10-Q 1 e400893_10q-donnkenny.txt QUARTERLY REPORT SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2004 ------------------ OR |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _________ to __________ Commission file number 0-21940 ------- Donnkenny, Inc. --------------- (Exact name of registrant as specified in its charter) Delaware 51-0228891 -------- ---------- (State or jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 1411 Broadway, New York, NY 10018 --------------------------------- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code (212) 790-3900 -------------- NOT APPLICABLE -------------- (Former name, former address and former fiscal year, if changed since last report.) 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), Yes |X| No |_| and (2) has been the subject to such filing requirements for the past 90 days. Yes |X| No |_|. Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act) Yes |_| No |X|. Indicate the number of shares outstanding of each of the issuer's classes of Common Stock, as of the latest practicable date. Common Stock $0.01 par value 4,367,417 ---------------------------- ---------------------------------- (Class) (Outstanding at November 11, 2004) DONNKENNY, INC AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS (FORM 10-Q)
PART I - FINANCIAL INFORMATION Page ---- Item 1. Consolidated financial statements: Balance sheets as of September 30, 2004 (unaudited) and December 31, 2003..............................................................1 Statements of operations for the three and nine months ended September 30, 2004 and 2003 (unaudited)............................................2 Statements of cash flows for the nine months ended September 30, 2004 and 2003 (unaudited)............................................3 Notes to Consolidated Financial Statements (unaudited)...........................4-9 Item 2. Management's Discussion and Analysis of Financial Condition and Results Of Operations..................................................................10-16 Item 3. Quantitative and Qualitative Disclosures about Market Risk........................17 Item 4. Controls and Procedures...........................................................18 PART II - OTHER INFORMATION Item 1. Legal Proceedings.................................................................19 Item 6. Exhibits and Reports on Form 8-K..................................................19 Signatures.....................................................................20 Certifications..............................................................21-24
DONNKENNY, INC. AND SUBSIDIARIES Consolidated Balance Sheets (in thousands, except per share data) September 30, December 31, 2004 2003 ------------- ------------ ASSETS (Unaudited) CURRENT ASSETS Cash ............................................. $ 375 $ 64 Accounts receivable, net of allowance for doubtful accounts of $5 and $933, in 2004 and 2003 respectively ..................................... 293 1,287 Due from factor, net ............................. 17,239 20,730 Inventories, net ................................. 19,490 20,128 Prepaid expenses and other current assets ........ 1,735 1,256 Assets held for sale ............................. 240 270 -------- -------- Total current assets ............................. 39,372 43,735 PROPERTY, PLANT AND EQUIPMENT, NET ................. 3,667 3,631 OTHER ASSETS ....................................... 336 366 GOODWILL ........................................... 1,641 1,641 OTHER INTANGIBLE ASSETS ............................ 654 1,332 -------- -------- TOTAL .............................................. $ 45,670 $ 50,705 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIENCY) CURRENT LIABILITIES: Current portion of long-term debt ................ $ 40,121 $ 353 Accounts payable ................................. 8,369 7,713 Accrued expenses and other current liabilities ... 1,356 1,908 -------- -------- Total current liabilities ...................... 49,846 9,974 LONG-TERM DEBT ..................................... 408 35,707 COMMITMENTS AND CONTINGENCIES STOCKHOLDERS' EQUITY (DEFICIENCY): Preferred stock $.01 par value; authorized 500 shares, issued none .............................. -- -- Common stock, $.01 par value; authorized 10,000 shares, issued and outstanding 4,367 shares in 2004 and 2003 ................................. 44 44 Additional paid-in capital ....................... 50,449 50,449 Accumulated deficit .............................. (55,077) (45,469) -------- -------- Total Stockholders' (Deficiency) Equity .......... (4,584) 5,024 -------- -------- TOTAL .............................................. $ 45,670 $ 50,705 ======== ======== See accompanying notes to consolidated financial statements. -1- DONNKENNY, INC. AND SUBSIDIARIES Consolidated Statements of Operations (in thousands, except share and per share data) (unaudited)
Three Months Ended Nine Months Ended -------------------------------------- -------------------------------------- September 30, 2004 September 30, 2003 September 30, 2004 September 30, 2003 ------------------ ------------------ ------------------ ------------------ NET SALES .......................................... $ 22,561 $ 23,436 $ 61,410 $ 60,235 COST OF SALES ...................................... 20,867 18,276 52,806 45,472 ----------- ----------- ----------- ----------- Gross profit .................................. 1,694 5,160 8,604 14,763 OPERATING EXPENSES: Selling, general and administrative expenses ... 5,648 5,081 16,112 15,542 Amortization and impairment of intangibles .... 494 32 678 32 ----------- ----------- ----------- ----------- Operating (loss) income .................... (4,448) 47 (8,186) (811) INTEREST EXPENSE ................................... 559 406 1,553 1,018 ----------- ----------- ----------- ----------- Loss before provision for income taxes (benefit) (5,007) (359) (9,739) (1,829) INCOME TAXES PROVISION (BENEFIT) ................... 18 27 (131) 58 ----------- ----------- ----------- ----------- NET LOSS ..................................... $ (5,025) $ (386) $ (9,608) $ (1,887) =========== =========== =========== =========== Basic loss per common share: ....................... $ (1.15) $ (0.09) $ (2.20) $ (0.43) =========== =========== =========== =========== Diluted loss per common share: ..................... $ (1.15) $ (0.09) $ (2.20) $ (0.43) =========== =========== =========== =========== Shares used in the calculation of loss per share: Basic .......................................... 4,367,417 4,367,417 4,367,417 4,367,417 =========== =========== =========== =========== Diluted ........................................ 4,367,417 4,367,417 4,367,417 4,367,417 =========== =========== =========== ===========
See accompanying notes to consolidated financial statements. -2- DONNKENNY, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows (in thousands) (unaudited)
Nine Months Ended ---------------------------- September 30, September 30, 2004 2003 ------------- ------------- CASH FLOWS FROM OPERATING ACTIVITIES: Net loss ....................................................... $ (9,608) $ (1,887) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization of property, plant and equipment 797 1,051 Loss on disposal of fixed assets ............................. -- 16 Amortization and impairment of intangibles ................... 678 32 Bad debt (recovery) expense .................................. (928) 5 Changes in assets and liabilities: Decrease (increase) in accounts receivable ................... 1,922 (164) Decrease in amount due from factor ........................... 3,491 2,885 Decrease in recoverable income taxes ......................... -- 203 Decrease (increase) in inventories ........................... 638 (1,773) Increase in prepaid expenses and other current assets ........ (479) (640) Decrease (increase) in other non-current assets .............. 30 (135) Increase (decrease) in accounts payable ...................... 656 (3,594) Decrease in accrued expenses and other current liabilities ... (552) (238) -------- -------- Net cash used in operating activities ...................... (3,355) (4,239) -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property, plant and equipment .................... (803) (189) Proceeds from sale of property, plant and equipment .......... -- 80 License acquisition cost ..................................... -- (512) -------- -------- Net cash used in investing activities ...................... (803) (621) -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Repayment of long-term debt .................................. (395) (253) Borrowings under revolving credit line ....................... 71,352 68,323 Repayments under revolving credit line ....................... (66,488) (63,214) -------- -------- Net cash provided by financing activities .................. 4,469 4,856 -------- -------- NET INCREASE (DECREASE) IN CASH ................................ 311 (4) CASH, AT BEGINNING OF PERIOD ................................... 64 66 -------- -------- CASH, AT END OF PERIOD ......................................... $ 375 $ 62 ======== ======== SUPPLEMENTAL DISCLOSURES Income taxes paid .............................................. $ 6 $ 16 ======== ======== Interest paid .................................................. $ 1,551 $ 999 ======== ========
See accompanying notes to consolidated financial statements. -3- DONNKENNY, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Unaudited) NOTE 1 - BASIS OF PRESENTATION The accompanying unaudited consolidated financial statements have been prepared by the Company pursuant to the Rules of the Securities and Exchange Commission ("SEC") and, in the opinion of management, include all adjustments (consisting of normal recurring accruals) necessary for the fair presentation of financial position, results of operations and cash flows. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such SEC rules. The Company believes the disclosures made are adequate to make such financial statements not misleading. The results for the interim periods presented are not necessarily indicative of the results to be expected for the full year. These financial statements should be read in conjunction with the Company's Report on Form 10-K for the year ended December 31, 2003. Balance sheet data as of December 31, 2003 have been derived from audited financial statements of the Company. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. At September 30, 2004 the Company has working capital and stockholders' deficiencies of $10.5 million and $4.6 million, respectively. For the nine months ended September 30, 2004 the Company had a net loss of $9.6 million. The Company's ability to continue as a going concern is dependent upon ongoing financial support from its Lender. Without the continued support of its Lender to fund its operations for the balance of the year and the future, the Company would be without adequate working capital and funding, which would have a material adverse effect on the Company's ability to operate. The Company is preparing its 2005 fiscal plan to present to its Lender and management will continue to reorganize the business and streamline operations, as well as monitor overhead and administrative expenses (See Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operation). The consolidated financial statements do not include any adjustments related to the recoverability and classification of recorded asset amounts or the amounts or classification of liabilities that might be necessary should the Company be unable to continue in existence. NOTE 2 - STOCK BASED COMPENSATION The Company accounts for its stock-based employee compensation plans under the recognition and measurement principles of Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. No stock-based employee compensation cost is reflected in net income as all options granted under those plans had exercise prices equal to or greater than the market value of the Common Stock on the dates of grant. The following table details the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of Statement of Financial Accounting Statement ("SFAS") No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, to stock-based employee compensation. -4-
Three Months Ended Nine Months Ended ------------------ ----------------- September 30, September 30, September 30, September 30, 2004 2003 2004 2003 ------------- ------------- ------------- ------------- (in thousands except per share data) Net loss, as reported $ (5,025) $ (386) $ (9,608) $ (1,887) Deduct: Total stock-based employee Compensation expense determined under fair value based method 105 34 108 78 --------- --------- --------- --------- Pro-forma net loss $ (5,130) $ (420) $ (9,716) $ (1,965) ========= ========= ========= ========= Loss per share: Basic - as reported $ (1.15) $ (0.09) $ (2.20) $ (0.43) ========= ========= ========= ========= Basic - pro-forma $ (1.17) $ (0.10) $ (2.22) $ (0.45) ========= ========= ========= ========= Diluted - as reported $ (1.15) $ (0.09) $ (2.20) $ (0.43) ========= ========= ========= ========= Diluted - pro-forma $ (1.17) $ (0.10) $ (2.22) $ (0.45) ========= ========= ========= =========
Information regarding the Company's stock option plan is summarized below:
September 30, 2004 September 30, 2003 ------------------------- --------------------------- Weighted- Weighted- Average Average Options Exercise Price Options Exercise Price ------- -------------- ------- -------------- Outstanding at beginning of the period ........................ 389,687 $2.21 234,552 $6.95 Granted ....................... -- -- 11,250 0.84 Exercised ..................... -- -- -- -- Cancelled ..................... -- -- (85,776) 9.50 -------- ----- -------- ----- Outstanding at end of period .. 389,687 $2.21 160,026 $5.16 ======== ===== ======== ===== Exercisable at end of period .. 135,525 $4.74 131,026 $6.12 ======== ===== ======== ===== Available for grant at period end ........................... 85,488 315,149 ======== ========
The options outstanding at September 30, 2004 range in exercise price as follows:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE ------------------------------------------------------------------------------------------------------ Weighted-Average Range of Exercise Outstanding as of Remaining Contractual Weighted-Average Exercisable as of Weighted-Average Prices 09/30/2004 Life Exercise Price 09/30/2004 Exercise Price ------ ---------- ---- -------------- ---------- -------------- $0.00 - $7.23 368,412 8.5 $ 1.09 114,250 $ 1.49 $7.23 - $14.45 4,375 3.8 $11.29 4,375 $11.29 $14.45 - $28.90 13,125 2.8 $16.61 13,125 $16.61 $28.90 - $43.35 1,750 0.6 $33.25 1,750 $33.25 $43.35 - $72.25 2,025 1.6 $72.25 2,025 $72.25 ------- --- ------ ------- ------ 389,687 8.2 $ 2.21 135,525 $ 4.74 ======= === ====== ======= ======
-5- NOTE 3 - LOSS PER SHARE The basic net loss per share is computed by dividing net loss attributable to common stockholders by the weighted average number of common shares outstanding during the period. Diluted net income per share, if applicable, would be computed by dividing the net income attributable to common stockholders by the weighted average number of common and common equivalent shares outstanding during the period. For the three and nine months ended September 30, 2004, the effect of options to purchase 31,770 and 134,610 shares, respectively, of the Company's common stock at less than market value was not considered for the diluted earnings per share calculation as their effect would be antidilutive. For the three and nine months ended September 30, 2003, the effect of the options to purchase 11,065 and 26,208 shares, respectively, of the Company's common stock at less than market value was not considered for the diluted earnings per share calculation as their effect would be antidilutive. NOTE 4 - INVENTORIES Inventories consist of the following: September 30, December 31, 2004 2003 ---- ---- (In thousands) Raw materials ...................... $ 5,240 $ 3,317 Work-in-process .................... 1,086 2,189 Finished goods ..................... 14,147 15,873 Reserves ........................... (983) (1,251) -------- -------- $ 19,490 $ 20,128 ======== ======== Inventories at September 30, 2003 were $17.7 million consisting primarily of finished goods. NOTE 5 - DEBT The Company's liquidity requirements arise from the funding of working capital needs, primarily inventory and accounts receivable, and interest and principal payments related to certain indebtedness and capital expenditures. The Company's borrowing requirements for working capital fluctuate throughout the year. On June 29, 1999, the Company and its operating subsidiaries signed a Credit Agreement (the "Credit Agreement") with CIT Group/Commercial Services (the "Lender"). The Credit Agreement initially provided the Company with a $75 million facility comprised of a $72 million revolver with sub limits up to $52 million for direct borrowings, $35 million for letters of credit, certain overadvances and a $3 million term loan which was paid in full as of June 30, 2002. The Credit Agreement provides for advances of (i) up to 90% of eligible accounts receivable plus (ii) up to 60% of eligible inventory plus (iii) up to 60% of the undrawn amount of all outstanding letters of credit plus (iv) allowable overadvances. -6- Collateral for the Credit Agreement includes a first priority lien on all accounts receivable, machinery, equipment, trademarks, intangibles and inventory, a first mortgage on all real property and a pledge of the Company's stock interest in its operating subsidiaries, Donnkenny Apparel, Inc. and Beldoch Industries Corporation. The Credit Agreement contains numerous financial and operational covenants, including limitations on additional indebtedness, liens, dividends, stock repurchases and capital expenditures. In addition, the Company is required to maintain specified levels of tangible net worth and comply with a requirement for minimum earnings before depreciation, amortization, interest and taxes (EBITDA) and a minimum interest coverage ratio. Effective June 30, 2003, the Company through an Amendment and Waiver Agreement dated August 11, 2003, extended the Credit Agreement to June 30, 2007. This Amendment provided the Company with a $65 million facility; the sub-limits remained the same as in the original Credit Agreement. The interest rate on the revolving credit borrowings is the current prime rate plus one and one-quarter percent (6.00% at September 30, 2004). As previously reported, on December 31, 2003 and June 30, 2004, the Company was not in compliance with the financial covenants contained in the Credit Agreement. In each instance, the Lender has waived these events of non compliance. As of September 30, 2004, the Company was not in compliance with the quarterly financial covenants. Through an Amendment and Waiver Agreement dated October 1, 2004, the Lender agreed to waive the Company's non-compliance with its September 30, 2004 quarterly financial covenants. This Amendment and Waiver Agreement amended the financial covenants to provide that these covenants will be evaluated by the Lender monthly rather than quarterly beginning October 31, 2004. For the month ended October 31, 2004, the Company continued not to be in compliance with the Credit Agreement financial covenants. The Lender has waived this non-compliance. The Company does not expect to be in compliance with its financial covenants for the balance of 2004. Accordingly, the Company has recorded its obligation to the Lender as a current liability at September 30, 2004. The Company also has a factoring agreement with CIT Group/Commercial Services. The factoring agreement provides for a factoring commission equal to .35% of gross sales, plus certain customary charges. The factoring agreement renews annually in June each year unless either party to the agreement gives appropriate notice of non-renewal. In connection with the acquisition of Robyn Meredith (see Note 8 to the Consolidated Financial Statements), a note payable of $1.1 million was issued. This note is payable in monthly installments of $33,333 including imputed interest at an interest rate of 5.25%. The final payment will be due October 2006. At September 30, 2004 and December 31, 2003, the Company was contingently liable for outstanding letters of credit issued amounting to $2.8 million and $6.6 million, respectively. -7- NOTE 6 - GOODWILL AND INTANGIBLE ASSETS Goodwill and Other Intangible Assets consisted of the following at September 30, 2004 and December 31, 2003: (In Thousands) Sept. 30, Dec. 31, 2004 2003 ---- ---- Goodwill $ 1,641 $ 1,641 Covenant not to Compete 50 50 License agreements 821 1,333 Accumulated amortization (217) (51) ------- ------- $ 2,295 $ 2,973 ======= ======= The goodwill which represented the excess purchase price over the fair value of the net assets acquired and the covenant not to compete are attributable to the acquisition of Robyn Meredith (see Note 8 to the Consolidated Financial Statements). The covenant not to compete is being amortized over the contract life of four years. License Agreements of $0.8 million are attributable to the Pierre Cardin license acquired which was classified as an intangible asset with an indefinite life on the Company's December 31, 2003 Consolidated Balance Sheet because the Company held the license in perpetuity. On February 12, 2004, the Company signed a new Pierre Cardin license to provide for a term of three years in exchange for reduced future minimum payments. Beginning in 2004, this license is being amortized over three years. During the third quarter of 2004, the Company wrote off the remaining intangible asset costs of $0.4 million attributable to the acquisition of certain Bill Blass(R) Licenses due to its decision to discontinue the Coat division. NOTE 7 - CONTINGENCIES The Company is a party to legal proceedings arising in the ordinary course of its business. Management believes that the ultimate resolution of these proceedings will not, in the aggregate, have a material adverse effect on the financial condition, results of operations, liquidity or business of the Company. NOTE 8 - ROBYN MEREDITH ACQUISITION On October 1, 2003, the Company acquired certain assets of Robyn Meredith Inc.("RMI"). The assets that were acquired were the assets of RMI devoted to its women's sportswear business and consisted principally of inventory of finished goods, raw materials and trim and certain tradenames including the name "Robyn Meredith". The Company intends to continue to use these assets for the manufacture and distribution of women's sportswear. The purchase price paid to RMI by the Company was $4.6 million (excluding any future purchase price adjustments based on subsequent performance thresholds) which was determined by valuing the inventory and through negotiations between the parties as to the balance of the purchase price. -8- Pro Forma Financial Information: The pro forma financial information presented below gives effect to the Robyn Meredith acquisition as if it had occurred as of the beginning of the Company's fiscal year 2003. Actual results for 2004 have been included for comparative purposes. The information presented below is for illustrative purposes only and is not indicative of results that would have been achieved or results which may be achieved in the future.
Three and Nine Month Financial Information (in thousands except per share data) (unaudited) Three Months Ended Nine Months Ended ------------------ ----------------- Actual Pro-Forma Actual Pro-Forma September 30, September 30, September 30, September 30, 2004 2003 2004 2003 ---- ---- ---- ---- Net sales $ 22,561 $ 30,580 $ 61,410 $ 82,485 Net loss $ (5,025) $ (1,176) $ (9,608) $ (2,659) ========== ========== ========== =========== Basic net loss per common share $ (1.15) $ (0.27) $ (2.20) $ (0.61) ========== ========== ========== =========== Diluted net loss per common share $ (1.15) $ (0.27) $ (2.20) $ (0.61) ========== ========== ========== =========== Shares used in the calculation of loss per share: Basic 4,367,417 4,367,417 4,367,417 4,367,417 ========== ========== ========== =========== Diluted 4,367,417 4,367,417 4,367,417 4,367,417 ========== ========== ========== ===========
-9- DONNKENNY, INC. AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Introductory Overview The Company is engaged in the women's apparel business. The Company's business consists of importing and marketing women's apparel to its customers who in turn sell the Company's products to the ultimate retail consumers. As is explained in more detail below, the Company's cash and liquidity requirements for the daily operation of its business are provided through a Credit Agreement ("the Credit Agreement") with CIT Group/Commercial Services ("the Lender"), consisting of a revolving credit facility and letters of credit. As previously reported, as of September 30, 2004 and again as at October 29, 2004, the Company was not in compliance with its financial covenants contained in the Credit Agreement. The Lender has waived the Company's non-compliance through Amendment and Waiver Agreements which, in addition to waiving non-compliance with covenants, provide that these covenants will be evaluated by the Lender monthly rather than quarterly which had been the practice prior to October 1, 2004. The Company is wholly dependant upon its Lender to approve the Company's request for continued credit for the operation of its business. Absent continued support by its Lender, the Company will be left with inadequate working capital and funding, which would have a material adverse effect on the Company's ability to operate. The business of the Company is highly competitive. The Company's products consist of its in-house brand names ("In-House Branded Products") as well as those produced under a licensing arrangement for the use of Trademarks ("Licensed Products"). In addition to selling its In-House Branded and Licensed Products to its customers, the Company develops specific products ("Private Label Products") for some of its larger accounts, such as mass merchandisers and national chains. The Company is currently in the process of discontinuing its In-House Branded business. The women's apparel business is characterized by a large number of small companies selling branded and unbranded merchandise, and by several large companies that have developed widespread consumer recognition of the Trademarks and brand names associated with merchandise sold by these companies. In addition, retailers to whom the Company sells its products have sought to expand the development and marketing of their own brands and to obtain women's apparel products directly from the same sources from which the Company obtains its products. The Company's women's apparel business provides product for department stores, specialty stores, regional chains, discounters and warehouse clubs. Most of the Company's products are marketed for four selling seasons a year. To be competitive, the Company is required to create a substantially new line of products for each selling season. In addition, the Company makes presentations throughout the year to Private Label accounts, depending upon the size and number or orders that the Company receives each time it presents its products to its customers. -10- In this climate, the Company must constantly change its product mix to sell to its customers. This requires the Company not only to design products which it anticipates will have commercial appeal, but also to develop, acquire and sometimes discontinue the use of Products. In 2003, the Company discontinued the marketing of products under the Rebecca Jones Label and commenced a long-term strategy of being a Private Label and Licensed Product business to expand its avenues of distribution. In furtherance of this decision, the Company is in the process of discontinuing its Victoria Jones and Casey & Max labels. The Company acquired the use of Z. Cavaricci(R), Nicole Miller(R) and Bill Blass(R) Trademarks for certain products. The Company intends to discontinue the use of the Z. Cavaricci(R) and Bill Blass(R) Trademarks. On October 1, 2003, the Company acquired its Robyn Meredith Division, which primarily sells Private Label Product. On April 14, 2004, the Company entered into a licensing agreement to manufacture sportswear under the Nicole Miller(R) label. The Company intends to begin shipments of sportswear under this Label with the Spring 2005 season. Sales under the Bill Blass(R) Trademarks and Robyn Meredith Division began in the second half of 2003. Sales under the Z. Cavaricci(R) Trademark began in the first quarter of 2004. Sales for products under the Nicole Miller(R) trademarks for suits will begin in 2005. In the three months ended September 30, 2004, the Company's net sales were $22.6 million of which 26% was Licensed Product, 27% was In-House Branded Product and the balance was Private Label Product. Net Sales for the third quarter of 2003 were $23.4 million, of which 27% was Licensed Product, 50% was In-House Branded Product and the balance was Private Label Product. The $0.8 million net sales decrease was attributable to a $0.4 million decrease in Licensed Products, due to the loss of a major customer and an inability to substitute the business with other customers, and a decrease in the In-House Branded Products of $5.8, partially offset by a $5.4 million increase in the sales of the Company's Private Label Products due to the acquisition of the Robyn Meredith business in 2003 and an increased demand for the Company's Private Label Products. Sales of coats by the Company's Coat division for the nine months ended September 30, 2004, amounted to $2.1 million. These sales did not contribute to the Company's gross margin. The Company has decided to discontinue the operations of this division. In 2004, the Company's prior decision to become a Private Label and Licensed product maker of Ladies Sportswear, coupled with its decision to discontinue its In-House Brands, has caused a decrease in sales and a deterioration of its gross margin in 2004. The Company does not expect that this transformation will be complete until 2005, with the full effect to be reflected in the second half of 2005. The Company expects that the balance of 2004 may continue to be negatively effected by this strategic transformation. Comparison of Nine Months Ended September 30, 2004 and 2003 Net sales increased by $1.2 million, or 2.0% from $60.2 million in the first nine months of 2003 to $61.4 million in the first nine months of 2004. The increase was primarily due to the Company's Private Label business and the result of the acquisition of the Robyn Meredith business in 2003, partially offset by decreases in the Company's other businesses due to the loss of a major customer and the strategy to discontinue In-House Brands. In the nine months ended September 30, 2004, only one customer accounted for more than 10% of the Company's net sales, accounting for 30% of such sales. In the nine months ended September 30, 2003, two customers accounted for more than 10% of the Company's net sales. One accounted for 33% of such sales, the other for 17% of such sales. -11- Gross profit for the first nine months of 2004 was $8.6 million, or 14.0% of net sales, compared to $14.8 million, or 24.5% of net sales, during the first nine months of 2003. The decrease in gross profit was due to the loss of a major customer, the strategy to discontinue In-House Brands and the sell off of slow moving inventory, which resulted in lower margins. Selling, general and administrative expenses for the first nine months of 2004 and 2003 were $16.1 million and $15.5 million, respectively. Selling, general and administrative expenses in 2004 are net of a bad debt recovery in the second quarter of $0.8 million. In the first nine months the Company incurred expenses in connection with its repositioning strategy, the results of which will not be seen until 2005. During the third quarter of 2004, the Company wrote off the remaining intangible asset costs of $0.4 million attributable to the acquisition of certain Bill Blass(R) Licenses due to its decision to discontinue the Coat division. Net interest expense increased from $1.0 million during the first nine months of 2003 to $1.6 million during the first nine months of 2004. The increase was attributable to increases in the prime rate and higher revolving credit borrowings under the credit agreement. In 2003, the Company had lower revolving credit borrowings and received interest from an income tax refund which decreased interest expense for the first quarter. In the first quarter of 2004, the Company reversed prior years' tax liabilities of approximately $0.2 million. Comparison of Quarters Ended September 30, 2004 and 2003 Net sales decreased by $0.8 million, or 3.4% from $23.4 million in the third quarter of 2003 to $22.6 million in the second quarter of 2004. The decrease was primarily due to the loss of a major customer and an inability to substitute the business with other customers, the strategy to discontinue In-House Brands and the failure of the Coat Division to produce expected sales volumes partially offset by increases in the Company's Private Label business as a result of the acquisition of the Robyn Meredith business. Gross profit for the third quarter of 2004 was $1.7 million, or 7.5% of net sales, compared to $5.2 million, or 22.2% of net sales, during the third quarter of 2003. The decrease in gross profit was due to the loss of a major customer, the strategy to discontinue In-House Brands and the sell off of slow moving inventory, which resulted in lower margins. Selling, general and administrative expenses for the third quarter of 2004 were $5.6 million compared to $5.1 million in the third quarter of 2003. In the third quarter of 2004, the Company incurred expenses in connection with its repositioning strategy, the results of which will not be seen until 2005. During the third quarter of 2004, the Company wrote off the remaining intangible asset costs of $0.4 million attributable to the acquisition of certain Bill Blass(R) Licenses due to its decision to discontinue the Coat division. Net interest expense increased from $0.4 million during the third quarter of 2003 to $0.6 million during the third quarter of 2004. The increase was attributable to increases in the prime rate and higher revolving credit borrowings under the credit agreement. -12- Liquidity and Capital Resources The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. At September 30, 2004 the Company has working capital and stockholders' deficiencies of $10.5 million and $4.6 million, respectively. For the nine months ended September 30, 2004 the Company had a net loss of $9.6 million. The Company's ability to continue as a going concern is dependent upon ongoing financial support from its Lender. Without the continued support of its Lender to fund its operations for the balance of the year and the future, the Company would be without adequate working capital and funding, which would have a material adverse effect on the Company's ability to operate. The Company is preparing its 2005 fiscal plan to present to its Lender and management will continue to reorganize the business and streamline operations, as well as monitor overhead and administrative expenses. The consolidated financial statements do not include any adjustments related to the recoverability and classification of recorded asset amounts or the amounts or classification of liabilities that might be necessary should the Company be unable to continue in existence. The Company's liquidity requirements arise from the funding of working capital needs, primarily inventory and accounts receivable, and interest and principal payments related to certain indebtedness and capital expenditures. The Company's borrowing requirements for working capital fluctuate throughout the year. On June 29, 1999, the Company and its operating subsidiaries signed a Credit Agreement (the "Credit Agreement") with CIT Group/Commercial Services (the "Lender"). The Credit Agreement initially provided the Company with a $75 million facility comprised of a $72 million revolver with sub limits up to $52 million for direct borrowings, $35 million for letters of credit, certain overadvances and a $3 million term loan which was paid in full as of June 30, 2002. The Credit Agreement provides for advances of (i) up to 90% of eligible accounts receivable plus (ii) up to 60% of eligible inventory plus (iii) up to 60% of the undrawn amount of all outstanding letters of credit plus (iv) allowable overadvances. Collateral for the Credit Agreement includes a first priority lien on all accounts receivable, machinery, equipment, trademarks, intangibles and inventory, a first mortgage on all real property and a pledge of the Company's stock interest in its operating subsidiaries, Donnkenny Apparel, Inc. and Beldoch Industries Corporation. The Credit Agreement contains numerous financial and operational covenants, including limitations on additional indebtedness, liens, dividends, stock repurchases and capital expenditures. In addition, the Company is required to maintain specified levels of tangible net worth and comply with a requirement for minimum earnings before depreciation, amortization, interest and taxes (EBITDA) and a minimum interest coverage ratio. Effective June 30, 2003, the Company through an Amendment and Waiver Agreement dated August 11, 2003, extended the Credit Agreement to June 30, 2007. This Amendment provided the Company with a $65 million facility; the sub-limits remained the same as in the original Credit Agreement. The interest rate on the revolving credit borrowings is the current prime rate plus one and one-quarter percent (6.00% at September 30, 2004). As previously reported, on December 31, 2003 and June 30, 2004, the Company was not in compliance with the financial covenants contained in the Credit Agreement. In each instance, the Lender has waived these events of non compliance. As of September 30, 2004, the Company was not in compliance with the quarterly financial covenants. Through an Amendment and Waiver Agreement dated October 1, 2004, the Lender agreed to waive the Company's non-compliance with its September 30, 2004 quarterly financial covenants. This Amendment and Waiver Agreement amended the financial covenants to provide that these covenants will be evaluated by the Lender monthly rather than quarterly beginning October 31, 2004. For the month ended October 31, 2004, the Company continued not to be in compliance with the Credit Agreement financial covenants. The Lender has waived this non-compliance. -13- The Company does not expect to be in compliance with its financial covenants for the balance of 2004. Accordingly, the Company has recorded its obligation to the Lender as a current liability at September 30, 2004. The Company also has a factoring agreement with CIT Group/Commercial Services. The factoring agreement provides for a factoring commission equal to .35% of gross sales, plus certain customary charges. The factoring agreement renews annually in June each year unless either party to the agreement gives appropriate notice of non-renewal. Other Matters In connection with the acquisition of the Company's Robyn Meredith Division (see Note 8 to the Consolidated Financial Statements), a note payable of $1.1 million was issued. This note is payable in monthly installments of $33,333 including imputed interest at an interest rate of 5.25%. The final payment will be due October 2006. At September 30, 2004 and December 31, 2003, the Company was contingently liable for outstanding letters of credit issued amounting to $2.8 million and $6.6 million, respectively. During the first nine months of 2004, cash used by operating activities was $3.4 million, principally as the result of the net loss and increases in prepaid expenses and other current assets and decreases in accrued expenses and other current liabilities partially offset by decreases in amount due from factor and accounts receivable. On a comparable basis, net inventories at September 30, 2004 were $0.6 million less than at December 31, 2003. During the first nine months of 2003, cash used in operating activities was $4.2 million, principally as the result of the net loss and decreases in accounts payable and increases in inventory and prepaid expenses and other current assets partially offset by decreases in due from factor. Cash used in investing activities during the first nine months of 2004 was $0.8 million, mainly for leasehold improvements at the Company's New York showroom. Cash used in investing activities during the first nine months of 2003 was $0.6 million, mainly for the purchase of fixed assets, principally computer equipment and related software and costs associated with the acquisition of a license. Cash provided by financing activities during the first nine months of 2004 was $4.5 million, which represents net borrowings under the revolver of $4.9 million and repayments of $0.4 million on a note payable. Cash provided by financing activities during the nine months of 2003 was $4.9 million, which represents net borrowings under the revolver of $5.1 million and repayments of $0.3 million on the term loan. Recently Issued Accounting Standards There were no recently issued accounting standards that the Company believes will have a material effect on its financial position, its results of operations or its cash flows. -14- Contractual Commitments and Contingent Liabilities The following table summarizes the Company's contractual commitments at September 30, 2004:
Contractual Obligations Payments due Less than 1-3 years 3-5 years More than (In Thousands) by period 1 year 5 years Total Long Term debt $40,529 $40,121 $ 408 -- -- Operating Leases $ 7,937 $ 2,972 $ 3,670 $ 1,295 -- Guaranteed Minimum Royalties $10,668 $ 2,890 $ 6,524 $ 1,116 $ 138 Letters of Credit $ 2,757 $ 2,757 -- -- -- ------- ------- ------- ------- ------- Total $61,891 $48,740 $10,602 $ 2,411 $ 138
The Company has not provided any financial guarantees as of September 30, 2004. Included in the above are those guaranteed minimum royalties associated with the Coat Division. The Company is discontinuing its Coat Division and the related licenses and does not expect that the guaranteed minimum royalties of approximately $1.9 million will have to be paid. Seasonality of Business and Fashion Risk The Company's principal products are organized into seasonal lines for resale at the retail level during the Spring, Summer, Fall and Holiday seasons. Typically, the Company's products are designed as much as one year in advance and manufactured approximately one season in advance of the related retail selling season. Accordingly, the success of the Company's products is often dependent on the ability to successfully anticipate the needs of retailers and the tastes of the ultimate consumer up to a year prior to the relevant selling season. Critical Accounting Policies and Estimates The Company's significant accounting policies are more fully described in Note 1 to the Annual Consolidated Financial Statements filed on Form 10-K (not presented herein). Certain of the Company's accounting policies require the application of significant judgment by management in selecting the appropriate assumptions for calculating financial estimates. By their nature, these judgments are subject to an inherent degree of uncertainty. These judgments are based on historical experience, observation of trends in the industry, information provided by customers and information available from other outside sources, as appropriate. Critical accounting policies include: Revenue Recognition - The Company recognizes sales upon shipment of products to customers as title and risk of loss pass upon shipment. Provisions for estimated uncollectible accounts, discounts and returns and allowances are provided when sales are recorded based upon historical experience and current trends. While such amounts have been within expectations and the provisions established, the Company cannot guarantee that it will continue to experience the same rates as in the past. -15- Accounts Receivable and Due from Factor - Accounts Receivable and due from factor as shown on the Consolidated Balance Sheets, are net of allowances and anticipated discounts. An allowance for doubtful accounts is determined through analysis of the aging of accounts receivable at the date of the financial statements, assessments of collectibility based on historic trends and an evaluation of the impact of economic conditions. The allowance for doubtful accounts is not significant since the Company sells a substantial portion of its trade receivables to a commercial factor, without recourse, up to maximum credit limits established by the factor for each individual account. Receivables sold in excess of these limitations are subject to recourse in the event of non-payment by the customer. An allowance for discounts is based on those discounts relating to open invoices where trade discounts have been extended to customers. Costs associated with potential returns of products as well as allowable customer markdowns and operational charge backs, net of expected recoveries, are included as a reduction to net sales and are part of the provision for allowances. These provisions result from seasonal negotiations as well as historic deduction trends, net expected recoveries and the evaluation of current market conditions. Principally, the Company's historical estimates of these costs have not differed materially from actual results. Inventories - Inventory is stated at the lower of cost or market, cost being determined on the first-in, first-out method. Reserves for slow moving and aged merchandise are provided based on historical experience and current product demand. The Company evaluates the adequacy of the reserves quarterly. While markdowns have been within expectations and the provisions established, the Company cannot guarantee that it will continue to experience the same level of markdowns as in the past. Valuation of Long-Lived Assets - The Company periodically reviews the carrying value of its long-lived assets for continued appropriateness. This review is based upon projections of anticipated future undiscounted cash flows. While the Company believes that its estimates of future cash flows are reasonable, different assumptions regarding such cash flows could materially affect evaluations. Income Taxes - The Company provides for income taxes only to the extent that it expects to pay taxes (primarily state franchise and local taxes). The Company's cumulative net operating loss (NOL) carryforward of $20.0 million for federal income taxes and $31.0 million for state income taxes, have resulted in estimated tax benefits of $8.2 million as of December 31, 2003 being recorded as a deferred tax asset. The Company has recorded a valuation allowance against the entire net deferred tax assets balance due to the Company's history of unprofitable operations. However, should the Company conclude that future profitability is reasonably assured, the value of the deferred tax asset would be increased by eliminating some or all of the valuation allowance. Subsequent revisions to the estimated value of the deferred tax asset could cause the Company's provision for income taxes to vary from period to period; payments would remain unaffected until the benefit of the NOL is utilized. Forward Looking Statements - This Form 10-Q (including but not limited to the sections hereof entitled "Business" and "Management's Discussion and Analysis") contains or incorporates by reference forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Where any such forward-looking statement includes a statement of the assumptions or bases underlying such forward-looking statement, the Company cautions that assumed facts or bases almost always vary from the actual results, and the differences between assumed facts or bases and actual results can be material, depending on the circumstances. Where, in any forward-looking statement, the Company or its management expresses an expectation or belief as to future results, there can be no assurance that the statement of the expectation or belief will result, or be achieved or accomplished. The words "believe", "expect", "estimate", "project", "seek", "anticipate" and similar expressions may identify forward-looking statements. -16- Item 3. Quantitative and Qualitative Disclosures about Market Risk Interest Rate Risk - The Company is subject to market risk from exposure to changes in interest rates based primarily on its financing activities. The market risk inherent in the financial instruments represents the potential loss in earnings or cash flows arising from adverse changes in interest rates. These debt obligations with interest rates tied to the prime rate are described in "Liquidity and Capital Resources", as well as Note 5 of the Notes to the Consolidated Financial Statements. The Company manages these exposures through regular operating and financing activities. The Company has not entered into any derivative financial instruments for hedging or other purposes. The following quantitative disclosures are based on the prevailing prime rate. These quantitative disclosures do not represent the maximum possible loss or any expected loss that may occur, since actual results may differ from these estimates. At September 30, 2004 and December 31, 2003, the carrying amounts of the Company's revolving credit borrowings and term loans approximated fair value. Effective January 1, 2003, the Company's revolving credit borrowings under its Credit Agreement bear interest at the prime rate plus one and one-quarter percent (6.0% at September 30, 2004). As of September 30, 2004, a hypothetical immediate 10% adverse change in prime interest rates (from 4.75% to 5.23%) relating to the Company's revolving credit borrowings would have a $0.2 million unfavorable impact on the Company's earnings and cash flows over a one-year period. -17- Item 4. Controls and Procedures The Company's management with the participation of Daniel H. Levy, the Chief Executive Officer and Maureen d Schimmenti, the Chief Financial Officer of the Company has evaluated the effectiveness of the Company's disclosure controls and procedures as of the end of the period covered by this report. Based on this evaluation the Company's Chief Executive Officer and Chief Financial Officer, concluded that the Company's disclosure controls and procedures are effective in alerting them on a timely basis to material information required to be included in the reports that it files or submits under the Securities and Exchange Act of 1934, as amended. Such evaluation did not identify any change in the Company's internal control over financial reporting that occurred during the quarter ended September 30, 2004, that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. -18- PART II. OTHER INFORMATION ITEM 1. Legal Proceedings The Company is a party to legal proceedings arising in the ordinary course of its business. Management believes that the ultimate resolution of these proceedings will not, in the aggregate, have a material adverse effect on financial condition, results of operations, liquidity or business of the Company. ITEM 2. Not Applicable ITEM 3. Not Applicable ITEM 4. Not Applicable ITEM 5. Not Applicable ITEM 6. Exhibits and Reports on Form 8-K (a) Exhibits Exhibit No. Description of Exhibit 31.1 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (b) Reports on Form 8-K None -19- 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. Donnkenny, Inc. Registrant Date: November 15, 2004 /s/ Daniel H. Levy -------------------------------- Daniel H. Levy Chairman of the Board, Chief Executive Officer Date: November 15, 2004. /s/ Maureen d. Schimmenti -------------------------------- Maureen d. Schimmenti Vice President and Chief Financial Officer, (Principal Financial Officer) -20-