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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934.
For the quarterly period ended September 30, 2006.
OR
[_] 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 Issuer as Specified in its Charter)
DELAWARE 95-4654481
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
21900 BURBANK BOULEVARD, SUITE 270
WOODLAND HILLS, CALIFORNIA 91367
(Address of Principal Executive Offices)
(818) 444-4100
(Registrant's Telephone Number, Including Area Code)
Indicate by check mark whether the registrant: (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for past 90 days.
Yes [X] No [ ]
Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer or a non-accelerated filer . See definition of
"accelerated filer and large accelerated filer"in Rule 12b-2 of the Exchange
Act. (Check one):
Large accelerated filer [ ] 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 NOVEMBER 13, 2006 THE ISSUER HAD 18,466,433 SHARES OF COMMON STOCK,
$.001 PAR VALUE, ISSUED AND OUTSTANDING.
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TAG-IT PACIFIC, INC.
INDEX TO FORM 10-Q
PART I FINANCIAL INFORMATION PAGE
----
Item 1. Financial Statements...............................................3
Consolidated Balance Sheets as of September 30, 2006
(unaudited) and December 31, 2005 .................................3
Consolidated Statements of Operations for the Three Months and
the Nine Months Ended September 30, 2006 and 2005 (unaudited)......4
Consolidated Statements of Cash Flows for the
Nine Months Ended September 30, 2006 and 2005 (unaudited)..........5
Notes to the Consolidated Financial Statements.....................6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations.........................................18
Item 3. Quantitative and Qualitative Disclosures about Market Risk........35
Item 4. Controls and Procedures...........................................35
PART II OTHER INFORMATION
Item 1. Legal Proceedings.................................................38
Item 1A. Risk Factors .....................................................39
Item 4. Submission of Matters to a Vote of Security Holders...............39
Item 6. Exhibits .........................................................39
2
TAG-IT PACIFIC, INC.
CONSOLIDATED BALANCE SHEETS
(unaudited)
September 30, December 31,
2006 2005
------------ ------------
Assets
Current Assets:
Cash and cash equivalents ....................... $ 3,726,234 $ 2,277,397
Trade accounts receivable, net .................. 5,054,939 5,652,990
Note receivable ................................. 1,344,049 662,369
Inventories ..................................... 3,150,063 5,573,099
Prepaid expenses and other current assets ....... 681,513 618,577
------------ ------------
Total current assets ......................... 13,956,798 14,784,432
Property and equipment, net ........................ 5,846,119 6,438,096
Fixed assets held for sale ......................... 826,904 826,904
Note receivable, less current portion .............. 1,778,781 2,777,631
Due from related parties ........................... 643,774 730,489
Other intangible assets, net ....................... 4,172,001 4,255,125
Other assets ....................................... 449,396 508,117
------------ ------------
Total assets ....................................... $ 27,673,773 $ 30,320,794
============ ============
Liabilities and Stockholders' Equity
Current Liabilities:
Accounts payable ................................ $ 4,857,098 $ 6,719,226
Accrued legal costs ............................. 722,550 2,520,111
Other accrued expenses .......................... 3,814,618 4,168,552
Demand notes payable to related parties ......... 664,971 664,971
Current portion of capital lease obligations .... 425,896 590,884
Current portion of notes payable ................ 1,495,196 186,837
------------ ------------
Total current liabilities .................... 11,980,329 14,850,581
Capital lease obligations, less current portion .... 586,807 856,495
Notes payable, less current portion ................ 1,112,623 1,261,018
Secured convertible promissory notes ............... 12,464,557 12,440,623
------------ ------------
Total liabilities ............................ 26,144,316 29,408,717
------------ ------------
Commitments, Contingencies and guarantees - (Note 5) -- --
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 September 30, 2006;
18,241,045 at December 31, 2005 .............. 18,466 18,241
Additional paid-in capital ...................... 51,680,677 51,327,878
Accumulated deficit ............................. (50,169,686) (50,434,042)
------------ ------------
Total stockholders' equity ......................... 1,529,457 910,077
------------ ------------
Total liabilities and stockholders' equity ......... $ 27,673,773 $ 30,320,794
============ ============
See accompanying notes to consolidated financial statements.
3
TAG-IT PACIFIC, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------------- ---------------------------
2006 2005 2006 2005
------------ ------------ ------------ ------------
Net sales .......................... $ 13,366,945 $ 9,472,898 $ 38,251,248 $ 38,167,821
Cost of goods sold ................. 9,218,539 11,567,128 27,132,880 36,254,108
------------ ------------ ------------ ------------
Gross profit .................... 4,148,406 (2,094,230) 11,118,368 1,913,713
Selling expenses ................... 910,996 549,434 2,131,515 1,940,283
General and administrative expenses 2,684,695 4,908,555 8,136,448 19,649,868
Impairment of goodwill ............. -- 450,000 -- 450,000
Restructuring Costs ................ -- 2,278,835 -- 2,278,835
------------ ------------ ------------ ------------
Total operating expenses ........ 3,595,691 8,186,824 10,267,963 24,318,986
Income (loss) from operations ...... 552,715 (10,281,054) 850,405 (22,405,273)
Interest expense, net .............. 158,741 264,551 519,692 802.400
------------ ------------ ------------ ------------
Income (loss) before income taxes .. 393,974 (10,545,605) 330,713 (23,207,673)
Provision (benefit) for income taxes 54,857 (260,731) 66,357 1,202,282
------------ ------------ ------------ ------------
Net Income (loss) ............... $ 339,117 $(10,284,874) $ 264,356 $(24,409,955)
============ ============ ============ ============
Basic income (loss) per share ...... $ 0.02 $ (0.56) $ 0.01 $ (1.34)
============ ============ ============ ============
Diluted income (loss) per share .... $ 0.02 $ (0.56) $ 0.01 $ (1.34)
============ ============ ============ ============
Weighted average number of common
shares outstanding:
Basic ........................... 18,440,927 18,241,045 18,347,509 18,220,731
============ ============ ============ ============
Diluted ......................... 19,279,648 18,241,045 18,719,531 18,220,731
============ ============ ============ ============
See accompanying notes to consolidated financial statements.
4
TAG-IT PACIFIC, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
Nine Months Ended
September 30,
----------------------------
2006 2005
------------ ------------
Increase (decrease) in cash and cash equivalents
Cash flows from operating activities:
Net income (loss) ........................................... $ 264,356 $(24,409,952)
Adjustments to reconcile net income (loss) to net
cash used by operating activities:
Depreciation and amortization ................................ 766,917 1,441,087
(Decrease) increase in allowance for doubtful accounts ....... (1,046,500) 6,195,691
Increase in deferred tax asset valuation allowance ........... -- 1,000,000
(Decrease) increase in inventory valuation reserves .......... (5,844,532) 3,918,189
Asset impairment due to restructuring ........................ -- 2,036,091
Impairment of goodwill ....................................... -- 450,000
Disposal of assets ........................................... 255,320 --
Stock based compensation ..................................... 283,024 --
Changes in operating assets and liabilities:
Receivables, including related party ...................... 1,731,266 6,589,814
Inventories ............................................... 8,267,568 (4,450,771)
Prepaid expenses and other current assets ................. (63,273) 1,013,803
Note Receivable ........................................... 317,170 --
Other Assets .............................................. 58,721 337,541
Accounts payable and accrued expenses ..................... (2,087,081) 6,435,797
Accrued legal costs ....................................... (147,561) 141,003
Income taxes payable ...................................... 66,357 (116,319)
------------ ------------
Net cash provided by operating activities ....................... 2,821,752 581,974
------------ ------------
Cash flows from investing activities:
Acquisition of property and equipment ........................ (325,702) (1,634,024)
Proceeds from sale of equipment .............................. 2,500 --
------------ ------------
Net cash used by investing activities ........................... (323,202) (1,634,024)
------------ ------------
Cash flows from financing activities:
Repayment of bank line of credit, net ....................... -- (555,013)
Proceeds from exercise of stock options and warrants ........ -- 254,541
Payment of capital leases ................................... (434,676) (683,876)
Repayment of notes payable .................................. (615,037) (1,531,887)
------------ ------------
Net cash (used) by financing activities ......................... (1,049,713) (2,516,235)
------------ ------------
Net increase (decrease) in cash ................................. 1,448,837 (3,568,285)
Cash at beginning of period ..................................... 2,277,397 5,460,662
------------ ------------
Cash at end of period ........................................... $ 3,726,234 $ 1,892,377
============ ============
Supplemental disclosures of cash flow information:
Cash received (paid) during the period for:
Interest paid ............................................. $ (780,460) $ (923,839)
Income taxes refunded (paid) .............................. $ -- $ (47,720)
Interest received ......................................... $ 264,339 $ 29,734
Non-cash financing activities:
Capital lease obligation .................................. $ 64,433 $ 270,597
Accounts payable & accrued legal converted to notes payable $ 1,775,000 $ --
See accompanying notes to consolidated financial statements
5
TAG-IT PACIFIC, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 1 PRESENTATION OF INTERIM INFORMATION
The accompanying unaudited consolidated financial statements have been
prepared in accordance with accounting principles generally accepted in the
United States for interim financial information and in accordance with the
instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do
not include all of the information and footnotes required by accounting
principles generally accepted in the United States for complete financial
statements. The accompanying unaudited consolidated financial statements reflect
all adjustments that, in the opinion of the management of Tag-It Pacific, Inc.
and its subsidiaries (collectively, the "Company"), are considered necessary for
a fair presentation of the financial position, results of operations, and cash
flows for the periods presented. The results of operations for such periods are
not necessarily indicative of the results expected for the full fiscal year or
for any future period. The accompanying financial statements should be read in
conjunction with the audited consolidated financial statements of the Company
included in the Company's Form 10-K for the year ended December 31, 2005. The
balance sheet as of December 31, 2005 has been derived from the audited
financial statements as of that date but omits certain information and footnotes
required for complete financial statements.
The accompanying consolidated financial statements have been prepared
assuming that the Company will continue as a going concern, which contemplates
the realization of assets and the satisfaction of liabilities in the normal
course of business. The Company has experienced substantial recurring losses
from operations on declining revenues and has an accumulated deficit of $50.2
million as of September 30, 2006. These matters, among others, raise substantial
doubt about the Company's ability to continue as a going concern. The Company's
continuation as a going concern is dependent on its ability to generate
sufficient cash flow to meet its obligations on a timely basis, to obtain
additional financing as may be required, and ultimately to maintain profitable
operations. In response to these matters, during 2005 the Company adopted a
restructuring plan designed to better align the Company's organizational and
cost structures with its future growth opportunities. In connection with this
restructuring, management's operating plan for 2006 includes increased sales,
higher margins on certain products, reduced expenses as a percentage of revenues
and improved cash flows sufficient to cover the Company's operating needs. There
can be no assurance that the Company will be successful in these matters. The
financial statements do not include any adjustments that might result from the
outcome of this uncertainty.
6
NOTE 2 EARNINGS (LOSS) PER SHARE
The following is a reconciliation of the numerators and denominators of
the basic and diluted income (loss) per share computations:
THREE MONTHS ENDED SEPTEMBER 30, 2006: INCOME (LOSS) SHARES PER SHARE
------------ ------------ ------------
Basic Income per share:
Income available to common stockholders $ 339,117 18,440,927 $ 0.02
Effect of Dilutive Securities:
Options ............................... -- 838,721 --
Warrants .............................. -- -- --
------------ ------------ ------------
Income available to common stockholders $ 339,117 19,279,648 $ 0.02
============ ============ ============
THREE MONTHS ENDED SEPTEMBER 30, 2005:
Basic loss per share:
Loss available to common stockholders . $(10,284,874) 18,241,045 $ (0.56)
Effect of Dilutive Securities:
Options ............................... -- -- --
Warrants .............................. -- -- --
------------ ------------ ------------
Loss available to common stockholders . $(10,284,874) 18,241,045 $ (0.56)
============ ============ ============
NINE MONTHS ENDED SEPTEMBER 30, 2006:
Basic income per share:
Income available to common stockholders $ 264,356 18,347,509 $ 0.01
Effect of Dilutive Securities:
Options ............................... -- 372,022 --
Warrants .............................. -- -- --
------------ ------------ ------------
Income available to common stockholders $ 264,356 18,719,531 $ 0.01
============ ============ ============
NINE MONTHS ENDED SEPTEMBER 30, 2005:
Basic loss per share:
Loss available to common stockholders . $(24,409,955) 18,220,731 $ (1.34)
Effect of Dilutive Securities:
Options ............................... -- -- --
Warrants .............................. -- -- --
------------ ------------ ------------
Loss available to common stockholders
$(24,409,955) 18,220,731 $ (1.34)
============ ============ ============
Warrants to purchase 1,243,813 shares of common stock exercisable at
between $3.50 and $5.06 per share, options to purchase 4,897,635 shares of
common stock exercisable at between $0.37 and $5.23 per share, and convertible
debt of $12,500,000 convertible at $3.65 per share, were outstanding for the
three months ended September 30, 2006. In connection with the "Share-Based
Payment," ("SFAS 123(R)") calculation (see note 3), 3,435,135 shares and
2,775,135 shares were included in the computation of diluted income per share
for the three months and nine months ended September 30, 2006 respectively.
7
Warrants to purchase 1,510,479 shares of common stock exercisable at
between $3.50 and $5.06 per share, options to purchase 1,942,000 shares of
common stock exercisable at between $1.30 and $5.23 per share, convertible debt
of $500,000 convertible at $4.50 per share and convertible debt of $12.5 million
convertible at $3.65 per share were outstanding for the three and nine months
ended September 30, 2005, but were not included in the computation of diluted
earnings per share because exercise or conversion would have an antidilutive
effect on earnings per share.
NOTE 3 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 three
and nine months ended September 30, 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
three and nine months ended September 30, 2005. Stock-based compensation expense
recognized under SFAS 123(R) for employee and directors for the three and nine
months ended September 30, 2006 was $117,647 and $283,024, respectively. Basic
and diluted income per share for the quarter ended September 30, 2006 would have
been $0.02 per share, if the Company had not adopted SFAS 123(R), compared to
reported basic and diluted income of $0.02 per share. Basic and diluted income
per share for the nine months ended September 30, 2006 would have been $0.01 per
share, if the Company had not adopted SFAS 123(R), compared to reported basic
and diluted loss of $0.01 per share.
During the quarter ended September 30, 2006, the Company granted options
to acquire 660,000 shares at an exercise price of $.69 per share. During the
nine months ended September 30, 2006, the Company granted awards of stock for
225,388 shares at an average market price of $0.45 per share and options to
acquire 3,570,523 shares at an average exercise price of $0.47 per share. Awards
to acquire 1,625,000 shares were granted to employees outside of the 1997 Plan
(see Note 6), and awards of stock and options to acquire 165,253 shares were
granted to a consultant. The estimated fair value of all awards granted during
the quarter was $43,756, and the estimated fair value of all awards granted
during the nine months ended September 30, 2006 was $353,024 of which $70,000
was accrued for as of December 31, 2005. Assumptions used to value options
granted to employees during the nine months ended September 30, 2006 were
expected volatility of 57% to 64%, expected term of 5.0 years to 6.1 years,
risk-free interest rate of approximately 4.8%, and an expected dividend yield of
zero. Assumptions used to value options granted to consultants were expected
volatility of 65%, expected term of 10 years (contractual life), risk-free
interest rate of 4.5%, and expected divided yield of zero.
Options issued to consultants are being 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."
8
The following table illustrates the effect on net loss 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 for
the three months and nine months ended September 30, 2005. 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' requisite service periods
(vesting periods).
Three Months Nine Months
Ended Ended
September 30, September 30,
2005 2005
------------ ------------
Net loss as reported ........................... $(10,284,874) $(24,409,955)
Plus: Stock-based expense recognized in the
Statement of Operations, net of tax ......... -- --
Less: Stock-based expense determined under
fair-value based method, net of tax ......... (65,332) (142,393)
------------ ------------
Pro forma net loss ............................. $(10,350,206) $(24,552,348)
============ ============
------------------------------------------------
Net loss per share:
As reported -- basic and diluted ............... $ (0.56) $ (1.34)
Pro forma -- basic and diluted ................. $ (0.56) $ (1.34)
============ ============
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 three and nine months ended
September 30, 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 three and nine months ended September 30, 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 fiscal 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 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 three and nine months ended
September, 30, 2005, 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.
9
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
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).
NOTE 4 INVENTORIES
Inventories are stated at the lower of cost or market value and consist
of finished goods available for sale. Inventory reserves are recorded for
damaged, obsolete, excess and slow-moving inventory. Estimates are used to
determine 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: September 30, December 31,
2006 2005
----------- -----------
Finished goods ....................... $ 4,611,500 $12,879,100
Less reserves ........................ 1,461,500 7,306,000
----------- -----------
Total inventories .................... $ 3,150,000 $ 5,573,100
=========== ===========
NOTE 5 COMMITMENTS, CONTINGENCIES AND GUARANTEES
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.
10
On October 12, 2005, a shareholder class action complaint-- Huberman vs
Tag-It Pacific, Inc., et al., Case No. CV05-7352 R(Ex)--was filed against the
Company and certain of the Company's 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 the Company's 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 the
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.
Although the Company believes that it and the other defendants have meritorious
defenses to the class action complaint and intend to contest the lawsuit
vigorously, if there is an adverse resolution to the lawsuit the results could
have a material adverse effect on the Company's financial position and results
of operations. At this early stage of the litigation, the Company is not able to
reasonably predict the outcome of this action or estimate potential losses, if
any, related to the lawsuit.
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 the Company's
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 the Company 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. The Company 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, the Company amended its 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 the Company.
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 the Company infringed its United States Patent Nos. 5,987,721 and
6,566,285. The Company filed a reply denying the substantive allegations of the
amended counterclaims. At the Company's request, the Court bifurcated the breach
of contract issues for trial. The parties have filed summary judgment motions
which may dispose of some of the issues in this case prior to trial. On June 5,
2006 the Court denied one of the Company's motions for summary judgment, holding
that the issue of whether U.S. Patent No. 6,566,285 relating to curved
waistbands, was licensed to the Company presented a disputed question of
material fact which could not be resolved without a trial. On August 17, 2006
the Court denied the Company's motion for partial summary judgment holding that
summary adjudication that the Company did not breach its 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 the Company breached its agreement with Pro-Fit and, again, a
trial is required to determine issues concerning the Company's activities in
Columbia and whether other actions by Pro-Fit constituted an unwillingness or
inability to fill orders. Mediation to attempt to resolve this case is scheduled
to occur on December 11, 2006. No trial date is currently set for trial of any
issues. As the Company derives a significant amount of revenue from the sale of
11
products incorporating the stretch waistband technology, the Company's 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
the Company. Additionally, the Company has incurred significant legal fees in
this litigation, and unless the case is settled will continue to incur
additional legal fees in increasing amounts as the case accelerates to trial.
The Company currently has pending a number of other claims, suits and
complaints that arise in the ordinary course of its business. The Company
believes that it has 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 the Company's consolidated financial
condition if adversely determined against the Company.
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.
Effective June 1, 2006 accrued legal fees for services provided by the
Company's counsel in the amount of $1,650,000 were converted into a note
payable. The note is payable over a fourteen-month period, bearing interest at
3% per annum, and is secured with an assignment of a note receivable due from a
customer in substantially identical monthly payments. Additionally, during the
quarter ended June 30, 2006 a trade payable in the amount of $125,000 due to a
former supplier was converted into a non-interest bearing note payable due over
three months.
NOTE 6 STOCK OPTIONS AND WARRANTS
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
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.
12
As of September 30, 2006, the Company may issue awards to acquire up to
a total of 2,501,977 shares of common stock under the 1997 Plan. As of September
30, 2006, there were awards issued and outstanding under the 1997 Plan to
acquire a total of 3,272,635 shares of common stock, including options issued to
a consultant to acquire 75,000 shares of common stock at $0.57 per share and
stock grants of 225,388 shares. During the nine months ended September 30, 2006,
the Company issued options outside the plan to acquire 1,625,000 shares of
common stock at an average exercise price of $0.46 per share.
The following table summarizes all options and grants issued to
employees and directors including those issued outside the plan.
The following table summarizes the activity for the periods:
Weighted
Average
EMPLOYEE AND DIRECTOR Number of Exercise
Shares Price
---------- ----------
Options outstanding - January 1, 2005 ............... 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 ........................................ 3,405,270 $ 0.47
Issued ......................................... (135,135) $ 0.37
Canceled ....................................... (280,500) $ 3.26
---------- ----------
Options outstanding - September 30, 2006 ............ 4,822,635 $ 1.43
========== ==========
The Company has also issued certain warrants, stock and options to
non-employees. As of September 30, 2006, there were warrants issued to acquire a
total of 1,243,813 shares of common stock, a stock grant of 90,253 shares and
options to acquire 75,000 shares of common stock outstanding.
The following table summarizes all stock-based awards (warrants, grants
and options) to non- employees:
Weighted
Average
Number of Exercise
NON-EMPLOYEE Shares Price
----------------------------------------------------- ---------- ----------
Outstanding - January 1, 2005 ....................... 1,377,147 $ 4.36
Granted ........................................... -- --
---------- ----------
Outstanding - December 31, 2005 ..................... 1,377,147 $ 4.36
Granted ........................................... 165,253 $ 0.57
Issued ............................................ (90,253) $ 0.57
Cancelled ......................................... (133,334) $ 4.54
---------- ----------
Outstanding - September 30, 2006 .................... 1,318,813 $ 4.13
13
The weighted average exercise prices, remaining contractual lives and
aggregate intrinsic values for employee and director shares and options granted,
expected to vest, and exercisable as of December 31, 2005 and September 30, 2006
were as follows:
Weighted
Weighted Average
Average Remaining
Number of Exercise Contractual Intrinsic
EMPLOYEE AND DIRECTOR Shares Price Life (Years) Value
--------------------------------- --------- -------- ----------- ---------
OPTIONS AS OF DECEMBER 31, 2005:
Outstanding...................... 1,833,000 $3.46 6.02 $0.00
Vested and Expected to Vest...... 1,809,000 $3.44 5.98 $0.00
Exercisable...................... 1,788,000 $3.44 5.97 $0.00
OPTIONS AS OF SEPTEMBER 30, 2006:
Outstanding...................... 4,822,635 $1.43 8.32 $1,640,430
Vested and Expected to Vest...... 4,819,363 $1.43 8.31 $1,638,847
Exercisable...................... 1,622,833 $3.31 5.40 $69,750
The aggregate intrinsic value excludes options that have an exercise
price in excess of market price of the common stock as of December 31, 2005 and
September 30, 2006, respectively. Awards that are expected to vest take into
consideration, estimated forfeitures for awards not yet vested.
The weighted average exercise prices, remaining contractual lives and
aggregate intrinsic values for non-employee warrants, shares and options
granted, exercisable, and expected to vest as of December 31, 2005 and September
30, 2006 were as follows:
Weighted
Weighted Average
NON-EMPLOYEE Average Remaining
WARRANTS & OPTIONS AS OF Number of Exercise Contractual Intrinsic
DECEMBER 31, 2005: Shares Price Life (Years) Value
---------------------------------- --------- -------- ----------- ---------
Outstanding ...................... 1,377,147 $4.36 2.6 $0.00
Vested and Expected to Vest ...... 1,377,147 $4.36 2.6 $0.00
Exercisable ...................... 1,377,147 $4.36 2.6 $0.00
WARRANTS AS OF SEPTEMBER 30, 2006:
Outstanding ...................... 1,318,813 $4.13 2.53 $29,500
Vested and Expected to Vest ...... 1,318,813 $4.13 2.53 $29,500
Exercisable ...................... 1,293,813 $4.20 2.40 $19,500
The aggregate intrinsic value excludes warrants and options that have an
exercise price in excess of the market price of the common stock as of December
31, 2005 and September 30, 2006, respectively. Awards that are expected to vest
take into consideration, estimated forfeitures for awards not yet vested.
The intrinsic value of options exercised in 2005, 2004, and 2003 were
$1,500; $183,000; and $261,000, respectively. The total fair value of awards
vested during the years ended December 31, 2005, 2004 and 2003 was $220,000,
14
$55,000 and $140,000, respectively. The fair value of the awards approximates
the values expensed for pro-forma purposes for these periods.
As of September 30, 2006, there was $695,866 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.
When options are exercised, the Company's policy is to issue previously
registered, unissued shares of common stock. As of September 30, 2006, the
Company had 2,501,977 unissued shares of common stock available in its 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.
NOTE 7 NEW ACCOUNTING PRONOUNCEMENTS
Effective January 1, 2006 the Company implemented FASB Statement of
Financial Accounting Standards (SFAS) No. 154, "Accounting Changes and Error
Corrections", an amendment to accounting Principles Bulletin (APB) Opinion No.
20, "Accounting Changes", and SFAS No. 3, "Reporting Accounting Changes in
Interim Financial Statements". Though SFAS No. 154 carries forward the guidance
in APB No.20 and SFAS No.3 with respect to accounting for changes in estimates,
changes in reporting entity, and the correction of errors, SFAS No. 154
established new standards on accounting for changes in accounting principles,
whereby all such changes must be accounted for by retrospective application to
the financial statements of prior periods unless it is impracticable to do so.
SFAS No. 154 was effective for accounting changes and error corrections made in
fiscal years beginning after December 15, 2005. The adoption of this new
standard did not have a material impact upon the Company's financial position,
results of operations or cash flows.
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. The
adoption of this new standard did not have a material impact upon the Company's
financial position, results of operations or cash flows.
In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing
of Financial Assets" ("SFAS No. 156"), which provides an approach to simplify
efforts to obtain hedge-like (offset) accounting. This Statement amends FASB
Statement No. 140, "Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities", with respect to the accounting for
separately recognized servicing assets and servicing liabilities. The Statement
(1) requires an entity to recognize a servicing asset or servicing liability
each time it undertakes an obligation to service a financial asset by entering
into a servicing contract in certain situations; (2) requires that a separately
recognized servicing asset or servicing liability be initially measured at fair
value, if practicable; (3) permits an entity to choose either the amortization
method or the fair value method for subsequent measurement for each class of
separately recognized servicing assets or servicing liabilities; (4) permits at
initial adoption a one-time reclassification of available-for-sale securities to
trading securities by an entity with recognized servicing rights, provided the
securities reclassified offset the entity's exposure to changes in the fair
value of the servicing assets or liabilities; and (5) requires separate
presentation of servicing assets and servicing liabilities subsequently measured
15
at fair value in the balance sheet and additional disclosures for all separately
recognized servicing assets and servicing liabilities. SFAS No. 156 is effective
for all separately recognized servicing assets and liabilities as of the
beginning of an entity's fiscal year that begins after September 15, 2006, with
earlier adoption permitted in certain circumstances. The Statement also
describes the manner in which it should be initially applied. The adoption of
this new standard did not have a material impact upon the Company's financial
position, results of operations or cash flows.
In June 2006, the 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 position.
In September 2006, the FASB issued SFAS No. 157, "Fair Value
Measurements" ("SFAS No. 157"), which establishes a framework for measuring fair
value in generally accepted accounting principles, and expands disclosures about
fair value measurements. SFAS No. 157 is effective for financial statements
issued for fiscal years beginning after November 15, 2007. The Company is
required to adopt the provisions of SFAS No. 157 as applicable, beginning in
fiscal year 2008. The adoption of this new standard is not expected to have a
material impact upon the Company's financial position, results of operations or
cash flows.
NOTE 8 GEOGRAPHIC INFORMATION
The Company specializes in the distribution of a full range of apparel
zipper and 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 account for these products
separately or to justify segmented reporting by product type.
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:
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------- -------------------------
Country / Region 2006 2005 2006 2005
------------------------ ----------- ----------- ----------- -----------
United States .......... $ 1,205,400 $ 1,676,700 $ 3,143,800 $ 4,771,000
Asia ................... 7,206,900 4,092,300 21,940,700 14,427,500
Mexico ................. 722,500 824,200 3,302,200 9,487,300
Dominican Republic ..... 3,423,400 1,487,300 7,695,500 5,381,700
Other .................. 808,800 1,392,500 2,169,000 3,740,500
----------- ----------- ----------- -----------
$13,367,000 $ 9,473,000 $38,251,200 $38,168,000
=========== =========== =========== ===========
16
September 30, December 31,
2006 2005
----------- -----------
Long-lived Assets:
United States ..................... $ 9,754,600 $10,493,900
Asia .............................. 385,400 226,200
Mexico ............................ 9,600 23,700
Dominican Republic ................ 695,400 776,300
----------- -----------
$10,845,000 $11,520,100
=========== ===========
17
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
FORWARD LOOKING STATEMENTS
This report and other documents we file with the SEC contain forward
looking statements that are based on current expectations, estimates, forecasts
and projections about us, our future performance, our business or others on our
behalf, our beliefs and our management's assumptions. These statements are not
guarantees of future performance and involve certain risks, uncertainties, and
assumptions that are difficult to predict. We describe our respective risks,
uncertainties, and assumptions that could affect the outcome or results of
operations below. We have based our forward looking statements on our
management's beliefs and assumptions based on information available to our
management at the time the statements are made. We caution you that actual
outcomes and results may differ materially from what is expressed, implied, or
forecast by our forward looking statements. Reference is made in particular to
forward looking statements regarding projections or estimates concerning our
business, including demand for our products and services, mix of revenue
streams, ability to control and/or reduce operating expenses, anticipated gross
margins and operating results, cost savings, product development efforts,
general outlook of our business and industry, international businesses,
competitive position, adequate liquidity to fund our operations and meet our
other cash requirements.
OVERVIEW
The following management's discussion and analysis is intended to
assist the reader in understanding our consolidated financial statements. This
management's discussion and analysis 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.
During the third quarter of 2005 we restructured 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 development, design,
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. The restructuring (described more fully below) discontinued the
supply of trim products in preassembled kits. We will continue to supply trim to
customers however we will not provide the trim components in a preassembled kit.
We plan to aggressively expand our trim business footprint 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.
18
Our Tekfit services provide manufacturers with the patented technology,
manufacturing know-how and materials required to produce pants incorporating an
expandable waistband. These products are currently produced by several
manufacturers for one single brand. In October 2006 our exclusive supply
contract with this single 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,
purchase commitments from the previous single brand are expected to decline
significantly through the next two quarters, 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 the product
will grow significantly as we market our products to new customers in the coming
months.
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 Contingencies and Guarantees (see Note 5 to our unaudited consolidated
financial statements), 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 21% of our consolidated
revenues for the nine months ended September 30, 2006 and 2005, and 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.
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
over the next twelve months as we focus on acquiring high quality customers, and
decrease our customer concentration. As a result of this restructuring, we will
operate with fewer employees and will have lower associated operating and
distribution expenses.
RESULTS OF OPERATIONS
The following table sets forth selected statements of operations data
shown as a percentage of net sales for the periods indicated:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------- --------------------
2006 2005 2006 2005
-------- -------- -------- --------
Net sales ................................ 100.0% 100.0% 100.0% 100.0%
Cost of goods sold ....................... 69.0 122.1 70.9 95.0
-------- -------- -------- --------
Gross profit ............................. 31.0 (22.1) 29.1 5.0
Selling expenses ......................... 6.2 5.8 5.4 5.1
General and administrative expenses ...... 20.7 51.8 21.5 51.5
Impairment of goodwill ................... -- 4.7 -- 1.2
Restructuring costs ...................... -- 24.1 -- 6.0
Interest & Taxes ......................... 1.6 0.0 1.5 0.0
-------- -------- -------- --------
Operating (loss) income .................. 2.5% (108.5)% 0.7% (58.8)%
-------- -------- -------- --------
19
SALES
For the three months ended September 30, 2006 and 2005, sales by
geographic region based on the location of the customer as a percentage of
sales:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------- --------------------
COUNTRY / REGION 2006 2005 2006 2005
-------------------------------- -------- -------- -------- --------
United States .................. 9.0% 17.7% 8.2% 12.5%
Asia ........................... 53.9% 43.2% 57.4% 37.8%
Mexico ......................... 5.4% 8.7% 8.6% 25.8%
Dominican Republic ............. 25.6% 15.7% 20.1% 14.1%
Other .......................... 6.1% 14.7% 5.7% 9.8%
-------- -------- -------- --------
100.0% 100.0% 100.0% 100.0%
======== ======== ======== ========
Sales for the three months ended September 30, 2006 were $13.4 million
or $3.9 million (41%) more than sales for the three months ended September 30,
2005. Sales for the nine months ended September 30, 2006 were $38.3 million or
$.1 million (.2%) greater than sales for the same period in 2005. The increase
in sales for the three months ended September 30, 2006 as compared to the same
period in 2005 reflects double-digit revenue growth in all of our product
categories. Sales in the three months ended September 30, 2005 were negatively
impacted by the business restructuring that began in the third quarter of 2005,
and also included sales of $1.4 million of thread products, whereas only
liquidation sales of these products existed in 2006. Thread product sales for
the three months ended September 30, 2006 and 2005 were not significant. Thread
products represented lower margin sales, and the discontinuance of this product
offering coincided with our discontinuance of selling preassembled trim kits and
allows us to focus more on other market opportunities such as zippers and trim
that we believe add more value.
Sales for the three months and nine months ended September 30, 2006 as
compared to the same periods in 2005 also increased despite lower sales of trim
products to our customers in Mexico and the shift of both the U.S. and Mexico
production from these areas to Asia and other worldwide markets. Sales within
the Asian markets for the three and nine months ended September 30, 2006
increased $3.1 million and $7.5 million, respectively over the same periods in
2005. Sales within the U.S. and Mexico for the three and nine months ended
September 30, 2006 declined $.6 million and $7.8 million, respectively, compared
with the same periods in 2005. The net decrease is primarily the result of the
shift of apparel production from Latin America to Asia and other worldwide
markets that began in 2004, and the resulting decrease in sales to our customers
in Mexico of trim products. The Company responded to this shift with our growth
and expansion activities in the Asian markets and with the restructuring plans
implemented in 2005 closing the Mexican assembly and U.S. manufacturing
facilities.
COST OF SALES
Cost of sales for the three months ended September 30, 2006 was $9.2
million or $2.3 million (20%) less than cost of sales for the same period in
2005, and Cost of sales for the nine months ended September 30, 2006 was $27.1
million or $9.1 million (25%) less than cost of sales for the same period in
2005. The reduction in cost of sales for the three and nine months ended
September 30, 2006 as compared to the same periods in 2005 was attributable to
costs associated with sales volume changes, improved product margins resulting
from our focus on higher margin sales, reduced distribution charges since more
products are now sourced and delivered within the same marketplace, reduced
manufacturing and assembly overhead costs as these operations were closed in the
third quarter of 2005, and lower provisions for obsolescence as inventory levels
have been reduced and turns accelerated. A brief recap of
20
the change in sales, cost of sales and gross margin for the three and nine
months ended September 30, 2006 as compared with the same periods in 2005 is as
follows:
(Amounts in thousands)
THREE MONTHS NINE MONTHS
------------------------- ------------------------
AMOUNT %(1) AMOUNT %(1)
---------- ---------- ---------- ----------
Sales increase ....................... $ 3,894 41.1% $ 83 0.2%
COST OF SALES (INCREASE) DECREASE:
Cost of change in sales volumes ...... (1,569) (13.6) (33) (0.1)
Improved margin on sales ............. 374 3.2 2,165 6.0
Reduced freight and duty costs ....... 394 3.4 1,693 4.7
Lower manufacturing & assembly costs . 106 0.9 777 2.1
Reduced obsolescence ................. (28) (0.2) 1,113 3.1
Restructuring costs .................. 3,447 29.8 3,447 9.5
Other cost of sales .................. (376) (3.3) (41) (0.1)
---------- ---------- ---------- ----------
2,348 20.2% 9,121 25.2%
---------- ---------- ----------
GROSS MARGIN INCREASE ........ $ 6,242 $ 9,204
========== ==========
(1) Represents the percentage change in the 2006 period, as compared to the
same period in 2005.
SELLING EXPENSES
Selling expenses for the three months ended September 30, 2006 were
$0.9 million (6.8% of sales) as compared to $0.5 million (5.8% of sales) for the
same period in 2005. The increase in selling expense for the quarter is
principally due to higher marketing and promotion costs of $283,000 and
increased commissions of $95,000 partially offset by lower travel expenses and
employee costs.
Selling expenses for the nine months ended September 30, 2006 were $2.1
million (4.9% of sales) as compared to $1.9 million (5.1% of sales) for the same
period in 2005. The increase in selling expense for the period is due to higher
marketing and promotion costs of $232,000 and increased commissions of $266,000
resulting from a compensation program implemented in 2006, offset by lower
employee and related costs in the U.S. and Mexico associated with the
restructuring plan adopted in 2005 of $86,000 and the reduction of travel
related expenses of $221,000.
GENERAL AND ADMINISTRATIVE EXPENSES
General and administrative expenses for the three months ended
September 30, 2006 were $2.7 million or $4.9 million (65%) less than for the
same period in 2005. General and administrative expenses for the nine months
ended September 30, 2006 were $8.1 million or $14.2 million (64%) less than for
the same period in 2005. General and administrative expense for the three and
nine months ended September 30, 2005 included $2.3 million in restructuring
costs and $450,000 from the impairment of goodwill not included in 2006.
Additional changes in general and administrative expense for the three
months ended September 30, 2006 as compared to the same period in 2005 includes
approximately: $117,000 in stock based compensation not included in 2005; lower
legal and professional fees by $1.3 million; lower employee costs by $300,000
resulting from staff reductions; lower bad debt expense by $250,000 due to fewer
provisions and to recoveries of $135,000; and other lower operating costs
associated with travel, facilities, supplies, insurance, and other miscellaneous
costs of approximately $400,000.
21
For the nine month period ended September 30, 2006 as compared to the
same period of 2005, the general and administrative costs declined from the
prior year by $11.5 million in addition to the reduction from the restructuring
costs and goodwill impairment charges. This reduction was principally the result
of $6.6 million in provisions for bad debts recorded in 2005 as compared to
$530,000 in bad debt recoveries in 2006; a $1.7 million decrease in employee
related costs associated with employee reductions in the U.S., Mexico and Hong
Kong that we implemented with our restructuring plan in 2005; lower legal and
professional fees by $1.3 million; reduced travel costs of $520,000; and overall
reductions in the costs of facilities, supplies, insurance and other
miscellaneous costs of approximately $800,000; partially offset by $283,000 in
non-cash compensation costs recorded with the adoption of FAS 123(R).
Effective January 1, 2006, we adopted FAS 123(R) which requires the
company to recognize a non-cash expense associated with options and warrants
issued to employees, directors and consultants. For the three and nine months
ended September 30, 2006 we incurred $117,000 and $283,000, respectively of
costs associated with the implementation of this accounting requirement. The
majority of the recognized cost is associated with the option grants issued to
the executive management team in the first quarter of 2006.
INTEREST EXPENSE
Interest expense decreased by approximately $106,000 to $159,000 for
the three months ended September 30, 2006, as compared to the same period in
2005. Interest expense decreased by approximately $283,000 to $520,000 for the
nine months ended September 30, 2006, as compared to the same period in 2005.
The change for both the three and nine month period from 2005 is due primarily
to lower borrowings under a bank line of credit and certain notes.
INCOME TAXES
Income tax expense for the three and nine months ended September 30,
2006 was $55,000 and $66,000, respectively associated with foreign income taxes
from earnings within our Asian facilities. Due to prior operating losses
incurred within the year no benefit for domestic income taxes has been recorded
since there is not sufficient evidence to determine that we will be able to
utilize our net operating loss carry forwards to offset future taxable income.
Income tax expense for the three and nine months ended September 30
2005 was $0.3 million income tax benefit and $1.2 million income tax expense
respectfully. Income taxes for 2005 included an increase of $1.0 million in the
deferred tax asset valuation allowance, and a provision for earned income within
our foreign subsidiary.
LIQUIDITY AND CAPITAL RESOURCES
The following table summarizes selected financial data at:
SEPTEMBER 30, DECEMBER 31,
2006 2005
----------- -----------
Cash and cash equivalents .............. $ 3,726,200 $ 2,277,400
Total assets ........................... $27,673,800 $30,320,800
Current debt ........................... $11,980,300 $14,850,600
Non-current debt ....................... $14,164,000 $14,558,100
Stockholders' equity ................... $ 1,529,500 $ 912,100
22
CASH AND CASH EQUIVALENTS
Cash and cash equivalents for the nine months ended September 30, 2006
increased $1,449,000 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 approximately $2.8 million for the nine months ended September
30, 2006. The cash provided by operating activities during the nine months
resulted principally from:
Net earnings before non-cash expenses ..................... $ 1,570,000
Payments received from Notes Receivable ................... 317,000
Inventory reductions, net of reserves ..................... 2,423,000
Receivable reductions, net of reserves .................... 685,000
Reduction of accounts payable ............................. (2,087,000)
Other ..................................................... (86,000)
-----------
$ 2,822,000
During the nine months ended September 30, 2006 a net decrease in
inventory of $2.4 million resulted from the elimination of $8.3 million in
inventory, net of reserves established against these products of $5.9 million.
Estimated days of sales included in inventory at September 30, 2006 were
approximately 46 days supply as compared to approximately 149 days at December
31, 2005. Accounts receivable for the period declined by $1.7 million as a
result of approximately $0.6 million of reserved accounts written-off, and
improved overall collections. The estimated DSO (day's sales outstanding) of
Accounts Receivable at September 30, 2006 was 36 days, improved from 52 days at
December 31, 2005. Accounts receivable reserve reductions include $0.6 million
applied against the accounts written-off, and $0.5 million associated with the
collection of accounts reserved in prior years as a bad debt.
Net cash used in investing activities for the nine months ended
September 30, 2006 was $323,000 as compared to $1.6 million for the nine months
ended September 30, 2005. The cash used in investing activities in 2006
represents capital expenditures for leasehold improvements in China. In 2005 the
cash used for investing activities consisted primarily of capital expenditures
for zipper equipment and leasehold improvements for the manufacturing facility
in North Carolina.
Net cash used in financing activities for the nine months ended
September 30, 2006 was approximately $1,050,000 and primarily reflects the
repayment of borrowings under capital leases and notes payable. For the nine
months ended September 30, 2005 the cash used by financing activities was $2.5
million and represented the repayment of notes payable, a bank line of credit
and capital leases, partially offset by funds raised from the exercise of stock
options and warrants.
We currently satisfy our working capital requirements primarily through
cash flows generated from operations. As we continue to respond to the current
industry trend of large retail brands to outsource apparel manufacturing to
offshore locations, our foreign customers, though backed by U.S. brands and
retailers, are increasing. This makes receivables based financing with
traditional U.S. banks more difficult. Our current borrowings may not provide
the level of financing we may need to expand into additional foreign markets. As
a result, we are continuing to evaluate non-traditional financing of our foreign
assets.
We have incurred significant legal fees in our litigation with Pro-Fit
Holdings Limited. Unless the case is settled, we will continue to incur
additional legal fees in increasing amounts as the case accelerates to trial.
23
We believe that our existing cash and cash equivalents and anticipated
cash flows from our operating activities 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 assumption that we will be successful in
restructuring our operations in accordance with the restructuring plan adopted
in 2005, and that we will collect our note and accounts receivable in accordance
to existing terms. If we are unable to successfully fully implement our
restructuring initiative or collect the note receivable, or experience greater
than anticipated reductions in sales, we may need to raise additional capital 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
reduce the scope of our business in response to our failure to implement our
restructuring initiative in accordance with our plan, there may be substantial
doubt about our ability to continue as a going concern. Our auditors have
included in their report on our financial statements for the year ended December
31, 2005 an explanatory paragraph expressing substantial doubt about our ability
to continue as a going concern if we fail to successfully implement our
restructuring initiative.
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, our borrowing base
availability limitations related to eligible accounts receivable and inventories
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 the
Asian, Central and South American and Caribbean 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
tradename, and we may need to implement additional cost savings initiatives.
CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS
The following summarizes our contractual obligations at September 30,
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 TO 3 4 TO 5 AFTER
CONTRACTUAL OBLIGATIONS TOTAL 1 YEAR YEARS YEARS 5 YEARS
------------------------------- ----------- ----------- ----------- ----------- -----------
Demand notes payable to related
parties (1)................ $ 665,000 $ 665,000 $ 0 $ 0 $ 0
Capital lease obligations ..... $ 1,012,700 $ 425,900 $ 586,800 $ 0 $ 0
Operating leases .............. $ 1,647,500 $ 565,000 $ 1,082,500 $ 0 $ 0
Notes payable ................. $ 2,607,800 $ 1,495,200 $ 495,400 $ 617,200 $ 0
Convertible notes payable ..... $12,464,600 $ 0 $12,464,600 $ 0 $ 0
(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 September 30, 2006.
24
At September 30, 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.
RELATED PARTY TRANSACTIONS
Prior to 2005 the company operated an apparel trim supply agreement
with Tarrant Apparel Group. Two of Tarrant's executive officers and significant
shareholders are also significant shareholders of our company. The supply
agreement was terminated in December 2004; however we continue to conduct
business with Tarrant Apparel Group on a limited basis. Sales to Tarrant or its
affiliates for the nine months ended September 30, 2005 were $165,000.
As of September 30, 2006 accounts receivable included $1,500 due from
Tarrant. At September 30, 2005 accounts receivable, related party included $1.4
million due from Tarrant's affiliate, United Apparel Ventures. United Apparel
Ventures paid this balance over a nine-month period and it was fully paid as of
December 31, 2005.
As of September 30, 2006 and December 31, 2005, we had outstanding
related-party notes payable of $665,000, at interest rates ranging from 0% to
11%. The majority of related-party debt is due on demand, with the remainder due
and payable within 15 days of demand. Accrued interest associated with these
notes is included in other accrued liabilities.
As of September 30, 2006 and December 31, 2005, we had receivables due
from related parties of $644,000 and $730,000, respectively. The receivables
consist of unsecured notes, advances and accrued interest receivable from a
former officer and stockholder of the Company who is related to or affiliated
with a director of the Company. The notes and advances bear interest at 0%, 8.5%
and prime and, together with accrued interest, are due on demand.
Consulting fees paid to The Link Trading, a company owned by a member
of our Board of Directors, amounted to $36,000 and $108,000 for the three and
nine months ended September 30, 2006. Consulting fees paid to Diversified
Investments, a company owned by a member of our Board of Directors, amounted to
$37,500 and $112,500 for the three and nine months ended September 30, 2006,
respectively.
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
25
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 deteriorates, 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.
o Inventories are stated at the lower of cost or market value.
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
future sales of this type of inventory.
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. 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.
26
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.
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
Effective January 1, 2006 the Company implemented FASB Statement of
Financial Accounting Standards (SFAS) No. 154, "Accounting Changes and Error
Corrections", an amendment to accounting Principles Bulletin (APB) Opinion No.
20, "Accounting Changes", and SFAS No. 3, "Reporting Accounting Changes in
Interim Financial Statements". Though SFAS No. 154 carries forward the guidance
in APB No.20 and SFAS No.3 with respect to accounting for changes in estimates,
changes in reporting entity, and the correction of errors, SFAS No. 154
established new standards on accounting for changes in accounting principles,
whereby all such changes must be accounted for by retrospective application to
the financial statements of prior periods unless it is impracticable to do so.
SFAS No. 154 was effective for accounting changes and error corrections made in
fiscal years beginning after December 15, 2005. The adoption of this new
standard did not have a material impact upon the Company's financial position,
or results of operations.
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. The
adoption of this new standard did not have a material impact upon the Company's
financial position, or results of operations.
In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing
of Financial Assets" ("SFAS No. 156"), which provides an approach to simplify
efforts to obtain hedge-like (offset) accounting. This Statement amends FASB
Statement No. 140, "Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities", with respect to the accounting for
separately recognized servicing assets and servicing liabilities. The Statement
(1) requires an entity to recognize a servicing asset or servicing liability
each time it undertakes an obligation to service a financial asset by entering
into a servicing contract in certain situations; (2) requires that a separately
recognized servicing asset or servicing liability be initially measured at fair
value, if practicable; (3) permits an entity to choose either the amortization
method or the fair value method for subsequent measurement for each class of
separately recognized servicing assets or servicing liabilities; (4) permits at
27
initial adoption a one-time reclassification of available-for-sale securities to
trading securities by an entity with recognized servicing rights, provided the
securities reclassified offset the entity's exposure to changes in the fair
value of the servicing assets or liabilities; and (5) requires separate
presentation of servicing assets and servicing liabilities subsequently measured
at fair value in the balance sheet and additional disclosures for all separately
recognized servicing assets and servicing liabilities. SFAS No. 156 is effective
for all separately recognized servicing assets and liabilities as of the
beginning of an entity's fiscal year that begins after September 15, 2006, with
earlier adoption permitted in certain circumstances. The Statement also
describes the manner in which it should be initially applied. The adoption of
this new standard did not have a material impact upon the Company's financial
position, or results of operations.
In June 2006, the 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 position.
In September 2006, the FASB issued SFAS No. 157, "Fair Value
Measurements" ("SFAS No. 157"), which establishes a framework for measuring fair
value in generally accepted accounting principles, and expands disclosures about
fair value measurements. SFAS No. 157 is effective for financial statements
issued for fiscal years beginning after November 15, 2007. The Company is
required to adopt the provisions of SFAS No. 157 as applicable, beginning in
fiscal year 2008. The adoption of this new standard is not expected to have a
material impact upon the Company's financial position, results of operations or
cash flows.
CAUTIONARY STATEMENTS AND RISK FACTORS
Several of the matters discussed in this document contain
forward-looking statements that involve risks and uncertainties. Factors
associated with the forward-looking statements that could cause actual results
to differ from those projected or forecast are included in the statements below.
In addition to other information contained in this report, readers should
carefully consider the following cautionary statements and risk factors.
OUR GROWTH AND OPERATING RESULTS COULD BE MATERIALLY, ADVERSELY
AFFECTED IF WE ARE UNSUCCESSFUL IN RESOLVING A DISPUTE THAT NOW EXISTS REGARDING
OUR RIGHTS UNDER OUR EXCLUSIVE LICENSE AND INTELLECTUAL PROPERTY AGREEMENT
("AGREEMENT") WITH PRO-FIT. Pursuant to our agreement with Pro-Fit Holdings,
Limited, we have exclusive rights in certain geographic areas to Pro-Fit's
stretch and rigid waistband technology. We are in litigation with Pro-Fit
regarding our rights. See Part II, Item 1, "Legal Proceedings" for discussion of
this litigation. We derive a significant amount of revenues from the sale of
products incorporating the stretch waistband technology. Our business, results
of operations and financial condition could be materially adversely affected if
we are unable to conclude our present negotiations in a manner acceptable to us
and ensuing litigation 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.
WHILE WE EXPECT THAT THE RESTRUCTURING WILL RESULT IN REDUCED OPERATING
COSTS AND IMPROVED OPERATING RESULTS AND CASH FLOWS, THERE CAN BE NO ASSURANCE
THAT THESE RESULTS WILL BE ACHIEVED. We recorded restructuring costs during 2005
of $6.4 million. We face many challenges related to our decision to implement
28
this restructuring plan, including that we may not execute the restructuring
effectively, and our expectation that we will benefit from greater efficiencies
may not be realized. Any failure on our part to successfully manage these
challenges or other unanticipated consequences may result in the loss of
customers and sales, which could cause our results to differ materially from our
current expectations. The challenges we face include:
o Our ability to execute successfully through business cycles
while we continue to implement the restructuring plan and cost
reductions;
o Our ability to meet and achieve the benefits of our
cost-reduction goals and otherwise successfully adapt our cost
structures to continuing changes in business conditions;
o The risk that our cost-cutting initiatives will impair our
ability to develop products and remain competitive and to
operate effectively;
o We may experience delays in implementing our restructuring
plan and incur additional costs;
o We may experience decreases in employee morale; and
o We may experience unanticipated expenses winding down
manufacturing operations, including labor costs, which may
adversely affect our results of operations in the short term.
WE MAY BE UNABLE TO CONTINUE AS A GOING CONCERN IF WE DO NOT
SUCCESSFULLY ACHIEVE CERTAIN OBJECTIVES. If we are unable to successfully fully
implement our restructuring initiative, or collect the note receivable, or
experience greater than anticipated reductions in sales, we may need to raise
additional capital or further reduce the scope of our business to fully satisfy
our future short-term liquidity requirements. If we cannot raise additional
capital, or reduce the scope of our business in response to our failure to
implement our restructuring initiative in accordance with our plan, or fail to
achieve other operating objectives, the Company may be otherwise unable to
achieve its goals or continue its operations. Our auditors have included in
their report on our financial statements for the year ending December 31, 2005
an explanatory paragraph expressing substantial doubt about our ability to
continue as a going concern.
IF WE LOSE OUR LARGER CUSTOMERS OR THEY FAIL TO PURCHASE AT ANTICIPATED
LEVELS, OUR SALES AND OPERATING RESULTS WILL BE ADVERSELY AFFECTED. Our results
of operations will depend to a significant extent upon the commercial success of
our larger customers. If these customers fail to purchase our products at
anticipated levels, or our relationship with these customers terminates, it may
have an adverse affect on our results because:
o We will lose a primary source of revenue if these customers
choose not to purchase our products or services;
o We may not be able to reduce fixed costs incurred in
developing the relationship with these customers in a timely
manner;
o We may not be able to recoup setup and inventory costs;
o We may be left holding inventory that cannot be sold to other
customers; and
o We may not be able to collect our receivables from them.
IF CUSTOMERS DEFAULT ON INVENTORY PURCHASE COMMITMENTS WITH US, WE WILL
BE LEFT HOLDING NON-SALABLE INVENTORY. We hold significant inventories for
specific customer programs, which the customers have committed to purchase. If
any customer defaults on these commitments, or insists on markdowns, we may
incur a charge in connection with our holding significant amounts of non-salable
inventory and this would have a negative impact on our operations and cash flow.
29
OUR REVENUES MAY BE HARMED IF GENERAL ECONOMIC CONDITIONS WORSEN. OUR
REVENUES DEPEND ON THE HEALTH OF THE ECONOMY AND THE GROWTH OF OUR CUSTOMERS AND
POTENTIAL FUTURE CUSTOMERS. When economic conditions weaken, certain apparel
manufacturers and retailers, including some of our customers may experience
financial difficulties that increase the risk of extending credit to such
customers. Customers adversely affected by economic conditions have also
attempted to improve their own operating efficiencies by concentrating their
purchasing power among a narrowing group of vendors. There can be no assurance
that we will remain a preferred vendor to our existing customers. A decrease in
business from or loss of a major customer could have a material adverse effect
on our results of operations. Further, if the economic conditions in the United
States worsen or if a wider or global economic slowdown occurs, we may
experience a material adverse impact on our business, operating results, and
financial condition.
BECAUSE WE DEPEND ON A LIMITED NUMBER OF SUPPLIERS, WE MAY NOT BE ABLE
TO ALWAYS OBTAIN MATERIALS WHEN WE NEED THEM AND WE MAY LOSE SALES AND
CUSTOMERS. Lead times for materials we order can vary significantly and depend
on many factors, including the specific supplier, the contract terms and the
demand for particular materials at a given time. From time to time, we may
experience fluctuations in the prices, and disruptions in the supply, of
materials. Shortages or disruptions in the supply of materials, or our inability
to procure materials from alternate sources at acceptable prices in a timely
manner, could lead us to miss deadlines for orders and lose sales and customers.
WE OPERATE IN AN INDUSTRY THAT IS SUBJECT TO SIGNIFICANT FLUCTUATIONS
IN OPERATING RESULTS THAT MAY RESULT IN UNEXPECTED REDUCTIONS IN REVENUE AND
STOCK PRICE VOLATILITY. We operate in an industry that is subject to significant
fluctuations in operating results from quarter to quarter, which may lead to
unexpected reductions in revenues and stock price volatility. Factors that may
influence our quarterly operating results include:
o The volume and timing of customer orders received during the
quarter;
o The timing and magnitude of customers' marketing campaigns;
o The loss or addition of a major customer;
o The availability and pricing of materials for our products;
o The increased expenses incurred in connection with the
introduction of new products;
o Currency fluctuations;
o Delays caused by third parties; and
o Changes in our product mix or in the relative contribution to
sales of our subsidiaries.
Due to these factors, it is possible that in some quarters our
operating results may be below our stockholders' expectations and those of
public market analysts. If this occurs, the price of our common stock could be
adversely affected. In the past, following periods of volatility in the market
price of a company's securities, securities class action litigation has often
been instituted against such a company. In October 2005, a securities class
action lawsuit was filed against us. See footnote 5, Commitments, Contingencies
and Guarantees for a detailed description of this lawsuit.
THE OUTCOME OF LITIGATION IN WHICH WE HAVE BEEN NAMED, AS A DEFENDANT
IS UNPREDICTABLE AND AN ADVERSE DECISION IN ANY SUCH MATTER COULD HAVE A
MATERIAL ADVERSE AFFECT ON OUR FINANCIAL POSITION AND RESULTS OF OPERATIONS. We
are defendants in a number of litigation matters. These claims may divert
financial and management resources that would otherwise be used to benefit our
operations. Although we believe that we have meritorious defenses to the claims
30
made in each and all of the litigation matters to which we have been named a
party, and intend to contest each lawsuit vigorously, no assurances can be given
that the results of these matters will be favorable to us. An adverse resolution
of any of these lawsuits could have a material adverse affect on our financial
position and results of operations.
We maintain product liability and director and officer insurance that
we regard as reasonably adequate to protect us from potential claims; however we
cannot assure you that it will be adequate to cover any losses. Further, the
costs of insurance have increased dramatically in recent years, and the
availability of coverage has decreased. As a result, we cannot assure you that
we will be able to maintain our current levels of insurance at a reasonable
cost, or at all.
OUR CUSTOMERS HAVE CYCLICAL BUYING PATTERNS WHICH MAY CAUSE US TO HAVE
PERIODS OF LOW SALES VOLUME. Most of our customers are in the apparel industry.
The apparel industry historically has been subject to substantial cyclical
variations. Our business has experienced, and we expect our business to continue
to experience, significant cyclical fluctuations due, in part, to customer
buying patterns, which may result in periods of low sales usually in the first
and fourth quarters of our financial year.
OUR BUSINESS MODEL IS DEPENDENT ON INTEGRATION OF INFORMATION SYSTEMS
ON A GLOBAL BASIS AND, TO THE EXTENT THAT WE FAIL TO MAINTAIN AND SUPPORT OUR
INFORMATION SYSTEMS, IT CAN RESULT IN LOST REVENUES. We must consolidate and
centralize the management information from our subsidiaries and significantly
expand and improve our financial and operating controls. Additionally, we must
effectively integrate the information systems of our worldwide operations with
the information systems of our corporate offices in California. Our failure to
do so could result in lost revenues, delayed financial reporting or adverse
effects on the information reported.
THE LOSS OF KEY MANAGEMENT AND SALES PERSONNEL COULD ADVERSELY AFFECT
OUR BUSINESS, INCLUDING OUR ABILITY TO OBTAIN AND SECURE ACCOUNTS AND GENERATE
SALES. Our success has and will continue to depend to a significant extent upon
key management and sales personnel, many of whom would be difficult to replace.
In connection with our restructuring, we significantly reduced the number of
employees within our company, which has increased our reliance on those
employees that have remained with the company. The loss of the services of key
employees could have a material adverse effect on our business, including our
ability to establish and maintain client relationships. Our future success will
depend in large part upon our ability to attract and retain personnel with a
variety of sales, operating and managerial skills.
IF WE EXPERIENCE DISRUPTIONS AT ANY OF OUR FOREIGN FACILITIES, WE WILL
NOT BE ABLE TO MEET OUR OBLIGATIONS AND MAY LOSE SALES AND CUSTOMERS. Currently,
we do not operate duplicate facilities in different geographic areas. Therefore,
in the event of a regional disruption where we maintain one or more of our
facilities, it is unlikely that we could shift our operations to a different
geographic region and we may have to cease or curtail our operations. This may
cause us to lose sales and customers. The types of disruptions that may occur
include:
o Foreign trade disruptions;
o Import restrictions;
o Labor disruptions;
o Embargoes;
o Government intervention;
o Natural disasters; or
o Regional pandemics.
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INTERNET-BASED SYSTEMS THAT HOST OUR MANAGED TRIM SOLUTION MAY
EXPERIENCE DISRUPTIONS AND AS A RESULT WE MAY LOSE REVENUES AND CUSTOMERS. Our
Managed Trim Solution is designed as an Internet-based business-to-business
e-commerce system. To the extent that we fail to adequately update and maintain
the hardware and software of the system, our customers orders may be delayed or
interrupted due to defects in our hardware or our source code. In addition,
since our software is Internet-based, interruptions in Internet service
generally can negatively impact our ability to use the Managed Trim Solution to
monitor and manage various aspects of our customer's trim needs. Such defects or
interruptions could result in lost revenues and lost customers.
THERE ARE MANY COMPANIES THAT OFFER SOME OR ALL OF THE PRODUCTS AND
SERVICES WE SELL AND IF WE ARE UNABLE TO SUCCESSFULLY COMPETE OUR BUSINESS WILL
BE ADVERSELY AFFECTED. We compete in highly competitive and fragmented
industries with numerous local and regional companies that provide some or all
of the products and services we offer. We compete with national and
international design companies, distributors and manufacturers of tags,
packaging products, zippers and other trim items. Some of our competitors have
greater name recognition, longer operating histories and greater financial and
other resources than we do.
UNAUTHORIZED USE OF OUR PROPRIETARY TECHNOLOGY MAY INCREASE OUR
LITIGATION COSTS AND ADVERSELY AFFECT OUR SALES. We rely on trademark, trade
secret and copyright laws to protect our designs and other proprietary property
worldwide. We cannot be certain that these laws will be sufficient to protect
our property. In particular, the laws of some countries in which our products
are distributed or may be distributed in the future may not protect our products
and intellectual rights to the same extent as the laws of the United States. If
litigation is necessary in the future to enforce our intellectual property
rights, to protect our trade secrets or to determine the validity and scope of
the proprietary rights of others, such litigation could result in substantial
costs and diversion of resources. This could have a material adverse effect on
our operating results and financial condition. Ultimately, we may be unable, for
financial or other reasons, to enforce our rights under intellectual property
laws, which could result in lost sales.
IF OUR PRODUCTS INFRINGE ANY OTHER PERSON'S PROPRIETARY RIGHTS, WE MAY
BE SUED AND HAVE TO PAY LEGAL EXPENSES AND JUDGMENTS AND REDESIGN OR DISCONTINUE
SELLING OUR PRODUCTS. From time to time in our industry, third parties allege
infringement of their proprietary rights. Any infringement claims, whether or
not meritorious, could result in costly litigation or require us to enter into
royalty or licensing agreements as a means of settlement. If we are found to
have infringed the proprietary rights of others, we could be required to pay
damages, cease sales of the infringing products and redesign the products or
discontinue their sale. Any of these outcomes, individually or collectively,
could have a material adverse effect on our operating results and financial
condition.
OUR STOCK PRICE MAY DECREASE, WHICH COULD ADVERSELY AFFECT OUR BUSINESS
AND CAUSE OUR STOCKHOLDERS TO SUFFER SIGNIFICANT LOSSES. The following factors
could cause the market price of our common stock to decrease, perhaps
substantially:
o The failure of our quarterly operating results to meet
expectations of investors or securities analysts;
o Adverse developments in the financial markets, the apparel
industry and the worldwide or regional economies;
o Interest rates;
o Changes in accounting principles;
o Intellectual property and legal matters;
o Sales of common stock by existing shareholders or holders of
options;
o Announcements of key developments by our competitors; and
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o The reaction of markets and securities analysts to
announcements and developments involving our company.
IF WE NEED TO SELL OR ISSUE ADDITIONAL SHARES OF COMMON STOCK OR ASSUME
ADDITIONAL DEBT TO FINANCE FUTURE GROWTH, OUR STOCKHOLDERS' OWNERSHIP COULD BE
DILUTED OR OUR EARNINGS COULD BE ADVERSELY IMPACTED. Our business strategy may
include expansion through internal growth, by acquiring complementary businesses
or by establishing strategic relationships with targeted customers and
suppliers. In order to do so or to fund our other activities, we may issue
additional equity securities that could dilute our stockholders' value. We may
also assume additional debt and incur impairment losses to our intangible assets
if we acquire another company.
IF WE ARE NOT ABLE TO REGAIN COMPLIANCE WITH LISTING REQUIREMENTS, OUR
SHARES MAY BE REMOVED FROM LISTING ON AMEX. In May 2006 we were advised by AMEX
that we were non-compliant with the minimum net equity listing requirements and
we were afforded an opportunity to submit a plan to AMEX that provides for
increases in our equity beyond the minimum $4.0 million equity within an
eighteen-month timeframe from the date of the notice from AMEX. On August 3,
2006 AMEX accepted our plan to regain compliance and has given us an extension
until November 16, 2007 to become compliant with the AMEX continued listing
standards. During this period, we 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. In addition we
have suffered substantial recurring losses and may fail to comply with other
listing requirements of AMEX. We may not be able to regain compliance with these
matters within the time allowed by the exchange, and our shares of common stock
may be removed from the listing on AMEX.
WE MAY NOT BE ABLE TO REALIZE THE ANTICIPATED BENEFITS OF ACQUISITIONS.
We may consider strategic acquisitions as opportunities arise, subject to the
obtaining of any necessary financing. Acquisitions involve numerous risks,
including diversion of our management's attention away from our operating
activities. We cannot assure you that we will not encounter unanticipated
problems or liabilities relating to the integration of an acquired company's
operations, nor can we assure you that we will realize the anticipated benefits
of any future acquisitions.
OUR ACTUAL TAX LIABILITIES MAY DIFFER FROM ESTIMATED TAX RESULTING IN
UNFAVORABLE ADJUSTMENTS TO OUR FUTURE RESULTS. The amount of income taxes we pay
is subject to ongoing audits by federal, state and foreign tax authorities. Our
estimate of the potential outcome of uncertain tax issues is subject to our
assessment of relevant risks, facts, and circumstances existing at that time.
Our future results may include favorable or unfavorable adjustments to our
estimated tax liabilities in the period the assessments are made or resolved,
which may impact our effective tax rate and our financial results.
WE HAVE ADOPTED A NUMBER OF ANTI-TAKEOVER MEASURES THAT MAY DEPRESS THE
PRICE OF OUR COMMON STOCK. Our stockholders' rights plan, our ability to issue
additional shares of preferred stock and some provisions of our certificate of
incorporation and bylaws and of Delaware law could make it more difficult for a
third party to make an unsolicited takeover attempt of us. These anti-takeover
measures may depress the price of our common stock by making it more difficult
for third parties to acquire us by offering to purchase shares of our stock at a
premium to its market price.
INSIDERS OWN A SIGNIFICANT PORTION OF OUR COMMON STOCK, WHICH COULD
LIMIT OUR STOCKHOLDERS' ABILITY TO INFLUENCE THE OUTCOME OF KEY TRANSACTIONS. As
of September 30, 2006, our officers and directors and their affiliates
beneficially owned approximately 20% of the outstanding shares of our common
stock. The Dyne family, which includes Mark Dyne, Colin Dyne, and Jonathan
Burstein, who are also our directors; Larry Dyne and the estate of Harold Dyne;
beneficially owned approximately 15% of the outstanding shares of our common
stock at September 30, 2006. As a result, our officers and directors and the
Dyne family are able to exert considerable influence over the outcome of any
matters submitted to a vote of the holders of our common stock, including the
election of our Board of Directors. The voting power of these stockholders could
also discourage others from seeking to acquire control of us through the
purchase of our common stock, which might depress the price of our common stock.
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WE MAY FACE INTERRUPTION OF PRODUCTION AND SERVICES DUE TO INCREASED
SECURITY MEASURES IN RESPONSE TO TERRORISM. Our business depends on the free
flow of products and services through the channels of commerce. In response to
terrorists' activities and threats aimed at the United States, transportation,
mail, financial and other services may be slowed or stopped altogether.
Extensive delays or stoppages in transportation, mail, financial or other
services could have a material adverse effect on our business, results of
operations and financial condition. Furthermore, we may experience an increase
in operating costs, such as costs for transportation, insurance and security as
a result of the activities and potential delays. We may also experience delays
in receiving payments from payers that have been affected by the terrorist
activities. The United States economy in general may be adversely affected by
the terrorist activities and any economic downturn could adversely impact our
results of operations, impair our ability to raise capital or otherwise
adversely affect our ability to grow our business.
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ITEM 3. 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 British Pounds and Chinese Yuan. There
were no hedging contracts outstanding as of September 30, 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 bank accounts and we
do not believe we have significant market risk exposure with regard to our
investments.
ITEM 4. CONTROLS AND PROCEDURES
EVALUATION OF CONTROLS AND PROCEDURES
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, as defined in
Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as
amended, or the Exchange Act, as of September 30, 2006, to ensure that
information required to be disclosed by us in the reports filed or submitted by
us under 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. Based on
that evaluation, our Chief Executive Officer and Chief Financial Officer have
concluded that as of September 30, 2006, our internal controls and procedures,
and as a consequence, our disclosure controls and procedures were not effective
at the reasonable assurance level.
The ineffectiveness of our disclosure controls and procedures arises
principally from the material weaknesses in internal control identified in
conjunction with the preparation of our Annual Report on Form 10-K for the
fiscal year ended December 31, 2005. Additional internal control processes and
controls have been implemented since the identification of these material
weaknesses; however, given that some of the weaknesses are with respect to
processes that are conducted annually or periodically, it is not possible to
adequately test these controls on an interim basis to ensure that the new
controls are effective. Accordingly we have not relied on these controls, but
have performed additional analysis and other post-closing procedures to ensure
that our consolidated financial statements were prepared in accordance with
generally accepted accounting principles. Accordingly, we believe that the
consolidated financial statements included in this report fairly present, in all
material respects, our financial condition, results of operations and cash flows
for the periods presented.
A brief summary of the material weaknesses identified during the
preparation of our Annual Report on Form 10-K for the fiscal year ended December
31, 2005 is described below. The additional analysis and remediation steps we
have implemented in our disclosure controls and procedures also are summarized
below.
MATERIAL WEAKNESSES
A material weakness is a control deficiency (within the meaning of the
Public Company Accounting Oversight Board (PCAOB) Auditing Standard No. 2) or
combination of control deficiencies that result in more than a remote likelihood
that a material misstatement of the annual or interim financial statements will
not be prevented or detected. Management previously identified the following
deficiencies that represented material weaknesses in internal control over
financial reporting which have caused
35
management to conclude that our disclosure controls and procedures were not
effective at the reasonable assurance level:
In conjunction with preparing our Annual Report on Form 10-K for the
fiscal year ended December 31, 2005, management reviewed our revenue recognition
practices as they relate to the recognition of revenues on certain sale and
inventory storage transactions. As a result of this review, management concluded
that our controls over the identification and monitoring of assumptions and
factors affecting the recording of revenue were not in accordance with generally
accepted accounting principles and that our revenue for the quarters ended June
30, 2005 and September 30, 2005 had been misstated. Based upon this conclusion,
management with concurrence of our Audit Committee restated our financial
statements as of and for those quarters to reflect the corrections in the
application of our revenue recognition policies. We believe the control weakness
identified in 2005 has been corrected and did not result in a material
misstatement of our consolidated financial statements for the current interim
period or the first nine months of 2006.
In fiscal year 2005 we previously reported the failure to maintain
sufficient documentation supporting inventory costs necessary to effectively
analyze our inventory for lower-of-cost or market reserves. We believe this
control weakness has been corrected and did not result in a material
misstatement of our consolidated financial statements.
In fiscal year 2005 we failed to maintain sufficient documentation
supporting our perpetual inventory counts and our year end physical inventories
were not effectively controlled, requiring a recount of our inventory balances
at year end. We believe we have implemented appropriate procedures to ensure
this weakness is remedied; however as of September 30, 2006 we have not tested
these procedures. This control deficiency did not result in a material
misstatement of our consolidated financial statements.
To address these material weaknesses, management performed additional
analyses and other procedures to ensure that the financial statements included
herein fairly present, in all material respects, our financial position, results
of operations and cash flows for the periods presented.
REMEDIATION OF MATERIAL WEAKNESSES
To remediate the material weaknesses in our disclosure controls and
procedures identified above, we have done the following which correspond to the
material weaknesses identified above:
We have revised our review procedures over the application of our
revenue recognition practices, particularly as they relate to inventory storage
transactions. We have instituted additional control and disclosure procedures to
effectively and timely identify such transactions including a review of all
major sale transactions by our disclosure committee.
We have implemented additional documentation control procedures over
the assumptions and factors affecting our inventory costs and reserves to ensure
that inventory balances are appropriately supported and reduced to their net
realizable values on a timely basis. These controls include the segregation and
review of selected inventory adjustment transactions and management analysis of
inventory cost and reserve changes during the reporting period.
We have modified our physical inventory process procedures and
instructions to ensure that the appropriate documentation regarding physical
inventories is maintained and controlled, and that the physical counting of
inventories is performed at regular intervals.
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CHANGES IN INTERNAL CONTROLS OVER FINANCIAL REPORTING
There were no significant changes in our internal controls over
financial reporting that occurred during the nine months ended September 30,
2006 that have materially affected, or are reasonably likely to materially
affect, our internal control over financial reporting, other than the changes we
implemented as discussed above to address the material weaknesses.
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PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
On October 12, 2005, a shareholder class action complaint-- Huberman vs
Tag-It Pacific, Inc., et al., Case No. CV05-7352 R(Ex)--was filed against the
Company and certain of the Company's 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 the Company's 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 the
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.
Although the Company believes that it and the other defendants have meritorious
defenses to the class action complaint and intend to contest the lawsuit
vigorously, if there is an adverse resolution to the lawsuit the results could
have a material adverse effect on the Company's financial position and results
of operations. At this early stage of the litigation, the Company is not able to
reasonably predict the outcome of this action or estimate potential losses, if
any, related to the lawsuit.
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 the Company's
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 the Company 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. The Company 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, the Company amended its 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 the Company.
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 the Company infringed its United States Patent Nos. 5,987,721 and
6,566,285. The Company filed a reply denying the substantive allegations of the
amended counterclaims. At the Company's request, the Court bifurcated the breach
of contract issues for trial. The parties have filed summary judgment motions
which may dispose of some of the issues in this case prior to trial. On June 5,
2006 the Court denied one of the Company's motions for summary judgment, holding
that the issue of whether U.S. Patent No. 6,566,285 relating to curved
waistbands, was licensed to the Company presented a disputed question of
material fact which could not be resolved without a trial. On August 17, 2006
the Court denied the Company's motion for partial summary judgment holding that
summary adjudication that the Company did not breach its 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 the Company breached its agreement with Pro-
38
Fit and, again, a trial is required to determine issues concerning the Company's
activities in Columbia and whether other actions by Pro-Fit constituted an
unwillingness or inability to fill orders. Mediation to attempt to resolve this
case is scheduled to occur on December 11, 2006. No trial date is currently set
for trial of any issues. As the Company derives a significant amount of revenue
from the sale of products incorporating the stretch waistband technology, the
Company's 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 the Company. Additionally, the Company has incurred
significant legal fees in this litigation, and unless the case is settled will
continue to incur additional legal fees in increasing amounts as the case
accelerates to trial.
We currently have pending a number of other claims, suits and
complaints that arise in the ordinary course of its 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 affect on our consolidated financial condition if adversely
determined against us.
ITEM 1A. RISK FACTORS
A restated description of the risk factors associated with the Company
is included under "Cautionary Statements and Risk Factors" in Management's
Discussion and Analysis of Financial Condition and Results of Operations,"
contained in Item 2 of Part I of this report. This description includes any
material changes to and supersedes the description of the risk factors
associated with the Company previously disclosed in the Company's 2005 Annual
Report on Form 10-K and is incorporated herein by reference.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
For information regarding our Annual Meeting of Stockholders, held on
July 31, 2006, see Item 8.01 of our Current Report on Form 8-K filed on August
4, 2006, which is incorporated herein by reference.
ITEM 6. EXHIBITS
3.1 Certificate of Incorporation of Registrant. Incorporated by
reference to Exhibit 3.1 to Form SB-2 filed on October 21,
1997, and the amendments thereto.
3.1.1 Certificate of Designation of Rights, Preferences and
Privileges of Series A Preferred Stock. Incorporated by
reference to Exhibit A to the Rights Agreement filed as
Exhibit 4.1 to Current Report on Form 8-K filed on November 4,
1998.
3.1.2 Certificate of Amendment of Certificate of Incorporation of
Registrant. Incorporated by reference to Exhibit 3.4 to Annual
Report on Form 10-KSB, filed on March 28, 2000.
3.1.3 Certificate of Amendment of Certificate of Incorporation of
Registrant. Incorporated by reference to Exhibit 3.1.3 to
Current Report on Form 8-K filed on August 4, 2006.
10.7 Amended and Restated 1997 Stock Incentive Plan. *
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.
* Management contract or compensatory plan or arrangement.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Dated: November 13, 2006 TAG-IT PACIFIC, INC.
/s/ Lonnie D. Schnell
--------------------------------
By: Lonnie D. Schnell
Its: Chief Financial Officer
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