UNITED STATESSECURITIES AND EXCHANGE COMMISSION
Form 10-Q
For the quarterly period ended November 30, 2004
For the transition period from............to..........
Commission file number 001-14669
HELEN OF TROY LIMITED
Clarendon HouseChurch StreetHamilton, Bermuda(Address of Principal Executive Offices)
Registrant’s telephone number, including area code: (915) 225-8000
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.Yes þ No o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).Yes þ No o
As of January 5, 2005 there were 29,822,525 shares of Common Stock, $.10 par value, outstanding.
HELEN OF TROY LIMITED AND SUBSIDIARIES
INDEX
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PART 1. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
Consolidated Condensed Balance Sheets(in thousands, except shares and par value)
See accompanying notes to consolidated condensed financial statements.
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Consolidated Condensed Statements of Income(unaudited)(in thousands, except per share data)
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certificates by February 11, 2005. If we purchase these certificates, we will have purchased tax reserve certificates totaling $28,460,000. On December 11, 2004, we purchased an additional $4,281,000 of these certificates. Tax reserve certificates represent the prepayment by a taxpayer of potential tax liabilities. The amounts paid for tax reserve certificates are refundable in the event that the value of the tax reserve certificates exceeds the related tax liability. These certificates are denominated in Hong Kong dollars and are subject to the risks associated with foreign currency fluctuations.
If the IRD’s position were to prevail and if it were to assert the same position for fiscal years after fiscal year 2003, the resulting assessment could total $18,659,000 (U.S.) in tax for fiscal year 2004 and the first three fiscal quarters of 2005. We vigorously disagree with the proposed adjustments and intend to aggressively contest this matter through applicable taxing authority and judicial procedures, as appropriate. Although the final resolution of the proposed adjustments is uncertain and involves unsettled areas of the law, based on currently available information, we have provided for our best estimate of the probable tax liability for this matter. While the resolution of the issue may result in tax liabilities which are significantly higher or lower than the reserves established for this matter, management currently believes that the resolution will not have a material effect on our consolidated financial position or liquidity. However, an unfavorable resolution could have a material effect on our consolidated results of operations or cash flows in the quarter in which an adjustment is recorded or the tax is due or paid.
United States Income Taxes - The Internal Revenue Service (“the IRS”) is currently auditing the U.S. federal tax returns of our largest U.S. subsidiary for fiscal years 2000, 2001 and 2002. The IRS has provided notice of proposed adjustments to taxes of approximately $13,424,000 for the three years under audit. We vigorously disagree with the proposed adjustments and are aggressively contesting this matter through applicable IRS and judicial procedures, as appropriate. Although the final resolution of the proposed adjustments is uncertain and involves areas of law subject to varying interpretation, based on currently available information, we have provided for our best estimate of the probable tax liability for these matters. This estimate includes additional tax liabilities related to U.S. taxable income for all periods subsequent to fiscal year 2002, as well as the years currently under audit. While the resolution of the issue may result in tax liabilities which are significantly higher or lower than the reserves established for this matter, management currently believes that the resolution will not have a material effect on our consolidated financial position or liquidity. However, an unfavorable resolution could have a material effect on our consolidated results of operations or cash flows in the quarter in which an adjustment is recorded or the tax is due or paid.
The American Jobs Creation Act (“AJCA”) was signed into law by the President on October 22, 2004. The AJCA creates a temporary incentive for U.S. multinational corporations to repatriate accumulated income earned outside the United States by providing an 85% dividend received deduction for certain dividends from controlled foreign corporations. According to the AJCA, the amount of eligible repatriation is limited to $500 million or the amount described as permanently reinvested earnings outside the United States in the most recent audited financial statements filed with the Securities and Exchange Commission on or before June 30, 2003. Whether the Company will ultimately take advantage of the provision depends on a number of factors including potential forthcoming Congressional actions, Treasury regulations and development of a qualified reinvestment plan.
At this time, we have not made any changes to our existing position on reinvestment of foreign earnings subject to the AJCA. Our position is that we will permanently reinvest all of the undistributed earnings of the non-U.S. subsidiaries of certain U.S. subsidiaries, and accordingly have made no provision for U.S. federal income taxes on these undistributed earnings. At November 30, 2004, undistributed earnings for which we had not provided deferred U.S. federal income taxes totaled $37,748,000.
Income Tax Provisions - We must make certain estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments occur in the calculation of certain tax assets and liabilities, which arise from differences in the timing of recognition of revenue and expense for tax and financial statement purposes. We must assess the likelihood that we will be able to recover our deferred tax
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assets. If recovery is not likely, we must increase our provision for taxes by recording a valuation allowance against the deferred tax assets that we estimate will not ultimately be recoverable. As changes occur in our assessments regarding our ability to recover our deferred tax assets, our tax provision is increased in any period in which we determine that the recovery is not probable.
In 1994, we engaged in a corporate restructuring that, among other things, resulted in a greater portion of our income not being subject to taxation in the United States. If such income were subject to U.S. federal income taxes, our effective income tax rate would increase materially. The AJCA includes an anti-inversion provision that denies certain tax benefits to companies that have reincorporated outside the United States after March 4, 2003. We completed our reincorporation in 1994; therefore, our transaction is grandfathered by the AJCA, and we expect to continue to benefit from our current structure. In addition to future changes in tax laws, our position on various tax matters may be challenged. Our ability to maintain our position that the parent company is not a Controlled Foreign Corporation (as defined under the U.S. Internal Revenue Code) is critical to the tax treatment of our non-U.S. earnings. A Controlled Foreign Corporation is a non-U.S. corporation whose largest U.S. shareholders (i.e., those owning 10 percent or more of its stock) together own more than 50 percent of the stock in such corporation. If a change of ownership were to occur such that the parent company became a Controlled Foreign Corporation, such a change could have a material negative effect on the largest U.S. shareholders and, in turn, on our business.
In addition, the calculation of our tax liabilities involves dealing with uncertainties in the application of other complex tax regulations. We recognize liabilities for anticipated tax audit issues in the United States and other tax jurisdictions based on our estimate of whether, and the extent to which, additional taxes will be due. If we ultimately determine that payment of these amounts are not probable, we reverse the liability and recognize a tax benefit during the period in which we determine that the liability is no longer probable. We record an additional charge in our provision for taxes in the period in which we determine that the recorded tax liability is less than we expect the ultimate assessment to be.
The table on the following page discloses information regarding the carrying amounts and associated accumulated amortization for all intangible assets and indicates the operating segments to which they belong:
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During the quarter ended November 30, 2004, we reclassified $17,717,000 from Brut® goodwill to Brut® trademarks having an indefinite life and have reclassified this amount in both the November 30, 2004 and February 29, 2004 consolidated condensed balance sheets and related schedules accordingly. The reclassification has no impact on the consolidated condensed statements of income. Management believes this reclassification to be a more appropriate characterization of the nature of the acquisition costs paid for the Brut® brand.
The $18,000,000 license not subject to amortization is for a perpetual, royalty free license for the Sea Breeze® brand of products, which we acquired in October 2002. All other licenses are amortized over the primary life of the underlying license agreements, ranging from 8 to 25 years. In the first fiscal quarter of 2005, as part of the proceeds of our sale of Tactica, we recorded $2,255,000 for the Epil Stop® trademark, which we believe to have an indefinite useful life (see Note 13). In the second fiscal quarter of 2005, we recorded additional trademarks with indefinite useful lives (and thus not subject to amortization) of $75,200,000, and other intangible assets totaling $18,155,000 (subsequently adjusted to $18,202,000). The other intangible assets are subject to amortization over varying lives ranging from 2 to 13 years (see Note 14). On September 29, 2004, we recorded $11,906,000 for the Skin Milk® and Time Block® trademarks which we acquired from Naterra International, Inc. We believe these new trademarks have an indefinite useful life (See Note 15).
The table on the following page summarizes the amortization expense attributable to intangible assets for the three months and nine months ending November 30, 2004 and 2003, as well as estimated amortization expense for the fiscal years ending the last day of February 2005 through 2010.
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Debt Agreements Outstanding at February 29, 2004
The following current and long-term borrowings were available or outstanding at February 29, 2004.
On September 22, 2003, certain subsidiaries of the Company entered into a $50,000,000 unsecured revolving credit facility with Bank of America to facilitate short-term borrowings and the issuance of letters of credit. The $50,000,000 unsecured revolving credit facility was cancelled effective June 1, 2004.
On January 5, 1996, one of our U.S. subsidiaries issued guaranteed Senior Notes at face value of $40,000,000. Interest is paid quarterly at an annual rate of 7.01 percent. The Senior Notes are unsecured, and are guaranteed by Helen of Troy Limited and certain of our subsidiaries. Annual principal payments of $10,000,000 each begin January 5, 2005, with the final payment due January 5, 2008.
On July 18, 1997, one of our U.S. subsidiaries issued a $15,000,000 Senior Note. Interest is paid quarterly at an annual rate of 7.24 percent. The $15,000,000 Senior Note is unsecured, is guaranteed by Helen of Troy Limited and certain of our subsidiaries and is due July 18, 2012. Annual principal payments of $3,000,000 each begin July 18, 2008, with the final payment due July 18, 2012.
Both the $40,000,000 and $15,000,000 Senior Notes contain covenants that require that we meet certain net worth and other financial requirements. Additionally, the notes restrict us from incurring liens on any of our properties, except under certain conditions as defined in the Senior Note agreements. We are in compliance with all the terms of these notes. Under the terms of the Senior Notes, one of our U.S. subsidiaries is the borrower. Our consolidated group’s parent company, located in Bermuda, one of our subsidiaries located in Barbados, and three of our U.S. subsidiaries fully guarantee the Senior Notes on a joint and several basis.
On June 1, 2004, we entered into a five year $75,000,000 Revolving Line of Credit Agreement, dated as of June 1, 2004, with Bank of America, N.A. and other lenders and a one year $200,000,000 Term Loan
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Credit Agreement, dated as of June 1, 2004, with Banc of America Mezzanine Capital, LLC. The Term Loan Credit Agreement was a temporary financing to fund the balance of OXO’s purchase price (see Note 14). We entered into this Term Loan Credit Agreement until more permanent long-term financing could be put into place. The purchase price of the OXO International acquisition was funded by borrowings of $73,173,000 under the new Revolving Line of Credit Agreement and $200,000,000 under the Term Loan Credit Agreement. Borrowings under the Term Loan Credit Agreement were subsequently paid off with the proceeds of the funding of $225,000,000 Floating Rate Senior Notes on June 29, 2004 (see below). For the period outstanding, borrowings under the Term Loan Credit Agreement accrued interest at LIBOR plus a margin of 1.125%.
Borrowings under the Revolving Line of Credit Agreement accrue interest equal to the higher of the Federal Funds Rate plus 0.50% or Bank of America’s prime rate. Alternatively, upon timely election by the Company, borrowings accrue interest based on the respective 1, 2, 3, or 6-month LIBOR rate plus a margin of 0.75% to 1.25% based upon the “Leverage Ratio” at the time of the borrowing. The “Leverage Ratio” is defined by the Revolving Line of Credit Agreement as the ratio of total consolidated indebtedness, including the subject funding on such date to consolidated EBITDA (“Earnings Before Interest, Taxes, Depreciation and Amortization”) for the period of the four consecutive fiscal quarters most recently ended, with EBITDA adjusted on a pro forma basis to reflect the acquisition of OXO and the disposition of Tactica. At the time of funding, we elected LIBOR based funding with an initial margin rate of 1.125%. The rates paid on various draws for the current fiscal quarter ranged from 2.705 percent to 3.465 percent. The new credit line allows for the issuance of letters of credit up to $10,000,000. Outstanding letters of credit reduce the $75,000,000 borrowing limit dollar for dollar. Upon the execution of this new credit facility, our previous $50,000,000 unsecured revolving credit facility with Bank of America was cancelled. As of November 30, 2004, there were $46,000,000 of revolving loans and $1,282,000 of open letters of credit outstanding against this facility (including a $295,000 standby letter of credit to a lessor, as more fully discussed under “Other Letters of Credit” below).
The Revolving Line of Credit Agreement continues to require and the Term Loan Credit Agreement required the maintenance of certain Debt/EBITDA, fixed charge coverage ratios, and other customary covenants. The agreements were guaranteed, on a joint and several basis, by the parent company, Helen of Troy Limited, and certain U.S. subsidiaries.
On June 29, 2004, we closed on a $225,000,000 Floating Rate Senior Note (“Senior Notes”) financing arranged by Banc of America Securities LLC with a group of ten financial institutions. The Senior Notes consist of $100,000,000 of five year notes, $50,000,000 of seven year notes, and $75,000,000 of ten year notes. Interest on the notes is payable quarterly. Interest rates are reset quarterly based on the 3 month LIBOR rate plus 85 basis points for the five and seven year notes, and the 3 month LIBOR rate plus 90 basis points for the ten year notes. At closing, the initial interest rates were 2.436 percent for the five and seven year notes, and 2.486 percent for the ten year notes. On September 29, 2004, the interest rates on these notes were reset for the next three months at 2.82 percent for the five and seven year notes and 2.87 percent for the ten year notes. On December 29, 2004, the interest rates on these notes were reset for the next three months at 3.410 percent for the five and seven year notes and 3.460 percent for the ten year notes. The Senior Notes allow for prepayment subject to the following terms: five year notes can be prepaid in the first year with a 2 percent penalty, thereafter there is no penalty; seven and ten year notes can be prepaid after one year with a 1 percent penalty, and after two years with no penalty.
The proceeds of the Senior Notes financing were used to repay the $200,000,000 borrowings under the Term Loan Credit Agreement, and $25,000,000 of the outstanding borrowings on our $75,000,000 Revolving Line of Credit Agreement.
The Senior Notes are unsecured and require the maintenance of certain Debt/EBITDA, fixed charge coverage ratios, consolidated net worth levels, and other customary covenants. The Senior Notes have been guaranteed, on a joint and several basis, by the parent company, Helen of Troy Limited, and certain U.S. subsidiaries.
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Other Letters of Credit
One of the Company’s U.S. subsidiaries had issued a $389,000 standby letter of credit to the lessor of Tactica’s office space in New York City. The lessor could draw funds from the standby letter of credit if Tactica failed to meet its obligations under the lease. After our sale of Tactica (see Note 13), we took measures to cancel the original letter of credit and issue another standby letter of credit under a new banking relationship. Tactica has since filed for bankruptcy and did indeed fail to meet its obligations under the lease. The lessor has drawn against the original letter of credit for a total of $241,000, through November 30, 2004, which has been adequately provided for in our financial statements for the quarter ending November 30, 2004.
Product Warranties
The Company’s products are under warranty against defects in material and workmanship for a maximum of two years. We have established accruals to cover future warranty costs of approximately $10,670,000 and $4,114,000 as of November 30, 2004 and February 29, 2004, respectively. We estimate our warranty accrual using historical trends. We believe that these trends are the most reliable method by which we can estimate our warranty liability. The following table summarizes the activity in the Company’s accrual for the three months and nine months ended November 30, 2004 and fiscal year ended February 29, 2004:
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Contractual Obligations
Our contractual obligations and commercial commitments as of November 30, 2004 were:
The following table sets forth the computation of basic and diluted earnings per share for the three months and nine months ended November 30, 2004 and 2003, respectively, and illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of SFAS 123, “Accounting for Stock-Based Compensation” to stock-based employee compensation.
Under stock option and restricted stock plans adopted in 1994 and 1998 (the “1994 Plan” and the “1998 Plan,” respectively) the Company reserved a total of 14,000,000 shares of its common stock for issuance to key officers and employees. Pursuant to the 1994 and 1998 Plans, we grant options to purchase our common stock at a price equal to or greater than the fair market value on the grant date. Both plans contain provisions for incentive stock options, non-qualified stock options, and restricted stock grants. Generally, options granted under the 1994 and 1998 Plans become exercisable immediately, or over a one, four, or five-year vesting period and expire on a date ranging from seven to ten years from their date of grant. 24,986 and 80,411 shares remained available for future grants under the 1998 Plan at November 30, 2004 and February 29, 2004, respectively.
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Under a stock option plan for non-employee directors (the “Directors’ Plan”), adopted in fiscal 1996, the Company reserved a total of 980,000 shares of its common stock for issuance to non-employee members of the Board of Directors. We grant options under the Directors’ Plan at a price equal to the fair market value of our common stock at the date of grant. Options granted under the Directors’ Plan vest one year from their date of issuance and expire ten years after issuance. 364,000 and 432,000 shares remained available for future grants under this plan at November 30, 2004 and February 29, 2004, respectively.
In fiscal 1999, our shareholders approved an employee stock purchase plan (the “Stock Purchase Plan”) under which 500,000 shares of common stock were reserved for issuance to our employees, nearly all of whom are eligible to participate. Under the terms of the Stock Purchase Plan employees authorize us to withhold from 1 percent to 15 percent of their wages or salaries to purchase the Company’s common stock. The purchase price for stock purchased under the plan is equal to the lower of 85 percent of the stock’s fair market value on either the first day of each option period or the last day of each period.
During the second quarter of fiscal 2005, plan participants acquired 5,614 shares at an average price of $23.35 per share from the Company under the stock purchase plan. At November 30, 2004 and February 29, 2004, 360,648 and 366,262 shares respectively, remained available for future purchases under this plan.
During the three months ended November 30, 2004, we used $368,000 of credits against these transactions and expect to use most of the remaining advertising credits acquired by the end of fiscal year 2005. All remaining credits are included in the line item entitled “Prepaid expenses” on our consolidated condensed balance sheets and are valued at $1,743,000 and $1,100,000 at November 30, 2004 and February 29, 2004, respectively.
We identify foreign currency risk by regularly monitoring our foreign currency-denominated transactions and balances. Where operating conditions permit, we reduce our foreign currency risk by purchasing most of our inventory using U.S. Dollars and by converting cash balances denominated in foreign currencies to U.S. Dollars.
We also hedge against foreign currency exchange rate-risk by using a series of forward contracts designated as cash flow hedges to protect against the foreign currency exchange risk inherent in our forecasted transactions denominated in currencies other than the U.S. Dollar. For transactions designated as cash flow hedges, the effective portion of the change in the fair value (arising from the change in the spot rates from
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period to period) is deferred in other comprehensive income. These amounts are subsequently recognized in “Selling, general and administrative expense” in the consolidated condensed statements of income in the same period as the forecasted transactions close out over the remaining balance of their terms. The ineffective portion of the change in fair value (arising from the change in the difference between the spot rate and the forward rate) is recognized in the period it occurred. These amounts are also recognized in “Selling, general and administrative expense” in the consolidated condensed statements of income. We do not enter into any forward exchange contracts or similar instruments for trading or other speculative purposes.
The following table summarizes the various forward contracts we designated as cash flow hedges that were open at November 30, 2004 and February 29, 2004:
Assets Received in Noncash Exchange for Ownership Interest in Tacticaat April 29, 2004(in thousands)
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The marketable securities received in the Tactica sale carry a restriction that prevents us from disposing of the stock prior to July 31, 2005. At November 30, 2004 the market value of these securities was $420,000. During the quarter ended November 30, 2004, management determined the decline in market value to be other than temporary and accordingly recorded a $2,610,000 loss in other income (expense), net. $2,010,000 of this loss had previously been recorded in other comprehensive income as of the quarter ended August 31, 2004.
Tactica was sold because we believed it no longer fit into our business model and that a sale was the most appropriate course of action to maximize our long-term shareholder value.
Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”) requires at least an annual impairment review of goodwill and other intangible assets, which we normally undertake on March 1 of each year. SFAS 142 also requires a review of goodwill for impairment upon the occurrence of certain events that would more likely than not reduce the fair value of a segment below its carrying amount. One of those events is the impending disposal of a segment. After evaluating the facts and circumstances surrounding the fiscal 2004 operations of our Tactica operating segment and its subsequent sale, against the guidelines established by SFAS 142, we recorded a loss of $5,699,000 for the impairment of 100 percent of the Tactica goodwill, net of $1,938,000 of related tax benefits, in the fourth fiscal quarter of 2004.
Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”) provides accounting guidance for accounting segments to be disposed by sale and, in our circumstances, required us to report Tactica as a discontinued operation. In accordance with SFAS 144, we classified all assets and liabilities of Tactica as “Assets of discontinued segment held for sale” and “Liabilities of discontinued segment held for sale” in the accompanying consolidated condensed balance sheet as of February 29, 2004. SFAS 144 also requires us to report Tactica’s operating results, net of taxes, as a separate summarized component after income from continuing operations for each year presented. The accompanying consolidated condensed statements of income and consolidated condensed statements of cash flows contain all appropriate reclassifications for each period presented.
The assets acquired in the OXO acquisition included intellectual property, contracts, goodwill, inventory and books and records. The assumed liabilities included contractual obligations and accruals, and certain lease obligations assumed in connection with OXO’s office facilities in New York City. Thirty five OXO employees, including its President, joined the Company as part of the acquisition.
OXO is a world leader in providing innovative consumer products in a variety of product areas. OXO offers approximately 500 consumer product tools in several categories, including: kitchen, cleaning, barbecue, barware, garden, automotive, storage, and organization. OXO also has strong customer relationships with leading specialty and department store retailers. Each year approximately 90 products are introduced through the OXO Good Grips®, OXO Steel™, OXO Good Grips i-Series®, and OXO SoftWorks® product lines.
The schedule on the following page presents the net assets of OXO acquired at closing:
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OXO — Net Assets Acquired on June 1, 2004(in thousands)
The allocations above reflect the completion of our analysis of the economic lives of the assets acquired and appropriate allocation of the initial purchase price based upon independent appraisals. We believe that the OXO acquisition resulted in recognition of goodwill primarily because of its industry position, management strength, and business growth potential. “Other intangible assets” are subject to amortization over varying lives ranging from 2 to 13 years and consist of patents, customer lists and a non-compete agreement.
The following pro forma unaudited financial data for the three- and nine-month periods ending November 30, 2004 and November 30, 2003 is presented to illustrate the estimated effects of the OXO acquisition as if the transaction had occurred as of the beginning of the fiscal periods presented.
Results of Operations if OXO Acquisition Had Been Completed at March 1, 2003(in thousands, except per share data)
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This discussion contains a number of forward-looking statements, all of which are based on current expectations. Actual results may differ materially due to a number of factors, including those discussed in the section entitled “Forward-Looking Information and Factors That May Affect Future Results”, Item 3. “Quantitative and Qualitative Disclosures About Market Risk”, and in the Company’s most recent report on Form 10-K.
OVERVIEW OF THE QUARTER’S ACTIVITIES:
Our first fiscal quarter of each year is our seasonal low point in terms of overall activity, with sales tending to run approximately 20 percent of the year’s total on a historical basis. Our second fiscal quarter is characterized by stable sales in the June through first half of July timeframe with increasing sales in the second half of the July through August timeframe as we build towards a peak shipping season in the third quarter. The second and third fiscal quarters of 2005 also include the operations of our housewares segment (the operations of OXO International (“OXO”) acquired on June 1, 2004), offering home product tools in several categories, including: kitchen, cleaning, barbecue, barware, garden, automotive, storage and organization. Overall, revenues were up 24.4 and 25.4 percent for the third fiscal quarter of 2005 and year-to-date, respectively, over the same periods in the prior year. Profitability followed revenue growth with fiscal third quarter and year-to-date increases of 35.2 and 32.9 percent, respectively, for operating income and 20.1 and 17.1 percent, respectively, for income from continuing operations.
Personal Care Segment
Housewares Segment
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In addition to the above activities, we continued to invest in our business, with a view toward potential future growth, through the following activities:
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RESULTS OF OPERATIONS
Comparison of fiscal quarter and nine-month periods ended November 30, 2004 to the same periods ended November 30, 2003
The following table sets forth, for the periods indicated, our selected operating data, in dollars, as a percentage of net sales, and as a year-over-year percentage change.
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As more fully discussed in Note 5 to the accompanying consolidated condensed financial statements, in the first fiscal quarter of 2005, we reported a single operating segment, Personal Care and a discontinued segment. The Personal Care Segment includes the hair care appliances, hair brushes, combs, hair accessories, hair and skin care liquids and powders and other personal care products business. The Discontinued Segment includes the operations of Tactica International, Inc. (See Note 13 to the consolidated condensed financial statements for a further discussion of the sale of Tactica). Beginning with the second fiscal quarter of 2005, we are presenting an additional operating segment: housewares, to report the operations of OXO, which offers home product tools in several categories, including: kitchen, cleaning, barbecue, barware, garden, automotive, storage and organization (See Note 14 to the consolidated condensed financial statements for a further discussion of the OXO acquisition). The accompanying discussion and analysis reflects this new change in operating segments.
Consolidated Sales and Gross Profit Margins
Our net sales for the three- and nine-months ended November 30, 2004 increased 24.4 and 25.4 percent, or $40,296,000 and $91,975,000, respectively, versus the same periods a year earlier. New product acquisitions accounted for 21.1 percent or $34,857,000 and $76,467,000 respectively of the sales percentage growth for the three- and nine-months ended November 30, 2004 verses the same periods a year earlier. Sales of Brut® men’s grooming products for September 2004 are included in new product acquisitions because Brut® was acquired September 29, 2003. The OXO product lines which we acquired from WKI Holding Company in June 2004 to form our new housewares segment and the TimeBlock® and Skin Milk® body and skin care brands acquired from Naterra International, Inc. in September 2004 are also included in new product acquisitions. Core growth (growth without acquisitions) accounted for 3.3 and 4.3 percent, respectively, or $5,439,000 and $15,508,000, respectively, of the sales growth over the same three-and nine-month periods last year. The core growth for the first nine months came from sales growth from our appliance business and growth in grooming, skin care and hair products, offset somewhat by sales volume declines in our brushes, combs and accessories business.
Also contributing to growth has been the strengthening of the British Pound, Canadian Dollar and the Euro versus the U.S. Dollar, offset somewhat by the impact of the weakening Mexican Peso vs. the U.S. Dollar. With the growth in our Latin American operations, the Mexican Peso exposure is growing and will be included in our foreign currency impact analysis. The overall net impact of foreign currency changes was to provide approximately $2,461,000 and $3,702,000 of additional sales dollars for the three- and nine-month periods ended November 30, 2004, respectively, versus the same periods a year earlier.
Consolidated gross profit, as a percentage of sales for the three- and nine-month periods ended November 30, 2004, increased 2.5 and 1.7 percentage points, respectively, to 48.0 and 47.5 percent compared to the same periods in the prior year. The increase is primarily due to a combination of sales mix changes to higher margin items resulting from Brut and OXO acquisitions and margin improvement due to selected product purchase cost decreases.
Selling, general and administrative expenses
Selling, general and administrative expenses, expressed as a percentage of net sales, increased from 26.3 to 27.1 percent for the three-months, and from 27.7 to 28.4 percent for the nine-months ended November 30, 2004 compared to the same periods in the prior year. The increase for the quarter ending November 30, 2004 is primarily due to higher management incentive costs resulting from improved operating results and higher consulting and depreciation costs related to our new computer system.
The increase for the nine months ended November 30, 2004 is primarily due to higher management incentive costs, higher media advertising costs and higher consulting and depreciation costs related to our new computer system.
Interest expense and other income / expense
Interest expense for the three- and nine-month periods ended November 30, 2004 increased compared with the three- and nine-month periods ended November 30, 2003, to $3,052,000 and $6,727,000 from $1,024,000 and $2,989,000.
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The overall increase in interest expense is the result of the use of both short-term and long-term debt to fund the $273,173,000 acquisition of OXO and the $12,001,000 acquisition of Timeblock® and Skin Milk® (See Notes 8, 14 and 15 for related discussions of new debt financings and the OXO, Timeblock® and Skin Milk® acquisitions).
Other income (expense), net for the three- and nine-month periods ended November 30, 2004 was $2,399,000 and $2,280,000 of net expense, respectively, compared with other income, net of $696,000 and $4,434,000, respectively, for the same periods in the prior year. The following schedule shows key components of other income and expense:
Interest income is lower for the three- and nine-month periods ended November 30, 2004 compared to the same periods last year due to lower levels of temporarily investable cash being held this year.
Realized and unrealized losses on securities for the three- and nine- month periods ended November 30, 2004 includes a $2,610,000 loss on marketable securities acquired in connection with the sale of Tactica (see Note 13). These marketable securities carry a restriction that prevents us from disposing of the stock prior to July 31, 2005, and are accordingly classified as stock available for sale. At acquisition, the securities had a market value of $3,030,000. At November 30, 2004 the market value of these securities was $420,000. Management determined the decline in market value to be other than temporary and accordingly recorded the $2,610,000 loss. $2,010,000 of this loss had previously been recorded in other comprehensive income as of the quarter ended August 31, 2004.
In the fiscal quarter ended November 30, 2003 we recorded other income of $2,600,000 in connection with the settlement of litigation.
Income tax expense
Income tax expense for the three- and nine-month periods ended November 30, 2004 was 16.7 and 17.1 percent of earnings before income taxes, respectively, versus 17.3 and 17.4 percent of earnings before income taxes, respectively, for the same periods in the prior year. The overall year-to-year decline in rates is due to more of our income in fiscal 2005 being taxed in lower tax rate jurisdictions.
DISCONTINUED OPERATIONS
On April 29, 2004, we completed the sale of our 55 percent interest in Tactica back to certain shareholder-operating managers. In exchange for our 55 percent ownership share of Tactica and the release of $16,936,000 of its secured debt and accrued interest owed to us, we received marketable securities, intellectual properties, and the right to certain tax refunds. The fair value of net assets received was equal to the book value of net assets transferred. Accordingly, no gain or loss was recorded as a result of this sale.
Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”) requires at least an annual impairment review of goodwill and other intangible assets, which we normally undertake on March 1 of each year. SFAS 142 also requires a review of goodwill for impairment upon the occurrence of certain events that would more likely than not reduce the fair value of a segment below its carrying amount. One of those events at the end of fiscal 2004 was the impending disposal of Tactica. After evaluating the facts and circumstances surrounding Tactica’s fiscal 2004 operations and its subsequent sale against the guidelines established by SFAS 142, we recorded a loss of $5,699,000 as of February 29, 2004 for the impairment of 100 percent of the Tactica goodwill, net of $1,938,000 of related tax benefits.
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FINANCIAL CONDITION, LIQUIDITY, AND CAPITAL RESOURCES
Selected measures of our liquidity and capital resources as of November 30, 2004 and November 30, 2003 are shown below:
Operating Activities
Our cash balance was $8,951,000 at November 30, 2004 compared to $53,048,000 at February 29, 2004. Operating activities used $20,228,000 of cash during the first nine months of fiscal 2005, compared to $1,450,000 of cash provided during the first nine months of fiscal 2004. Inventories increased $35,222,000 during the first nine months of fiscal 2005 compared to $12,879,000 during the first nine months of fiscal 2004. Inventory levels in fiscal 2005 increased due to the acquisition and building of inventory for our new housewares segment, which accounted for $16,442,000 of our inventory balance at November 30, 2004. Overall, inventory increases are consistent with our 24.4 percent sales increase for the latest fiscal quarter and 25.4 percent sales increase for the nine month period ended November 30, 2004 versus the same periods a year earlier.
The increase in accounts receivable of $109,949,000 for the first nine months of fiscal 2005, compared to $72,614,000 for the first nine months of fiscal 2004 was primarily due to the Company’s growth in sales, including
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receivables added by the new housewares segment, and the overall seasonal impact of the third fiscal quarter being our strongest shipping quarter due to the holiday selling season at retail. Sales increased $91,975,000, or 25.4 percent, for the nine months ended November 30, 2004, compared to the nine months ended November 30, 2003.
Our accounts receivable turnover days increased to 72.2 days at November 30, 2004 from 69.0 days at November 30, 2003. This increase over the prior year is due to higher sales in the third quarter on which extended holiday dating is provided and growth in our international sales which has longer credit terms on average. Our inventory turnover improved to 2.5 times at November 30, 2004 compared to 2.2 times at November 30, 2003. The improvement is due to the fact that in fiscal 2004, we accelerated inventory purchases and receipts in advance of anticipated ocean freight rate increases, and built inventory levels of newly acquired skin and hair care brands. Our inventory turnover is also improving due to the growth in sales of our grooming, skin care and hair care products, the majority of which we source in the United States allowing us to carry lower levels of inventory compared to products that we source from Asia.
Working capital increased to $160,023,000 at November 30, 2004, a $1,941,000 increase from November 30, 2003. Our current ratio decreased to 1.8:1 at November 30, 2004 from 2.5:1 at November 30, 2003. The decrease in the current ratio was due to a change in the classification of a $10,000,000 note payment due in January 2005 to a current liability, an additional $25,000,000 of revolving credit outstanding over the same period in fiscal 2004, an increase in the overall level of accrued expenses of $44,870,000 over the same period in fiscal 2004, and a reduction of our cash balances in order to reduce our short-term borrowings. The $10,000,000 note payment due in January 2005 is the first in a series of scheduled payments we will make against our $55,000,000 unsecured Senior Notes.
Investing Activities
Investing activities used $282,055,000 of cash during the nine months ended November 30, 2004. Listed below are some significant highlights of our investing activities:
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Financing Activities
Financing activities provided $258,186,000 of cash during the nine months ended November 30, 2004.
During the three- and nine-month periods ended November 30, 2004, 5,700 and 282,804 stock option grants, respectively, were exercised for shares of our common stock providing $52,000 and $2,727,000 of cash. Purchases through our employee stock purchase plan of 5,614 shares at an average price of $23.33 provided an additional $131,000 of cash during the same periods. An additional 1,000,000 stock options were exercised during the fiscal quarter ending August 31, 2004 in a non-cash transaction in which the key employee tendered company stock having a market value of $5,757,900 as payment of the options’ exercise price.
During the six-month period ended August 31, 2004, we also repurchased 757,710 shares of our common stock for $25,039,465, at an average share price of $33.05. No additional shares were repurchased during the quarter ended November 30, 2004. All repurchases were made pursuant to our August 2003 Board of Directors resolution authorizing us to purchase, in open market or private transactions, up to 3,000,000 shares of our common stock. From September 1, 2003 through November 30, 2004, we have repurchased 1,563,836 shares at a total cost of $45,611,690 or an average share price of $29.17.
Included in our stock repurchases for the second fiscal quarter were 381,650 shares tendered by a key employee-shareholder as payment of the $13,797,000 of stock purchase price and related federal income tax obligations arising from the exercise of 1,000,000 stock options by the key employee-shareholder. This transaction was valued at an average share price of $36.15 using the average of the high bid and low bid prices for Helen of Troy stock as reported on the NASDAQ National Market System on the day the stock was tendered.
As mentioned in Note 8 to our consolidated condensed financial statements, and further discussed under “Forward-Looking Information and Factors that may affect Future Results”, during the quarter ended August 31, 2004 we entered into a series of financing transactions that established a new five-year, $75,000,000 revolving credit facility, cancelled our existing $50,000,000 revolving credit facility, borrowed and subsequently repaid a $200,000,000 Term Loan Credit Agreement, and placed $225,000,000 of floating rate senior debt with five, seven and ten year maturities.
On June 1, 2004, we acquired certain assets and liabilities of OXO International for a net cash purchase price of approximately $273,173,000 including the assumption of approximately $4,040,000 of certain liabilities.
To fund the acquisition, we entered into a five-year $75,000,000 Revolving Line of Credit Agreement, dated as of June 1, 2004, with Bank of America, N.A. and other lenders and a one year $200,000,000 Term Loan Credit Agreement, dated as of June 1, 2004, with Banc of America Mezzanine Capital, LLC. The purchase price of the OXO International acquisition was funded by borrowings of $73,173,000 under the Revolving Line of Credit Agreement and $200,000,000 under the Term Loan Credit Agreement.
Borrowings under the Revolving Line of Credit Agreement accrue interest equal to the higher of the Federal Funds Rate plus 0.50% or the prime rate. Alternatively, upon timely election by the Company, borrowings accrue interest based on the respective 1, 2, 3, or 6-month LIBOR rate plus a margin of 0.75% to 1.25% based upon the “Leverage Ratio” at the time of the borrowing. The “Leverage Ratio” is defined by the Revolving Line of Credit Agreement as the ratio of total consolidated indebtedness, including the subject funding on such date to consolidated EBITDA (“Earnings Before Interest, Taxes, Depreciation and Amortization”) for the period of the four consecutive fiscal quarters most recently ended, with EBITDA adjusted on a pro forma basis to reflect the acquisition of OXO and the disposition of Tactica. At the time of funding, we elected LIBOR based funding with an initial margin rate of 1.125%. The rates paid on various draws for the current fiscal quarter ranged from 2.705 percent to 3.465 percent. The new credit line allows for the issuance of letters of credit up to $10,000,000. Outstanding letters of credit reduce the $75,000,000 borrowing limit dollar for dollar. Upon the execution of this new credit facility, our previous $50,000,000 unsecured revolving credit facility was cancelled.
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Borrowings under the $200,000,000 Term Loan Credit Agreement were subsequently paid off with the proceeds of the funding of $225,000,000 Floating Rate Senior Notes on June 29, 2004 (see Note 8). For the period, outstanding borrowings under the Term Loan Credit Agreement accrued interest at LIBOR plus a margin of 1.125%.
The Revolving Line of Credit Agreement requires the maintenance of certain Debt/EBITDA, fixed charge coverage ratios, and other customary covenants. The agreement has been guaranteed, on a joint and several basis, by the parent company, Helen of Troy Limited, and certain U.S. subsidiaries.
On June 29, 2004, we closed on a $225,000,000 Floating Rate Senior Note (“Senior Notes”). The Senior Notes consist of $100,000,000 of five year notes, $50,000,000 of seven year notes, and $75,000,000 of ten year notes. Interest on the notes is payable quarterly. Interest rates are reset quarterly based on the 3 month LIBOR rate plus 85 basis points for the five and seven year notes, and the 3 month LIBOR rate plus 90 basis points for the ten year notes. At closing, the initial interest rates were 2.436 percent for the five and seven year notes, and 2.486 percent for the ten year notes. On September 29, 2004, the interest rates on these notes were reset for the next three months at 2.82 percent for the five and seven year notes and 2.87 percent for the ten year notes. On December 29, 2004 the interest rates on these notes were reset for the next three months at 3.410 percent for the five and seven year notes and 3.460 percent for the ten year notes. The Senior Notes allow for prepayment subject to the following terms: five year notes can be prepaid in the first year with a 2 percent penalty, thereafter there is no penalty; seven and ten year notes can be prepaid after one year with a 1 percent penalty, and after two years with no penalty.
In connection with these series of financing transactions, we incurred $4,429,000 of financing costs. These costs are being amortized over the related lives of the various notes financed, ranging from 5 to 10 years.
With the completion of these financings, the Company now operates under substantially more leverage and incurs higher interest costs. While at May 31, 2004 we had total indebtedness of $55,000,000, as of November 30, 2004 we had $326,000,000 in total indebtedness outstanding. This increase in debt has added new constraints on our ability to operate our business, including but not limited to:
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PAYMENTS DUE BY PERIOD(in thousands)
We have no existing activities involving special purpose entities or off-balance sheet financing.
Current and Future Capital Needs
Based on our current financial condition and current operations, we believe that cash flows from operations and available financing sources will continue to provide sufficient capital resources to fund the Company’s foreseeable short and long-term liquidity requirements. The Company’s cash used by operating activities of $20,228,000 over the first three fiscal quarters of 2005 resulted from the inventory and accounts receivable increases required as a result of the OXO acquisition, typical seasonal inventory increases as a result of third quarter sales activity, and normal seasonal receivable collection patterns. Typically, we can expect cash flow from operating activities in the second half of the fiscal year to recoup the cash used in the first half of the fiscal year and provide additional positive cash flow as third quarter seasonal peak accounts receivable are collected and seasonal peak inventory levels are lowered. We expect that our capital needs will stem primarily from the need to purchase sufficient levels of inventory and to carry normal levels of accounts receivable on our balance sheet. In addition, we will continue to evaluate acquisition opportunities on a regular basis and may augment our internal growth with acquisitions of complementary businesses or product lines. Subject to the limitations imposed by our new financing arrangements, we may finance acquisition activity with available cash, the issuance of stock, or with additional debt, depending upon the size and nature of any such transaction and the status of the capital markets at the time of such acquisition.
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INCOME TAXES
Hong Kong Income Taxes - The Inland Revenue Department (“the IRD”) in Hong Kong has assessed a total of $32,086,000 (U.S.) in tax on certain profits of our foreign subsidiaries for the fiscal years 1995 through 2003. Hong Kong taxes income earned from certain activities conducted in Hong Kong. We are vigorously defending our position that we conducted the activities that produced the profits in question outside of Hong Kong. We also assert that we have complied with all applicable reporting and tax payment obligations. In connection with the IRD’s tax assessment for the fiscal years 1995 through 1997, we were required to purchase $3,282,000 (U.S.) in tax reserve certificates in Hong Kong. In the first fiscal quarter of 2005, we purchased additional tax reserve certificates in the amount of $3,583,000 (U.S.) as required by the IRD. In the third fiscal quarter of 2005, we purchased additional tax reserve certificates in the amount of $8,635,000 (U.S.) as required by the IRD. The IRD has asked us to purchase an additional $12,960,000 of tax reserve certificates by February 11, 2005. If we purchase these certificates, we will have purchased tax reserve certificates totaling $28,460,000. On December 11, 2004, we purchased an additional $4,281,000 of these certificates. Tax reserve certificates represent the prepayment by a taxpayer of potential tax liabilities. The amounts paid for tax reserve certificates are refundable in the event that the value of the tax reserve certificates exceeds the related tax liability. These certificates are denominated in Hong Kong dollars and are subject to the risks associated with foreign currency fluctuations.
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Income Tax Provisions - We must make certain estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments occur in the calculation of certain tax assets and liabilities, which arise from differences in the timing of recognition of revenue and expense for tax and financial statement purposes. We must assess the likelihood that we will be able to recover our deferred tax assets. If recovery is not likely, we must increase our provision for taxes by recording a valuation allowance against the deferred tax assets that we estimate will not ultimately be recoverable. As changes occur in our assessments regarding our ability to recover our deferred tax assets, our tax provision is increased in any period in which we determine that the recovery is not probable.
CRITICAL ACCOUNTING POLICIES
The U.S. Securities and Exchange Commission defines critical accounting policies as “those that are both most important to the portrayal of a company’s financial condition and results, and require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.” Preparation of our financial statements involves the application of several such policies. These policies include: estimates of our exposure to liability for income taxes, estimates of credits to be issued to customers for sales that have already been recorded, the valuation of inventory on a lower-of-cost-or-market basis, the carrying value of long-lived assets, and the economic useful life of intangible assets.
Income Taxes - We must make certain estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments occur in the calculation of certain tax assets and liabilities, which arise from differences in the timing of recognition of revenue and expense for tax and financial statement purposes.
We must assess the likelihood that we will be able to recover our deferred tax assets. If recovery is not likely, we must increase our provision for taxes by recording a valuation allowance against the deferred tax assets that we estimate will not ultimately be recoverable. As changes occur in our assessments regarding our ability to recover our deferred tax assets, our tax provision is increased in any period in which we determine that the recovery is not probable.
In addition, the calculation of our tax liabilities involves dealing with uncertainties in the application of other complex tax regulations. We recognize liabilities for anticipated tax audit issues in the United States and other tax
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jurisdictions based on our estimate of whether, and the extent to which, additional taxes will be due. If we ultimately determine that payment of these amounts are unnecessary, we reverse the liability and recognize a tax benefit during the period in which we determine that the liability is no longer necessary. We record an additional charge in our provision for taxes in the period in which we determine that the recorded tax liability is less than we expect the ultimate assessment to be.
Estimates of credits to be issued to customers - We regularly receive requests for credits from retailers for returned products or in connection with sales incentives, such as cooperative advertising and volume rebate agreements, as well as general returns due to product quality issues. We reduce sales or increase selling, general and administrative expenses, depending on the nature of the credits, for estimated future credits to customers. Our estimates of these amounts are based either on historical information about credits issued, relative to total sales, or on specific knowledge of incentives offered to retailers. With respect to credits for product quality issues, we also estimate our warranty accrual using historical trends and believe these trends are the most reliable method by which we can estimate our warranty liability.
Valuation of inventory - We account for our inventory using a first-in-first-out system in which we record inventory on our balance sheet at the lower of its cost or its net realizable value. Determination of net realizable value requires management to estimate the point in time at which an item’s net realizable value drops below its cost. We regularly review our inventory for slow-moving items and for items that we are unable to sell at prices above their original cost. When we identify such an item, we reduce its book value to the net amount that we expect to realize upon its sale. This process entails a significant amount of inherent subjectivity and uncertainty.
Carrying value of long-lived assets - We apply the provisions of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”) and Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”) in assessing the carrying values of our long-lived assets. SFAS 142 and SFAS 144 both require that a company consider whether circumstances or conditions exist that suggest that the carrying value of a long-lived asset might be impaired. If such circumstances or conditions exist, further steps are required in order to determine whether the carrying value of the asset exceeds its fair value. If analyses indicate that the asset’s carrying value does exceed its fair market value, the next step is to record a loss equal to the excess of the asset’s carrying value over its fair value. The steps required by SFAS 142 and SFAS 144 entail significant amounts of judgment and subjectivity. We completed our annual analysis of the carrying value of our goodwill during the first quarter of fiscal 2005 and, accordingly, recorded no impairment.
Economic useful life of intangible assets - We apply SFAS 142 in determining the useful economic lives of intangible assets that we acquire and that we report on our consolidated balance sheets. SFAS 142 requires that companies amortize intangible assets, such as licenses and trademarks, over their economic useful lives, unless those assets’ economic useful lives are indefinite. If an intangible asset’s economic useful life is deemed to be indefinite, that asset is not amortized. When we acquire an intangible asset, we consider factors such as the asset’s history, our plans for that asset, and the market for products associated with the asset. We consider these same factors when reviewing the economic useful lives of our previously acquired intangible assets as well. We review the economic useful lives of our intangible assets at least annually. The determination of the economic useful life of an intangible asset requires a significant amount of judgment and entails significant subjectivity and uncertainty. We have completed our annual analysis of the remaining useful economic lives of our intangible assets during the first quarter of fiscal 2005 and determined that the useful lives currently being used to determine amortization of each asset are appropriate.
With respect to the June 1, 2004 acquisition of intangible assets of OXO International, and the September 29, 2004 acquisition of TimeBlock® and Skin Milk® body and skin care products lines from Naterra International, Inc., we have completed our analysis of the economic lives of the assets acquired and have made an allocation of the initial purchase price based upon independent appraisals.
For a more comprehensive list of our accounting policies, we encourage you to read Note 1 - Summary of Significant Accounting Policies, included in the consolidated financial statements included in our latest annual report on Form 10-K. Note 1 in the consolidated financial statements included with Form 10-K contains several other policies,
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including policies governing the timing of revenue recognition, that are important to the preparation of our consolidated financial statements, but do not meet the SEC’s definition of critical accounting policies because they do not involve subjective or complex judgments.
FORWARD-LOOKING INFORMATION AND FACTORS THAT MAY AFFECT FUTURE RESULTS
Certain written and oral statements made by our Company and subsidiaries or with the approval of an authorized executive officer of our Company may constitute “forward-looking statements” as defined under the Private Securities Litigation Reform Act of 1995. This includes statements made in this report, in other filings with the Securities and Exchange Commission, in press releases, and in certain other oral and written presentations. Generally, the words “anticipates”, “believes”, “expects”, “plans”, “may”, “will”, “should”, “seeks”, “estimates”, “predict”, “potential”, “continue”, “intends”, and other similar words identify forward-looking statements. All statements that address operating results, events or developments that we expect or anticipate will occur in the future, including statements related to sales, earnings per share results, and statements expressing general expectations about future operating results, are forward-looking statements. The Company cautions readers not to place undue reliance on forward-looking statements. Forward-looking statements are subject to risks that could cause such statements to differ materially from actual results. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.
Risk Factors
Factors that could cause actual results to differ from those anticipated include:
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parent company became a Controlled Foreign Corporation, such a change could have a material negative effect on the largest U.S. shareholders and, in turn, on the Company’s business.
Deployment of a New Global Enterprise Resource Planning System
On September 7, 2004, we implemented our new Global Enterprise Resource Planning System, along with other new technologies. With the implementation of this new system, most of our businesses with the significant exception of the newly acquired housewares segment run under one integrated information system. We are currently in the process of closely monitoring the new system and making normal and expected adjustments to improve its effectiveness. We expect this process to continue over the remainder of the fiscal year. Complications resulting from the project could potentially cause considerable disruptions to our business. In the third fiscal quarter, we experienced some backlog in the processing of customer shipments while our sales operations and distribution groups were learning and adapting to the new system. This backlog was eliminated and we regained our normal operational pace mid-way through the quarter. The change from the old system to the new system will continue to involve risk. Application program bugs, system conflict crashes, user error, data integrity issues, customer data conflicts and integration issues with certain remaining legacy systems all pose potential risks. Implementing new data standards and converting existing data to accommodate the new system’s requirements has required a significant effort across our entire organization. Also during the third quarter, we began the implementation and transition of our housewares segment to the new system. We also are investigating several significant functionality enhancements planned for implementation under Phase 2 of our IT enhancement program. These additional implementations will continue to strain our internal resources, could impact our ability to do business, and may result in higher implementation costs and concurrent reallocation of human resources.
To support these new technologies, we are building and supporting a much larger and more complex information technology infrastructure. Increased computing capacity, power requirements, back-up capacities, broadband network infrastructure and increased security needs are all potential areas for failure and risk. We have relied substantially on outside vendors to assist us with the conversion and will continue to rely on certain vendors to assist us in maintaining some of our new infrastructure. Should they fail to perform due to events outside our control, it could affect our service levels and threaten our ability to conduct business. Natural disasters may disrupt our infrastructure and our disaster recovery process may not be sufficient to protect against loss.
Additionally, our business operations are dependent on our logistical systems, which include our order management system and our computerized warehouse network. These logistical systems depend on our new Global Enterprise Resource Planning System. Any interruption in our logistical systems would impact our ability to procure our products from our factories and suppliers, transport them to our distribution facilities, store them and deliver them to our customers on time and in the correct amounts.
Incurrence of New Debt to Fund Acquisitions
During the second quarter of fiscal 2005, we incurred substantial debt as more fully described in Note 8 to the consolidated condensed financial statements and under the “Financing Activities” section of our Management’s Discussion and Analysis of Financial Condition and Results of Operations. We are now operating under substantially more leverage and have begun to incur higher interest costs. This substantial increase in debt has added new constraints on our ability to operate our business, including but not limited to:
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Acquisitions
As previously mentioned, we acquired certain assets and liabilities of OXO International on June 1, 2004. On September 29, 2004, we acquired certain assets related to the worldwide production and distribution of TimeBlock® and Skin Milk® body and skin care products lines from Naterra International, Inc. TimeBlock® is a line of clinically tested anti-aging skin care products. Skin Milk® is a line of body, bath and skin care products enriched with real milk proteins, vitamins and botanical extracts. To the extent that these acquisitions are not favorably received by shareholders, analysts, and others in the investment community, the price of our common stock could be adversely affected. In addition, acquisitions involve numerous risks, including:
If we are unable to successfully integrate the operations, technologies, products or personnel that we have acquired, our business, results of operations, and financial condition could be materially adversely affected.
Projections of Sales and Earnings
We currently do not have contracts with our major customers that require them to purchase a minimum amount of our products. Most of our major customers purchase our products electronically through electronic data interchange and expect us to promptly deliver products from our existing inventories to the customers’ retail stores or distribution centers. This method of ordering products allows our customers to immediately respond to changes in demands of their retail customers. From time to time we provide projections to our shareholders and the investment community of our future sales and earnings. Since we do not have long-term purchase commitments from our major customers and the customer order and ship process is short, it is difficult for us to accurately predict the amount of our sales and related earnings. Our projections are based on management’s best estimate of sales using historical sales data and other information deemed relevant. These projections are highly subjective since sales to our customers can fluctuate substantially based on the demands of their retail customers.
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Because our ability to forecast sales is highly subjective, there is a risk that our future sales and earnings could vary in a material amount from our projections.
Internal Control Over Financial Reporting
Section 404 of the Sarbanes-Oxley Act of 2002 requires most publicly traded companies to include in their annual reports an assessment by management of the companies’ internal control structures and procedures for financial reporting, and an attestation by the companies’ registered public accounting firms of that management assessment. We continue to document, review and test our internal control over financial reporting to help achieve compliance with the Section 404 requirements of the Sarbanes-Oxley Act. If during the course of completing this work, our management identifies one or more material weaknesses in our internal control over financial reporting, we will be unable to assert that our internal control is effective. If we are unable to assert that our internal control over financial reporting is effective, this may impact the reliability of our internal controls over financial reporting until such time as the proper controls can be implemented. Another possibility is that our independent registered public accounting firm may not be satisfied with our internal control over financial reporting or with the level at which it is documented, designed, operated or reviewed. They may decline to attest to management’s assessment or may issue a qualified report identifying either a significant deficiency or a material weakness in our internal controls. Either of these outcomes could result in significant additional expenditures responding to the Section 404 internal control audit, a diversion of management attention, heightened regulatory scrutiny and potentially an adverse effect to the price of our company stock.
NEW ACCOUNTING GUIDANCE
In March 2004, the EITF reached a consensus on EITF Issue No. 03-1 (“EITF 03-1”), “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” for which the measurement and recognition provisions were to be effective for reporting periods beginning after June 15, 2004. However, in September 2004, the EITF issued FASB Staff Position EITF Issue No. 03-1-1, “Effective Date of Paragraphs 10-20 of EITF Issue No. 03-1, `The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,’” which postponed the measurement and recognition provisions of EITF 03-1, but maintained the disclosure requirements for all investments within the scope of the guidance to be effective in annual financial statements for fiscal years ending after June 15, 2004. EITF 03-1 provides a three-step process for determining whether investments, including equity securities, are other than temporarily impaired and requires additional disclosures in annual financial statements. An investment is impaired if the fair value of the investment is less than its cost. EITF 03-1 outlines that an impairment would be considered other-than-temporary unless: a) the investor has the ability and intent to hold an investment for a reasonable period of time sufficient for the recovery of the fair value up to (or beyond) the cost of the investment, and b) evidence indicating that the cost of the investment is recoverable within a reasonable period of time outweighs evidence to the contrary. In addition, the severity and duration of the impairment should also be considered in determining whether the impairment is other-than-temporary. We have applied the guidance provided by EITF 03-1 and determined that certain recent declines in the market value of securities acquired in connection with the sale of Tactica (see Note 13) were “other than temporary”, and recorded the appropriate recognition of a loss in the current quarter’s operating results.
In November 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4” (FAS 151). FAS 151 clarifies that abnormal inventory costs such as costs of idle facilities, excess freight and handling costs, and wasted materials (spoilage) are required to be recognized as current period charges. The provisions of FAS 151 are effective for fiscal years beginning June 1, 2006 or later. Management is currently evaluating the provisions of FAS 151 and does not expect that the adoption will have a material impact on the Company’s consolidated financial position or results of operations.
In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123R “Share-Based Payment” which revises SFAS No. 123, Accounting for Stock-Based Compensation, and supercedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”. The statement addresses the accounting for share-based payment transactions (for example, stock options and awards of restricted stock) in which an employer receives employee-services in exchange for equity securities of the company or liabilities that are
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based on the fair value of the company’s equity securities. The statement eliminates the use of APB Opinion No. 25, Accounting for Stock Issued to Employees, and generally requires such transactions be accounted for using a fair-value-based method and recording compensation expense rather than an optional pro forma disclosure of what expense amounts might be. The provisions of SFAS 123R are effective for public companies with interim or annual periods beginning after June 15, 2005. We are currently evaluating the provisions of SFAS 123R, and expect that the compensation expense we will record beginning with our third fiscal quarter 2006 will not materially vary in magnitude or trend from the pro-forma compensation that we have reported under the standard presently in effect.
In December 2004, the FASB issued FASB Staff Position (FSP) No. 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Job Creation Act of 2004”. FSP No. 109-2 amends the existing accounting literature that requires companies to record deferred taxes on foreign earnings, unless they intend to indefinitely reinvest those earnings outside the U.S. This pronouncement temporarily allows companies that are evaluating whether to repatriate foreign earnings under the American Jobs Creation Act of 2004 to delay recognizing any related taxes until that decision is made. This pronouncement also requires companies that are considering repatriating earnings to disclose the status of their evaluation and the potential amounts being considered for repatriation. The U.S. Treasury Department has not issued final guidelines for applying the repatriation provisions of the American Jobs Creation Act. We continue to evaluate this legislation and FSP No. 109-2 to determine whether we will repatriate any foreign earnings and the impact, if any, that this pronouncement will have on our consolidated financial statements.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Changes in interest rates and currency exchange rates represent our primary financial market risks. Fluctuation in interest rates causes variation in the amount of interest that we can earn on our available cash and the amount of interest expense we incur on our borrowings. Interest on our long-term debt outstanding as of November 30, 2004 is both floating and fixed. Fixed rates are in place on $55,000,000 senior notes at rates ranging from 7.01 percent to 7.24 percent. Floating rates are in place on $225,000,000 of senior notes. Interest rates on these notes are reset quarterly based on the 3 month LIBOR rate plus 85 basis points for the five and seven year notes, and the 3 month LIBOR rate plus 90 basis points for the ten year notes. At closing on June 29, 2004, the initial interest rates were 2.436 percent for the five and seven year notes, and 2.486 percent for the ten year notes. On September 29, 2004, the interest rates on these notes were reset for the next three months at 2.82 percent for the five and seven year notes and 2.87 percent for the ten year notes. On December 29, 2004, the interest rate on these notes were reset for the next three months at 3.410 percent for the five and seven year notes and 3.460 percent for the ten year notes. Increases in interest rates expose us to risk on this debt. Also, with respect to our $55,000,000 senior notes, as interest rates drop below the rates on this debt, our interest cost can exceed the cost of capital of companies who borrow at lower rates of interest.
As mentioned in “Financial Condition, Liquidity, and Capital Resources”, interest rates on our revolving credit agreement vary based on the LIBOR rate and the applicable period for the LIBOR rate. Therefore, the potential for interest rate increases exposes us to interest rate risk on our revolving credit agreement. Our revolving credit agreement allows for maximum revolving borrowings of $75,000,000. At November 30, 2004, there were $46,000,000 of outstanding borrowings and open letters of credit of $1,282,000 under this credit line. The need to continue to borrow under this and similar successor agreements could ultimately subject us to higher interest rates, thus increasing the future cost of such debt. We do not currently hedge against interest rate risk.
As mentioned under Note 8 to our consolidated condensed financial statements, “Financial Condition, Liquidity, and Capital Resources”, and “Forward-Looking Information and Factors that may affect Future Results”, on June 29, 2004, we established a new five year, $75,000,000 revolving credit facility, cancelled our existing $50,000,000 revolving credit facility, and placed $225,000,000 of floating rate senior debt with five, seven, and ten year maturities. Both the new revolving credit facility and the senior debt bear floating rates of interest. For example, a 1 percent increase in our base interest rates could impact us by adding up to $3,000,000 of additional interest cost annually. The addition of this level of debt exposure to our consolidated operations, and the uncertainty regarding the level of our future interest rates, substantially increases our risk profile.
Because we purchase a majority of our inventory using U.S. Dollars, we are subject to minimal short-term foreign exchange rate risk in purchasing inventory. However long-term declines in the value of the U.S. Dollar could subject us to higher inventory costs. Such an increase in inventory costs could occur if foreign vendors were to react to such a decline by raising prices. Sales in the United States are transacted in U.S. Dollars. The majority of our sales in the United Kingdom are transacted in British Pounds, in France and Germany are transacted in Euros, in Mexico are transacted in Pesos, and in Canada are transacted in Canadian Dollars. When the U.S. Dollar strengthens against other currencies in which we transact sales, we are exposed to foreign exchange losses on those sales because our foreign currency sales prices are not adjusted for currency fluctuations. When the U.S. Dollar weakens against those currencies, we could realize foreign currency gains.
During the three- and nine-month periods ended November 30, 2004, we transacted 18 and 16 percent, respectively, of our sales from continuing operations in foreign currencies. For the three- and nine-month periods ended November 30, 2003, we transacted 18 and 14 percent respectively, of our sales from continuing operations in foreign currencies. For the three- and nine-month periods ended November 30, 2004 we incurred foreign currency exchange losses of $1,334,000 and $710,000. For the same periods in fiscal 2004, we incurred foreign exchange gains of $940,000 and $853,000.
We hedge against foreign currency exchange rate-risk by entering into a series of forward contracts designated as cash flow hedges to protect against the foreign currency exchange risk inherent in our forecasted transactions denominated in currencies other than the U.S. Dollar. For transactions designated as cash flow hedges, the effective
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portion of the change in the fair value (arising from the change in the spot rates from period to period) is deferred in Other Comprehensive Income. These amounts are subsequently recognized in “Selling, general and administrative expense” in the consolidated condensed statements of income in the same period as the forecasted transactions close out over the remaining balance of their terms. The ineffective portion of the change in fair value (arising from the change in the difference between the spot rate and the forward rate) is recognized in the period it occurred. These amounts are also recognized in “Selling, general and administrative expense” in the consolidated condensed statements of income. We do not enter into any forward exchange contracts or similar instruments for trading or other speculative purposes.
We expect that as currency market conditions warrant, and our foreign denominated transaction exposure grows, we will continue to execute additional contracts in order to hedge against potential foreign exchange losses.
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ITEM 4. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS
As of the end of the period covered by this Form 10-Q, we conducted an evaluation of the effectiveness of the design and operation of our “disclosure controls and procedures” (Disclosure Controls). The controls evaluation was done under the supervision and with the participation of management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO).
Disclosure Controls are controls and procedures designed to reasonably assure that information required to be disclosed in our reports filed under the Exchange Act, such as this Quarterly Report, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure Controls are also designed to reasonably assure that such information is accumulated and communicated to our management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. Our Disclosure Controls include components of our internal control over financial reporting, which consists of control processes designed to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements in accordance with generally accepted accounting principles in the United States.
Our management, including the CEO and CFO, does not expect that our Disclosure Controls or our internal control over financial reporting will prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.
In the process of our evaluation, among other matters, we considered the existence of any “significant deficiencies” or “material weaknesses” in our internal control over financial reporting, and whether we had identified any acts of fraud involving personnel with a significant role in our internal control over financial reporting. In the professional auditing literature, “significant deficiencies” are referred to as “reportable conditions,” which are deficiencies in the design or operation of controls that could adversely affect our ability to record, process, summarize and report financial data in the financial statements. Auditing literature defines “material weakness” as a particularly serious reportable condition in which the internal control does not reduce to a relatively low level the risk that misstatements caused by error or fraud may occur in amounts that would be material in relation to the financial statements and the risk that such misstatements would not be detected within a timely period by employees in the normal course of performing their assigned functions.
Through the date of this report, no corrective actions were required to be taken with regard to either significant deficiencies or material weaknesses in our controls. Based on their evaluation, as of the end of the period covered by this Form 10-Q, our CEO and CFO have concluded that our disclosure controls and procedures (as defined in Rule 13a-15(e) or 15d-15(e) under the Securities Exchange Act of 1934) are effective.
In connection with the evaluation described above, we identified no change in our internal control over financial reporting that occurred during our fiscal quarter ended November 30, 2004, and that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
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COMPLIANCE WITH SECTION 404 OF THE SARBANES-OXLEY ACT OF 2002
Under Section 404 of the Sarbanes-Oxley Act of 2002 (“404”), we are required to include, for the first time in our Annual Report on Form 10-K for 2005 (the “10-K”), management’s assessment of the effectiveness of our internal controls over financial reporting (the “Assessment”), and our independent auditor’s attestation of that assessment (the “Attestation”). We are working diligently to complete our work required for the Assessment and Attestation. To date, however, we have experienced an increased workload versus initial expectations and have realized some delays in executing against our internal 404 project plan as a result of our conversion to a new global information system which was placed into service on September 7, 2004. Due to the complexities of the conversion to the new global information system, we expect to continue to experience a period of significant changes and refinements of our procedures for the next three to six months. While nothing has come to our attention that would lead us to believe that we may experience errors or misstatements of our financial results during this time-frame, we recognize that this continues to be a challenging transition for us and creates difficulties in the documentation of our internal controls.
We remain committed to conducting a thorough review of our internal controls in preparation for compliance with the requirements of Section 404. In the third quarter of fiscal 2005 we re-evaluated that plan, adding both internal staffing resources and external consultants to our 404 project team. The revised 404 project plan contains many time-critical milestones. Our efforts during January and February 2005 will be critical to our success. If during the course of completion of our internal work, our management identifies one or more material weaknesses in our internal control over financial reporting, we will be unable to assert that our internal control is effective. If we are unable to assert that our internal control over financial reporting is effective, this may impact the reliability of our internal controls over financial reporting until such time as the proper controls can be implemented. Another possibility is that our evaluation of internal controls may not be completed in time for our external auditors to complete their assessment in a timely basis. If this were to occur, we may be unable to assert that the internal controls over financial reporting are effective, or our independent registered public accountants may not be able to render the required attestation concerning our effectiveness of the internal controls over financial reporting in a timely manner.
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PART II. OTHER INFORMATION
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
During the quarter ended August 31, 2003, our Board of Directors authorized us to purchase, in open market or through private transactions, up to 3,000,000 shares of our common stock over a period extending to May 31, 2006. During the quarter ended November 30, 2004, we did not purchase any shares. From September 1, 2003 through November 30, 2004, we have repurchased 1,563,836 shares at a total cost of $45,611,690 or an average share price of $29.17. An additional 1,436,164 shares are authorized for purchase under this plan.
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ITEM 5. OTHER INFORMATION
On April 29, 2004, we completed the sale of our 55 percent interest in Tactica International, Inc. (“Tactica”) back to certain shareholder-managers. Statement of Financial Accounting Standards No.144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”), provides accounting guidance for these circumstances and requires us to present any operating results for Tactica in the accompanying consolidated condensed financial statements as a discontinued operation. Under discontinued operations accounting treatment, we must report Tactica’s operating results, net of taxes, as a separate summarized component after income from continuing operations for each period presented. Accordingly, the accompanying consolidated condensed statements of income contain all appropriate reclassifications for each prior period presented. In order to facilitate investors’ trend analysis, we believe it appropriate to provide the following supplementary schedule of restated quarterly operating results for fiscal 2004. The schedule shows all four quarter’s operating results presented in accordance with SFAS 144.
Consolidated Quarterly Statements of Income Restated For Tactica Discontinued Operations for Fiscal 2004(Unaudited)(in thousands, except per share data)
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ITEM 6. EXHIBITS
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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.
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Index to Exhibits
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