior to the date of the grant; those option awards generally vest
over periods determined by the Board from immediate to 4 years of continuous
service, and have 10 year contractual terms.
As of December 31, 2006, the Company may issue awards to acquire up to
a total of 2,321,977 shares of common stock under the 1997 Plan, and there were
awards issued and outstanding under the Plan to acquire a total of 3,452,635
shares of common stock, including options issued to a consultant to acquire
75,000 shares of common stock at $0.57 per share. During 2006 the Company issued
options outside the Plan to employees to acquire 1,625,000 shares of stock at an
average exercise price of $0.46 per share, and granted 135,135 shares of stock
to an employee with a fair market value of $50,000.
The following table summarizes all options issued to employees and
directors including those issued outside the plan.
The following table summarizes the activity for the periods:
Weighted
Average
Number of Exercise
EMPLOYEE AND DIRECTOR Shares Price
------------- -------------
Options outstanding - January 1, 2004 ......... 1,978,000 $ 3.55
Granted .................................. -- $ --
Exercised ................................ (115,375) $ 3.36
Canceled ................................. (120,625) $ 4.00
------------- -------------
Options outstanding - December 31, 2004 ....... 1,742,000 $ 3.53
Granted .................................. 425,000 $ 3.22
Exercised ................................ (1,250) $ 3.63
Canceled ................................. (332,750) $ 3.50
------------- -------------
Options outstanding - December 31, 2005 ....... 1,833,000 $ 3.46
Granted .................................. 3,471,135 $ 0.31
Canceled ................................. (301,500) $ 3.56
------------- -------------
Options outstanding - December 31, 2006 ....... 5,002,635 $ 1.41
============= =============
The Company has also issued certain warrants and options to
non-employees. As of December 31, 2006, there were warrants issued to acquire a
total of 1,243,813 shares of common stock, and options to acquire 75,000 shares
of common stock outstanding to non-employees. During 2006 the Company issued
90,253 shares of stock to a consultant in exchange for services with a fair
market value of $51,000.
43
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following table summarizes the activity for the periods:
Weighted
Average
Number of Exercise
NON-EMPLOYEES Shares Price
------------- -------------
Options & warrants outstanding - January 1, 2004 ....... 1,277,885 $ 4.58
Granted ........................................... 416,989 $ 3.65
Exercised ......................................... (80,901) $ 2.68
Canceled .......................................... (35,000) $ 4.55
------------- -------------
Options & warrants outstanding - December 31, 2004 ..... 1,578,973 $ 4.35
Granted ........................................... -- $ --
Exercised ......................................... (68,494) $ 3.65
Canceled .......................................... (133,332) $ 4.54
------------- -------------
Options & warrants outstanding - December 31, 2005 ..... 1,377,147 $ 4.36
Granted ........................................... 75,000 $ 0.57
Exercised ......................................... -- $ --
Canceled .......................................... (133,334) $ 4.54
------------- -------------
Options & warrants outstanding - December 31, 2006 ..... 1,318,813 $ 4.13
============= =============
The Company's determination of fair value of share-based payment awards
to employees and directors on the date of grant uses the Black-Scholes model and
the assumptions noted in the following table for the years ended December 31, as
indicated. Expected volatilities are based on the historical volatility of the
Company's stock price and other factors. These variables include, but are not
limited to, the expected stock price volatility over the expected term of the
awards, and actual and projected employee stock option exercise behaviors. The
expected option term is estimated using the "safe harbor" provisions under SAB
107. The risk free rate for periods within the contractual life of the option is
based on the U.S. Treasury yield in effect at the time of the grant.
2006 2005 2004(1)
------- ------- -------
Expected volatility ......................... 65% 64% n/a
Expected term in years ...................... 6.1 yrs 1.2 yrs n/a
Expected dividends .......................... -- -- n/a
Risk-free rate .............................. 4.5% 2.0% n/a
(1) No share-based grants were made in 2004.
44
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A summary of the option activity under the 1997 Plan as of December 31,
2006, and changes during the year then ended is as follows:
Weighted
Weighted Average
Average Remaining
Number of Exercise Contractual Intrinsic
EMPLOYEE AND DIRECTOR Shares Price Life (Years) Value
------------ ------------ ------------ ------------
Outstanding at December 31, 2006 ...... 5,002,635 $ 1.41 7.90 $ 1,875,639
Vested and Expected to Vest ........... 4,927,355 $ 1.43 7.88 $ 1,837,150
Exercisable ........................... 2,223,968 $ 2.51 6.25 $ 447,389
The weighted average grant-date fair value of options granted to
employee's and director's during the years ended December 31, 2006 and 2005 were
$0.31 and $0.76, respectively. There were no grants in 2004. The total intrinsic
value of options exercised during the years ended December 31, 2005 and 2004 was
$1,700, and $130,000, respectively. There were no options exercised in 2006.
Weighted
Weighted Average
Average Remaining
Number of Exercise Contractual Intrinsic
NON-EMPLOYEE OPTIONS & WARRANTS: Shares Price Life (Years) Value
------------ ------------ ------------ ------------
Outstanding at December 31, 2006 1,318,813 $ 4.13 2.28 $ 34,500
Vested and Expected to Vest.... 1,318,813 $ 4.13 2.28 $ 34,500
Exercisable........................ 1,318,813 $ 4.13 2.28 $ 34,500
The weighted average grant-date fair value of options and warrants
granted to non-employees during the years ended December 31, 2006, and 2004 was
$0.57 and $3.70, respectively. There were no grants in 2005. The total intrinsic
value of options and warrants exercised during the years ended December 31, 2005
and 2004 was $91,000 and $135,000, respectively. There were no options exercised
in 2006. The fair value of the awards approximates the values expensed for
pro-forma purposes for these periods.
As of December 31, 2006, there was $645,248 of total unrecognized
compensation costs related to non-vested share-based compensation arrangements
granted, including warrants. This cost is expected to be recognized over the
weighted-average period of 2.0 years. The total fair value of shares vested
during the years ended December 31, 2006, 2005 and 2004 was $236,000, $217,000
and $1,597,000, respectively.
When options are exercised, the Company's policy is to issue previously
registered, unissued shares of common stock. As of December 31, 2006, the
Company had 2,321,977 unissued shares of common stock available in its 1997
Plan. On July 31, 2006, at the annual shareholders meeting an amendment to the
1997 Stock Incentive Plan was adopted to increase the number of authorized
shares under the 1997 Plan to a total of 6,000,000 shares. The additional plan
shares authorized on July 31, 2006 of 2,922,500 shares have not yet been
registered.
45
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 10 - INCOME (LOSS) PER SHARE
The following is a reconciliation of the numerators and denominators of
the basic and diluted income (loss) per share computations:
December 31, 2006 December 31, 2005
------------------------------------------ ------------------------------------------
Income Shares Per Share Loss Shares Per Share
YEARS ENDED: (Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
- -------------------- ------------ ------------ ------------ ------------ ------------ ------------
Basic income (loss):
Income (loss)
available
to common
stockholders ... $ 309,303 18,377,484 $ 0.02 $(29,537,70) 18,225,851 $ (1.62)
Effect of dilutive
securities:
Options ........ -- 578,312 0.00 -- -- --
Warrants ....... -- -- -- -- -- --
------------ ------------ ------------ ------------ ------------ ------------
Income (loss)
available to common
stockholders ....... $ 309,303 18,955,796 $ 0.02 $(29,537,70) 18,225,851 $ (1.62)
============ ============ ============ ============ ============ ============
December 31, 2004
------------------------------------------
Loss Shares Per Share
YEARS ENDED: (Numerator) (Denominator) Amount
- -------------------- ------------ ------------ ------------
Basic income (loss):
Income (loss)
available
to common
stockholders ... $(17,639,47) 17,316,202 $ (1.02)
Effect of dilutive
securities:
Options ........ -- -- --
Warrants ....... -- -- --
------------ ------------ ------------
Income (loss)
available to common
stockholders ....... $(17,639,47) 17,316,202 $ (1.02)
============ ============ ============
Warrants to purchase 1,243,813 shares of common stock at between $3.50
and $5.06; options to purchase 1,642,500 shares of common stock at between $1.27
and $5.23; convertible debt of $12,500,000 convertible at $3.65 per share, and
other convertible debt of $500,000 convertible at $4.50 per share were
outstanding for the year ended December 31, 2006, but were not included in the
computation of diluted loss per share because the effect of exercise or
conversion would have an antidilutive effect on the income per share.
Warrants to purchase 1,377,147 shares of common stock at between $3.50
and $5.06, options to purchase 1,833,000 shares of common stock at between $0.41
and $5.23, convertible debt of $12,500,000 convertible at $3.65 per share, and
other convertible debt of $500,000 convertible at $4.50 per share were
outstanding for the year ended December 31, 2005, but were not included in the
computation of diluted loss per share because the effect of exercise or
conversion would have an antidilutive effect on loss per share.
Warrants to purchase 1,578,973 shares of common stock at between $3.50
and $5.06, options to purchase 1,742,000 shares of common stock at between $1.30
and $4.63, convertible debt of $12,500,000 convertible at $3.65 per share, and
other convertible debt of $500,000 convertible at $4.50 per share were
outstanding for the year ended December 31, 2004, but were not included in the
computation of diluted loss per share because the effect of exercise or
conversion would have an antidilutive effect on loss per share.
NOTE 11 - 2005 RESTRUCTURING PLAN
In an effort to better align the Company's organizational and cost
structures with its future growth opportunities, in August 2005 the Company's
Board of Directors adopted a restructuring plan for the Company that was
substantially completed by December 2005. The plan included restructuring the
Company's global operations by eliminating redundancies in its Hong Kong
operation, closing its Mexican facilities, converting its Guatemala facility
from a manufacturing site to a distributor, and closing its North Carolina
manufacturing facility. The Company also refocused its sales efforts on higher
margin products, which may have resulted in lower net sales with certain
customers. As a result, the Company now operates with fewer employees and
reduced associated operating and manufacturing expenses. The Company recorded
charges in connection with its restructuring plan in accordance with SFAS No.
146 (As Amended), "Accounting for Costs Associated with Exit or Disposal
Activities." In addition, the Company's restructuring plan resulted in the
carrying value of certain long-lived assets, primarily equipment, being
impaired. Accordingly, in 2005 the Company recorded a charge to recognize the
impairment of these assets in accordance with SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets.
46
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The North Carolina manufacturing facility is a long-lived asset that is
classified as "held for sale" because it meets the criteria listed in Paragraph
30 of SFAS 144. Management has committed to sell the asset, and is listing the
property for sale with a commercial real estate agent. The Company believes the
sale of the asset is probable and the sale is expected to be completed within
one year. The major components of manufacturing equipment used in this plant to
manufacture zippers are not classified as held for sale since the Company
intends to re-deploy this equipment in the manufacture of Talon zippers through
investment or sale of this equipment to its distributors of Talon zippers. This
equipment is separately identified as idle equipment as a component of "Property
and equipment" which are included in the accompanying consolidated balance
sheets (See Note 1).
Restructuring costs recorded in 2005 were $6,371,000. Restructuring
costs include $3,447,000 of inventory write-downs, restructuring charges of
$2,474,000 consisting of $2,036,000 for the impairment of long-lived assets,
primarily machinery and equipment, $170,000 of one-time employee termination
benefits and other costs of $268,000, which were fully paid by the end of 2005.
In addition, an impairment charge to goodwill in the amount of $450,000 was
recorded. This goodwill was associated with an acquisition made to benefit the
Central and South American operations. Since these operations are being exited,
management concluded that this goodwill was impaired and should be written off.
These restructuring costs were recorded in the Consolidated Statement of
Operations for the year ended December 31, 2005 in the following line items and
amounts:
Cost of goods sold ......................................... $3,447,000
Operating expenses:
General & administrative expenses ....................... 450,000
Restructuring charges ................................... 2,474,000
----------
Total restructuring costs .................................. $6,371,000
==========
NOTE 12 - INCOME TAXES
The components of the provision (benefit) for income taxes included in
the consolidated statements of operations are as follows:
Year Ended December 31,
----------------------------------------------
2006 2005 2004
---------- ---------- ----------
Current:
Federal ............. $ 29,900 $ 55,479 $ 405,632
State ............... 4,000 4,000 71,582
---------- ---------- ----------
33,900 59,479 477,214
Deferred:
Federal ............. -- 850,000 1,530,000
State ............... -- 150,000 270,000
---------- ---------- ----------
-- 1,000,000 1,800,000
---------- ---------- ----------
$ 33,900 $1,059,479 $2,277,214
========== ========== ==========
47
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A reconciliation of the statutory Federal income tax rate with the
Company's effective income tax rate is as follows:
Year Ended December 31,
----------------------------
2006 2005 2004
------ ------ ------
Current:
Federal statutory rate ...................... 34.0% (34.0)% (34.0)%
State taxes net of federal benefit .......... 2.3 (5.8) (6.0)
Income earned from foreign subsidiaries ..... 18.7 0.2 3.1
Net operating loss valuation allowance
adjustments ............................... (71.7) 43.5 51.3
Change in effective state tax rate .......... 22.4 -- --
Other ....................................... 4.2 (0.2) 0.5
------ ------ ------
9.9% 3.7% 14.9%
====== ====== ======
Income (loss) before income taxes is as follows:
Year Ended December 31,
----------------------------------------------------
2006 2005 2004
------------ ------------ ------------
Domestic ........... $ (1,341,475) $(28,724,518) $(17,574,926)
Foreign ............ 1,684,678 246,288 2,243,172
------------ ------------ ------------
$ 343,203 $(28,478,230 $(15,331,754)
============ ============ ============
The primary components of temporary differences which give rise to the
Company's deferred tax assets and deferred tax liabilities are as follows:
Year Ended December 31,
-------------------------------
2006 2005
------------ ------------
Net deferred tax asset:
Net operating loss carry-forwards ..... $ 19,053,346 $ 20,820,849
Depreciation and amortization ......... (551,643) (442,909)
Bad debt reserve ...................... 17,961 403,494
Related party interest ................ 189,605 160,996
Inventory reserve ..................... 289,813 448,674
Other ................................. 225,656 56,343
------------ ------------
19,224,738 21,447,447
Less: Valuation Allowance ............ (19,224,738) (21,447,447)
------------ ------------
$ -- $ --
============ ============
At December 31, 2006, Tag-It Pacific, Inc. had Federal and state net
operating loss carry-forwards (or "NOLs") of approximately $53.6 million and
$13.9 million, respectively. The Federal NOL is available to offset future
taxable income through 2024, and the state NOL expires in 2014. Section 382 of
the Internal Revenue Code places a limitation on the realizability of net
operating losses in future periods if the ownership of the Company has changed
more than 50% within a three-year period. As of December 31, 2006, some of our
net operating losses may be limited by the Section 382 rules. The amount of such
limitations, if any, has not yet been determined.
Income taxes are accounted for under the asset and liability method.
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
48
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
bases and tax benefit carry-forwards. Deferred tax liabilities and assets at the
end of each period are determined using enacted tax rates. The Company records
deferred tax assets arising from temporary timing differences between recorded
net income and taxable net income when and if it believes that future earnings
will be sufficient to realize the tax benefit. For those jurisdictions where the
expiration date of tax benefit carry-forwards or the projected taxable earnings
indicate that realization is not likely, a valuation allowance is provided.
The provisions of SFAS No. 109, "Accounting for Income Taxes," require
the establishment of a valuation allowance when, based on currently available
information and other factors, it is more likely than not that all or a portion
of a deferred tax asset will not be realized. SFAS No. 109 provides that an
important factor in determining whether a deferred tax asset will be realized is
whether there has been sufficient income in recent years and whether sufficient
income is expected in future years in order to utilize the deferred tax asset.
In 2006 and in prior years, the Company determined, based upon its
cumulative operating losses, that it was more likely than not that it would not
be in a position to fully realize all of its deferred tax assets in future
years. Accordingly, at December 31, 2006 the Company has recorded a valuation
allowance of $19.2 million, which reduces the carrying value of its net deferred
tax assets to $0. For the year ended December 31, 2006 the Company recorded
operating income and various rate and tax timing differences and the value of
its net deferred tax assets declined by $2.2 million. Accordingly, a
corresponding reduction in the valuation allowance was made, which retained the
carrying value of the Company's net deferred tax assets at $0. During 2005 the
Company incurred additional operating losses which resulted in an increase in
the Company's net deferred tax assets by $11.5 million. Accordingly, it was
determined that the valuation allowance from 2004 be increased by $12.5 million
to $21.4 million, which reduced the carrying value of its net deferred tax
assets to $0 at December 31, 2005. In 2004 the Company recorded a valuation
allowance of $8.9 million based upon its cumulative operating losses, and
reduced the carrying value of its net deferred tax asset to $1.0 million at
December 31, 2004.
The Company intends to maintain a valuation allowance for its deferred
tax assets until sufficient evidence exists to support the reversal or reduction
of the allowance. At the end of each period, the Company will review supporting
evidence, including the performance against sales and income projections, to
determine if a release of the valuation allowance is warranted. If in future
periods it is determined that it is more likely than not that the Company will
be able to recognize all or a greater portion of its deferred tax assets, the
Company will at that time reverse or reduce the valuation allowance.
The Company believes that its estimate of deferred tax assets and
determination to record a valuation allowance against such assets are critical
accounting estimates because they are subject to, among other things, an
estimate of future taxable income, which is susceptible to change and dependent
upon events that may or may not occur, and because the impact of recording a
valuation allowance may be material to the assets reported on its balance sheet
and results of operations.
The Company has not provided withholding of U.S. federal income taxes
on undistributed earnings of its foreign subsidiaries because the Company
intends to reinvest those earnings indefinitely or any taxes on these earnings
will be offset by the approximate credits for foreign taxes paid. It is not
practical to determine the U.S. federal tax liability, if any, which would be
payable if such earnings were not invested indefinitely. At December 31, 2006
and 2005, undistributed earnings from our foreign subsidiaries were $4,581,000
and $4,689,000, respectively.
49
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 13 - COMMITMENTS AND CONTINGENCIES
OPERATING LEASES
The Company is a party to a number of non-cancelable operating lease
agreements involving buildings and equipment, which expire at various dates
through 2010. The Company accounts for its leases in accordance with SFAS No.
13, whereby step provisions, escalation clauses, tenant improvement allowances,
increases based on an existing index or rate, and other lease concessions are
accounted for in the minimum lease payments and are charged to the income
statement on a straight-line basis over the related lease term.
The future minimum lease commitments at December 31, 2006 are as
follows:
Years Ending December 31, Amount
----------------------------------------------- ----------
2007 ...................................... $ 437,226
2008 ...................................... 407,224
2009 ...................................... 346,184
2010 ...................................... 213,364
2011 and thereafter ....................... 16,757
----------
Total minimum payments .................... $1,420,755
==========
Total rental expense for the years ended December 31, 2006, 2005 and
2004 aggregated $640,864, $750,536, and $696,590, respectively.
PROFIT SHARING PLAN
In October 1999, the Company established a 401(k) profit-sharing plan
for the benefit of eligible employees. The Company may make annual contributions
to the plan as determined by the Board of Directors. Total contributions for the
years ended December 31, 2006 and 2005 amounted to $22,276 and $16,807,
respectively. There were no contributions made during the year ended December
31, 2004.
CONTINGENCIES
In May, 2006, the Company received notice from the American Stock
Exchange ("AMEX") that it was not in compliance with certain of the continued
listing standards as set forth in the AMEX Company Guide due to the failure to
comply with Section 1003(a)(i) and Section 1003(a)(ii) of the Company Guide,
which effectively required that the Company maintain shareholders' equity of at
least $4,000,000. Following the notice from AMEX the Company was afforded the
opportunity to submit a "plan of compliance" to AMEX outlining in detail how the
Company expected to achieve the minimum equity requirements and to regain
compliance. On August 3, 2006 the Company received notification from AMEX that
the Company's plan to regain compliance with the minimum shareholders' equity
requirements of the AMEX Company Guide had been accepted and the Company has
been granted an extension until November 16, 2007 to achieve the AMEX continued
listing requirements. During this period the Company will be subject to periodic
review by the AMEX Staff and failure to make progress consistent with the plan
or to regain compliance with continued listing standards by the end of the
extension period could result in being delisted from the American Stock
Exchange.
On October 12, 2005, a shareholder class action complaint-- Huberman v.
Tag-It Pacific, Inc., et al., Case No. CV05-7352 R(Ex)--was filed against us and
certain of our current and former officers and directors in the United States
District Court for the Central District of California alleging claims under
Section 10(b) and Section 20 of the Securities Exchange Act of 1934, as amended,
and Rule 10b-5 promulgated thereunder. The action is brought on behalf of all
50
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
purchasers of our publicly-traded securities during the period from November 14,
2003 to August 12, 2005. On January 23, 2006 the court heard competing motions
for appointment of lead plaintiff/counsel and appointed Seth Huberman as lead
plaintiff. The lead plaintiff thereafter filed an amended complaint on March 13,
2006. The amended complaint alleges that defendants made false and misleading
statements about the company's financial situation and its relationship with
certain of its large customers during a purported class period between November
13, 2003 and August 12, 2005. It purports to state claims under Section
10(b)/Rule 10b-5 and Section 20(a) of the Securities Exchange Act of 1934. The
Company filed a motion to dismiss the amended complaint, which motion was denied
by the court on July 17, 2006. On December 21, 2006 the court established a
trial date of May 1, 2007 and ordered completion of discovery by March 19, 2007.
On February 20, 2007 the court denied class certification. Plaintiff has moved
the court to reconsider the ruling, and also to intervene a new plaintiff to
pursue class certification. Both of those motions were denied on April 2, 2007.
In addition, the same day, the Court granted Defendants' motion for summary
judgment, and it is anticipated that the Court will enter a judgment in favor of
all Defendants shortly. It is possible that Plaintiff will appeal the summary
judgment and class certification rulings. The Company believes that this matter
will be resolved in trial or in settlement within the limits of its insurance
coverage, however the outcomes of this action or an estimate of the potential
losses, if any, related to the lawsuit cannot be reasonably predicted, and an
adverse resolution of any of the lawsuit could potentially have a material
adverse effect on our financial position and results of operations.
On April 16, 2004 the Company filed suit against Pro-Fit Holdings,
Limited ("Pro-Fit") in the U.S. District Court for the Central District of
California -- Tag-It Pacific, Inc. v. Pro-Fit Holdings, Limited, CV 04-2694 LGB
(RCx) -- asserting various contractual and tort claims relating to our exclusive
license and intellectual property agreement with Pro-Fit, seeking declaratory
relief, injunctive relief and damages. It is the Company's position that the
agreement with Pro-Fit gives us the exclusive rights in certain geographic areas
to Pro-Fit's stretch and rigid waistband technology. On September 17, 2004,
Pro-Fit filed an answer denying the material allegations of the complaint and
filed counterclaims alleging various contractual and tort claims seeking
injunctive relief and damages. We filed a reply denying the material allegations
of Pro-Fit's pleading. Pro-Fit has since purported to terminate the exclusive
license and intellectual property agreement based on the same alleged breaches
of the agreement that are the subject of the parties' existing litigation, as
well as on an additional basis. On February 9, 2005, and again on June 16, 2005,
we amended our pleadings in the litigation to assert additional breaches by
Pro-Fit of its obligations under the agreement and under certain additional
letter agreements, and for a declaratory judgment that Pro-Fit's patent No.
5,987,721 is invalid and not infringed by us. Thereafter, Pro-Fit filed an
amended answer and counterclaims denying the material allegations of the amended
complaint and alleging various contractual and tort claims seeking injunctive
relief and damages. Pro-Fit further asserted that we infringed its United States
Patent Nos. 5,987,721 and 6,566,285. We filed a reply denying the substantive
allegations of the amended counterclaims. On June 5, 2006 the Court denied the
Company's motion for partial summary judgment holding that summary
adjudification that we did not breach our agreement with Pro-Fit by engaging in
certain activities in Columbia was not appropriate. The Court also held that
Pro-Fit was not "unwilling or unable" to fulfill orders by refusing to fill
orders with goods produced in the United States. The Court did not find that we
breached our agreement with Pro-Fit and a trial is required to determine issues
concerning our activities in Columbia and whether other actions by Pro-Fit
constituted an unwillingness or inability to fill orders. As a result of a
change in the law, we dismissed our antitrust claims against Pro-Fit. The court
has not yet set a date for trial of this matter. We derive a significant amount
of revenue from the sale of products incorporating the stretch waistband
technology our business, results of operations and financial condition could be
materially adversely affected if the dispute with Pro-Fit is not resolved in a
manner favorable to us. Additionally, we have incurred significant legal fees in
this litigation, and unless the case is settled, we will continue to incur
additional legal fees in increasing amounts as the case accelerates to trial.
Tag-It Pacific, Inc. has agreements with its foreign subsidiaries that
provide for royalty payments to the U.S. parent company for the sales of
products carrying the Talon(R) brand name, and that also provide for a cost
sharing arrangement associated with various corporate administrative and
operations support costs. These agreements may give rise to inquiries and
51
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
possible disputes by the foreign taxing authority, resulting in the possible
disallowance of some of these costs and potentially resulting in higher foreign
income taxes than has been provided. The Company believes that its basis of
charging these royalties and its allocation of costs to foreign subsidiaries is
appropriate under the various taxing agency laws, and that any disagreement or
disallowance regarding such costs will not have a material affect on the
financial statements of the Company. A subsidiary, Tag-It de Mexico, S.A. de
C.V., has operated under the Mexican government's Maquiladora Program, which
entitles Tag-It de Mexico to certain favorable treatment as respects taxes and
duties regarding certain imports. In July of 2005, the Mexican Federal Tax
Authority asserted a claim against Tag-It de Mexico alleging that certain taxes
had not been paid on imported products during the years 2000, 2001, 2002 and
2003. In October of 2005, the Company filed a procedural opposition to the claim
and submitted documents to the Mexican Tax Authority in opposition to this
claim, supporting the Company's position that the claim was without merit. The
Mexican Federal Tax Authority failed to respond to the opposition filed, and the
required response period by the Tax Authority has lapsed. In addition, a
controlled entity incorporated in Mexico (Logistica en Avios, S.A. de C.V.)
through which the Company conducted its operations in 2005, may be subjected to
a claim or claims from the Mexican Tax Authority, as identified directly above,
and additionally to other tax issues, including those arising from employment
taxes. The Company believes that any such claim is defective on both procedural
and documentary grounds and is without merit. An estimate of the possible loss
or range of loss if any associated with these matters cannot be made at this
time. The Company does not believe these matters will have a material adverse
affect on the Company.
The Company currently has pending a number of other claims, suits and
complaints that arise in the ordinary course of our business. We believe that we
have meritorious defenses to these claims and that the claims are either covered
by insurance or, after taking into account the insurance in place, would not
have a material effect on our consolidated financial condition if adversely
determined against us.
In November 2002, the FASB issued FIN No. 45 "Guarantor's Accounting
and Disclosure Requirements for Guarantees, including Indirect Guarantees of
Indebtedness of Others - and interpretation of FASB Statements No. 5, 57 and 107
and rescission of FIN 34." The following is a summary of the Company's
agreements that it has determined are within the scope of FIN 45:
In accordance with the bylaws of the Company, officers and directors
are indemnified for certain events or occurrences arising as a result of the
officer or director's serving in such capacity. The term of the indemnification
period is for the lifetime of the officer or director. The maximum potential
amount of future payments the Company could be required to make under the
indemnification provisions of its bylaws is unlimited. However, the Company has
a director and officer liability insurance policy that reduces its exposure and
enables it to recover a portion of any future amounts paid. As a result of its
insurance policy coverage, the Company believes the estimated fair value of the
indemnification provisions of its bylaws is minimal and therefore, the Company
has not recorded any related liabilities.
The Company enters into indemnification provisions under its agreements
with investors and its agreements with other parties in the normal course of
business, typically with suppliers, customers and landlords. Under these
provisions, the Company generally indemnifies and holds harmless the indemnified
party for losses suffered or incurred by the indemnified party as a result of
the Company's activities or, in some cases, as a result of the indemnified
party's activities under the agreement. These indemnification provisions often
include indemnifications relating to representations made by the Company with
regard to intellectual property rights. These indemnification provisions
generally survive termination of the underlying agreement. The maximum potential
amount of future payments the Company could be required to make under these
indemnification provisions is unlimited. The Company has not incurred material
costs to defend lawsuits or settle claims related to these indemnification
agreements. As a result, the Company believes the estimated fair value of these
agreements is minimal. Accordingly, the Company has not recorded any related
liabilities.
52
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 14 - GEOGRAPHIC INFORMATION
The Company specializes in the distribution of a full range of trim
items to manufacturers of fashion apparel, specialty retailers and mass
merchandisers. There is not enough difference between the types of products
developed and distributed by the Company to justify segmented reporting by
product type. The Company believes that revenue by each major product class is a
valuable business measurement. The net revenues for the three primary product
groups is as follows:
Year Ended December 31,
-------------------------------------------
2006 2005 2004
----------- ----------- -----------
Product Group Net Revenue:
Talon zipper .............. $17,005,203 $13,593,479 $12,712,689
Trim ...................... 22,502,947 24,788,397 28,805,347
Tekfit .................... 9,316,852 8,949,300 13,591,445
----------- -----------
$48,825,002 $47,331,176 $55,109,481
=========== =========== ===========
The Company distributes its products internationally and has reporting
requirements based on geographic regions. Long-lived assets are attributed to
countries based on the location of the assets and revenues are attributed to
countries based on customer delivery locations, as follows:
Year Ended December 31,
-------------------------------------------
2006 2005 2004
----------- ----------- -----------
Sales:
United States ............. $ 5,287,236 $ 8,902,734 $ 4,822,935
Asia ...................... 28,974,546 20,005,036 12,785,977
Mexico .................... 2,476,313 8,526,367 21,452,805
Dominican Republic ........ 9,138,404 5,914,792 9,678,078
Other ..................... 2,948,503 3,982,247 6,369,686
----------- ----------- -----------
$48,825,002 $47,331,176 $55,109,481
=========== =========== ===========
Long-lived Assets:
United States ............. $ 9,531,659 $ 9,797,110 $12,911,377
Asia ...................... 386,516 226,221 234,746
Mexico .................... 5,078 23,754 187,721
Dominican Republic ........ 668,067 776,279 866,807
----------- ----------- -----------
$10,591,320 $10,823,364 $14,200,651
=========== =========== ===========
NOTE 15 - MAJOR CUSTOMERS AND VENDORS
For the year ended December 31, 2006, no single customer represented
more than 9% of the Company's consolidated net sales; however the Company's
three largest customers represented approximately 18% of consolidated net sales.
For the year ended December 31, 2005, no single customer represented more than
10% of consolidated net sales; however, the Company's three largest customers
represented approximately 22% of consolidated net sales. Two major customers
accounted for approximately 22% of the Company's net sales for the year ended
December 31, 2004.
One major vendor accounted for substantially all of the Company's
purchases associated with its TekFit product for the year ended December 31,
2006 and represented 24% of the Company's overall purchases; and three vendors,
each representing more than 10% of the Company's purchases, accounted for
approximately 45% of the Company's purchases for the year ended December 31,
2006. Three vendors accounted for approximately 39% of the Company's purchases
for the year ended December 31, 2005, and four vendors accounted for
approximately 70% of the Company's purchases for the year ended December 31,
53
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2004. Included in accounts payable and accrued expenses at December 31, 2006 and
2005 is $2,682,000 and $2,206,000 due to these vendors. Terms are sight to 60
days.
NOTE 16 - RELATED PARTY TRANSACTIONS
Prior to 2004 the Company operated an apparel trim supply agreement
with Tarrant Apparel Group. Two of Tarrant's directors and significant
shareholders are also significant shareholders of the Company. In 2004,
following negotiations with Tarrant Apparel Group, the Company determined that a
significant portion of the obligations due from this customer were
uncollectible. Accordingly, included in general and administrative expenses for
2004 are charges of $4.3 million related primarily to the write-down of this
receivable and leaving a remaining balance receivable from this customer of $4.5
million at December 31, 2004. An affiliate of the customer repaid the $4.5
million receivable balance over the period from May through December 2005. The
Company terminated its supply relationship with Tarrant in 2004; however the
Company continues to conduct business with Tarrant on a limited basis. Total
sales to Tarrant for the years ended December 31, 2006, 2005 and 2004 were
$3,000, $574,000 and $758,000, respectively. As of December 31, 2005, accounts
receivable, related party included $0.05 million due from Tarrant. No amounts
were due from Tarrant at December 31, 2006.
Colin Dyne, a director of the Company is a significant shareholder in
People's Liberation, Inc., the parent company of Versatile Entertainment, Inc.
During 2006 and 2005 the Company had sales of $147,000 and $ 76,000
respectively, to Versatile Entertainment. At December 31, 2006 accounts
receivable of $83,400 were outstanding from Versatile Entertainment.
Due from related parties at December 31, 2006 and 2005 includes
$675,137 and $655,489 respectively, of unsecured notes, advances and accrued
interest receivable from Colin Dyne,. The notes and advances bear interest at
7.5% and are due on demand.
Demand notes payable to related parties includes notes and advances to
Mark Dyne, the Chairman of the Board of Directors of the Company or to parties
related to or affiliated with Mark Dyne. The balance of Demand notes payable to
related parties at December 31, 2006 and 2005 was $664,971. See Note 4 for
further discussion of these notes, and related accrued interest and interest
expense.
Transportation fees in the amount of $211,000 were paid to or on behalf
of a company that Mark Dyne has an ownership interest in for the year ended
December 31, 2004. Consulting fees paid to Diversified Investments, a company
owned by Mark Dyne, amounted to $150,000 for each of the years ended December
31, 2006, 2005 and 2004.
Consulting fees of $335,000 were paid for services provided by Colin
Dyne, for the year ended December 31, 2006. Brent Cohen and Raymond Musci, both
members of the Board of Directors were paid for services provided during the
year ended December 31, 2005 in the amount of $24,000, and $21,000,
respectively. Mr. Cohen and Kevin Bermiester, a former director of the Company,
were paid for services provided during the year ended December 31, 2004 in the
amounts of $57,000 and $41,000, respectively.
54
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 17 - QUARTERLY RESULTS (UNAUDITED)
Quarterly results for the years ended December 31, 2006 and 2005 are
reflected below:
4th 3rd 2nd 1st
------------ ------------ ------------ ------------
2006
- ----
Revenue .................... $ 10,573,755 $ 13,366,944 $ 14,246,087 $ 10,638,216
Gross profit ............... $ 3,350,600 $ 4,148,406 $ 4,127,237 $ 2,842,725
Operating income (loss) .... $ 248,177 $ 630,273 $ 895,481 $ (442,275)
Net Income(loss) ........... $ 44,950 $ 339,115 $ 654,643 $ (729,404)
Basic and diluted income
(loss) per share ........... $ 0.00 $ 0.02 $ 0.04 $ (0.04)
2005
- ----
Revenue .................... $ 9,163,355 $ 9,472,898 $ 15,639,646 $ 13,055,277
Gross profit (loss) (1) .... $ (1,652,918) $ (2,094,230) $ 756,120 $ 3,251,823
Operating (loss) income
(1,2) ...................... $ (4,925,076) $(10,203,361) $(10,829,928) $ (1,140,089)
Net (loss) income (1,2) .... $ (5,127,754) $(10,284,874) $(12,476,638) $ (1,648,443)
Basic and diluted (loss)
per share .................. $ (0.28) $ (0.56) $ (0.68) $ (0.09)
(1) The Company recorded restructuring charges of $6.2 million in the third
quarter of 2005, of which $3.4 million, related to inventory
write-downs (Note 11); theCompany recorded $2.5 million in inventory
obsolescence reserves and $1.5 million in inventory overhead
adjustments in the fourth quarter affecting gross profit.
(2) The Company recorded $3.6 million in bad debt reserves principally
associated with one customer in the second quarter of 2005; direct
write-off to bad debts of $1.8 million in the third quarter of 2005
principally from another customer, and $0.5 million in bad debts in the
fourth quarter of 2005 associated with the acceptance of a note
receivable. In the third quarter of 2005, the Company recorded
restructuring charges included in operating costs of $2.8 millionand a
decrease in net deferred tax asset resulting in a charge to the
provision for income taxes of $1 million during 2005.
During 2006, the Company had no material unusual or infrequently
occurring items or adjustments that were recognized during the year.
Quarterly and year-to-date computations of per share amounts are made
independently. Therefore, the sum of per share amounts for the quarters may not
agree with the per share amounts for the year.
NOTE 18 - SUBSEQUENT EVENT (UNAUDITED)
On April 11, 2007 a favorable verdict was awarded to the plaintiff in a
trademark infringement lawsuit in which Azteca Production International, Inc. is
a defendant. We have an outstanding note receivable from Azteca (see Note 2),
and this adverse ruling against them may impact their ability to repay our note
receivable. The outcome of this event or an estimate of the potential impact if
any, on the collectibility of our note receivable cannot be reasonably predicted
at this time. The failure to collect payments under this note as scheduled could
have a material adverse effect on our financial position and results of
operations.
55
ITEM 9A. CONTROLS AND PROCEDURES
EVALUATION OF CONTROLS AND PROCEDURES
We maintain disclosure controls and procedures that are designed to
ensure that information required to be disclosed in our reports under the
Securities Exchange Act of 1934, as amended, or the Exchange Act is recorded,
processed, summarized and reported, within the time periods specified in the
Securities Exchange Commission's rules and forms, including to ensure that
information required to be disclosed by us in the reports filed or submitted by
us under the Exchange Act is accumulated and communicated to our management,
including our principal executive and principal financial officers, or persons
performing similar functions, as appropriate to allow timely decisions regarding
required disclosure as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange
Act.
As of December 31, 2006, we conducted an evaluation, with the
participation of our Chief Executive Officer and Chief Financial Officer, of the
effectiveness of the design and operation of our disclosure controls and
procedures. Based on that evaluation, our Chief Executive Officer and Chief
Financial Officer have concluded that as of December 31, 2006, our disclosure
controls and procedures were effective.
CHANGES IN INTERNAL CONTROLS
During the last fiscal quarter, there have been no changes in our
internal control over financial reporting that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.
56
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a) FINANCIAL STATEMENTS AND SCHEDULES.
57
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM'S REPORT ON SCHEDULE II
To the Board of Directors
Tag it Pacific, Inc.
Woodland Hills, California
The audits referred to in our report, dated April 9, 2007 included in the
related financial statement schedule as of December 31, 2006 and for the two
years ended December 31, 2006, included in the annual report on Form 10-K of
Tag-It Pacific, Inc. This financial statement scheduled is the responsibility of
the Company's management. Our responsibility is to express an opinion on this
financial statement schedule based on our audit. In our opinion, such financial
statement schedule presents fairly, in all material respects, the information
set forth therein.
/S/ SINGER LEWAK GREENBAUM & GOLDSTEIN
- ------------------------------------------
SINGER LEWAK GREENBAUM & GOLDSTEIN
Los Angeles, California
April 9, 2007
58
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM'S REPORT ON SCHEDULE II
To the Board of Directors
Tag-It Pacific, Inc.
Los Angeles, California
The audit referred to in our report, dated March 31, 2005, included the related
financial statement schedule as of and for the year ended December 31, 2004
included in the annual report on Form 10-K of Tag-It Pacific, Inc. This
financial statement schedule is the responsibility of the Company's management.
Our responsibility is to express an opinion on this financial statement schedule
based on our audit. In our opinion, such financial statement schedule presents
fairly, in all material respects, the information set forth therein.
/s/ BDO Seidman, LLP
- ------------------------------------------
BDO Seidman, LLP
Los Angeles, California
March 31, 2005
59
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E
Balance at
Beginning Balance at
Description of Year Additions Deductions End of Year
- -------------------------------------------- ----------- ----------- ----------- -----------
2006
- ----
Allowance for doubtful accounts
deducted from accounts receivable
in the balance sheet ..................... $ 1,189,000 $ 198,000 $ 1,315,500 $ 71,500
Reserve for obsolescence deducted
from inventories on the balance
sheet .................................... 7,306,000 557,000 6,621,000 1,242,000
Valuation reserve deducted from
deferred tax assets ...................... 21,447,000 -- 2,222,000 19,225,000
----------- ----------- ----------- -----------
$29,942,000 $ 755,000 $10,158,500 $20,538,500
=========== =========== =========== ===========
2005
- ----
Allowance for doubtful accounts
deducted from accounts receivable
in the balance sheet ..................... $ 6,086,000 $ 4,160,000 $ 9,057,000 $ 1,189,000
Reserve for obsolescence deducted
from inventories on the balance
sheet .................................... 6,365,000 2,538,000 1,597,000 7,306,500
Valuation reserve deducted from
deferred tax assets ...................... 8,900,000 12,547,000 -- 21,447,000
----------- ----------- ----------- -----------
$21,351,000 $19,245,000 $10,654,000 $29,942,000
=========== =========== =========== ===========
2004
- ----
Allowance for doubtful accounts
deducted from accounts receivable
in the balance sheet ..................... $ 2,044,000 $ 5,500,000 $ 1,458,000 $ 6,086,000
Reserve for obsolescence deducted
from inventories on the balance
sheet .................................... 6,125,000 1,040,000 800,000 6,365,500
Valuation reserve deducted from
deferred tax assets ...................... 1,119,000 7,781,000 -- 8,900,000
----------- ----------- ----------- -----------
$ 9,288,000 $14,321,000 $ 2,258,000 $21,351,000
=========== =========== =========== ===========
(1) Additions to the allowance for doubtful accounts include provisions for
uncollectible accounts. Bad debt expense includes (and additions above
exclude) net recoveries of $712,000 for the year ended December 31,
2006, and net direct write-offs of $1,698,000 and $2,916,000 for the
years ended December 31, 2005 and 2004, respectively. Additions to the
inventory obsolescence reserve include current year provisions.
Additionally, in 2005 there were direct write-offs of inventory of $3.4
million in connection with the restructuring, and in 2006 there were
direct write-offs of $0.2 million.
(2) Deductions from the allowance for doubtful accounts includes amounts
applied to write-offs, reversals of prior period provisions, and, for
the year ended December 31, 2005, deductions include $7,528,000 related
to the conversion of a trade account receivable to a note receivable.
Deductions from the inventory obsolescence reserve include application
of the reserve against obsolete, excess, slow-moving or disposed
inventory.
(b) EXHIBITS:
See Exhibit Index attached to this Annual Report of Form 10-K.
60
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
TAG-IT PACIFIC, INC.
----------------------------
By: Lonnie D. Schnell
Its: Chief Financial Officer
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, this report has been signed below by the following persons
on behalf of the Registrant and in the capacities and on the dates indicated.
Signature Title Date
--------- ----- ----
Chairman of the Board of Directors
- ---------------------
Mark Dyne
Chief Executive Officer
- --------------------- (Principal Executive
Stephen Forte Officer) and Director
Chief Financial Officer
- --------------------- (Principal Accounting and
Lonnie D. Schnell Financial Officer)
Director
- ---------------------
Colin Dyne
Director
- ---------------------
Brent Cohen
Director
- ---------------------
Raymond Musci
Director
- ---------------------
Joseph Miller
Director
- ---------------------
William Sweedler
61
EXHIBIT INDEX
Exhibit
Number Exhibit Description
- ------- -----------------------------------------------------------------------
23.1 Consent of Singer Lewak Greenbaum & Goldstein LLP.
23.2 Consent of BDO Seidman, LLP.
31.1 Certificate of Chief Executive Officer pursuant to Rule 13a-14(a) under
the Securities and Exchange Act of 1934, as amended
31.2 Certificate of Chief Financial Officer pursuant to Rule 13a-14(a) under
the Securities and Exchange Act of 1934, as amended
32.1 Certificate of Chief Executive Officer and Chief Financial Officer
pursuant to Rule 13a-14(b) under the Securities and Exchange Act of
1934, as amended.
62
ATTACHMENT C
TALON INTERNATIONAL, INC.
ANNUAL REPORT ON FORM 10-K/A
AMENDED ITEMS
================================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K/A
(AMENDMENT NO. 2)
[X] Annual Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2006
[_] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
Commission file number 1-13669
TAG-IT PACIFIC, INC.
(Exact Name of Registrant as Specified in Its Charter)
DELAWARE 95-4654481
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
21900 BURBANK BLVD., SUITE 270
WOODLAND HILLS, CALIFORNIA 91367
(Address of Principal Executive Offices) (Zip Code)
(818) 444-4100
(Registrant's Telephone Number, Including Area Code)
Securities registered pursuant to Section 12(b) of the Act:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
------------------- -----------------------------------------
COMMON STOCK, $.001 PAR VALUE AMERICAN STOCK EXCHANGE
Securities registered pursuant to Section 12(g) of the Act:
NONE
Indicate by check mark if the registrant is a well-known seasoned issuer, as
defined in Rule 405 of the Securities Act.
Yes [_] No [X]
Indicate by check mark if the registration is not required to file reports
pursuant to Section 13 or Section 15(d) of the Act. Yes [_] No [X]
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 past 90 days.
Yes [X] No [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K [_]
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer or a non-accelerated filer (as defined in Rule 12b-2 of the
Exchange Act).
Large accelerated filer [_] Accelerated filer [_] Non-accelerated filer [X]
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Act). Yes [_] No [X]
At June 30, 2006 the aggregate market value of the voting and non-voting common
stock held by non-affiliates of the registrant was $12,147,000. At April 10,
2007 the issuer had 18,466,433 shares of Common Stock, $.001 par value, issued
and outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
None.
================================================================================
EXPLANATORY NOTE
This Amendment No. 2 to Form 10-K on Form 10-K/A (this "Amendment")
amends Talon International, Inc.'s (formerly, Tag-It Pacific, Inc.) (the
"Company") Annual Report on Form 10-K for the fiscal year ended December 31,
2006, originally filed on April 12, 2007, and amended by Amendment No. 1 to Form
10-K on Form 10-K/A filed on April 30, 2007 (as amended, the "Original Filing").
The Company is filing this Amendment to amend the disclosure contained in Item
3, Item 6, Item 7, Item 8, Item 9A and Item 15 of the Original Filing.
Except as described above, no other changes have been made to the
Original Filing. This Amendment continues to speak as of the date of the
Original Filing, and the Company has not updated the disclosures contained
therein to reflect any events which occurred at a date subsequent to the filing
of the Original Filing. In this Amendment, unless the context indicates
otherwise, the terms "Company," "we," "us," and "our" refer to Talon
International, Inc. and its subsidiaries.
1
ITEM 3. LEGAL PROCEEDINGS
On October 12, 2005, a shareholder class action complaint-- HUBERMAN V.
TAG-IT PACIFIC, INC., ET AL., Case No. CV05-7352 R(Ex)--was filed against us and
certain of our current and former officers and directors in the United States
District Court for the Central District of California alleging claims under
Section 10(b) and Section 20 of the Securities Exchange Act of 1934, as amended,
and Rule 10b-5 promulgated thereunder. The action is brought on behalf of all
purchasers of our publicly-traded securities during the period from November 14,
2003 to August 12, 2005. On January 23, 2006 the court heard competing motions
for appointment of lead plaintiff/counsel and appointed Seth Huberman as lead
plaintiff. The lead plaintiff thereafter filed an amended complaint on March 13,
2006. The amended complaint alleges that defendants made false and misleading
statements about the company's financial situation and its relationship with
certain of its large customers during a purported class period between November
13, 2003 and August 12, 2005. It purports to state claims under Section
10(b)/Rule 10b-5 and Section 20(a) of the Securities Exchange Act of 1934. The
Company filed a motion to dismiss the amended complaint, which motion was denied
by the court on July 17, 2006. On December 21, 2006 the court established a
trial date of May 1, 2007 and ordered completion of discovery by March 19, 2007.
On February 20, 2007 the court denied class certification. Plaintiff has moved
the court to reconsider the ruling, and also to intervene a new plaintiff to
pursue class certification. Both of those motions were denied on April 2, 2007.
In addition, the same day, the Court granted Defendants' motion for summary
judgment, and it is anticipated that the Court will enter a judgment in favor of
all Defendants shortly. It is possible that Plaintiff will appeal the summary
judgment and class certification rulings. We believe that this matter will be
resolved in trial or in settlement within the limits of our insurance coverage,
however the outcomes of this action or an estimate of the potential losses, if
any, related to the lawsuit cannot be reasonably predicted, and an adverse
resolution of the lawsuit could potentially have a material adverse effect on
our financial position and results of operations.
On April 16, 2004 we filed suit against Pro-Fit Holdings, Limited
("Pro-Fit") in the U.S. District Court for the Central District of California --
TAG-IT PACIFIC, INC. V. PRO-FIT HOLDINGS, LIMITED, CV 04-2694 LGB (RCx) --
asserting various contractual and tort claims relating to our exclusive license
and intellectual property agreement with Pro-Fit, seeking declaratory relief,
injunctive relief and damages. It is our position that the agreement with
Pro-Fit gives us the exclusive rights in certain geographic areas to Pro-Fit's
stretch and rigid waistband technology. On September 17, 2004, Pro-Fit filed an
answer denying the material allegations of the complaint and filed counterclaims
alleging various contractual and tort claims seeking injunctive relief and
damages. We filed a reply denying the material allegations of Pro-Fit's
pleading. Pro-Fit has since purported to terminate the exclusive license and
intellectual property agreement based on the same alleged breaches of the
agreement that are the subject of the parties' existing litigation, as well as
on an additional basis. On February 9, 2005, and again on June 16, 2005, we
amended our pleadings in the litigation to assert additional breaches by Pro-Fit
of its obligations under the agreement and under certain additional letter
agreements, and for a declaratory judgment that Pro-Fit's patent No. 5,987,721
is invalid and not infringed by us. Thereafter, Pro-Fit filed an amended answer
and counterclaims denying the material allegations of the amended complaint and
alleging various contractual and tort claims seeking injunctive relief and
damages. Pro-Fit further asserted that we infringed its United States Patent
Nos. 5,987,721 and 6,566,285. We filed a reply denying the substantive
allegations of the amended counterclaims. On June 5, 2006 the Court denied our
motion for partial summary judgment holding that summary adjudication that we
did not breach our agreement with Pro-Fit by engaging in certain activities in
Columbia was not appropriate. The Court also held that Pro-Fit was not
"unwilling or unable" to fulfill orders by refusing to fill orders with goods
produced in the United States. The Court did not find that we breached our
agreement with Pro-Fit and a trial is required to determine issues concerning
our activities in Columbia and whether other actions by Pro-Fit constituted an
unwillingness or inability to fill orders. As a result of a change in the law,
we dismissed our antitrust claims against Pro-Fit. The court has not yet set a
date for trial of this matter. We have derived a significant amount of revenue
from the sale of products incorporating the stretch waistband technology, and
our business, results of operations and financial condition could be materially
adversely affected if the dispute with Pro-Fit is not resolved in a manner
favorable to us. Additionally, we have incurred significant legal fees in this
2
litigation, and unless the case is settled, we will continue to incur additional
legal fees in increasing amounts as the case accelerates to trial.
We have agreements with our foreign subsidiaries that provide for
royalty payments to the U.S. parent company for the sales of products carrying
the TALON(R) brand name, and that also provide for a cost sharing arrangement
associated with various corporate administrative and operations support costs.
These agreements may give rise to inquiries and possible disputes by the foreign
taxing authority, resulting in the possible disallowance of some of these costs
and potentially resulting in higher foreign income taxes than has been provided.
We believe that our basis of charging these royalties and its allocation of
costs to foreign subsidiaries is appropriate under the various taxing agency
laws, and that any disagreement or disallowance regarding such costs will not
have a material affect on the financial statements of the Company. A subsidiary,
Tag-It de Mexico, S.A. de C.V., has operated under the Mexican government's
Maquiladora Program, which entitles Tag-It de Mexico to certain favorable
treatment as respects taxes and duties regarding certain imports. In July of
2005, the Mexican Federal Tax Authority asserted a claim against Tag-It de
Mexico alleging that certain taxes had not been paid on imported products during
the years 2000, 2001, 2002 and 2003. In October of 2005, we filed a procedural
opposition to the claim and submitted documents to the Mexican Tax Authority in
opposition to this claim, supporting our position that the claim was without
merit. The Mexican Federal Tax Authority failed to respond to the opposition
filed, and the required response period by the Tax Authority has lapsed. In
addition, a controlled entity incorporated in Mexico (Logistica en Avios, S.A.
de C.V.) through which we conducted our operations in 2005, may be subjected to
a claim or claims from the Mexican Tax Authority, as identified directly above,
and additionally to other tax issues, including those arising from employment
taxes. We believe that any such claim is defective on both procedural and
documentary grounds and is without merit. An estimate of the possible loss or
range of loss if any associated with these matters cannot be made at this time.
We do not believe these matters will have a material adverse affect on us.
We currently have pending a number of other claims, suits and
complaints that arise in the ordinary course of our business. We believe that we
have meritorious defenses to these claims and that the claims are either covered
by insurance or, after taking into account the insurance in place, would not
have a material effect on our consolidated financial condition if adversely
determined against us.
3
PART II
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data is not necessarily indicative of
our future financial position or results of future operations, and should be
read in conjunction with Item 7, "Management's Discussion and Analysis of
Financial Condition and Results of Operations" and the Consolidated Financial
Statements and Notes thereto included in Item 8, "Financial Statements and
Supplementary Data" of this Report on Form 10-K.
YEARS ENDED DECEMBER 31,
(In thousands except per share data)
2002 2003(1) 2004(1,2) 2005(1) 2006
------------ ---------- ----------- ----------- --------------
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Total revenue...................................... $ 60,073 $ 64,443 $ 55,109 $ 47,331 $ 48,825
Income (loss) from operations...................... $ 3,044 $ (5,881) $ (14,482) $ (27,098) $ 1,332
Net income (loss).................................. $ 1,496 $ (4,745) $ (17,609) $ (29,538) $ 309
Net income (loss) per share - basic................ $ 0.14 $ (0.46) $ (1.02) $ (1.62) $ 0.02
Net income (loss) per share - diluted.............. $ 0.14 $ (0.46) $ (1.02) $ (1.62) $ 0.02
Weighted average shares outstanding - basic........ 9,232 10,651 17,316 18,226 18,377
Weighted average shares outstanding - diluted...... 9,531 10,651 17,316 18,226 18,956
CONSOLIDATED BALANCE SHEET DATA:
Cash and cash equivalents.......................... $ 285 $ 14,443 $ 5,461 $ 2,277 $ 2,935
Total assets....................................... $ 54,055 $ 67,770 $ 56,448 $ 30,321 $ 25,694
Capital lease obligations, line of credit and notes $ 21,263 $ 11,759 $ 18,792 $ 16,001 $ 16,214
payable
Convertible redeemable preferred stock............. $ 2,895 $ 2,895 $ - $ - $ -
Stockholders' equity............................... $ 18,467 $ 43,564 $ 30,195 $ 912 $ 1,686
Total liabilities and stockholders' equity......... $ 54,055 $ 67,770 $ 56,448 $ 30,321 $ 25,694
PER SHARE DATA:
Net book value per common share.................... $ 1.98 $ 3.79 $ 1.66 $ 0.05 $ 0.09
Common shares outstanding.......................... 9,320 11,508 18,171 18,241 18,466
- ----------------------
(1) We incurred restructuring costs of $6.4 million, $.4 million, and $7.7
million during the years ended December 31, 2005, 2004 and 2003, respectively.
(2) We incurred net charges of $4.3 million from the write-off of obligations
due from a former major customer and other fourth quarter adjustments totaling
$9.5 million during the year ended December 31, 2004.
4
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
The following management's discussion and analysis is intended to
assist the reader in understanding our consolidated financial statements. This
discussion is provided as a supplement to, and should be read in conjunction
with, our consolidated financial statements and accompanying notes.
Tag-It Pacific, Inc. designs, sells, manufactures and distributes
apparel zippers, specialty waistbands and various apparel trim products to
manufacturers of fashion apparel, specialty retailers and mass merchandisers. We
sell and market these products under various branded names including TALON and
TEKFIT. We operate the business globally under three product groups.
We plan to increase our global expansion of TALON zippers through the
establishment of a network of Talon owned sales, distribution and manufacturing
locations, distribution relationships and joint ventures. The network of these
distributors and manufacturing joint ventures, in combination with TALON owned
and affiliated facilities under the TALON brand, is expected to improve our
time-to-market by eliminating the typical setup and build-out phase for new
manufacturing capacity throughout the world, and by sourcing, finishing and
distributing to apparel manufacturers in their local markets.
We have structured our trim business to focus as an outsourced product
development, sourcing and sampling department for the most demanding brands and
retailers. We believe that trim design differentiation among brands and
retailers has become a critical marketing tool for our customers. By assisting
our customers in the design, development, sampling and sourcing of trim, we
expect to achieve higher margins for our trim products, create long-term
relationships with our customers, grow our sales to a particular customer by
supplying trim for a larger proportion of their brands, and better differentiate
our trim sales and services from those of our competitors. We plan to
aggressively expand our trim business globally, so we may better serve our
apparel factory customers in the field, in addition to our brand and retail
customer. We believe we can lead the industry in trim sourcing by having both an
intimate relationship with our brand and retail customers, and having a
distributed service organization to serve our factory customers (those that
manufacture for the apparel brand and retailers) globally.
Our TEKFIT services provide manufacturers with the patented technology,
manufacturing know-how and materials required to produce pants incorporating an
expandable waistband. These products were previously produced by several
manufacturers for one single brand. In October 2006 our exclusive supply
contract with this brand expired. With the expiration of this exclusive contract
we now have broader access to other customers and we intend to actively expand
this product offering to other brands. Orders have already been placed by a new
brand customer in October 2006 as a result of these efforts. However sales to
the previous brand are expected to decline significantly in 2007 and orders from
new brands are not expected to fully offset these declines in the near term.
Consequently, we expect sales and earnings contributions from this product line
to decline significantly for at least the first half of 2007; though we believe
our sales of this product will grow subsequently as we market our products to
new customers throughout the year.
Our efforts to expand this product offering to other customers have
also been limited by a licensing dispute. As described more fully in this report
under Item 3. "Legal Proceedings", we are presently in litigation with Pro-Fit
Holdings Limited related to our exclusively licensed rights to sell or
sublicense stretch waistbands manufactured under Pro-Fit's patented technology.
The revenues we derive from the sale of products incorporating the
stretch waistband technology, represented approximately 19% of our consolidated
revenues for the years ended December 31, 2006 and 2005, and 25% in 2004;
accordingly the results of operations and financial condition could be
materially adversely affected if our dispute with Pro-Fit is not resolved in a
manner favorable to us, or if we are unsuccessful in securing new customers to
replace the revenues previously generated by the single brand.
5
In an effort to better align our organizational and cost structures
with its future growth opportunities, in August 2005 our Board of Directors
adopted a restructuring plan that was substantially completed by December 31,
2005. The plan included restructuring our global operations by eliminating
redundancies in our Hong Kong operation, closing our facilities in Mexico, and
closing our North Carolina manufacturing facility. We have also refocused our
sales efforts on higher margin products, which may result in lower net sales
initially as we focus on acquiring high quality customers, and decrease our
customer concentration. As a result of this restructuring, we now operate with
fewer employees and will have lower associated operating and distribution
expenses.
During 2005, we recorded charges in connection with this restructuring
plan in accordance with SFAS No. 146 (as amended), "Accounting for Costs
Associated with Exit or Disposal Activities." In addition, the restructuring
plan resulted in the carrying value of certain long-lived assets, primarily
equipment, being impaired. Accordingly, in 2005 we recorded a charge to
recognize the impairment of these assets in accordance with SFAS No. 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets."
Our North Carolina manufacturing facility has been classified as "Fixed
assets held for sale" in our consolidated financial statements. Management has
committed to sell the asset and has listed the property for sale with a
commercial real estate agent. We believe the sale of the asset is probable and
that the sale is expected to be completed within one year. The major components
of manufacturing equipment used in this plant to manufacture zippers are not
classified as assets held for sale since management intends to re-deploy this
equipment in the manufacture of TALON zippers through investment or sale of this
equipment to distributors of TALON zippers. This equipment is separately
identified as idle equipment as a component of "Property and Equipment". See
"Notes to consolidated financial statements," Note 1.
Restructuring costs recorded in the third quarter of 2005 were $6.2
million. Additional restructuring costs of $0.2 million were incurred in the
fourth quarter of 2005. Total restructuring costs in 2005 were $6.4 million.
These costs include $3.4 million of inventory write-downs charged to cost of
goods sold; $2.2 million for the impairment of long-lived assets (primarily
machinery and equipment), $0.2 million of one-time employee termination benefits
and other costs of $0.2 million which were charged to operating expenses. In
addition, an impairment charge to goodwill of $0.4 million was recorded. This
goodwill was associated with an acquisition made to benefit our Central and
South American operations. Since these operations were closed during 2005, the
goodwill was impaired and written off. As a result of the restructuring, the
Company expected to reduce general and administrative operating costs by
approximately 25% to 30%, or $5.0 to $6.0 million on an annualized basis.
Initial savings anticipated during the fourth quarter of 2005 were expected to
be approximately $1.0 million offset by $0.8 million in costs to implement the
restructuring including a $0.4 million write-off of goodwill. During fiscal year
2006 general and administrative expense savings, principally as a result of the
restructuring, were approximately $4.4 million. The initial savings were
slightly less than anticipated in the restructuring plan due to necessary
outside consulting and temporary employee costs occurring due to the staff
reductions. During the first quarter of 2004, we incurred and recorded residual
restructuring charges of $0.4 million from a restructuring plan implemented in
2003.
In 2004, following negotiations with Tarrant Apparel Group, a former
customer, we determined that a significant portion of the obligations due from
this customer were uncollectible. Accordingly, included in general and
administrative expenses for 2004 are charges of $4.3 million related primarily
to the write-down of this receivable and leaving a remaining balance receivable
from this customer of $4.5 million. An affiliate of the customer repaid the $4.5
million receivable balance over the period from May through December 2005. In
addition to this $4.3 million write-down in 2004, we also recorded an accounts
receivable reserve of $5.0 million (or 9.1% of net sales) in the fourth quarter
of 2004 based on management's estimate of the collectibility of accounts
receivable primarily related to two other customers.
Our bad debt expense for the year ended December 31, 2005 includes
reserves of $3.6 million recorded in the second quarter of 2005 based on
management's estimate at the time of the collectibility of accounts receivable
from one customer. The fourth quarter of 2005 includes charges of $0.6 million
6
representing the present value discount of a subsequent note received in 2006 in
exchange for that same customer's accounts receivable. Bad debt expense also
includes a write-off in the third quarter of $1.8 million principally associated
with a single customer.
In connection with our 2005 restructuring plan, we recorded an
inventory write-down of $3.4 million in the third quarter of 2005. During the
fourth quarter of 2004, we recorded inventory write-downs totaling $2.5 million
based on management's estimate of the net realizable value of certain
inventories.
In 2004, we incurred net operating losses and increased our valuation
allowance for deferred tax assets to reduce our net deferred tax asset from $2.8
million to $1.0 million. The decrease in the net deferred tax asset resulted in
a charge of $1.8 million against the provision for income taxes in the fourth
quarter of 2004. In 2005, we further reduced the net carrying value of the
deferred tax asset to zero, resulting in an addition to the provision for income
taxes of $1.0 million for the year ended December 31, 2005.
RESULTS OF OPERATIONS
NET SALES
For the years ended December 31, 2006, 2005, and 2004, total sales by
geographic region based on customer delivery locations were as follows (amounts
in thousands):
2006 CHANGE 2005 CHANGE 2004
------- ------- ------- ------- -------
United States ............ $ 5,287 (41)% $ 8,903 85% $ 4,823
Asia ..................... 28,975 45 20,005 57 12,786
Mexico ................... 2,476 (71) 8,526 (60) 21,453
Dominican Republic ....... 9,138 54 5,915 (39) 9,678
Other .................... 2,949 (26) 3,982 (38) 6,369
------- ------- ------- ------- -------
Total ................ $48,825 3% $47,331 (14)% $55,109
======= ======= ======= ======= =======
The net revenues for the three primary product groups is as follows:
Year Ended December 31,
-------------------------------------------
2006 2005 2004
----------- ----------- -----------
Product Group Net Revenue:
Talon zipper .............. $17,005,203 $13,593,479 $12,712,689
Trim ...................... 22,502,947 24,788,397 28,805,347
Tekfit .................... 9,316,852 8,949,300 13,591,445
----------- ----------- -----------
$48,825,002 $47,331,176 $55,109,481
=========== =========== ===========
Sales are influenced by a number of factors, including demand, pricing
strategies, foreign exchange effects, new product launches and indications,
competitive products, product supply, and acquisitions. See Item 1 "Business"
for a discussion of our principal products.
Sales in 2006 increased modestly from 2005 as a net result of a
substantial decline within selected markets offset by large increases in other
geographical markets. Sales, principally of Trim products, to customers in
Mexico declined sharply in 2006 from 2005 ($6.0 million) as the industry shift
of apparel production from Latin America to Asia continued from 2005, from the
discontinuance of approximately $4.0 million in sales of products from 2005, and
as we completed the closure of our assembly and distribution operations within
Mexico. Total Trim product sales declined by approximately $2.3 million in 2006
as compared to 2005 as a consequence of the reductions from Mexico and the U.S.
described above offset by increased sales in Asia and the Dominican Republic
resulting mainly from the shift in industry trends. Sales of TALON products to
7
customers within the U.S. also declined significantly (approximately $3.6
million) as a result of the industry shift of apparel production and as a result
of our closure of our manufacturing facility in North Carolina during the third
quarter of 2005. The decline of Talon product sales from the North and Central
American regions was substantially offset by the shifting of this production to
manufacturers within Asia, and our expansion of operations with customers in
this region, resulting in a net increase in Talon product sales for 2006 over
2005 of approximately $3.4 million. Additionally, expanded demand by our
exclusive customer for the TEKFIT waistband also resulted in an increase of
approximately $0.4 million in 2006 over 2005 in our sales to the Dominican
Republic, where the principal manufacturers of this product are located, and
sales of Trim products into this region increased as key customer sales shifted
out of the Mexico marketplace to this region. Sales within Other geographical
regions also reflect the worldwide shifting of apparel production to Asia.
The net decrease of sales in 2005 was primarily due to a decrease in
sales to our customers in Mexico of Trim products and, to a lesser extent, TALON
zippers, resulting from the industry shift of apparel production from Latin
America to Asia, and due to the restructuring in the third quarter of 2005 which
disrupted sales in the Mexico regions as we prepared for a shift of operations
to Asia. Sales in Asia of our Trim products and Talon zippers increased
significantly during 2005 partially offsetting the declines from the Mexico and
the Latin American regions for the Trim products and resulting in a net gain in
Talon product sales overall. We responded to these market changes in 2005 with
the implementation of a restructuring plan that included reducing our operations
in Mexico and focusing our efforts on the market in Asia. Sales of our TEKFIT
waistband decreased in 2005 because of lower demand from our exclusive customer
for this product. During 2005, we continued our plan to decrease reliance on two
significant customers in Mexico. These two customers contributed approximately
$7.7 million or 16.3% of revenues for the year ended December 31, 2005.
COST OF GOODS SOLD AND SELECTED OPERATING EXPENSES
The following table summarizes cost of goods sold and selected
operating expenses for the years ended December 31, 2006, 2005, and 2004
(amounts in thousands):
2006 CHANGE 2005 CHANGE 2004
-------- -------- -------- -------- --------
Sales ............................ $ 48,825 3% $ 47,331 (14)% $ 55,109
-------- -------- -------- -------- --------
Cost of goods sold ............... 34,356 (27)% 47,070 5% 44,814
% of sales ................... 70% -- 99% -- 81%
-------- -------- -------- -------- --------
Selling expenses ................. 2,778 (5)% 2,929 1% 2,899
% of sales ................... 6% -- 6% -- 5%
-------- -------- -------- -------- --------
General and administrative expense 10,873 (32)% 16,098 23% 13,047
% of sales ................... 22% -- 34% -- 24%
-------- -------- -------- -------- --------
Bad debt expense (recoveries) .... (513) (109)% 5,858 (30)% 8,416
-------- -------- -------- -------- --------
1% -- 12% -- 15%
-------- -------- -------- -------- --------
Restructuring charges ............ 0 (100)% 2,474 496% 415
% of sales ................... 0% -- 5% -- 1%
-------- -------- -------- -------- --------
COST OF GOODS SOLD
Cost of goods sold for the year ended December 31, 2006 declined 27%
from 2005 as the result of a number of the actions we implemented in connection
with our 2005 restructuring plan, and as a result of our focus on higher margin
product sales and continued efforts to reduce costs worldwide. Cost of goods
sold in 2006 declined by approximately $4.8 million (10.3%) from 2005 as a
result of higher direct margins on products sold; by approximately $1.9 million
(4.0%) from lower freight & duty charges as a result of relocating our
operations closer to our customers in Asia; by a reduction in inventory
adjustments and obsolescence of $1.6 million (3.5%) due primarily to inventories
8
located at our Mexico production operations; by the elimination of $3.4 million
(7.3%) in restructuring charges incurred in 2005; and by approximately $1.8
million (3.8%) from reductions in manufacturing and overhead charges as a result
of reduced employee related costs and operating expenses of our North Carolina
and Mexico operations; offset by increases of approximately $0.8 million (1.8%)
on higher sales volumes.
Cost of goods sold increased 5% for the year ended December 31, 2005
primarily due to a $3.4 million (7.7%) write-down of inventory in connection
with the 2005 restructuring plan, and an increase in our inventory obsolescence
reserve of $2.1 million (4.7%), including $0.5 million in the fourth quarter of
2005. Cost of sales also increased as a percentage of sales due to unabsorbed
overhead costs incurred in our North Carolina manufacturing facility and charges
of approximately $0.2 million (0.5%) associated with unrealized charge-backs
recorded in the second quarter of 2005 and $0.6 million (1.3%) in credits issued
to customers during the first quarter for defective products received from a
major supplier. Cost of goods sold declined by approximately $4.1 million (9.1%)
as a result of the decline in revenue from 2004 to 2005.
Cost of goods sold for the year ended December 31, 2004, included
inventory write-downs totaling $2.7 million (5% of net sales) recorded in the
fourth quarter of 2004 based on management's estimate of the net realizable
value of certain inventory.
SELLING EXPENSES
Selling expense for the year ended December 31, 2006 decreased $0.2
million (5.0%) from 2005 as a result of lower travel and entertainment costs of
$0.3 million; lower legal costs of $0.3 million; and other employee benefit and
administrative cost reductions of approximately $0.1 million; offset by
increases in sales commissions of approximately $0.3 million and increased
spending for sales and marketing programs of $0.2 million. Selling expenses
increased 1.0% for the year ended December 31, 2005 because we were unable to
reduce expenses in direct proportion to the decrease in sales. In 2004, selling
expenses represented 5% of net sales, and included $0.4 million in royalty
expense related to the intellectual property rights agreement with Pro-Fit.
GENERAL AND ADMINISTRATIVE EXPENSES
General and administrative expenses for the year ended December 31,
2006 decreased $5.2 million or 32% from 2005. $0.5 million of the reduction from
2005 was the result of the write-off of goodwill primarily associated with
closed operations;, reductions in legal costs by $1.9 million principally as a
reduction of our costs associated with the ProFit litigation; lower employee and
benefit costs by $1.9 million from reduced employment levels; reduced facility
costs of $0.6 million; and reductions in other administrative and travel costs
of $1.4 million; offset by approximately $0.7 million in increased professional
and audit fees as we changed auditors and utilized more professional consultants
in lieu of full time regular employees; and stock based compensation expense of
$0.4 million associated with the implementation of FAS 123(R).
General and administrative expenses increased approximately $3.0
million (23%) in 2005 compared to 2004. This increase in general and
administrative expenses resulted from higher legal expenses of approximately
$3.5 million related primarily to the Pro-Fit litigation, and an impairment
charge to goodwill of $0.5 million incurred in connection with the 2005
restructuring plan; offset by reductions of approximately $1.0 million
associated with lower employment levels and related costs in connection with the
restructuring plan.
Included in general and administrative expenses for the year ended
December 31, 2004 are charges of $4.3 million related primarily to the
write-down of receivables due from one customer. We also recorded an accounts
receivable reserve of $5.0 million (or 9% of net sales) in the fourth quarter of
2004 based on management's estimate of the collectibility of accounts receivable
primarily related to two other customers. In the first quarter of 2004, we
incurred additional restructuring charges of $0.4 million related to the final
residual costs associated with our restructuring plan implemented in the fourth
quarter of 2003.
9
BAD DEBT EXPENSE
Bad debt expenses for the year ended December 31, 2006 reflected a net
recovery of $0.5 million as compared to bad debt expenses of $5.9 million for
the year ended December 31, 2005. The bad debt recoveries in 2006 represent
collections of accounts written-off in prior years as uncollectible, and the
2005 expense is primarily related to outstanding unsettled receivables from a
former customer. Bad debt expense in 2004 were $8.4 million, and include charges
of $4.3 million related primarily to the write-down of receivables due from one
customer; recovery of approximately $1.4 associated with a customer account
written-off in 2003 and settled in 2004; and provisions of $5.5 million ($5.0
million, or 9% of net sales, recorded in the fourth quarter of 2004 based on
management's estimate of the collectability of accounts receivable primarily
related to two other customers).
RESTRUCTURING CHARGES
Restructuring costs in 2005 were the result of the adoption of our 2005
restructuring plan. Restructuring costs recorded in the third quarter of 2005
were $6.2 million. Additional costs of $0.2 million were incurred in the fourth
quarter of 2005. Total restructuring costs of $6.4 million were recorded in the
Consolidated Statement of Operations for the year ended December 31, 2005 as
follows (in millions):
Cost of goods sold ........................ $ 3.4
Operating expenses:
General & administrative expenses ...... 0.5
Restructuring charges .................. 2.5
------
Total restructuring costs ................. $ 6.4
======
During the first quarter of 2004, we incurred restructuring charges of
$0.4 million for final residual costs associated with our 2003 restructuring
plan.
INTEREST EXPENSE AND INTEREST INCOME
Interest expense of $1,357,000 for the year ended December 31, 2006
decreased approximately $89,000 from $1,446,000 during 2005 as a result of lower
average debt levels in 2006 compared to 2005. For both years ended December 31,
2006 and 2005, interest expenses included $311,000 in amortized deferred
financing charges related primarily to the secured convertible notes payable.
Interest income for the year ended December 31, 2006 of $368,000 increased
approximately $302,000 from $66,000 during 2005 related primarily to the note
receivable discussed in Note 2 to the consolidated financial statements.
Interest expense increased for the year ended December 31, 2005
approximately $594,000 (or 64%) to $1,446,000 from $882,000 for 2004. The
increase in interest expense was primarily due to higher debt levels associated
with the $12.5 million 6% secured convertible notes payable dated November 2004,
the $0.8 million 6.5% mortgage note payable to First National Bank dated June
2004, and the $0.9 million 6.5% equipment note payable to First National Bank
dated November 2004 which were outstanding for the entire year in 2005 compared
to a partial year in 2004; partially offset by the repayment of a remaining $1.4
million due pursuant to a note payable and a reduction in amounts due to factor
in 2005. Included in interest expense for the years ended December 31, 2005 and
2004 was $311,000 and $45,000, respectively, in amortized deferred financing
charges related primarily to the secured convertible notes payable. Interest
income for the years ended December 31, 2005 and 2004 was $66,000 and $32,000,
respectively.
INCOME TAXES
Income tax provisions for the year ended December 31, 2006 principally
include a royalty tax from the Inland Revenue Department in Hong Kong applicable
to 2005, net of an estimated tax benefit for 2006 foreign losses and minimum
federal and state filing fees.
10
The provision for income taxes for the year ended December 31, 2005
principally reflects the elimination of the net deferred tax asset in 2005 of
$1.0 million, and estimated foreign taxes. Based on the Company's net operating
losses, there is not sufficient evidence to determine that it is more likely
than not that the Company will be able to utilize its net operating loss carry
forwards to offset future taxable income.
The provision for income taxes was $2.3 million for the year ended
December 31, 2004 .The income tax provision primarily reflects a charge of $1.8
million as a result of a decrease in the value of net deferred tax assets, and
foreign income taxes of $0.5 million on foreign earnings.
LIQUIDITY AND CAPITAL RESOURCES
The following table summarizes selected financial data (amounts in
thousands):
DECEMBER 31, DECEMBER 31,
2006 2005
------------ ------------
Cash and cash equivalents ........................ $ 2,935 $ 2,277
Total assets ..................................... 25,694 30,321
Current debt ..................................... 22,471 14,851
Non-current debt ................................. 1,536 14,558
Stockholders' equity ............................. 1,686 912
CASH AND CASH EQUIVALENTS
Our cash is held with financial institutions. Substantially all of the
balances at December 31, 2006 and 2005 are in excess of federally insured
limits. As of December 31, 2006 and 2005 we had restricted cash balances of
$50,000 related to cash collateral for a letter of credit with Wells Fargo Bank.
FINANCING ARRANGEMENTS
The Company currently does not have an active financing arrangement to
provide for working capital requirements and cash provided by operating
activities is our only recurring source of funds. We financed building, land and
equipment purchases through notes payable and capital lease obligations expiring
through June 2011. These obligations bear interest at rates of 6.5% and 6.6% per
annum, and under these obligations, we are required to make monthly payments of
principal and interest. In June 2006 we entered into a note payable with our
legal counsel in exchange for legal fees outstanding to this firm related to our
Pro-Fit litigation. The note agreement provides for monthly payments against the
note in amounts equal to payments we receive from our note receivable until such
time as the note is paid in full. The note receivable is fully pledged as
collateral against this note payable.
A factoring agreement for the purchase of eligible receivables from our
Hong Kong subsidiary exists with East Asia Heller, wherein the factor purchases
our eligible accounts receivable and may assume the credit risk with respect to
those accounts for which the factor has given its prior approval. If the factor
does not assume the credit risk for a receivable, the collection risk associated
with the receivable remains with us. The agreement provides for us to pay a
fixed commission rate and for us to borrow up to 80% of eligible accounts
receivable. Interest is charged at 1.5% over the Hong Kong Dollar prime rate.
However, during 2005 and 2006 the factor declined to advance funds to us under
this agreement. Accordingly, no outstanding advances as of December 31, 2006 and
2005 existed.
In 2005, we entered into a letter of credit with Wells Fargo Bank. This
letter of credit provides for a maximum of $50,000, expires in June 2007 and is
secured by cash on hand managed by Wells Fargo Bank. At December 31, 2006,
outstanding letters of credit under the Wells Fargo facility were $50,000. This
letter is pledged as collateral for a bond posted in connection with our
litigation with Todo Textile, S. A. in which a settlement agreement was reached
11
in 2006. Upon release of the bond held by the court in this matter, the letter
of credit will be released and the settlement amount of $40,000 paid from the
proceeds.
The outstanding balance of our demand notes payable to related parties
at December 31, 2006 and 2005 was $665,000. Included is a $500,000 convertible
secured promissory note payable with interest at 11% payable quarterly. The note
is due on demand and is convertible into common stock at the election of the
holder at a rate of $4.50 per share. The remaining demand notes totaling
$165,000 bear interest at 0%-10%, have no scheduled monthly payments, and are
due within fifteen days from demand.
CASH FLOWS
The following table summarizes our cash flow activity for the years
ended December 31, 2006, 2005, and 2004 (amounts in thousands):
2006 2005 2004
-------- -------- --------
Net cash provided by (used in) operating activities $ 1,794 $ 1,112 $(11,382)
Net cash used in investing activities .............. (345) (1,454) (3,616)
Net cash provided by (used in) financing activities (791) (2,841) 6,016
Net increase (decrease) in cash and cash equivalents 657 (3,183) (8,982)
OPERATING ACTIVITIES
Cash and cash equivalents for the year ended December 31, 2006
increased by $0.7 million from December 31, 2005 principally arising from cash
generated by operating activities, net of payments on notes payable and capital
leases.
Cash provided by operating activities is our only recurring source of
funds and was $1.8 million for the year ended December 31, 2006. The cash
generated by operating activities during 2006 resulted primarily from net
earnings (before non-cash expenses) of approximately $2.3 million; reductions in
inventory net of applied reserves of $2.5 million; $1.0 million in reductions in
accounts receivable net of reserves applied, and approximately $0.6 million in
collections on the note receivable; net of reductions in accounts payable of
$2.6 million; repayments on notes payable of $0.9 million and reductions in
other liabilities, net of approximately $1.2 million. The note receivable
collections are associated with unsettled accounts receivable from a former
customer converted into a note receivable in early 2006. The repayments on the
notes payable are principally associated with previously accrued legal expenses
converted into a note payable in May of 2006. Payments on the note payable are
made from collections received from the note receivable which is pledged to the
note payable. These notes are non-recurring settlements associated primarily
with sales and expenses from 2005 and prior transactions. See notes to
consolidated financial statements, Note 2 - "Accounts and Note Receivable" and
Note 6 - "Notes Payable."
The net decrease in inventory of $2.5 million reflects the Company's
efforts to dispose of and lower slower-moving and obsolete inventory components.
The cost of net inventories eliminated during the year was $8.6 million, and
reserves applicable to this inventory of $6.1 million were applied to these
dispositions. Accounts receivable for the year ended December 31, 2006 declined
by $2.1 million primarily as a result of improved collections and faster turns
of accounts receivable, and by approximately $0.7 million in accounts
written-off. Accounts receivable reserves declined by $1.1 million from the
write-off of uncollectible accounts and by approximately $0.4 million from the
collection of accounts reserved for in prior years. In addition, during 2006
collections of accounts written-off in prior years was $0.5 million.
The increase in cash provided by operating activities during the year
ended December 31, 2005 resulted from, among other changes, a $10.6 million
decrease in accounts receivable, including the collection of a $4.5 million
12
receivable from one customer; a $3 million increase in accounts payable; a $2.8
million decrease in inventories; a $2.1 million increase in accrued legal costs;
substantially offset by a net loss of $29.5 million.
At December 31, 2005, accounts receivable from Azteca Productions
International ("Azteca"), a significant customer, was approximately $10,968,000
less a reserve of $7,528,000, totaling $3,440,000, net. In February 2006, the
Company accepted a note agreement from Azteca which provides for total payments
including principal and interest of $4.0 million in exchange for the net
outstanding accounts receivable balance. The balance of the note receivable at
December 31, 2005 of $3,440,000 reflects a $560,000 charge to discount the note,
using a 10.5% discount rate, to its net present value. The Azteca accounts
receivable, net at December 31, 2005 was reclassified on the accompanying
consolidated balance sheets to note receivable to reflect this subsequent
settlement.
The decrease in cash provided by operations for 2004 resulted primarily
from a net loss of $17.6 million together with a net increase of $7.6 million in
accounts receivable due primarily to slower customer collections of receivables
during the year. This decrease was partially offset by a $4 million net increase
in the allowance for doubtful accounts and a $7.8 million decrease in
inventories.
INVESTING ACTIVITIES
Net cash used in investing activities for the year ended December 31,
2006 and 2005 consisted of capital expenditures of $0.3 million and $1.5
million, respectively for leasehold improvements and equipment purchases.
Net cash used in investing activities for the year ended December 31,
2004 consisted of capital expenditures of $3.6 million for computer equipment,
the purchase of additional TALON zipper equipment and building, land and
leasehold improvements related to the TALON manufacturing facility in North
Carolina. The building and land purchase of the TALON manufacturing facility was
reported as a non-cash financing transaction.
FINANCING ACTIVITIES
Net cash used in financing activities for the years ended December 31,
2006 and 2005 reflects the repayment of notes payable and capital lease
obligations. In 2005 cash used in financing activities also included, the
repayment of borrowings under a bank line of credit partially offset by proceeds
from the exercise of stock options and warrants.
Net cash provided by financing activities for the year ended December
31, 2004 primarily reflects funds raised from secured convertible promissory
notes of $12.5 million, the exercise of stock options and warrants, proceeds
from notes payable and a capital lease obligation, offset by the repayment of
borrowings under our credit facility and notes payable.
We currently satisfy our working capital requirements primarily through
cash flows generated from operations. As the major apparel industry brands
continue to outsource apparel manufacturing to offshore locations, our foreign
customers, though backed by U.S. brands and retailers, will continue to
increase. This makes traditional financing arrangements with U.S. banks and
financial institutions difficult and accordingly we continue to evaluate
non-traditional financing of our foreign assets.
We believe that our existing cash and cash equivalents and anticipated
cash flows from our operating activities and available financing will be
sufficient to fund our minimum working capital and capital expenditure needs for
at least the next twelve months. This conclusion is based on the belief and
expectation that we have successfully completed the restructuring plan adopted
in 2005 and that our strategic plan and the company's current structure will
allow for continued profitability; that we will collect our note and accounts
receivable in accordance to existing terms; and that we will complete a
refinancing of the convertible notes payable by their maturity date in November
2007. We have discussed the refinancing of these notes with the current note
13
holders and with various financial and investment institutions. We believe that
we will be successful in completing a modification or replacement of these notes
prior to their maturity.
If we are unable to successfully complete the refinancing of the
convertible notes or to collect our note and accounts receivable, or experience
greater than anticipated reductions in sales, we may need to raise additional
capital, or obtain alternate financing to repay the convertible notes, or
further reduce the scope of our business in order to fully satisfy our future
short-term liquidity requirements. If we cannot raise additional capital or
arrange for alternate financing or reduce the scope of our business in response
to a substantial decline in sales, we may default on the payment of the
convertible notes payable. The event of a default on the payment of these notes
will materially affect the business operations in the long-term, however the
on-going operations for 2007 are nevertheless anticipated to substantially
continue throughout the 2007 year-end as operations from assets not pledged to
these notes continues.
The extent of our future long-term capital requirements will depend on
many factors, including our results of operations, future demand for our
products, the size and timing of future acquisitions, and our expansion into
foreign markets. Our need for additional long-term financing includes the
integration and expansion of our operations to exploit our rights under our
TALON trade name, the expansion of our operations in Asia and other markets and
the further development of our waistband technology. If our cash from operations
is less than anticipated or our working capital requirements and capital
expenditures are greater than we expect, we may need to raise additional debt or
equity financing in order to provide for our operations. We are continually
evaluating various financing strategies to be used to expand our business and
fund future growth or acquisitions. There can be no assurance that additional
debt or equity financing will be available on acceptable terms or at all. If we
are unable to secure additional financing, we may not be able to execute our
plans for expansion, including expansion into foreign markets to promote our
TALON brand trade name, and we may need to implement additional cost savings
initiatives.
CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS
The following summarizes our contractual obligations at December 31,
2006 and the effects such obligations are expected to have on liquidity and cash
flow in future periods:
Payments Due by Period
-------------------------------------------------------------------
Less than 1-3 4-5 After
Contractual Obligations Total 1 Year Years Years 5 Years
- ------------------------- ----------- ----------- ----------- ----------- -----------
Demand notes payable
to related parties (1) $ 1,181,000 $ 1,181,000 $ -- $ -- $ --
Capital lease obligations $ 1,027,000 $ 506,000 $ 521,000 $ -- $ --
Operating leases ........ $ 1,421,000 $ 437,000 $ 754,000 $ 229,000 $ 1,000
Notes payable ........... $ 2,426,000 $ 1,193,000 $ 604,000 $ 629,000 $ --
Convertible notes payable $13,143,000 $13,143,000 $ -- $ -- $ --
----------- ----------- ----------- ----------- -----------
Total Obligations .. $19,198,000 $16,460,000 $ 1,879,000 $ 858,000 $ 1,000
=========== =========== =========== =========== ===========
(1) The majority of notes payable to related parties are due on demand with
the remainder due and payable on the fifteenth day following the date
of delivery of written demand for payment, and include accrued interest
payable through December 31, 2006.
At December 31, 2006 and 2005, we did not have any relationships with
unconsolidated entities or financial partnerships, such as entities often
referred to as structured finance or special purpose entities, which would have
been established for the purpose of facilitating off-balance sheet arrangements
or other contractually narrow or limited purposes. As such, we are not exposed
to any financing, liquidity, market or credit risk that could arise if we had
engaged in such relationships.
14
RELATED PARTY TRANSACTIONS
For a description of transactions to which we were or will be a party,
and in which any director, executive officer, or shareholder of more than 5% of
our common stock or any member of their immediate family had or will have a
direct or indirect material interest, see Note 16 of the Notes to the
consolidated financial statements included in Item 8 of this Report.
APPLICATION OF CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions for the reporting period and as of
the financial statement date. We base our estimates on historical experience and
on various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. These estimates and assumptions affect the reported amounts of
assets and liabilities, the disclosure of contingent liabilities and the
reported amounts of revenue and expense. Actual results could differ from those
estimates.
Critical accounting policies are those that are important to the
portrayal of our financial condition and results, and which require us to make
difficult, subjective and/or complex judgments. Critical accounting policies
cover accounting matters that are inherently uncertain because the future
resolution of such matters is unknown. We believe the following critical
accounting policies affect our more significant judgments and estimates used in
the preparation of our consolidated financial statements:
o Accounts receivable balances are evaluated on a continual
basis and allowances are provided for potentially
uncollectible accounts based on management's estimate of the
collectibility of customer accounts. If the financial
condition of a customer were to deteriorate, resulting in an
impairment of its ability to make payments, an additional
allowance may be required. Allowance adjustments are charged
to operations in the period in which the facts that give rise
to the adjustments become known. During the year ended
December 31, 2006, net recoveries were $0.5 million (with
provisions of $0.2 million), and bad debt expense for the
years ended December 31, 2005 and 2004 were $5.9 million and
$8.4 million, respectively. The bad debt expense in 2004 and
2005 was primarily associated with specific receivables from a
former customer that were settled in early 2006 with the
acceptance of a note receivable at a substantial discount and
with the full write-off of customer accounts (one customer
primarily) where most all collection efforts had failed.
During 2006 accounts receivable delinquencies were
substantially eliminated lowering the risk for additional
material write-offs. The note receivable accepted from the
former customer in early 2006 represents a continuing risk of
collection and its performance is evaluated each quarter.
o Inventories are stated at the lower of cost, determined using
the first-in, first-out basis, or market value and are all
substantially finished goods. The costs of inventory include
the purchase price, inbound freight and duties, conversion
costs and certain allocated production overhead costs.
Inventory is evaluated on a continual basis and reserve
adjustments are made based on management's estimate of future
sales value, if any, of specific inventory items. Inventory
reserves are recorded for damaged, obsolete, excess and
slow-moving inventory. We use estimates to record these
reserves. Slow-moving inventory is reviewed by category and
may be partially or fully reserved for depending on the type
of product and the length of time the product has been
included in inventory. Reserve adjustments are made for the
difference between the cost of the inventory and the estimated
market value, if lower, and charged to operations in the
period in which the facts that give rise to these adjustments
become known. Market value of inventory is estimated based on
the impact of market trends, an evaluation of economic
conditions and the value of current orders relating to the
15
future sales of this type of inventory. Provisions for
reserves for inventory valuation for the years ended December
31, 2006, 2005 and 2004, were $0.6 million, $2.5 million and
$1.0 million, respectively. The increase in the provision
during 2005 was primarily related to the remaining inventory
we owned at our operations in Mexico. The closure of our
manufacturing operations and from the exit of operations in
Mexico as part of the 2005 restructuring plan substantially
eliminates our acquisition or production of inventory that is
not directly associated with a customer's order. Accordingly,
the risk of future inventory obsolescence adjustments is
substantially reduced in 2006. The provisions recorded in
prior years are considered adequate to dispose of the
remaining inventories without further adjustment.
o We record deferred tax assets arising from temporary timing
differences between recorded net income and taxable net income
when and if we believe that future earnings will be sufficient
to realize the tax benefit. For those jurisdictions where the
expiration date of tax benefit carry-forwards or the projected
taxable earnings indicate that realization is not likely, a
valuation allowance is provided. If we determine that we may
not realize all of our deferred tax assets in the future, we
will make an adjustment to the carrying value of the deferred
tax asset, which would be reflected as an income tax expense.
Conversely, if we determine that we will realize a deferred
tax asset, which currently has a valuation allowance, we would
be required to reverse the valuation allowance, which would be
reflected as an income tax benefit. We believe that our
estimate of deferred tax assets and determination to record a
valuation allowance against such assets are critical
accounting estimates because they are subject to, among other
things, an estimate of future taxable income, which is
susceptible to change and dependent upon events that may or
may not occur, and because the impact of recording a valuation
allowance may be material to the assets reported on the
balance sheet and results of operations. See Notes to
consolidated financial statements, Note 12, "Income Taxes". As
of December 31, 2005 the deferred tax assets were fully
reserved.
o We record impairment charges when the carrying amounts of
long-lived assets are determined not to be recoverable.
Impairment is measured by assessing the usefulness of an asset
or by comparing the carrying value of an asset to its fair
value. Fair value is typically determined using quoted market
prices, if available, or an estimate of undiscounted future
cash flows expected to result from the use of the asset and
its eventual disposition. The amount of impairment loss is
calculated as the excess of the carrying value over the fair
value. Changes in market conditions and management strategy
have historically caused us to reassess the carrying amount of
our long-lived assets. Long-lived assets are evaluated on a
continual basis and impairment adjustments are made based upon
management's valuations. As part of our 2005 restructuring
plan, certain long-lived assets, primarily machinery and
equipment, were impaired and their values adjusted
accordingly. The long-lived assets are planned to be
re-deployed through manufacturing arrangements with our
principal suppliers in Asia. The fair value of these assets
will be affected by our ability to secure appropriate
manufacturing arrangements and to utilize the equipment to
meet future production requirements. If we are unable to
secure favorable arrangements or to secure sufficient
production through these operations the fair value of this
equipment may be impaired.
o Sales are recognized when persuasive evidence of an
arrangement exists, product delivery has occurred, pricing is
fixed or determinable, and collection is reasonably assured.
Sales resulting from customer buy-back agreements, or
associated inventory storage arrangements are recognized upon
delivery of the products to the customer, the customer's
designated manufacturer, or upon notice from the customer to
destroy or dispose of the goods. Sales, provisions for
estimated sales returns, and the cost of products sold are
recorded at the time title transfers to customers. Actual
product returns are charged against estimated sales return
allowances.
16
o Upon approval of a restructuring plan by management, we record
restructuring reserves for certain costs associated with
facility closures and business reorganization activities as
they are incurred or when they become probable and estimable.
Such costs are recorded as a current liability. We record
restructuring reserves in compliance with SFAS 146 "Accounting
for Costs Associated with Exit or Disposal Activities",
resulting in the recognition of employee severance and related
termination benefits for recurring arrangements when they
became probable and estimable and on the accrual basis for
one-time benefit arrangements. We record other costs
associated with exit activities as they are incurred. Employee
severance and termination benefits are estimates based on
agreements with the relevant union representatives or plans
adopted by us that are applicable to employees not affiliated
with unions. These costs are not associated with nor do they
benefit continuing activities. Inherent in the estimation of
these costs are assessments related to the most likely
expected outcome of the significant actions to accomplish the
restructuring. Changing business conditions may affect the
assumptions related to the timing and extent of facility
closure activities. We review the status of restructuring
activities on a quarterly basis and, if appropriate, records
changes based on updated estimates. See Note 11, "2005
Restructuring Costs".
o We are currently involved in various lawsuits, claims and
inquiries, most of which are routine to the nature of the
business, and in accordance with SFAS No. 5, "Accounting for
Contingencies." We accrue estimates of the probable and
estimable losses for the resolution of these claims. The
ultimate resolution of these claims could affect our future
results of operations for any particular quarterly or annual
period should our exposure be materially different from our
earlier estimates or should liabilities be incurred that were
not previously accrued.
NEW ACCOUNTING PRONOUNCEMENTS
In September 2006, the FASB issued SFAS No. 157, "Fair Value
Measurements", ("SFAS No. 157"). SFAS No. 157 defines fair value, establishes a
framework for measuring fair value in generally accepted accounting principles
(GAAP), and expands disclosures about fair value measurements. This Statement
applies under other accounting pronouncements that require or permit fair value
measurements, and does not require any new fair value measurements. The
application of SFAS No. 157, however, may change current practice within an
organization. SFAS No. 157 is effective for all fiscal years beginning after
November 15, 2007, with earlier application encouraged. We do not believe that
SFAS No. 157 will have a material impact on our financial position, results of
operations or cash flows.
In September 2006, the SEC issued Staff Accounting Bulletin No. 108,
CONSIDERING THE EFFECTS OF PRIOR YEAR MISSTATEMENTS WHEN QUANTIFYING
MISSTATEMENTS IN CURRENT YEAR FINANCIAL STATEMENTS ("SAB 108"), to address
diversity in practice in quantifying financial statement misstatements. SAB 108
requires the quantification of misstatements based on their impact on both the
balance sheet and the income statement to determine materiality. The guidance
provides for a one-time cumulative effect adjustment to correct for
misstatements that were not deemed material under a company's prior approach but
are material under the SAB 108 approach. SAB 108 is effective for fiscal years
ending after November 15, 2006. The implementation of SAB 108 did not have a
material impact on our financial position, results of operations or cash flows.
In June 2006, the Financial Accounting Standards Board ("FASB") issued
Interpretation No. 48, ACCOUNTING FOR UNCERTAINTY IN INCOME TAXES -- AN
INTERPRETATION OF FASB STATEMENT NO. 109, (FIN 48). FIN 48 clarifies the
accounting for uncertainty in income taxes recognized in an enterprise's
financial statements in accordance with FASB Statement No. 109, ACCOUNTING FOR
INCOME TAXES. FIN 48 also prescribes a recognition threshold and measurement
attribute for the financial statement recognition and measurement of a tax
position taken or expected to be taken in a tax return that results in a tax
benefit. Additionally, FIN 48 provides guidance on de-recognition, income
statement classification of interest and penalties, accounting in interim
periods, disclosure, and transition. This interpretation is effective for fiscal
years beginning after December 15, 2006. We are currently evaluating the effect
that the application of FIN 48 will have on its results of operations and
financial condition.
17
In February 2006, the FASB issued Statement of Financial Accounting
Standards No. 155, "Accounting for Certain Hybrid Financial Instruments" ("SFAS
155"), which amends SFAS No. 133, "Accounting for Derivatives Instruments and
Hedging Activities" ("SFAS 133") and SFAS No. 140, "Accounting for Transfers and
Servicing of Financial Assets and Extinguishment of Liabilities" ("SFAS 140).
SFAS 155 amends SFAS 133 to narrow the scope exception for interest-only and
principal-only strips on debt instruments to include only such strips
representing rights to receive a specified portion of the contractual interest
or principle cash flows. SFAS 155 also amends SFAS 140 to allow qualifying
special-purpose entities to hold a passive derivative financial instrument
pertaining to beneficial interests that itself is a derivative instrument. SFAS
No. 155 is effective for all financial instruments acquired or issued after the
beginning of an entity's first fiscal year that begins after September 15, 2006.
We do not believe that SFAS No. 155 will have a material impact on the Company's
financial position, results of operations or cash flows.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
All of our sales are denominated in United States dollars or the currency of the
country in which our products originate. We are exposed to market risk for
fluctuations in the foreign currency exchange rates for certain product
purchases that are denominated in Hong Kong dollars, Chinese Yuan's and British
Pounds. During 2004, we purchased forward exchange contracts for British Pounds
to hedge the payments of product purchases. We do not intend to purchase
additional contracts to hedge the exchange exposure for future product
purchases. There were no hedging contracts outstanding as of December 31, 2006.
Currency fluctuations can increase the price of our products to foreign
customers which can adversely impact the level of our export sales from time to
time. The majority of our cash equivalents are held in United States dollars in
various bank accounts and we do not believe we have significant market risk
exposure with regard to our investments. At December 31, 2006, none of our
indebtedness was subject to interest rate fluctuations.
18
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
TABLE OF CONTENTS
PAGE
----
Report of Independent Registered Public Accounting Firm................... 34
Report of Independent Registered Public Accounting Firm................... 35
Consolidated Balance Sheets............................................... 36
Consolidated Statements of Operations..................................... 37
Consolidated Statements of Stockholders' Equity and Convertible
Redeemable Preferred Stock............................................. 38
Consolidated Statements of Cash Flows..................................... 39
Notes to Consolidated Financial Statements................................ 40
19
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders
Tag It Pacific Inc.
Woodland Hills, California
We have audited the consolidated balance sheets of Tag It Pacific Inc. and
subsidiaries as of December 31, 2006 and 2005, and the related consolidated
statements of operations, stockholders' equity and convertible redeemable
preferred stock, and cash flows for each of the two years in the period ended
December 31, 2006. Our audits also included the financial statement schedules of
Tag It Pacific Inc., listed in Item 15(a). These financial statements and
financial statement schedules are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provided a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Tag It Pacific Inc.
and subsidiaries as of December 31, 2006 and 2005, and the results of their
operations and their cash flows for each of the two years in the period ended
December 31, 2006, in conformity with U.S. generally accepted accounting
principles. Also, in our opinion, the related financial statement schedules,
when considered in relation to the basic consolidated financial statements,
taken as a whole, present fairly in all material respects the information set
forth therein.
/S/ SINGER LEWAK GREENBAUM & GOLDSTEIN LLP
- ------------------------------------------
Los Angeles, California
April 9, 2007
20
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors
Tag-It Pacific, Inc.
Los Angeles, California
We have audited the accompanying consolidated statements of operations,
stockholders' equity and convertible redeemable preferred stock and cash flows
of Tag-It Pacific, Inc. and subsidiaries for the year ended December 31, 2004.
The financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audit.
We conducted our audit in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. The Company is not
required to have, nor were we engaged to perform, an audit of its internal
control over financial reporting. Our audit included consideration of internal
control over financial reporting as a basis for designing audit procedures that
are appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company's internal control over financial
reporting. Accordingly, we express no such opinion. An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements and assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provided a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the results of operations of Tag-It
Pacific, Inc. and subsidiaries and their cash flows for the year ended December
31, 2004, in conformity with accounting principles generally accepted in the
United States of America.
/s/ BDO Seidman, LLP
Los Angeles, California
March 31, 2005
21
TAG-IT PACIFIC, INC.
CONSOLIDATED BALANCE SHEETS
December 31, December 31,
2006 2005
------------ ------------
Assets
Current Assets:
Cash and cash equivalents ............................. $ 2,934,673 $ 2,277,397
Accounts receivable, net .............................. 4,664,766 5,652,990
Note receivable ...................................... 1,378,491 662,369
Inventories, net ...................................... 3,051,220 5,573,099
Prepaid expenses and other current assets ............. 541,034 618,577
------------ ------------
Total current assets ..................................... 12,570,184 14,784,432
Property and equipment, net .............................. 5,623,040 6,438,096
Fixed assets held for sale ............................... 826,904 826,904
Note receivable, less current portion .................... 1,420,969 2,777,631
Due from related parties ................................. 675,137 655,489
Other intangible assets, net ............................. 4,139,625 4,255,125
Other assets ............................................. 437,569 583,117
------------ ------------
Total assets ............................................. $ 25,693,428 $ 30,320,794
============ ============
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable ....................................... $ 4,006,241 $ 6,719,226
Accrued legal costs .................................... 427,917 2,520,111
Other accrued expenses ................................. 3,359,267 4,168,552
Demand notes payable to related parties ................ 664,970 664,971
Current portion of capital lease obligations ........... 432,728 590,884
Current portion of notes payable ....................... 1,107,207 186,837
Current portion of secured convertible promissory notes 12,472,622 --
------------ ------------
Total current liabilities ................................ 22,470,952 14,850,581
Capital lease obligations, less current portion .......... 474,733 856,495
Notes payable, less current portion ...................... 1,061,514 1,261,018
Secured convertible promissory notes ..................... -- 12,440,623
------------ ------------
Total liabilities ........................................ 24,007,199 29,408,717
------------ ------------
Commitments and contingencies (Note 13)
Stockholders' Equity:
Preferred stock Series A, $0.001 par value; 250,000
shares authorized; no shares issued or outstanding .... -- --
Common stock, $0.001 par value, 100,000,000 shares
authorized; 18,466,433 shares issued and outstanding
at December 31, 2006; 18,241,045 at December 31, 2005 18,466 18,241
Additional paid-in capital ............................. 51,792,502 51,327,878
Accumulated deficit .................................... (50,124,739) (50,434,042)
------------ ------------
Total stockholders' equity ............................... 1,686,229 912,077
------------ ------------
Total liabilities and stockholders' equity ............... $ 25,693,428 $ 30,320,794
============ ============
See accompanying notes.
22
TAG-IT PACIFIC, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2006 2005 2004
------------ ------------ ------------
Net sales ................................. $ 48,825,002 $ 47,331,176 $ 55,109,481
Cost of goods sold ........................ 34,356,034 47,070,381 44,813,736
------------ ------------ ------------
Gross profit .............................. 14,468,968 260,795 10,295,745
Selling expenses .......................... 2,777,772 2,928,659 2,899,329
General and administrative expenses ....... 10,872,887 16,098,363 13,047,215
Bad debt expense (recoveries) ............. (513,347) 5,857,946 8,416,392
Restructuring charges ..................... -- 2,474,281 414,675
------------ ------------ ------------
Total operating expenses .................. 13,137,312 27,359,249 24,777,611
Income (loss) from operations ............. 1,331,656 (27,098,454) (14,481,866)
Interest expense, net ..................... 988,453 1,379,786 849,888
------------ ------------ ------------
Income (loss) before income taxes ......... 343,203 (28,478,230) (15,331,754)
Provision for income taxes ................ 33,900 1,059,479 2,277,214
------------ ------------ ------------
Net income (loss) ......................... 309,303 (29,537,709) (17,608,968)
Less: Preferred stock dividends ........... -- -- (30,505)
------------ ------------ ------------
Net income(loss) to common shareholders .. $ 309,303 $(29,537,709) $(17,639,473)
============ ============ ============
Basic income(loss) per share .............. $ 0.02 $ (1.62) $ (1.02)
============ ============ ============
Diluted income( loss) per share ........... $ 0.02 $ (1.62) $ (1.02)
============ ============ ============
Basic weighted average shares outstanding . 18,377,484 18,225,851 17,316,202
============ ============ ============
Diluted weighted average shares outstanding 18,955,796 18,225,851 17,316,202
============ ============ ============
See accompanying notes.
23
TAG-IT PACIFIC, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND CONVERTIBLE REDEEMABLE PREFERRED STOCK
YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004
Preferred Stock Preferred Stock
Common Stock Series A Series D
--------------------------- --------------------------- ----------------------------
Shares Amount Shares Amount Shares Amount
------------ ------------ ------------ ------------ ------------ ------------
BALANCE, JANUARY 1, 2004 ... 11,508,201 $ 11,510 -- -- 572,818 $ 22,918,693
Conversion of preferred
stock Series C and
accrued dividends ..... 700,144 700 -- -- -- --
Conversion of preferred
stock Series D ........ 5,728,180 5,728 -- -- (572,818) (22,918,693)
Warrants issued in
private placement
transaction ........... -- -- -- -- -- --
Common stock issued upon
exercise of options and
warrants .............. 214,276 214 -- -- -- --
Common stock and warrants
issued for services ... 20,500 21 -- -- -- --
Tax benefit from exercise
of stock options ...... -- -- -- -- -- --
Preferred stock dividends -- -- -- -- -- --
Net loss ................ -- -- -- -- -- --
------------ ------------ ------------ ------------ ------------ ------------
BALANCE, DECEMBER 31, 2004 . 18,171,301 18,173 -- -- -- --
Common stock issued upon
exercise of options and
warrants .............. 69,744 68 -- -- -- --
Net loss ................ -- -- -- -- -- --
------------ ------------ ------------ ------------ ------------ ------------
BALANCE, DECEMBER 31, 2005 . 18,241,045 18,241 -- -- -- --
Common stock issued for
services .............. 225,388 225 -- -- -- --
Stock based compensation -- -- -- -- -- --
Net income .............. -- -- -- -- -- --
------------ ------------ ------------ ------------ ------------ ------------
BALANCE, DECEMBER 31, 2006 . 18,466,433 $ 18,466 -- -- -- --
============ ============ ============ ============ ============ ============
Convertible
Redeemable Preferred Stock
Additional Retained Series C
Paid-In Earnings ----------------------------
Capital (Deficit) Total Shares Amount
------------ -------------- ------------ ------------ ------------
BALANCE, JANUARY 1, 2004 ... $ 23,890,356 $ (3,256,860) $ 43,563,699 759,494 $ 2,895,001
Conversion of preferred
stock Series C and
accrued dividends ..... 3,353,008 -- 3,353,708 (759,494) (2,895,001)
Conversion of preferred
stock Series D ........ 22,912,965 -- -- -- --
Warrants issued in
private placement
transaction ........... 189,815 -- 189,815 -- --
Common stock issued upon
exercise of options and
warrants .............. 557,514 -- 557,728 -- --
Common stock and warrants
issued for services ... 85,710 -- 85,731 -- --
Tax benefit from exercise
of stock options ...... 84,034 -- 84,034 -- --
Preferred stock dividends -- (30,505) (30,505) -- --
Net loss ................ -- (17,608,968) (17,608,968) -- --
------------ -------------- ------------ ------------ ------------
BALANCE, DECEMBER 31, 2004 . 51,073,402 (20,896,333) 30,195,242 -- --
Common stock issued upon
exercise of options and
warrants .............. 254,476 -- 254,544 -- --
Net loss ................ -- (29,537,709) (29,537,709) -- --
------------ -------------- ------------ ------------ ------------
BALANCE, DECEMBER 31, 2005 . 51,327,878 (50,434,042) 912,077 -- --
Common stock issued for
services .............. 102,504 -- 102,729 -- --
Stock based compensation 362,120 -- 362,120 -- --
Net income .............. -- 309,303 309,303 -- --
------------ -------------- ------------ ------------ ------------
BALANCE, DECEMBER 31, 2006 . $ 51,792,502 $ (50,124,739) $ 1,686,229 -- --
============ ============== ============ ============ ============
See accompanying notes.
24
TAG-IT PACIFIC, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2006 2005 2004
------------ ------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) .......................................... $ 309,303 $(29,537,709) $(17,608,968)
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Depreciation and amortization ............................ 1,523,225 1,931,990 1,547,223
Decrease in deferred income taxes ........................ -- 1,000,000 1,800,000
Common stock and warrants issued for services ............ 32,729 -- 85,731
Stock based compensation ................................. 362,120
Increase(decrease) in allowance for doubtful accounts .... (1,117,500) 2,630,759 4,042,428
Increase(decrease) in inventory valuation reserve ........ (6,064,000) 940,973 (240,000)
Asset impairment due to restructuring .................... -- 2,343,531 --
Impairment of goodwill ................................... -- 450,000 --
Disposal of assets ....................................... 129,179 -- --
Changes in operating assets and liabilities:
Accounts receivable ...................................... 2,086,076 10,666,295 (7,640,984)
Note receivable collections .............................. 640,539 -- --
Inventories .............................................. 8,585,879 2,791,747 7,551,060
Prepaid expenses and other current assets ................ 77,543 1,880,443 13,121
Other assets ............................................. (140,217) 314,998 147,046
Accounts payable ......................................... (2,587,985) 2,986,302 (2,647,692)
Accrued legal costs ...................................... (442,194) 2,113,197 245,796
Other accrued expenses ................................... (733,767) 671,348 831,346
Repayment of notes payable converted from accounts payable (867,297) -- --
Income taxes payable ..................................... (480) (71,589) 12,032
------------ ------------ ------------
Net cash provided by (used in) operating activities ........ 1,794,153 1,112,285 (11,381,861)
------------ ------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from sale of equipment ............................ 2,500 -- --
Acquisition of property and equipment ...................... (347,188) (1,453,848) (3,615,899)
------------ ------------ ------------
Net cash used in investing activities ...................... (344,688) (1,453,848) (3,615,899)
------------ ------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from secured convertible promissory notes ......... -- -- 11,663,685
Proceeds from exercise of stock options and warrants ....... -- 254,544 557,728
(Repayment) of line of credit and due to factor, net ....... -- (614,506) (6,481,007)
Proceeds from capital lease obligation ..................... -- -- 950,000
Payment of capital lease obligations ....................... (604,351) (906,765) (332,583)
Proceeds from notes payable ................................ -- -- 880,000
Repayment of notes payable ................................. (186,838) (1,574,975) (1,222,170)
------------ ------------ ------------
Net cash (used in) provided by financing activities ........ (791,189) (2,841,702) 6,015,653
------------ ------------ ------------
Net increase (decrease) in cash and cash equivalents .......... 657,276 (3,183,265) (8,982,107)
Cash and cash equivalents, beginning of year .................. 2,277,397 5,460,662 14,442,769
------------ ------------ ------------
Cash and cash equivalents, end of year ........................ $ 2,934,673 $ 2,277,397 $ 5,460,662
============ ============ ============
See accompanying notes.
25
TAG-IT PACIFIC, INC.
Consolidated Statements of Cash Flows
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2006 2005 2004
------------ ------------ ------------
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash received (paid) during the year for:
Interest paid ........................................... $ (975,609) $ (1,264,539) $ (693,045)
Interest received ....................................... $ 320,232 $ 42,516 $ 32,340
Income taxes paid ....................................... $ (33,900) $ (64,064) $ (495,345)
Income taxes received ................................... $ -- $ 39,571 $ 17,903
Non-cash financing activity:
Capital lease obligation ................................ $ 64,432 $ 273,376 $ 249,418
Accounts receivable, net converted to notes receivable .. $ -- $ 3,440,000 $ 470,799
Trade payable & accrued legal, converted to notes payable $ 1,775,000 $ -- $ --
Preferred Series D stock converted to common stock ...... $ -- $ -- $ 22,918,693
Preferred Series C stock converted to common stock ...... $ -- $ -- $ 2,895,001
Accrued dividends converted to common stock ............. $ -- $ -- $ 458,707
Mortgage note payable ................................... $ -- $ -- $ 765,000
Warrants issued to placement agent ...................... $ -- $ -- $ 93,815
See accompanying notes.
26
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
NATURE OF BUSINESS
Tag-It Pacific, Inc. (the "Company") is an apparel company that
specializes in the distribution of trim items to manufacturers of fashion
apparel, specialty retailers and mass merchandisers. The Company acts as a full
service outsourced trim management department for manufacturers, a specified
supplier of trim items to owners of specific brands, brand licensees and
retailers, a manufacturer and distributor of zippers under the TALON brand name
and a distributor of stretch waistbands that utilize licensed patented
technology under the TEKFIT brand name.
ORGANIZATION AND BASIS OF PRESENTATION
Tag-It Pacific, Inc. is the parent holding company of Tag-It, Inc., a
California corporation, Tag-It Pacific (HK) Ltd., a BVI corporation, Tag-It de
Mexico, S.A. de C.V., A.G.S. Stationery, Inc., a California corporation
(collectively, the "Subsidiaries"), all of which were consolidated under a
parent limited liability company on October 17, 1997 and became wholly-owned
subsidiaries of the Company immediately prior to the effective date of the
Company's initial public offering in January 1998. Immediately prior to the
initial public offering, the outstanding membership units of Tag-It Pacific LLC
were converted to 2,470,001 shares of Common Stock of the Company. In January
2000, the Company formed Tag-It Pacific Limited, a Hong Kong corporation, and in
April 2000, the Company formed Talon International, Inc., a Delaware
corporation. During 2006 we formed two wholly owned subsidiaries of Tag-It
Pacific, Inc.; Talon Zipper (Shenzhen) Company Ltd. in China, and Talon
International Pvt. Ltd., in India. All newly formed corporations are 100%
wholly-owned Subsidiaries of Tag-It Pacific, Inc. Logistica en Avios, S.A. de
C.V. was an affiliated entity over which the Company exercised control, and as
such, is accounted for in the same manner as a wholly-owned subsidiary.
All significant intercompany accounts and transactions have been
eliminated in consolidation. Assets and liabilities of foreign subsidiaries are
translated at rates of exchange in effect at the close of the period. Revenues
and expenses are translated at the weighted average of exchange rates in effect
during the year. The resulting translation gains and losses are deferred and are
shown as a separate component of stockholders' equity, if material, and
transaction gains and losses, if any, are recorded in the consolidated statement
of income in the period incurred. During 2006, 2005 and 2004, foreign currency
translation and transaction gains and losses were not material. The Company does
not engage in hedging activities with respect to exchange rate risk.
USE OF ESTIMATES
The preparation of consolidated financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the year.
Actual results could differ from those estimates.
CASH AND CASH EQUIVALENTS
The Company considers all highly liquid investments purchased with an
initial maturity of three months or less to be cash equivalents. The Company had
approximately $2.9 million and $2.2 million at financial institutions in excess
of federally insured limits at December 31, 2006 and 2005.
27
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
ALLOWANCE FOR DOUBTFUL ACCOUNTS
We are required to make judgments as to the collectibility of accounts
receivable based on established aging policy, historical experience and future
expectations. The allowances for doubtful accounts represent allowances for
customer trade accounts receivable that are estimated to be partially or
entirely uncollectible. These allowances are used to reduce gross trade
receivables to their net realizable value. We record these allowances based on
estimates related to the following factors: (i) customer specific allowances;
(ii) amounts based upon an aging schedule; and (iii) an estimated amount, based
on our historical experience, for issues not yet identified.
INVENTORIES
Inventories are stated at the lower of cost, determined using the
first-in, first-out basis, or market value and are all substantially finished
goods. The costs of inventory include the purchase price, inbound freight and
duties, conversion costs and certain allocated production overhead costs.
Inventory reserves are recorded for damaged, obsolete, excess and slow-moving
inventory. We use estimates to record these reserves. Slow-moving inventory is
reviewed by category and may be partially or fully reserved for depending on the
type of product and the length of time the product has been included in
inventory. Reserve adjustments are made for the difference between the cost of
the inventory and the estimated market value, if lower, and charged to
operations in the period in which the facts that give rise to these adjustments
become known. Market value of inventory is estimated based on the impact of
market trends, an evaluation of economic conditions and the value of current
orders relating to the future sales of this type of inventory.
Inventories consist of the following:
Year Ended December 31,
--------------------------------
2006 2005
----------- -----------
Finished goods ....................... $ 4,293,220 $12,879,099
Less reserves ........................ 1,242,000 7,306,000
----------- -----------
Total inventories .................... $ 3,051,220 $ 5,573,099
=========== ===========
PROPERTY AND EQUIPMENT AND FIXED ASSETS HELD FOR SALE
Property and equipment are recorded at historical cost. Maintenance and
repairs are expensed as incurred. Upon retirement or other disposition of
property and equipment, the related cost and accumulated depreciation or
amortization are removed from the accounts and any gains or losses are included
in results of operations. During the year ended December 31, 2005 the Company
wrote-off fully depreciated equipment, films, dies and art designs no longer in
service, and changed its estimates of the expected useful lives of the dies and
molds to 3 months or 1 year, depending upon the nature of the tool.
Depreciation of property and equipment is computed using the
straight-line method based on estimated useful lives as follows:
Furniture and fixtures 5 years
Machinery and equipment 5 to 10 years
Computer equipment 5 years
Leasehold improvements Term of the lease or the estimated life of
the related improvements, whichever is
shorter.
Dies, and molds 3 months to 1 years
Idle equipment 5 to 10 years
28
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Property and equipment consist of the following:
Year Ended December 31,
---------------------------
2006 2005
----------- -----------
Furniture and fixtures ......................... $ 582,832 $ 551,623
Machinery and equipment ........................ 1,682,296 3,319,786
Computer equipment ............................. 3,422,058 3,325,997
Leasehold improvements ......................... 214,807 139,803
Dies, and molds ................................ 106,273 106,273
Idle equipment ................................. 4,434,980 2,806,475
----------- -----------
10,443,246 10,249,958
Accumulated depreciation and amortization ...... 4,820,206 3,811,862
----------- -----------
Net property and equipment ..................... $ 5,623,040 $ 6,438,096
=========== ===========
Depreciation expense for the years ended December 31, 2006, 2005 and
2004 was $1,090,000, $1,499,000, and $1,277,000, respectively.
During the year ended December 31, 2005, the Company wrote-off fixed
assets with a net book value of $2,036,000 in connection with the 2005
restructuring plan.
Idle equipment is principally machinery and equipment used for the
production of zipper chain and the assembly of finished zippers. This equipment
was originally associated with the production and assembly facilities in North
Carolina and in Mexico, and was temporarily rendered idle with the closing of
these operations in connection with the 2005 Restructuring Plan. The Company
intends to redeploy this equipment during the next year within production
operations being established in Asia and India. The equipment continues to be
depreciated based upon its estimated useful lives.
Fixed assets held for sale consists of the North Carolina land and
manufacturing facility. Management has the authority and has committed to sell
the asset; the asset is listed for sale with a commercial real estate agent who
is actively marketing the property; the sale of the asset is probable and the
sale is expected to be completed within one year. See Note 11, "2005
Restructuring Plan". This asset held for sale is financed by a mortgage note
with a balance of $712,950 at December 31, 2006 and $734,787 at December 31,
2005.
GOODWILL AND OTHER INTANGIBLE ASSETS
Intangible assets consist of goodwill, tradename, and exclusive license
and intellectual property rights. Goodwill represents the excess of costs over
fair value of assets of businesses acquired. Goodwill and intangible assets
acquired in a purchase business combination and determined to have an indefinite
useful life are not amortized, but instead tested for impairment at least
annually in accordance with the provisions of FASB Statement No. 142, Goodwill
and Other Intangible Assets. Intangible assets with estimable useful lives are
amortized over their respective estimated useful lives, which average 5 years,
to their estimated residual values, and reviewed for impairment in accordance
with FASB Statement No. 144, Accounting for Impairment or Disposal of Long-Lived
Assets.
29
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
At December 31, 2006, the Company evaluated its Other Intangible Assets
and determined that there was no impairment of these assets and made no changes
to the net carrying amount of Tradename for the years ended December 31, 2006
and 2005. At December 31, 2005, the Company evaluated its Goodwill and
determined that an impairment adjustment in the amount of $450,000 related to
goodwill was necessary to reduce the carrying value of goodwill to zero.
Amortization expense related to exclusive license and intellectual property
rights of $115,500 were recorded for each of the years ended December 31, 2006,
2005 and 2004.
Goodwill and other intangible assets as of December 31, 2006 and 2005
are as follows:
Year Ended December 31,
--------------------------
2006 2005
----------- -----------
Goodwill .................................................... $ -- $ 500,000
Accumulated amortization .................................. -- (50,000)
Impairment write-off ...................................... -- (450,000)
----------- -----------
Goodwill, net ............................................. $ -- $ --
=========== ===========
Other Intangible Assets:
Tradename ................................................. $ 4,110,750 $ 4,110,750
Accumulated amortization .................................. -- --
----------- -----------
Tradename, net ........................................ 4,110,750 4,110,750
Exclusive license and intellectual property rights ........ 577,500 577,500
Accumulated amortization .................................. (548,625) (433,125)
----------- -----------
Exclusive license and intellectual property rights, net 28,875 144,375
----------- -----------
Other intangible assets, net .............................. $ 4,139,625 $ 4,255,125
=========== ===========
The estimated amortization expense for these assets for succeeding
years is $28,875 for 2007.
IMPAIRMENT OF LONG-LIVED ASSETS
We record impairment charges when the carrying amounts of long-lived
assets are determined not to be recoverable. Impairment is measured by assessing
the usefulness of an asset or by comparing the carrying value of an asset to its
fair value. Fair value is typically determined using quoted market prices, if
available, or an estimate of undiscounted future cash flows expected to result
from the use of the asset and its eventual disposition. The amount of impairment
loss is calculated as the excess of the carrying value over the fair value.
Changes in market conditions and management strategy have historically caused us
to reassess the carrying amount of our long-lived assets. During the year ended
December 31, 2005, the Company recorded asset impairment charges in connection
with its 2005 Restructuring Plan (See Note 11).
30
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
ACCRUED EXPENSES
Included in the December 31, 2006 accrued expenses is a customer
payment of approximately $1,105,000. The payment is an advance on raw material
inventory purchases for this customer. We recorded these funds as a short term
obligation and not as revenue because the product for this customer's order was
not shipped as of December 31, 2006. The underlying order is expected to ship
within six months.
INCOME TAXES
Income taxes are accounted for under the asset and liability method.
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases and tax benefit carry-forwards. Deferred tax liabilities and assets at the
end of each period are determined using enacted tax rates. The Company records
deferred tax assets arising from temporary timing differences between recorded
net income and taxable net income when and if we believe that future earnings
will be sufficient to realize the tax benefit. For those jurisdictions where the
expiration date of tax benefit carry-forwards or the projected taxable earnings
indicate that realization is not likely, a valuation allowance is provided.
The provisions of SFAS No. 109, "Accounting for Income Taxes," require
the establishment of a valuation allowance when, based on currently available
information and other factors, it is more likely than not that all or a portion
of a deferred tax asset will not be realized. SFAS No. 109 provides that an
important factor in determining whether a deferred tax asset will be realized is
whether there has been sufficient income in recent years and whether sufficient
income is expected in future years in order to utilize the deferred tax asset.
The Company believes that its estimate of deferred tax assets and
determination to record a valuation allowance against such assets are critical
accounting estimates because they are subject to, among other things, an
estimate of future taxable income, which is susceptible to change and dependent
upon events that may or may not occur, and because the impact of recording a
valuation allowance may be material to the assets reported on the balance sheet
and results of operations.
STOCK-BASED COMPENSATION
On January 1, 2006, the Company adopted Statement of Financial
Accounting Standards No. 123 (revised 2004), "Share-Based Payment," ("SFAS
123(R)") which requires the measurement and recognition of compensation expense
for all share-based payment awards made to employees and directors based on
estimated fair values. SFAS 123(R) supersedes the Company's previous accounting
under Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued
to Employees" ("APB 25") for periods beginning in fiscal 2006. In March 2005,
the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107
("SAB 107") relating to SFAS 123(R). The Company has applied the provisions of
SAB 107 in its adoption of SFAS 123(R).
The Company adopted SFAS 123(R) using the modified prospective
transition method, which requires the application of the accounting standard as
of January 1, 2006. The Company's financial statements as of and for the year
ended December 31, 2006 reflect the impact of SFAS 123(R). In accordance with
the modified prospective transition method, the Company's financial statements
for prior periods have not been restated to reflect, and do not include, the
impact of SFAS 123(R). There was no stock-based compensation expense related to
employee or director stock options recognized during the years ended December
31, 2005 or 2004. Options issued to consultants are accounted for in accordance
with the provisions of Emerging Issues Task Force (EITF) No. 96-18, "Accounting
for Equity Instruments That Are Issued to Others Than Employees for Acquiring,
or in Conjunction with Selling, Goods or Services."
31
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
As a result of adopting SFAS 123(R) on January 1, 2006, the Company's
income before income taxes and net income for the year ended December 31, 2006
are $395,000 lower than if it had continued to account for share-based
compensation under APB Opinion 25.
The following table illustrates the effect on net income and loss per
share if the Company had applied the fair value recognition provisions of SFAS
123(R) to stock-based awards granted under the Company's stock option plans in
all periods presented. For purposes of this pro-forma disclosure, the fair value
of the options is estimated using the Black-Scholes-Merton option-pricing
formula ("Black-Scholes model") and amortized to expense generally over the
options' vesting periods.
2005 2004
------------ ------------
Net loss as reported ........................... $(29,537,709) $(17,608,968)
Add: Stock-based employee compensation expense
included in reported net income, net of
related tax effects ....................... -- --
Deduct: Total stock-based employee
compensation expense determined under fair
value method for all awards, net of
related tax effects ....................... (221,167) (55,228)
------------ ------------
Pro forma net loss ............................. $(29,758,876) $(17,664,196)
============ ============
Loss per share:
Basic - as reported ....................... $ (1.62) $ (1.02)
Basic - pro forma ......................... $ (1.63) $ (1.02)
SFAS 123(R) requires companies to estimate the fair value of
share-based payment awards to employees and directors on the date of grant using
an option-pricing model. The value of the portion of the award that is
ultimately expected to vest is recognized as expense over the requisite service
periods in the Company's Statements of Operations. Stock-based compensation
expense recognized in the Statements of Operations for the year ended December
31, 2006 included compensation expense for share-based payment awards granted
prior to, but not yet vested as of January 1, 2006 based on the grant date fair
value estimated in accordance with the pro-forma provisions of SFAS 123 and
compensation expense for the share-based payment awards granted subsequent to
January 1, 2006 based on the grant date fair value estimated in accordance with
the provisions of SFAS 123(R). For stock-based awards issued to employees and
directors, stock-based compensation is attributed to expense using the
straight-line single option method, which is consistent with how the
prior-period pro formas were provided. As stock-based compensation expense
recognized in the Statements of Operations for 2006 is based on awards expected
to vest, SFAS 123(R) requires forfeitures to be estimated at the time of grant
and revised, if necessary, in subsequent periods if actual forfeitures differ
from those estimates. For the year ended December 31, 2006, expected forfeitures
are immaterial and as such the Company is recognizing forfeitures as they occur.
In the pro-forma information provided under SFAS 123 for the periods prior to
2006, the Company accounted for forfeitures as they occurred.
Prior to the adoption of SFAS 123(R), the Company accounted for
stock-based awards to employees and directors using the intrinsic value method
in accordance with APB Opinion 25. Under the intrinsic value method, the Company
recognized share-based compensation equal to the award's intrinsic value at the
time of grant over the requisite service periods using the straight-line method.
Forfeitures were recognized as incurred. During the years ended December, 31,
32
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2005 and 2004, there was no stock-based compensation expense recognized in the
Statements of Operations for awards issued to employees and directors as the
awards had no intrinsic value at the time of grant because their exercise prices
equaled the fair values of the common stock at the time of grant.
The Company's determination of fair value of share-based payment awards
to employees and directors on the date of grant uses the Black-Scholes model,
which is affected by the Company's stock price as well as assumptions regarding
a number of complex and subjective variables. These variables include, but are
not limited to, the expected stock price volatility over the expected term of
the awards, and actual and projected employee stock option exercise behaviors.
The Company estimates expected volatility using historical data. The expected
option term is estimated using the "safe harbor" provisions under SAB 107.
The Company has elected to adopt the detailed method provided in SFAS
123(R) for calculating the beginning balance of the additional paid-in capital
pool ("APIC pool") related to the tax effects of employee stock-based
compensation, and to determine the subsequent impact on the APIC pool and
Statements of Cash Flows of the tax effects of employee stock-based compensation
awards that are outstanding upon adoption of SFAS 123(R).
COMPREHENSIVE INCOME
The Company has adopted Statement of Financial Standard No. 130,
"Reporting Comprehensive Income" ("SFAS 130"), issued by the FASB and effective
for financial statements with fiscal years beginning after December 15, 1997.
SFAS 130 establishes standards for reporting and display of comprehensive income
and its components in a full set of general-purpose financial statements. There
were no material other comprehensive income items for the years ended December
31, 2006, 2005 and 2004.
REVENUE RECOGNITION
Sales are recognized when persuasive evidence of an arrangement exists,
product delivery has occurred, pricing is fixed or determinable, and collection
is reasonably assured. Sales resulting from customer buy-back agreements, or
associated inventory storage arrangements are recognized upon delivery of the
products to the customer, the customer's designated manufacturer, or upon notice
from the customer to destroy or dispose of the goods. Sales, provisions for
estimated sales returns, and the cost of products sold are recorded at the time
title transfers to customers. Actual product returns are charged against
estimated sales return allowances.
Sales rebates and discounts are common practice in the industries in
which the Company operates. Volume, promotional, price, cash and other discounts
and customer incentives are accounted for as a reduction to gross sales. Rebates
and discounts are recorded based upon estimates at the time products are sold.
These estimates are based upon historical experience for similar programs and
products. The Company reviews such rebates and discounts on an ongoing basis and
accruals for rebates and discounts are adjusted, if necessary, as additional
information becomes available.
RECLASSIFICATION
Certain reclassifications have been made to the prior year financial
statements to conform to 2006 presentation. The amortization of deferred
financing costs and discounts are reported as "Interest Expense, net" on the
consolidated statement of operations. These items ($310,771 and $45,000 for 2005
and 2004, respectively) were previously reported as "General and Administrative
Expenses".
33
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
CLASSIFICATION OF EXPENSES
COST OF SALES - Cost of goods sold primarily includes expenses related
to inventory purchases, customs, duty, freight, overhead expenses and reserves
for obsolete inventory. Overhead expenses primarily consist of warehouse and
operations salaries, and other warehouse expenses.
SELLING EXPENSE - Selling expenses primarily include royalty expense,
sales salaries and commissions, travel and entertainment, marketing and other
sales-related costs.
GENERAL AND ADMINISTRATIVE EXPENSES - General and administrative
expenses primarily include administrative salaries, employee benefits,
professional service fees, facility expenses, information technology costs,
investor relations, travel and entertainment, depreciation and amortization, bad
debts, restructuring costs and other general corporate expenses.
INTEREST EXPENSE AND INTEREST INCOME - Interest expense reflects the
cost of borrowing and amortization of deferred financing costs and discounts.
Interest expense for the years ended December 31, 2006, 2005 and 2004 was
$1,357,000, $1,446,000, and $882,000, respectively. Interest income of $368,000,
$66,000 and $32,000 for the years ended December 31, 2006, 2005 and 2004,
respectively, consists of earnings from outstanding amounts due to the Company
under notes and other interest bearing receivables.
SHIPPING AND HANDLING COSTS
In accordance with Emerging Issues Task Force (EITF) 00-10, Accounting
for Shipping and Handling Fees and Costs, the Company records shipping and
handling costs billed to customers as a component of revenue, and shipping and
handling costs incurred by the Company for outbound freight are recorded as a
component of cost of sales. Total shipping and handling costs included as
component of revenue for the years ended December 31, 2006, 2005 and 2004
amounted to $146,000, $98,000 and $194,000. Total shipping and handling costs
included as a component of cost of sales for each of these years amounted to
$691,000, $925,000 and $1,002,000.
RESTRUCTURING CHARGES
The Company records restructuring reserves in compliance with SFAS 146
"Accounting for Costs Associated with Exit or Disposal Activities", resulting in
the recognition of employee severance and related termination benefits for
recurring arrangements as they are incurred and on the accrual basis for
one-time benefit arrangements. The Company records other costs associated with
exit activities as they are incurred. Employee severance and termination
benefits are estimates based on agreements with the relevant union
representatives or plans adopted by the Company that are applicable to employees
not affiliated with unions. These costs are not associated with nor do they
benefit continuing activities. Inherent in the estimation of these costs are
assessments related to the most likely expected outcome of the significant
actions to accomplish the restructuring. Changing business conditions may affect
the assumptions related to the timing and extent of facility closure activities.
The Company reviews the status of restructuring activities on a quarterly basis
and, if appropriate, records changes based on updated estimates. See Note 11,
"2005 Restructuring Plan".
LITIGATION
We are currently involved in various lawsuits, claims and inquiries,
most of which are routine to the nature of the business, and in accordance with
SFAS No. 5, "Accounting for Contingencies," we accrue estimates of the probable
and estimable losses for the resolution of these claims. The ultimate resolution
of these claims could affect our future results of operations for any particular
quarterly or annual period should
34
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
our exposure be materially different from our earlier estimates or should
liabilities be incurred that were not previously accrued.
FAIR VALUE OF FINANCIAL INFORMATION
The following methods and assumptions were used to estimate the fair
value of each class of financial instruments for which it is practicable to
estimate that value. Accounts receivable: Due to the short-term nature of the
receivables, the fair value approximates the carrying value. Due from related
parties and notes payable to related parties: Due to the short-term nature and
current market borrowing rates of the loans and notes, the fair value
approximates the carrying value. Notes payable: Fair value approximates carrying
value based upon current market borrowing rates for loans with similar terms and
maturities.
NEW ACCOUNTING PRONOUNCEMENTS
In September 2006, the FASB issued SFAS No. 157, "Fair Value
Measurements", ("SFAS No. 157"). SFAS No. 157 defines fair value, establishes a
framework for measuring fair value in generally accepted accounting principles
(GAAP), and expands disclosures about fair value measurements. This Statement
applies under other accounting pronouncements that require or permit fair value
measurements, and does not require any new fair value measurements. The
application of SFAS No. 157, however, may change current practice within an
organization. SFAS No. 157 is effective for all fiscal years beginning after
November 15, 2007, with earlier application encouraged. The Company does not
believe that SFAS No. 157 will have a material impact on the Company's financial
position, results of operations or cash flows.
In September 2006, the SEC issued Staff Accounting Bulletin No. 108,
Considering the Effects of Prior Year Misstatements when Quantifying
Misstatements in Current Year Financial Statements ("SAB 108"), to address
diversity in practice in quantifying financial statement misstatements. SAB 108
requires the quantification of misstatements based on their impact on both the
balance sheet and the income statement to determine materiality. The guidance
provides for a one-time cumulative effect adjustment to correct for
misstatements that were not deemed material under a company's prior approach but
are material under the SAB 108 approach. SAB 108 is effective for fiscal years
ending after November 15, 2006. The implementation of SAB 108 did not have a
material impact on the financial position, results of operations or cash flows
of the Company.
In June 2006, the Financial Accounting Standards Board ("FASB") issued
Interpretation No. 48, Accounting for Uncertainty in Income Taxes -- An
Interpretation of FASB Statement No. 109, (FIN 48). FIN 48 clarifies the
accounting for uncertainty in income taxes recognized in an enterprise's
financial statements in accordance with FASB Statement No. 109, Accounting for
Income Taxes. FIN 48 also prescribes a recognition threshold and measurement
attribute for the financial statement recognition and measurement of a tax
position taken or expected to be taken in a tax return that results in a tax
benefit. Additionally, FIN 48 provides guidance on de-recognition, income
statement classification of interest and penalties, accounting in interim
periods, disclosure, and transition. This interpretation is effective for fiscal
years beginning after December 15, 2006. The Company is currently evaluating the
effect that the application of FIN 48 will have on its results of operations and
financial condition.
In February 2006, the FASB issued Statement of Financial Accounting
Standards No. 155, "Accounting for Certain Hybrid Financial Instruments" ("SFAS
155"), which amends SFAS No. 133, "Accounting for Derivatives Instruments and
Hedging Activities" ("SFAS 133") and SFAS No. 140, "Accounting for Transfers and
Servicing of Financial Assets and Extinguishment of Liabilities" ("SFAS 140).
SFAS 155 amends SFAS 133 to narrow the scope exception for interest-only and
principal-only strips on debt instruments to include only such strips
representing rights to receive a specified portion of the contractual interest
or principle cash flows. SFAS 155 also amends SFAS 140 to allow qualifying
special-purpose entities to hold a passive derivative financial instrument
pertaining to beneficial interests that itself is
35
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
a derivative instrument. SFAS No. 155 is effective for all financial instruments
acquired or issued after the beginning of an entity's first fiscal year that
begins after September 15, 2006. The Company does not believe that SFAS No. 155
will have a material impact on the Company's financial position, results of
operations or cash flows.
NOTE 2 - ACCOUNTS AND NOTE RECEIVABLE
At December 31, 2006 a note receivable from Azteca Productions
International ("Azteca") was outstanding in the amount of $2,799,460. The note
is receivable in monthly installments over thirty-one months beginning March 1,
2006. The payments are $50,000 per month for the first 5 months, then range from
$133,000-$267,000 per month until paid in full. At December 31, 2005, accounts
receivable from Azteca, a significant customer in 2005, was approximately
$10,968,000 less a reserve of $7,528,000. In February 2006, the Company accepted
a note agreement from Azteca which provided for total payments including
principal and interest of $4.0 million in exchange for the net outstanding
accounts receivable balance. The value of the note receivable recorded effective
at December 31, 2005 reflected a $560,000 charge to the face value to discount
the note, using a 10.5% discount rate, to its net present value. The Azteca
accounts receivable, net at December 31, 2005 was reclassified on the
accompanying consolidated balance sheets to note receivable to reflect this
subsequent settlement. The following summarizes the future minimum payments of
the note receivable:
Years ending December 31, Amount
-----------
2007 .................................................... $ 1,599,996
2008 .................................................... 1,483,339
-----------
Total payments .......................................... 3,083,335
Less amount representing interest ....................... (283,875)
-----------
Balance at December 31, 2006 ............................ 2,799,460
Less current portion .................................... 1,378,491
-----------
Long-term portion ....................................... $ 1,420,969
===========
Accounts receivable are included on the accompanying consolidated
balance sheet net of an allowance for doubtful accounts. The total allowance for
doubtful accounts at December 31, 2006 was $71,500. The total allowance for
doubtful accounts at December 31, 2005 was $1,188,758, after reclassification of
the net Azteca receivable to note receivable.
In 2004, following negotiations with Tarrant Apparel Group, a former
customer, we determined that a significant portion of the obligations due from
this customer were uncollectible. Accordingly, included in general and
administrative expenses for 2004 are charges of $4.3 million related primarily
to the write-down of this receivable and leaving a remaining balance receivable
from this customer of $4.5 million. An affiliate of the customer repaid the $4.5
million receivable balance over the period from May through December 2005.
NOTE 3 - FACTORING AGREEMENT
The Company entered into a factoring agreement with East Asia Heller in
2004 for the purchase of eligible receivables from its Hong Kong subsidiary,
Tag-It Pacific (HK) Limited. The factor may purchase eligible accounts
receivable and assume the credit risk with respect to those accounts for which
they have given their prior approval. If the factor does not assume the credit
risk for a receivable, the collection risk associated with the receivable
remains with the Company. The Company pays a fixed commission rate and
36
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
may borrow up to 80% of its eligible accounts receivable. Interest is charged at
1.5% over the Hong Kong Dollar prime rate (7.75% and 7.75% at December 31, 2006
and 2005). However, during 2005 and 2006 the factor declined to advance funds to
the Company under this agreement. Accordingly, as of December 31, 2006, and 2005
there were no outstanding advances from the factor.
NOTE 4 - DEMAND NOTES PAYABLE TO RELATED PARTIES
Demand notes payable to related parties consist of the following:
Year Ended December 31,
-------------------------------
2006 2005
-------------- --------------
Two notes payable issued from 1995-1998 to
parties related to or affiliated with
directors of the Company with interest rates
ranging from 0% to 10% per annum, due and
payable on the fifteenth day following
delivery of written demand for payment .. $ 85,176 $ 85,176
Convertible secured note payable issued in
October 2000 to a director of the Company
bears interest at 11%, payable quarterly, is
due on demand and convertible into common
stock at the election of the holder at a
rate of $4.50 per share, the market value of
the Company's common stock on the date of
approval by the Company's Board of
Directors. The note is secured by
substantially all of the Company's
assets ........................................ 500,000 500,000
Unsecured notes payable to a director of the
Company accrue interest at 7% and 8.5% per
annum, principal and interest due on demand
and fifteen days from
demand ........................................ 79,795 79,795
-------------- --------------
$ 664,971 $ 664,971
============== ==============
Interest expense related to the demand notes payable to related parties
for the years ended December 31, 2006, 2005 and 2004 amounted to $67,753,
$67,753, and $81,628. Included in accrued expenses at December 31, 2006 and 2005
was $515,738 and $447,986 of related accrued interest. There was no interest
paid on the demand notes during the years ended December 31, 2006 and 2005.
37
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 5 - CAPITAL LEASE OBLIGATIONS
The Company financed equipment purchases through various capital lease
obligations expiring through August 2010. These obligations bear interest at
various rates ranging from 4.6% to 15% per annum. Future minimum annual payments
under these capital lease obligations are as follows:
Years ending December 31, Amount
-----------
2007 .................................................... $ 505,029
2008 .................................................... 336,970
2009 .................................................... 184,606
2010 .................................................... 430
-----------
Total payments .......................................... 1,027,035
Less amount representing interest ....................... (119,574)
-----------
Balance at December 31, 2006 ............................ 907,461
Less current portion .................................... 432,728
-----------
Long-term portion ....................................... $ 474,733
===========
At December 31, 2006, total property and equipment under capital lease
obligations and related accumulated depreciation was $3,533,154 and $1,178,469,
respectively. At December 31, 2005, total property and equipment under capital
lease obligations and related accumulated depreciation was $3,468,721 and
$661,533, respectively.
NOTE 6 - NOTES PAYABLE
Notes payable consist of the following:
Year Ended December 31,
-------------------------------
2006 2005
-------------- --------------
$765,000 note payable to First National Bank
dated June 3, 2004; interest at 6.5%;
payable in eighty-four monthly payments of
principal and interest of $5,746 beginning
July 2004; twenty-year amortization, all
unpaid principal and interest due June 3,
2011 (seven years); secured by building in
North
Carolina ...................................... $ 712,950 $ 734,787
$880,000 note payable to First National Bank
dated November 22, 2004; interest at 6.5%;
payable in sixty monthly payments of
principal and interest of $17,254 beginning
December 2004; all unpaid principal and
interest due November 22, 2009; secured by
manufacturing equipment ....................... 548,068 713,068
$1,650,000 note payable to Hennigan, Bennett
& Dorman, LLP dated May 31, 2006; interest
at 3.0%; payable in fourteen monthly
payments of principal and interest beginning
June 2006, of $50,000 for the first two
payments, and $133,333 for the next twelve
months thereafter until July 1, 2007;
secured by the note
receivable .................................... 907,703 --
-------------- --------------
Notes Payable ........................... 2,168,721 1,447,855
Less Current portion .................... 1,107,207 186,837
-------------- --------------
Notes payable, net of current portion $ 1,061,514 $ 1,261,018
============== ==============
38
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Future minimum annual payments under these notes payable obligations
are as follows:
Years ending December 31, Amount
----------
2007 .................................................. $1,107,207
2008 .................................................. 213,030
2009 .................................................. 210,218
2010 .................................................. 28,301
2011 and thereafter ................................... 609,965
----------
Total ................................................. $2,168,721
==========
NOTE 7 - SECURED CONVERTIBLE PROMISSORY NOTES
On November 10, 2004, the Company raised $12.5 million from the sale of
Secured Convertible Promissory Notes (the "Notes") to existing shareholders. The
Notes are convertible into common stock at a price of $3.65 per share, bear
interest at 6% payable quarterly, are due November 9, 2007 and are secured by
the Talon trademarks. The Notes are convertible at the option of the holder at
any time after closing. The Company may repay the Notes at any time after one
year from the closing date with a 15% prepayment penalty. Among other
restrictions, the Notes restrict the Company from declaring or paying a dividend
prior to conversion or payment of the Notes. At maturity, the Company may repay
the Notes in cash or require conversion if certain conditions are met. In
connection with the issuance of the Notes, the Company issued to the Note
holders, warrants to purchase up to 171,235 shares of common stock. The warrants
have a term of five years, an exercise price of $3.65 per share and vested 30
days after closing. The fair value of the warrants was estimated at
approximately $96,000 utilizing the Black-Scholes model and recorded as a
discount against the face value of the Notes. The discount is amortized over the
three-year term of the Notes on a straight-line basis. The Company has
registered the resale by the holders of the shares issuable upon conversion of
the Notes and exercise of the warrants. In connection with this financing, the
Company paid the placement agent $704,000 in cash, and issued the placement
agent a warrant to purchase 215,754 common shares at an exercise price of $3.65
per share. The warrant is exercisable beginning May 10, 2005 through November
10, 2009. The fair value of the warrant was estimated at $93,815 utilizing the
Black-Scholes model and recorded as deferred financing costs which are amortized
over the three- year term of the Notes. The full amount of principal under these
secured convertible promissory notes is due November 7, 2007. (See Item 7.
Management's Discussion and Analysis).
NOTE 8 - STOCKHOLDERS' EQUITY AND CONVERTIBLE REDEEMABLE PREFERRED STOCK
PREFERRED STOCK
STOCKHOLDER'S RIGHTS PLAN
In October 1998, the Company adopted a stockholder's rights plan. Under
the rights plan the Company distributed one preferred share purchase right for
each outstanding share of Common Stock outstanding on November 6, 1998. Upon the
occurrence of certain triggering events related to an unsolicited takeover
attempt of the Company, each purchase right not owned by the party or parties
making the unsolicited takeover attempt will entitle its holder to purchase
shares of the Company's Series A Preferred Stock at a value below the then
market value of the Series A Preferred Stock. The rights of holders of the
Common Stock will be subject to, and may be adversely affected by, the rights of
holders of the share
39
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
purchase rights, the Series A Preferred Stock and any other preferred stock that
may be issued in the future. The issuance of preferred stock, while providing
desirable flexibility in connection with possible acquisitions and other
corporate purposes, could make it more difficult for a third party to acquire a
majority of the Company's outstanding voting stock.
SERIES D PREFERRED STOCK PRIVATE PLACEMENT TRANSACTION
On December 18, 2003, the Company sold an aggregate of 572,818 shares
of non-voting Series D Convertible Preferred Stock, at a price of $44.00 per
share, to institutional investors and individual accredited investors in a
private placement transaction. The Company received net proceeds of $23,083,693
after commissions and other offering expenses. The Series D Convertible
Preferred Stock was convertible after approval at a special meeting of
stockholders at a rate of 10 common shares for each share of Series D
Convertible Preferred Stock. Except as required by law, the Series D Preferred
shares had no voting rights. The Series D Preferred shares accrued dividends,
commencing on June 1, 2004, at an annual rate of 5% of the initial stated value
of $44.00 per share, payable quarterly. In the event of a liquidation,
dissolution or winding-up of the Company, the Series D Preferred shares would
have been entitled to receive, prior to any distribution on the common stock, a
distribution equal to the initial stated value of the shares plus all accrued
and unpaid dividends.
At a special meeting of stockholders held on February 11, 2004, the
stockholders of the Company approved the issuance of 5,728,180 shares of common
stock upon conversion of the Series D Preferred Stock. At the conclusion of the
meeting, all of the shares of the Series D Convertible Preferred Stock
automatically converted into common shares and the Series D Convertible
Preferred Stock was eliminated.
The Company has registered the common shares issued upon conversion of
the Series D Convertible Preferred Stock for resale by the investors. In
conjunction with the private placement transaction the Company issued a warrant
to purchase 572,818 common shares to the placement agent at an exercise price of
$4.74 per share. The warrant is exercisable beginning June 18, 2004 through
December 18, 2008. The fair value of the warrant was estimated at approximately
$165,000 utilizing the Black-Scholes model and was recorded as a reduction of
the proceeds from the placement of the Series D Convertible Preferred Stock. The
Company has determined that this transaction did not result in a beneficial
conversion feature.
SERIES C PREFERRED STOCK PURCHASE AGREEMENT AND CO-MARKETING AND SUPPLY
AGREEMENT
In accordance with the Series C Preferred Stock Purchase Agreement
entered into with Coats North America Consolidated, Inc. ("Coats") on September
20, 2001, the Company issued 759,494 shares of Series C Convertible Redeemable
Preferred Stock to Coats North America Consolidated, Inc. in exchange for an
equity investment from Coats of $3,000,001 cash. The Series C Preferred shares
were convertible at the option of the holder after one year at the rate of the
closing price multiplied by 125% of the ten-day average closing price prior to
closing. The Series C Preferred shares were redeemable at the option of the
holder after four years. If the holders elected to redeem the Series C Preferred
shares, the Company had the option to redeem for cash at the stated value of
$3,000,001 or in the form of the Company's common stock at 85% of the market
price of the Company's common stock on the date of redemption. If the market
price of the Company's common stock on the date of redemption was less than
$2.75 per share, the Company was required to redeem for cash at the stated value
of the Series C Preferred shares. The Company could elect to redeem the Series C
Preferred shares at any time for cash at the stated value. The terms of the
Series C Preferred shares provided for cumulative dividends at a rate of 6% of
the stated value per annum, payable in cash or the Company's common stock. The
dividends were payable at the earlier of the declaration of the Board,
conversion or redemption. Each Series C Preferred share had the right to vote
for each of the Company's common shares that the Series C Preferred shares could
then be converted into on the record date. Total legal and other costs
associated with this transaction of $105,000 were netted against the $3,000,001
proceeds received from Coats.
40
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
In connection with the Series C Preferred Stock Purchase Agreement, the
Company also entered into a 10-year Co-Marketing and Supply Agreement with
Coats. The Co-Marketing and Supply Agreement provides for selected introductions
into Coats' customer base and the Company's trim packages will exclusively offer
thread manufactured by Coats.
On February 25, 2004, the holders of the Series C Preferred Stock
converted all 759,494 shares of Series C Preferred Stock, plus $458,707 of
accrued dividends, into 700,144 shares of common stock. The Series C Preferred
Stock was eliminated in March 2004.
SERIES B PREFERRED STOCK PURCHASE AGREEMENT, DISTRIBUTION AGREEMENT AND
TRADENAME PURCHASE AGREEMENT
On April 3, 2000, the Company entered into a ten-year exclusive license
and distribution agreement with Talon, Inc. and its parent company, Grupo
Industrial Cierres Ideal, S.A. de C.V. ("GICISA"). Under this agreement, Tag-It
Pacific, Inc. was the exclusive sales, marketing, distribution and e-commerce
arm for "Talon" products for all customers in the United States, Mexico-based
maquiladores, Canada and the Pacific Rim and had the exclusive license to market
trim products under the "Talon" brand name. In exchange for these exclusive
distribution rights, the Company issued 850,000 shares of Series B Convertible
Preferred stock to GICISA. After a period of 30 months, the shares were
convertible into the Company's common stock once the average price per share of
the Company's common stock reached or exceeded $8.00 for a 30-day consecutive
period. The preferred stock was automatically convertible into shares of the
Company's common stock based on a rate of one minus the fraction of $2.50 over
the average per share closing price of the Company's common stock for the 30-day
period preceding the conversion.
The Series B Convertible Preferred stock had a liquidation preference
of $.001 per share, and was entitled to receive non-cumulative dividends on an
as converted basis, if and when, such dividends were declared on the Company's
common stock and was redeemable by the Company under certain conditions as
outlined in the agreement.
The estimated fair value of the Series B Convertible Preferred stock on
April 3, 2000 was $1,400,000. The Company recorded the value of the license and
distribution rights as a long-term asset, which was being amortized over the
ten-year period of the agreement. The unamortized balance of the long-term asset
at December 21, 2001 was $1,166,667.
On September 30, 2000, the Company purchased inventory from GICISA in
exchange for an unsecured note payable in the amount of $2,830,024. The note
payable was non-interest bearing and was due April 1, 2002. The Company imputed
interest for the holding period of the note amounting to $272,000. The note was
subordinate to the obligations due under a credit facility with UPS Capital. The
note payable balance at December 21, 2001 was $2,767,182, net of imputed
interest of $62,842.
On December 21, 2001, the Company entered into an Asset Purchase
Agreement with Talon, Inc. and GICISA. Pursuant to the Asset Purchase Agreement,
the Company acquired from Talon, Inc. and GICISA: (1) certain inventory and
equipment, (2) all patent rights held by Talon, Inc. and (3) all of Talon's
rights to its trade names and trademarks bearing the Talon name. In addition,
the Asset Purchase Agreement terminated the exclusive 10-year license and
distribution agreement, dated as of April 3, 2000 by and among the Company,
GICISA and Talon, Inc.
Under the Asset Purchase Agreement, the Company issued to Talon, Inc.
500,000 shares of common stock, par value $0.001 per share, a promissory note in
the amount of $4,900,000 and $100,000 in cash held in escrow. The Asset Purchase
Agreement required Talon, Inc. to place 50,000 shares of the Company's common
stock and $100,000 in escrow for a period of 12 months to satisfy any
indemnification claims the Company may have under the Asset Purchase Agreement.
The common stock was valued at the market value of the Company's stock on the
date of closing. The promissory note was unsecured, and accrued interest at
41
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
prime plus 2%. In connection with the Asset Purchase Agreement, the Company also
entered into a mutual release with Talon, Inc. and GICISA pursuant to which
Talon, Inc. and GICISA released the Company from its obligations under the
unsecured note payable of $2,830,024 dated September 30, 2000 and other current
liabilities under the Exclusive License and Distribution Agreement. Further,
850,000 shares of the Company's series B convertible preferred stock held by
GICISA were canceled at the closing of the Asset Purchase Agreement. The balance
of the unsecured promissory note was $1.4 million at December 31, 2004. The
unsecured promissory note and all outstanding obligations due under the note
payable were paid in full as of June 1, 2005.
The Series B Convertible Preferred Stock was eliminated in February
2004.
COMMON STOCK
2003 PRIVATE PLACEMENT
On May 30, 2003, the Company raised approximately $6,037,500 in a
private placement transaction with five institutional investors. Pursuant to a
securities purchase agreement with these institutional investors, the Company
sold 1,725,000 shares of its common stock at a price per share of $3.50. After
commissions and expenses, the Company received net proceeds of approximately
$5.5 million. The Company has registered the shares issued in the private
placement with the Securities and Exchange Commission for resale by the
investors. In conjunction with the private placement transaction, the Company
issued warrants to purchase 172,500 shares of common stock to the placement
agent. The warrants are exercisable beginning August 30, 2003 through May 30,
2008 and have a per share exercise price of $5.06.
STOCK GRANT AGREEMENT
Pursuant to Stock Grant Agreements between the Company and Herman Roup,
dated December 1, 2001, January 1, 2002 and July 17, 2002, the Company issued to
Mr. Roup an aggregate 20,500 shares of common stock in 2004 for services
provided to the Company valued at $74,825.
EXCLUSIVE LICENSE AND INTELLECTUAL PROPERTY RIGHTS AGREEMENT
On April 2, 2002, the Company entered into an Exclusive License and
Intellectual Property Rights Agreement (the "Agreement") with Pro-Fit Holdings
Limited ("Pro-Fit"). The Agreement gives the Company the exclusive rights to
sell or sublicense waistbands manufactured under patented technology developed
by Pro-Fit for garments manufactured anywhere in the world for the United States
market and all United States brands. In accordance with the Agreement, the
Company issued 150,000 shares of its common stock which were recorded at the
market value of the stock on the date of the Agreement. The shares contain
restrictions related to the transfer of the shares and registration rights. The
Agreement has an indefinite term that extends for the duration of the trade
secrets licensed under the Agreement. The Company has recorded an intangible
asset amounting to $577,500 and is amortizing this asset on a straight-line
basis over its estimated useful life of five years. The Company is currently in
litigation with this supplier (See Notes 1 and 13).
NOTE 9 - STOCK OPTION INCENTIVE PLAN AND WARRANTS
STOCK OPTION INCENTIVE PLAN
On October 1, 1997, the Company adopted the 1997 Stock Incentive Plan
(the "1997 Plan"), which authorized the granting of a variety of stock-based
incentive awards. The Board of Directors, who determines the recipients and
terms of the awards granted, administers the 1997 Plan. On July 31, 2006 at the
42
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Company's annual meeting of stockholder's two amendments to the 1997 Stock Plan
were approved which (1) increased the maximum number of shares of common stock
that may be issued pursuant to awards granted under the 1997 Plan from 3,077,500
shares to 6,000,000 shares, and (2) increased the number of shares of common
stock that may be issued pursuant to awards granted to any individual under the
plan in a single year to 50% of the total number of shares available under the
plan.
The Company believes that such awards better align the interests of
its employees with those of its shareholders. Option awards are generally
granted with an exercise price equal to the market price of the Company's stock
on the date of the grant for years prior to 2006, and for the year ended
December 31, 2006, the average market price of the Company's stock for the five
trading days prior to the date of the grant; those option awards generally vest
over periods determined by the Board from immediate to 4 years of continuous
service, and have 10 year contractual terms.
As of December 31, 2006, the Company may issue awards to acquire up to
a total of 2,321,977 shares of common stock under the 1997 Plan, and there were
awards issued and outstanding under the Plan to acquire a total of 3,452,635
shares of common stock, including options issued to a consultant to acquire
75,000 shares of common stock at $0.57 per share. During 2006 the Company issued
options outside the Plan to employees to acquire 1,625,000 shares of stock at an
average exercise price of $0.46 per share, and granted 135,135 shares of stock
to an employee with a fair market value of $50,000.
The following table summarizes all options issued to employees and
directors including those issued outside the plan.
The following table summarizes the activity for the periods:
Weighted
Average
Number of Exercise
EMPLOYEE AND DIRECTOR Shares Price
------------- -------------
Options outstanding - January 1, 2004 ......... 1,978,000 $ 3.55
Granted .................................. -- $ --
Exercised ................................ (115,375) $ 3.36
Canceled ................................. (120,625) $ 4.00
------------- -------------
Options outstanding - December 31, 2004 ....... 1,742,000 $ 3.53
Granted .................................. 425,000 $ 3.22
Exercised ................................ (1,250) $ 3.63
Canceled ................................. (332,750) $ 3.50
------------- -------------
Options outstanding - December 31, 2005 ....... 1,833,000 $ 3.46
Granted .................................. 3,471,135 $ 0.31
Canceled ................................. (301,500) $ 3.56
------------- -------------
Options outstanding - December 31, 2006 ....... 5,002,635 $ 1.41
============= =============
The Company has also issued certain warrants and options to
non-employees. As of December 31, 2006, there were warrants issued to acquire a
total of 1,243,813 shares of common stock, and options to acquire 75,000 shares
of common stock outstanding to non-employees. During 2006 the Company issued
90,253 shares of stock to a consultant in exchange for services with a fair
market value of $51,000.
43
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following table summarizes the activity for the periods:
Weighted
Average
Number of Exercise
NON-EMPLOYEES Shares Price
------------- -------------
Options & warrants outstanding - January 1, 2004 ....... 1,277,885 $ 4.58
Granted ........................................... 416,989 $ 3.65
Exercised ......................................... (80,901) $ 2.68
Canceled .......................................... (35,000) $ 4.55
------------- -------------
Options & warrants outstanding - December 31, 2004 ..... 1,578,973 $ 4.35
Granted ........................................... -- $ --
Exercised ......................................... (68,494) $ 3.65
Canceled .......................................... (133,332) $ 4.54
------------- -------------
Options & warrants outstanding - December 31, 2005 ..... 1,377,147 $ 4.36
Granted ........................................... 75,000 $ 0.57
Exercised ......................................... -- $ --
Canceled .......................................... (133,334) $ 4.54
------------- -------------
Options & warrants outstanding - December 31, 2006 ..... 1,318,813 $ 4.13
============= =============
The Company's determination of fair value of share-based payment awards
to employees and directors on the date of grant uses the Black-Scholes model and
the assumptions noted in the following table for the years ended December 31, as
indicated. Expected volatilities are based on the historical volatility of the
Company's stock price and other factors. These variables include, but are not
limited to, the expected stock price volatility over the expected term of the
awards, and actual and projected employee stock option exercise behaviors. The
expected option term is estimated using the "safe harbor" provisions under SAB
107. The risk free rate for periods within the contractual life of the option is
based on the U.S. Treasury yield in effect at the time of the grant.
2006 2005 2004(1)
------- ------- -------
Expected volatility ......................... 65% 64% n/a
Expected term in years ...................... 6.1 yrs 1.2 yrs n/a
Expected dividends .......................... -- -- n/a
Risk-free rate .............................. 4.5% 2.0% n/a
(1) No share-based grants were made in 2004.
44
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A summary of the option activity under the 1997 Plan as of December 31,
2006, and changes during the year then ended is as follows:
Weighted
Weighted Average
Average Remaining
Number of Exercise Contractual Intrinsic
EMPLOYEE AND DIRECTOR Shares Price Life (Years) Value
------------ ------------ ------------ ------------
Outstanding at December 31, 2006 ...... 5,002,635 $ 1.41 7.90 $ 1,875,639
Vested and Expected to Vest ........... 4,927,355 $ 1.43 7.88 $ 1,837,150
Exercisable ........................... 2,223,968 $ 2.51 6.25 $ 447,389
The weighted average grant-date fair value of options granted to
employee's and director's during the years ended December 31, 2006 and 2005 were
$0.31 and $0.76, respectively. There were no grants in 2004. The total intrinsic
value of options exercised during the years ended December 31, 2005 and 2004 was
$1,700, and $130,000, respectively. There were no options exercised in 2006.
Weighted
Weighted Average
Average Remaining
Number of Exercise Contractual Intrinsic
NON-EMPLOYEE OPTIONS & WARRANTS: Shares Price Life (Years) Value
------------ ------------ ------------ ------------
Outstanding at December 31, 2006 1,318,813 $ 4.13 2.28 $ 34,500
Vested and Expected to Vest.... 1,318,813 $ 4.13 2.28 $ 34,500
Exercisable........................ 1,318,813 $ 4.13 2.28 $ 34,500
The weighted average grant-date fair value of options and warrants
granted to non-employees during the years ended December 31, 2006, and 2004 was
$0.57 and $3.70, respectively. There were no grants in 2005. The total intrinsic
value of options and warrants exercised during the years ended December 31, 2005
and 2004 was $91,000 and $135,000, respectively. There were no options exercised
in 2006. The fair value of the awards approximates the values expensed for
pro-forma purposes for these periods.
As of December 31, 2006, there was $645,248 of total unrecognized
compensation costs related to non-vested share-based compensation arrangements
granted, including warrants. This cost is expected to be recognized over the
weighted-average period of 2.0 years. The total fair value of shares vested
during the years ended December 31, 2006, 2005 and 2004 was $236,000, $217,000
and $1,597,000, respectively.
When options are exercised, the Company's policy is to issue previously
registered, unissued shares of common stock. As of December 31, 2006, the
Company had 2,321,977 unissued shares of common stock available in its 1997
Plan. On July 31, 2006, at the annual shareholders meeting an amendment to the
1997 Stock Incentive Plan was adopted to increase the number of authorized
shares under the 1997 Plan to a total of 6,000,000 shares. The additional plan
shares authorized on July 31, 2006 of 2,922,500 shares have not yet been
registered.
45
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 10 - INCOME (LOSS) PER SHARE
The following is a reconciliation of the numerators and denominators of
the basic and diluted income (loss) per share computations:
December 31, 2006 December 31, 2005
------------------------------------------ ------------------------------------------
Income Shares Per Share Loss Shares Per Share
YEARS ENDED: (Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
- -------------------- ------------ ------------ ------------ ------------ ------------ ------------
Basic income (loss):
pershare:
Income (loss)
available
to common
stockholders ... $ 309,303 18,377,484 $ 0.02 $(29,537,70) 18,225,851 $ (1.62)
Effect of dilutive
securities:
Options ........ -- 578,312 0.00 -- -- --
Warrants ....... -- -- -- -- -- --
------------ ------------ ------------ ------------ ------------ ------------
Income (loss)
available to common
stockholders ....... $ 309,303 18,955,796 $ 0.02 $(29,537,70) 18,225,851 $ (1.62)
============ ============ ============ ============ ============ ============
December 31, 2004
------------------------------------------
Loss Shares Per Share
YEARS ENDED: (Numerator) (Denominator) Amount
- -------------------- ------------ ------------ ------------
Basic income (loss):
pershare:
Income (loss)
available
to common
stockholders ... $(17,639,47) 17,316,202 $ (1.02)
Effect of dilutive
securities:
Options ........ -- -- --
Warrants ....... -- -- --
------------ ------------ ------------
Income (loss)
available to common
stockholders ....... $(17,639,47) 17,316,202 $ (1.02)
============ ============ ============
Warrants to purchase 1,243,813 shares of common stock at between $3.50
and $5.06; options to purchase 1,642,500 shares of common stock at between $1.27
and $5.23; convertible debt of $12,500,000 convertible at $3.65 per share, and
other convertible debt of $500,000 convertible at $4.50 per share were
outstanding for the year ended December 31, 2006, but were not included in the
computation of diluted loss per share because the effect of exercise or
conversion would have an antidilutive effect on the income per share.
Warrants to purchase 1,377,147 shares of common stock at between $3.50
and $5.06, options to purchase 1,833,000 shares of common stock at between $0.41
and $5.23, convertible debt of $12,500,000 convertible at $3.65 per share, and
other convertible debt of $500,000 convertible at $4.50 per share were
outstanding for the year ended December 31, 2005, but were not included in the
computation of diluted loss per share because the effect of exercise or
conversion would have an antidilutive effect on loss per share.
Warrants to purchase 1,578,973 shares of common stock at between $3.50
and $5.06, options to purchase 1,742,000 shares of common stock at between $1.30
and $4.63, convertible debt of $12,500,000 convertible at $3.65 per share, and
other convertible debt of $500,000 convertible at $4.50 per share were
outstanding for the year ended December 31, 2004, but were not included in the
computation of diluted loss per share because the effect of exercise or
conversion would have an antidilutive effect on loss per share.
NOTE 11 - 2005 RESTRUCTURING PLAN
In an effort to better align the Company's organizational and cost
structures with its future growth opportunities, in August 2005 the Company's
Board of Directors adopted a restructuring plan for the Company that was
substantially completed by December 2005. The plan included restructuring the
Company's global operations by eliminating redundancies in its Hong Kong
operation, closing its Mexican facilities, converting its Guatemala facility
from a manufacturing site to a distributor, and closing its North Carolina
manufacturing facility. The Company also refocused its sales efforts on higher
margin products, which may have resulted in lower net sales with certain
customers. As a result, the Company now operates with fewer employees and
reduced associated operating and manufacturing expenses. The Company recorded
charges in connection with its restructuring plan in accordance with SFAS No.
146 (As Amended), "Accounting for Costs Associated with Exit or Disposal
Activities." In addition, the Company's restructuring plan resulted in the
carrying value of certain long-lived assets, primarily equipment, being
impaired. Accordingly, in 2005 the Company recorded a charge to recognize the
impairment of these assets in accordance with SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets.
46
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The North Carolina manufacturing facility is a long-lived asset that is
classified as "held for sale" because it meets the criteria listed in Paragraph
30 of SFAS 144. Management has committed to sell the asset, and is listing the
property for sale with a commercial real estate agent. The Company believes the
sale of the asset is probable and the sale is expected to be completed within
one year. The major components of manufacturing equipment used in this plant to
manufacture zippers are not classified as held for sale since the Company
intends to re-deploy this equipment in the manufacture of Talon zippers through
investment or sale of this equipment to its distributors of Talon zippers. This
equipment is separately identified as idle equipment as a component of "Property
and equipment" which are included in the accompanying consolidated balance
sheets (See Note 1).
Restructuring costs recorded in 2005 were $6,371,000. Restructuring
costs include $3,447,000 of inventory write-downs, restructuring charges of
$2,474,000 consisting of $2,036,000 for the impairment of long-lived assets,
primarily machinery and equipment, $170,000 of one-time employee termination
benefits and other costs of $268,000, which were fully paid by the end of 2005.
In addition, an impairment charge to goodwill in the amount of $450,000 was
recorded. This goodwill was associated with an acquisition made to benefit the
Central and South American operations. Since these operations are being exited,
management concluded that this goodwill was impaired and should be written off.
These restructuring costs were recorded in the Consolidated Statement of
Operations for the year ended December 31, 2005 in the following line items and
amounts:
Cost of goods sold ......................................... $3,447,000
Operating expenses:
General & administrative expenses ....................... 450,000
Restructuring charges ................................... 2,474,000
----------
Total restructuring costs .................................. $6,371,000
==========
NOTE 12 - INCOME TAXES
The components of the provision (benefit) for income taxes included in
the consolidated statements of operations are as follows:
Year Ended December 31,
----------------------------------------------
2006 2005 2004
---------- ---------- ----------
Current:
Federal ............. $ 29,900 $ 55,479 $ 405,632
State ............... 4,000 4,000 71,582
---------- ---------- ----------
33,900 59,479 477,214
Deferred:
Federal ............. -- 850,000 1,530,000
State ............... -- 150,000 270,000
---------- ---------- ----------
-- 1,000,000 1,800,000
---------- ---------- ----------
$ 33,900 $1,059,479 $2,277,214
========== ========== ==========
47
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A reconciliation of the statutory Federal income tax rate with the
Company's effective income tax rate is as follows:
Year Ended December 31,
----------------------------
2006 2005 2004
------ ------ ------
Current:
Federal statutory rate ...................... 34.0% (34.0)% (34.0)%
State taxes net of federal benefit .......... 2.3 (5.8) (6.0)
Income earned from foreign subsidiaries ..... 18.7 0.2 3.1
Net operating loss valuation allowance
adjustments ............................... (71.7) 43.5 51.3
Change in effective state tax rate .......... 22.4 -- --
Other ....................................... 4.2 (0.2) 0.5
------ ------ ------
9.9% 3.7% 14.9%
====== ====== ======
Income (loss) before income taxes is as follows:
Year Ended December 31,
----------------------------------------------------
2006 2005 2004
------------ ------------ ------------
Domestic ........... $ (1,341,475) $(28,724,518) $(17,574,926)
Foreign ............ 1,684,678 246,288 2,243,172
------------ ------------ ------------
$ 343,203 $(28,478,230 $(15,331,754)
============ ============ ============
The primary components of temporary differences which give rise to the
Company's deferred tax assets and deferred tax liabilities are as follows:
Year Ended December 31,
-------------------------------
2006 2005
------------ ------------
Net deferred tax asset:
Net operating loss carry-forwards ..... $ 19,053,346 $ 20,820,849
Depreciation and amortization ......... (551,643) (442,909)
Bad debt reserve ...................... 17,961 403,494
Related party interest ................ 189,605 160,996
Inventory reserve ..................... 289,813 448,674
Other ................................. 225,656 56,343
------------ ------------
19,224,738 21,447,447
Less: Valuation Allowance ............ (19,224,738) (21,447,447)
------------ ------------
$ -- $ --
============ ============
At December 31, 2006, Tag-It Pacific, Inc. had Federal and state net
operating loss carry-forwards (or "NOLs") of approximately $53.6 million and
$13.9 million, respectively. The Federal NOL is available to offset future
taxable income through 2024, and the state NOL expires in 2014. Section 382 of
the Internal Revenue Code places a limitation on the realizability of net
operating losses in future periods if the ownership of the Company has changed
more than 50% within a three-year period. As of December 31, 2006, some of our
net operating losses may be limited by the Section 382 rules. The amount of such
limitations, if any, has not yet been determined.
Income taxes are accounted for under the asset and liability method.
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
48
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
bases and tax benefit carry-forwards. Deferred tax liabilities and assets at the
end of each period are determined using enacted tax rates. The Company records
deferred tax assets arising from temporary timing differences between recorded
net income and taxable net income when and if it believes that future earnings
will be sufficient to realize the tax benefit. For those jurisdictions where the
expiration date of tax benefit carry-forwards or the projected taxable earnings
indicate that realization is not likely, a valuation allowance is provided.
The provisions of SFAS No. 109, "Accounting for Income Taxes," require
the establishment of a valuation allowance when, based on currently available
information and other factors, it is more likely than not that all or a portion
of a deferred tax asset will not be realized. SFAS No. 109 provides that an
important factor in determining whether a deferred tax asset will be realized is
whether there has been sufficient income in recent years and whether sufficient
income is expected in future years in order to utilize the deferred tax asset.
In 2006 and in prior years, the Company determined, based upon its
cumulative operating losses, that it was more likely than not that it would not
be in a position to fully realize all of its deferred tax assets in future
years. Accordingly, at December 31, 2006 the Company has recorded a valuation
allowance of $19.2 million, which reduces the carrying value of its net deferred
tax assets to $0. For the year ended December 31, 2006 the Company recorded
operating income and various rate and tax timing differences and the value of
its net deferred tax assets declined by $2.2 million. Accordingly, a
corresponding reduction in the valuation allowance was made, which retained the
carrying value of the Company's net deferred tax assets at $0. During 2005 the
Company incurred additional operating losses which resulted in an increase in
the Company's net deferred tax assets by $11.5 million. Accordingly, it was
determined that the valuation allowance from 2004 be increased by $12.5 million
to $21.4 million, which reduced the carrying value of its net deferred tax
assets to $0 at December 31, 2005. In 2004 the Company recorded a valuation
allowance of $8.9 million based upon its cumulative operating losses, and
reduced the carrying value of its net deferred tax asset to $1.0 million at
December 31, 2004.
The Company intends to maintain a valuation allowance for its deferred
tax assets until sufficient evidence exists to support the reversal or reduction
of the allowance. At the end of each period, the Company will review supporting
evidence, including the performance against sales and income projections, to
determine if a release of the valuation allowance is warranted. If in future
periods it is determined that it is more likely than not that the Company will
be able to recognize all or a greater portion of its deferred tax assets, the
Company will at that time reverse or reduce the valuation allowance.
The Company believes that its estimate of deferred tax assets and
determination to record a valuation allowance against such assets are critical
accounting estimates because they are subject to, among other things, an
estimate of future taxable income, which is susceptible to change and dependent
upon events that may or may not occur, and because the impact of recording a
valuation allowance may be material to the assets reported on its balance sheet
and results of operations.
The Company has not provided withholding of U.S. federal income taxes
on undistributed earnings of its foreign subsidiaries because the Company
intends to reinvest those earnings indefinitely or any taxes on these earnings
will be offset by the approximate credits for foreign taxes paid. It is not
practical to determine the U.S. federal tax liability, if any, which would be
payable if such earnings were not invested indefinitely. At December 31, 2006
and 2005, undistributed earnings from our foreign subsidiaries were $4,581,000
and $4,689,000, respectively.
49
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 13 - COMMITMENTS AND CONTINGENCIES
OPERATING LEASES
The Company is a party to a number of non-cancelable operating lease
agreements involving buildings and equipment, which expire at various dates
through 2010. The Company accounts for its leases in accordance with SFAS No.
13, whereby step provisions, escalation clauses, tenant improvement allowances,
increases based on an existing index or rate, and other lease concessions are
accounted for in the minimum lease payments and are charged to the income
statement on a straight-line basis over the related lease term.
The future minimum lease commitments at December 31, 2006 are as
follows:
Years Ending December 31, Amount
----------------------------------------------- ----------
2007 ...................................... $ 437,226
2008 ...................................... 407,224
2009 ...................................... 346,184
2010 ...................................... 213,364
2011 and thereafter ....................... 16,757
----------
Total minimum payments .................... $1,420,755
==========
Total rental expense for the years ended December 31, 2006, 2005 and
2004 aggregated $640,864, $750,536, and $696,590, respectively.
PROFIT SHARING PLAN
In October 1999, the Company established a 401(k) profit-sharing plan
for the benefit of eligible employees. The Company may make annual contributions
to the plan as determined by the Board of Directors. Total contributions for the
years ended December 31, 2006 and 2005 amounted to $22,276 and $16,807,
respectively. There were no contributions made during the year ended December
31, 2004.
CONTINGENCIES
In May, 2006, the Company received notice from the American Stock
Exchange ("AMEX") that it was not in compliance with certain of the continued
listing standards as set forth in the AMEX Company Guide due to the failure to
comply with Section 1003(a)(i) and Section 1003(a)(ii) of the Company Guide,
which effectively required that the Company maintain shareholders' equity of at
least $4,000,000. Following the notice from AMEX the Company was afforded the
opportunity to submit a "plan of compliance" to AMEX outlining in detail how the
Company expected to achieve the minimum equity requirements and to regain
compliance. On August 3, 2006 the Company received notification from AMEX that
the Company's plan to regain compliance with the minimum shareholders' equity
requirements of the AMEX Company Guide had been accepted and the Company has
been granted an extension until November 16, 2007 to achieve the AMEX continued
listing requirements. During this period the Company will be subject to periodic
review by the AMEX Staff and failure to make progress consistent with the plan
or to regain compliance with continued listing standards by the end of the
extension period could result in being delisted from the American Stock
Exchange.
On October 12, 2005, a shareholder class action complaint-- Huberman v.
Tag-It Pacific, Inc., et al., Case No. CV05-7352 R(Ex)--was filed against us and
certain of our current and former officers and directors in the United States
District Court for the Central District of California alleging claims under
Section 10(b) and Section 20 of the Securities Exchange Act of 1934, as amended,
and Rule 10b-5 promulgated thereunder. The action is brought on behalf of all
50
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
purchasers of our publicly-traded securities during the period from November 14,
2003 to August 12, 2005. On January 23, 2006 the court heard competing motions
for appointment of lead plaintiff/counsel and appointed Seth Huberman as lead
plaintiff. The lead plaintiff thereafter filed an amended complaint on March 13,
2006. The amended complaint alleges that defendants made false and misleading
statements about the company's financial situation and its relationship with
certain of its large customers during a purported class period between November
13, 2003 and August 12, 2005. It purports to state claims under Section
10(b)/Rule 10b-5 and Section 20(a) of the Securities Exchange Act of 1934. The
Company filed a motion to dismiss the amended complaint, which motion was denied
by the court on July 17, 2006. On December 21, 2006 the court established a
trial date of May 1, 2007 and ordered completion of discovery by March 19, 2007.
On February 20, 2007 the court denied class certification. Plaintiff has moved
the court to reconsider the ruling, and also to intervene a new plaintiff to
pursue class certification. Both of those motions were denied on April 2, 2007.
In addition, the same day, the Court granted Defendants' motion for summary
judgment, and it is anticipated that the Court will enter a judgment in favor of
all Defendants shortly. It is possible that Plaintiff will appeal the summary
judgment and class certification rulings. The Company believes that this matter
will be resolved in trial or in settlement within the limits of its insurance
coverage, however the outcomes of this action or an estimate of the potential
losses, if any, related to the lawsuit cannot be reasonably predicted, and an
adverse resolution of any of the lawsuit could potentially have a material
adverse effect on our financial position and results of operations.
On April 16, 2004 the Company filed suit against Pro-Fit Holdings,
Limited ("Pro-Fit") in the U.S. District Court for the Central District of
California -- Tag-It Pacific, Inc. v. Pro-Fit Holdings, Limited, CV 04-2694 LGB
(RCx) -- asserting various contractual and tort claims relating to our exclusive
license and intellectual property agreement with Pro-Fit, seeking declaratory
relief, injunctive relief and damages. It is the Company's position that the
agreement with Pro-Fit gives us the exclusive rights in certain geographic areas
to Pro-Fit's stretch and rigid waistband technology. On September 17, 2004,
Pro-Fit filed an answer denying the material allegations of the complaint and
filed counterclaims alleging various contractual and tort claims seeking
injunctive relief and damages. We filed a reply denying the material allegations
of Pro-Fit's pleading. Pro-Fit has since purported to terminate the exclusive
license and intellectual property agreement based on the same alleged breaches
of the agreement that are the subject of the parties' existing litigation, as
well as on an additional basis. On February 9, 2005, and again on June 16, 2005,
we amended our pleadings in the litigation to assert additional breaches by
Pro-Fit of its obligations under the agreement and under certain additional
letter agreements, and for a declaratory judgment that Pro-Fit's patent No.
5,987,721 is invalid and not infringed by us. Thereafter, Pro-Fit filed an
amended answer and counterclaims denying the material allegations of the amended
complaint and alleging various contractual and tort claims seeking injunctive
relief and damages. Pro-Fit further asserted that we infringed its United States
Patent Nos. 5,987,721 and 6,566,285. We filed a reply denying the substantive
allegations of the amended counterclaims. On June 5, 2006 the Court denied the
Company's motion for partial summary judgment holding that summary
adjudification that we did not breach our agreement with Pro-Fit by engaging in
certain activities in Columbia was not appropriate. The Court also held that
Pro-Fit was not "unwilling or unable" to fulfill orders by refusing to fill
orders with goods produced in the United States. The Court did not find that we
breached our agreement with Pro-Fit and a trial is required to determine issues
concerning our activities in Columbia and whether other actions by Pro-Fit
constituted an unwillingness or inability to fill orders. As a result of a
change in the law, we dismissed our antitrust claims against Pro-Fit. The court
has not yet set a date for trial of this matter. We derive a significant amount
of revenue from the sale of products incorporating the stretch waistband
technology our business, results of operations and financial condition could be
materially adversely affected if the dispute with Pro-Fit is not resolved in a
manner favorable to us. Additionally, we have incurred significant legal fees in
this litigation, and unless the case is settled, we will continue to incur
additional legal fees in increasing amounts as the case accelerates to trial.
Tag-It Pacific, Inc. has agreements with its foreign subsidiaries that
provide for royalty payments to the U.S. parent company for the sales of
products carrying the Talon(R) brand name, and that also provide for a cost
sharing arrangement associated with various corporate administrative and
operations support costs. These agreements may give rise to inquiries and
51
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
possible disputes by the foreign taxing authority, resulting in the possible
disallowance of some of these costs and potentially resulting in higher foreign
income taxes than has been provided. The Company believes that its basis of
charging these royalties and its allocation of costs to foreign subsidiaries is
appropriate under the various taxing agency laws, and that any disagreement or
disallowance regarding such costs will not have a material affect on the
financial statements of the Company. A subsidiary, Tag-It de Mexico, S.A. de
C.V., has operated under the Mexican government's Maquiladora Program, which
entitles Tag-It de Mexico to certain favorable treatment as respects taxes and
duties regarding certain imports. In July of 2005, the Mexican Federal Tax
Authority asserted a claim against Tag-It de Mexico alleging that certain taxes
had not been paid on imported products during the years 2000, 2001, 2002 and
2003. In October of 2005, the Company filed a procedural opposition to the claim
and submitted documents to the Mexican Tax Authority in opposition to this
claim, supporting the Company's position that the claim was without merit. The
Mexican Federal Tax Authority failed to respond to the opposition filed, and the
required response period by the Tax Authority has lapsed. In addition, a
controlled entity incorporated in Mexico (Logistica en Avios, S.A. de C.V.)
through which the Company conducted its operations in 2005, may be subjected to
a claim or claims from the Mexican Tax Authority, as identified directly above,
and additionally to other tax issues, including those arising from employment
taxes. The Company believes that any such claim is defective on both procedural
and documentary grounds and is without merit. An estimate of the possible loss
or range of loss if any associated with these matters cannot be made at this
time. The Company does not believe these matters will have a material adverse
affect on the Company.
The Company currently has pending a number of other claims, suits and
complaints that arise in the ordinary course of our business. We believe that we
have meritorious defenses to these claims and that the claims are either covered
by insurance or, after taking into account the insurance in place, would not
have a material effect on our consolidated financial condition if adversely
determined against us.
In November 2002, the FASB issued FIN No. 45 "Guarantor's Accounting
and Disclosure Requirements for Guarantees, including Indirect Guarantees of
Indebtedness of Others - and interpretation of FASB Statements No. 5, 57 and 107
and rescission of FIN 34." The following is a summary of the Company's
agreements that it has determined are within the scope of FIN 45:
In accordance with the bylaws of the Company, officers and directors
are indemnified for certain events or occurrences arising as a result of the
officer or director's serving in such capacity. The term of the indemnification
period is for the lifetime of the officer or director. The maximum potential
amount of future payments the Company could be required to make under the
indemnification provisions of its bylaws is unlimited. However, the Company has
a director and officer liability insurance policy that reduces its exposure and
enables it to recover a portion of any future amounts paid. As a result of its
insurance policy coverage, the Company believes the estimated fair value of the
indemnification provisions of its bylaws is minimal and therefore, the Company
has not recorded any related liabilities.
The Company enters into indemnification provisions under its agreements
with investors and its agreements with other parties in the normal course of
business, typically with suppliers, customers and landlords. Under these
provisions, the Company generally indemnifies and holds harmless the indemnified
party for losses suffered or incurred by the indemnified party as a result of
the Company's activities or, in some cases, as a result of the indemnified
party's activities under the agreement. These indemnification provisions often
include indemnifications relating to representations made by the Company with
regard to intellectual property rights. These indemnification provisions
generally survive termination of the underlying agreement. The maximum potential
amount of future payments the Company could be required to make under these
indemnification provisions is unlimited. The Company has not incurred material
costs to defend lawsuits or settle claims related to these indemnification
agreements. As a result, the Company believes the estimated fair value of these
agreements is minimal. Accordingly, the Company has not recorded any related
liabilities.
52
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 14 - GEOGRAPHIC INFORMATION
The Company specializes in the distribution of a full range of trim
items to manufacturers of fashion apparel, specialty retailers and mass
merchandisers. There is not enough difference between the types of products
developed and distributed by the Company to justify segmented reporting by
product type. The Company believes that revenue by each major product class is a
valuable business measurement. The net revenues for the three primary product
groups is as follows:
Year Ended December 31,
-------------------------------------------
2006 2005 2004
----------- ----------- -----------
Product Group Net Revenue:
Talon zipper .............. $17,005,203 $13,593,479 $12,712,689
Trim ...................... 22,502,947 24,788,397 28,805,347
Tekfit .................... 9,316,852 8,949,300 13,591,445
----------- -----------
$48,825,002 $47,331,176 $55,109,481
=========== =========== ===========
The Company distributes its products internationally and has reporting
requirements based on geographic regions. Long-lived assets are attributed to
countries based on the location of the assets and revenues are attributed to
countries based on customer delivery locations, as follows:
Year Ended December 31,
-------------------------------------------
2006 2005 2004
----------- ----------- -----------
Sales:
United States ............. $ 5,287,236 $ 8,902,734 $ 4,822,935
Asia ...................... 28,974,546 20,005,036 12,785,977
Mexico .................... 2,476,313 8,526,367 21,452,805
Dominican Republic ........ 9,138,404 5,914,792 9,678,078
Other ..................... 2,948,503 3,982,247 6,369,686
----------- ----------- -----------
$48,825,002 $47,331,176 $55,109,481
=========== =========== ===========
Long-lived Assets:
United States ............. $ 9,531,659 $ 9,797,110 $12,911,377
Asia ...................... 386,516 226,221 234,746
Mexico .................... 5,078 23,754 187,721
Dominican Republic ........ 668,067 776,279 866,807
----------- ----------- -----------
$10,591,320 $10,823,364 $14,200,651
=========== =========== ===========
NOTE 15 - MAJOR CUSTOMERS AND VENDORS
For the year ended December 31, 2006, no single customer represented
more than 9% of the Company's consolidated net sales; however the Company's
three largest customers represented approximately 18% of consolidated net sales.
For the year ended December 31, 2005, no single customer represented more than
10% of consolidated net sales; however, the Company's three largest customers
represented approximately 22% of consolidated net sales. Two major customers
accounted for approximately 22% of the Company's net sales for the year ended
December 31, 2004.
One major vendor accounted for substantially all of the Company's
purchases associated with its TekFit product for the year ended December 31,
2006 and represented 24% of the Company's overall purchases; and three vendors,
each representing more than 10% of the Company's purchases, accounted for
approximately 45% of the Company's purchases for the year ended December 31,
2006. Three vendors accounted for approximately 39% of the Company's purchases
for the year ended December 31, 2005, and four vendors accounted for
approximately 70% of the Company's purchases for the year ended December 31,
53
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2004. Included in accounts payable and accrued expenses at December 31, 2006 and
2005 is $2,682,000 and $2,206,000 due to these vendors. Terms are sight to 60
days.
NOTE 16 - RELATED PARTY TRANSACTIONS
Prior to 2004 the Company operated an apparel trim supply agreement
with Tarrant Apparel Group. Two of Tarrant's directors and significant
shareholders are also significant shareholders of the Company. In 2004,
following negotiations with Tarrant Apparel Group, the Company determined that a
significant portion of the obligations due from this customer were
uncollectible. Accordingly, included in general and administrative expenses for
2004 are charges of $4.3 million related primarily to the write-down of this
receivable and leaving a remaining balance receivable from this customer of $4.5
million at December 31, 2004. An affiliate of the customer repaid the $4.5
million receivable balance over the period from May through December 2005. The
Company terminated its supply relationship with Tarrant in 2004; however the
Company continues to conduct business with Tarrant on a limited basis. Total
sales to Tarrant for the years ended December 31, 2006, 2005 and 2004 were
$3,000, $574,000 and $758,000, respectively. As of December 31, 2005, accounts
receivable, related party included $0.05 million due from Tarrant. No amounts
were due from Tarrant at December 31, 2006.
Colin Dyne, a director of the Company is a significant shareholder in
People's Liberation, Inc., the parent company of Versatile Entertainment, Inc.
During 2006 and 2005 the Company had sales of $147,000 and $ 76,000
respectively, to Versatile Entertainment. At December 31, 2006 accounts
receivable of $83,400 were outstanding from Versatile Entertainment.
Due from related parties at December 31, 2006 and 2005 includes
$675,137 and $655,489 respectively, of unsecured notes, advances and accrued
interest receivable from Colin Dyne,. The notes and advances bear interest at
7.5% and are due on demand.
Demand notes payable to related parties includes notes and advances to
Mark Dyne, the Chairman of the Board of Directors of the Company or to parties
related to or affiliated with Mark Dyne. The balance of Demand notes payable to
related parties at December 31, 2006 and 2005 was $664,971. See Note 4 for
further discussion of these notes, and related accrued interest and interest
expense.
Transportation fees in the amount of $211,000 were paid to or on behalf
of a company that Mark Dyne has an ownership interest in for the year ended
December 31, 2004. Consulting fees paid to Diversified Investments, a company
owned by Mark Dyne, amounted to $150,000 for each of the years ended December
31, 2006, 2005 and 2004.
Consulting fees of $335,000 were paid for services provided by Colin
Dyne, for the year ended December 31, 2006. Brent Cohen and Raymond Musci, both
members of the Board of Directors were paid for services provided during the
year ended December 31, 2005 in the amount of $24,000, and $21,000,
respectively. Mr. Cohen and Kevin Bermiester, a former director of the Company,
were paid for services provided during the year ended December 31, 2004 in the
amounts of $57,000 and $41,000, respectively.
54
TAG-IT PACIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 17 - QUARTERLY RESULTS (UNAUDITED)
Quarterly results for the years ended December 31, 2006 and 2005 are
reflected below:
4th 3rd 2nd 1st
------------ ------------ ------------ ------------
2006
- ----
Revenue .................... $ 10,573,755 $ 13,366,944 $ 14,246,087 $ 10,638,216
Gross profit ............... $ 3,350,600 $ 4,148,406 $ 4,127,237 $ 2,842,725
Operating income (loss) .... $ 248,177 $ 630,273 $ 895,481 $ (442,275)
Net Income(loss) ........... $ 44,950 $ 339,115 $ 654,643 $ (729,404)
Basic and diluted income
(loss) per share ........... $ 0.00 $ 0.02 $ 0.04 $ (0.04)
2005
- ----
Revenue .................... $ 9,163,355 $ 9,472,898 $ 15,639,646 $ 13,055,277
Gross profit (loss) (1,,) .. $ (1,652,918) $ (2,094,230) $ 756,120 $ 3,251,823
Operating (loss) income
(1,2,) ..................... $ (4,925,076) $(10,203,361) $(10,829,928) $ (1,140,089)
Net (loss) income (1,2) .... $ (5,127,754) $(10,284,874) $(12,476,638) $ (1,648,443)
Basic and diluted (loss)
per share .................. $ (0.28) $ (0.56) $ (0.68) $ (0.09)
(1) The Company recorded restructuring charges of $6.2 million in the third
quarter of 2005, of which $3.4 million, related to inventory
write-downs (Note 11); theCompany recorded $2.5 million in inventory
obsolescence reserves and $1.5 million in inventory overhead
adjustments in the fourth quarter affecting gross profit.
(2) The Company recorded $3.6 million in bad debt reserves principally
associated with one customer in the second quarter of 2005; direct
write-off to bad debts of $1.8 million in the third quarter of 2005
principally from another customer, and $0.5 million in bad debts in the
fourth quarter of 2005 associated with the acceptance of a note
receivable. In the third quarter of 2005, the Company recorded
restructuring charges included in operating costs of $2.8 millionand a
decrease in net deferred tax asset resulting in a charge to the
provision for income taxes of $1 million during 2005.
During 2006, the Company had no material unusual or infrequently
occurring items or adjustments that were recognized during the year.
Quarterly and year-to-date computations of per share amounts are made
independently. Therefore, the sum of per share amounts for the quarters may not
agree with the per share amounts for the year.
NOTE 18 - SUBSEQUENT EVENT (UNAUDITED)
On April 11, 2007 a favorable verdict was awarded to the plaintiff in a
trademark infringement lawsuit in which Azteca Production International, Inc. is
a defendant. We have an outstanding note receivable from Azteca (see Note 2),
and this adverse ruling against them may impact their ability to repay our note
receivable. The outcome of this event or an estimate of the potential impact if
any, on the collectibility of our note receivable cannot be reasonably predicted
at this time. The failure to collect payments under this note as scheduled could
have a material adverse effect on our financial position and results of
operations.
55
ITEM 9A. CONTROLS AND PROCEDURES
EVALUATION OF CONTROLS AND PROCEDURES
We maintain disclosure controls and procedures that are designed to
ensure that information required to be disclosed in our reports under the
Securities Exchange Act of 1934, as amended, or the Exchange Act is recorded,
processed, summarized and reported, within the time periods specified in the
Securities Exchange Commission's rules and forms, including to ensure that
information required to be disclosed by us in the reports filed or submitted by
us under the Exchange Act is accumulated and communicated to our management,
including our principal executive and principal financial officers, or persons
performing similar functions, as appropriate to allow timely decisions regarding
required disclosure as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange
Act.
As of December 31, 2006, we conducted an evaluation, with the
participation of our Chief Executive Officer and Chief Financial Officer, of the
effectiveness of the design and operation of our disclosure controls and
procedures. Based on that evaluation, our Chief Executive Officer and Chief
Financial Officer have concluded that as of December 31, 2006, our disclosure
controls and procedures were effective.
CHANGES IN INTERNAL CONTROLS
During the last fiscal quarter, there have been no changes in our
internal control over financial reporting that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.
56
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a) FINANCIAL STATEMENTS AND SCHEDULES.
57
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM'S REPORT ON SCHEDULE II
To the Board of Directors
Tag it Pacific, Inc.
Woodland Hills, California
The audits referred to in our report, dated April 9, 2007 included in the
related financial statement schedule as of December 31, 2006 and for the two
years ended December 31, 2006, included in the annual report on Form 10-K of
Tag-It Pacific, Inc. This financial statement scheduled is the responsibility of
the Company's management. Our responsibility is to express an opinion on this
financial statement schedule based on our audit. In our opinion, such financial
statement schedule presents fairly, in all material respects, the information
set forth therein.
/S/ SINGER LEWAK GREENBAUM & GOLDSTEIN
- ------------------------------------------
SINGER LEWAK GREENBAUM & GOLDSTEIN
Los Angeles, California
April 9, 2007
58
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM'S REPORT ON SCHEDULE II
To the Board of Directors
Tag-It Pacific, Inc.
Los Angeles, California
The audit referred to in our report, dated March 31, 2005, included the related
financial statement schedule as of and for the year ended December 31, 2004
included in the annual report on Form 10-K of Tag-It Pacific, Inc. This
financial statement schedule is the responsibility of the Company's management.
Our responsibility is to express an opinion on this financial statement schedule
based on our audit. In our opinion, such financial statement schedule presents
fairly, in all material respects, the information set forth therein.
/s/ BDO Seidman, LLP
- ------------------------------------------
BDO Seidman, LLP
Los Angeles, California
March 31, 2005
59
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E
Balance at
Beginning Balance at
Description of year Additions Deductions End of Year
- -------------------------------------------- ----------- ----------- ----------- -----------
2006
Allowance for doubtful accounts
deducted from accounts receivable
in the balance sheet ..................... $ 1,189,000 $ 198,000 $ 1,315,500 $ 71,500
Reserve for obsolescence deducted
from inventories on the balance
sheet .................................... 7,306,000 557,000 6,621,000 1,242,000
Valuation reserve deducted from
Deferred tax Assets ...................... 21,447,000 -- 2,222,000 19,225,000
----------- ----------- ----------- -----------
$29,942,000 $ 755,000 $10,158,500 $20,538,500
=========== =========== =========== ===========
2005
Allowance for doubtful accounts
deducted from accounts receivable
in the balance sheet ..................... $ 6,086,000 $ 4,160,000 $ 9,057,000 $ 1,189,000
Reserve for obsolescence deducted
from inventories on the balance
sheet .................................... 6,365,000 2,538,000 1,597,000 7,306,500
Valuation reserve deducted from
Deferred tax Assets ...................... 8,900,000 12,547,000 -- 21,447,000
----------- ----------- ----------- -----------
$21,351,000 $19,245,000 $10,654,000 $29,942,000
=========== =========== =========== ===========
2004
Allowance for doubtful accounts
deducted from accounts receivable
in the balance sheet ..................... $ 2,044,000 $ 5,500,000 $ 1,458,000 $ 6,086,000
Reserve for obsolescence deducted
from inventories on the balance
sheet .................................... 6,125,000 1,040,000 800,000 6,365,500
Valuation reserve deducted from Deferred tax
Assets ..................................... 1,119,000 7,781,000 -- 8,900,000
----------- ----------- ----------- -----------
$ 9,288,000 $14,321,000 $ 2,258,000 $21,351,000
=========== =========== =========== ===========
(1) Additions to the allowance for doubtful accounts include provisions for
uncollectible accounts. Bad debt expense includes (and additions above
exclude) net recoveries of $712,000 for the year ended December 31,
2006, and net direct write-offs of $1,698,000 and $2,916,000 for the
years ended December 31, 2005 and 2004, respectively. Additions to the
inventory obsolescence reserve include current year provisions.
Additionally, in 2005 there were direct write-offs of inventory of $3.4
million in connection with the restructuring, and in 2006 there were
direct write-offs of $0.2 million.
(2) Deductions from the allowance for doubtful accounts includes amounts
applied to write-offs, reversals of prior period provisions, and, for
the year ended December 31, 2005, deductions include $7,528,000 related
to the conversion of a trade account receivable to a note receivable.
Deductions from the inventory obsolescence reserve include application
of the reserve against obsolete, excess, slow-moving or disposed
inventory.
(b) EXHIBITS:
See Exhibit Index attached to this Annual Report of Form 10-K.
60
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
TAG-IT PACIFIC, INC.
----------------------------
By: Lonnie D. Schnell
Its: Chief Financial Officer
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, this report has been signed below by the following persons
on behalf of the Registrant and in the capacities and on the dates indicated.
Signature Title Date
--------- ----- ----
Chairman of the Board of Directors
- ---------------------
Mark Dyne
Chief Executive Officer
- --------------------- (Principal Executive
Stephen Forte Officer) and Director
Chief Financial Officer
- --------------------- (Principal Accounting and
Lonnie D. Schnell Financial Officer)
Director
- ---------------------
Colin Dyne
Director
- ---------------------
Brent Cohen
Director
- ---------------------
Raymond Musci
Director
- ---------------------
Joseph Miller
Director
- ---------------------
William Sweedler
61
EXHIBIT INDEX
Exhibit
Number Exhibit Description
- ------- -----------------------------------------------------------------------
23.1 Consent of Singer Lewak Greenbaum & Goldstein LLP.
23.2 Consent of BDO Seidman, LLP.
31.1 Certificate of Chief Executive Officer pursuant to Rule 13a-14(a) under
the Securities and Exchange Act of 1934, as amended
31.2 Certificate of Chief Financial Officer pursuant to Rule 13a-14(a) under
the Securities and Exchange Act of 1934, as amended
32.1 Certificate of Chief Executive Officer and Chief Financial Officer
pursuant to Rule 13a-14(b) under the Securities and Exchange Act of
1934, as amended.
62