Description
Filed with the SEC from July 12 to July 18:
Kid Brands (KID)
Morehead Opportunity Fund increased its holdings to 1,946,415 shares (8.9%), by buying 843,619 from May 23 through July 13 at $1.90 to $2.20 a share.
BUSINESS OVERVIEW
General
We are a leading designer, importer, marketer and distributor of branded infant and juvenile consumer products. Through our four principal wholly-owned operating subsidiaries – Kids Line, LLC (“Kids Line”); LaJobi, Inc. (“LaJobi”); Sassy, Inc. (“Sassy”); and CoCaLo, Inc. (“CoCaLo”) – we design and market branded infant and juvenile products in a number of complementary categories including, among others: infant bedding and related nursery accessories and décor, food preparation and nursery appliances, bath/spa products and diaper bags (Kids Line ® and CoCaLo ® ); nursery furniture and related products (LaJobi ® ); and developmental toys and feeding, bath and baby care items with features that address the various stages of an infant’s early years (Sassy ® ). In addition to our branded products, we also market certain categories of products under various licenses, including Carter’s ® , Disney ® , Graco ® and Serta ® .
Our products are sold primarily to retailers in North America, the United Kingdom (“U.K.”) and Australia, including large, national retail accounts and independent retailers (including toy, specialty, food, drug, apparel and other retailers). We maintain a direct sales force and distribution network to serve our customers in the United States, the U.K. and Australia. We also maintain relationships with several independent representatives to service select domestic and foreign retail customers, as well as international distributors to service certain retail customers in several foreign countries. We generated annual net sales of approximately $252.6 million in 2011. See “Products” below for a discussion of our current product categories.
We were founded in 1963 by the late Mr. Russell Berrie, and were incorporated in New Jersey as Russ Berrie and Company, Inc. in 1966. Our common stock has been traded on the New York Stock Exchange since its initial public offering on March 29, 1984 (under the symbol “RUS” until September 22, 2009, when we changed our name to Kid Brands, Inc., and under the symbol “KID” thereafter).
See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a discussion of the principal elements of our current global business strategy and recent developments regarding our business.
We maintain our principal executive offices at One Meadowlands Plaza, 8 th Floor, East Rutherford, New Jersey 07073. Our wholly-owned subsidiaries are located in the United States, the United Kingdom, Australia, the People’s Republic of China (the “PRC”), Hong Kong and Thailand, with distribution centers located in California, New Jersey and Michigan. See Item 2, “Properties”. Our telephone number is 201-405-2400.
Products
Our infant and juvenile product line currently consists of approximately 7,000 products that principally focus on children of the age group newborn to three years. We have also recently begun to expand the age range of our addressable consumer market by developing and marketing certain products for children of ages three through seven, including toddler bedding and beds as well as food preparation and kitchen products. Kids Line ® products, which are marketed primarily under the Kids Line ® , Carter’s ® and Disney ® brands, and CoCaLo ® products, which are marketed primarily under the CoCaLo Baby ® , CoCaLo Couture ® , and CoCaLo Naturals TM brands, each consist primarily of infant bedding and related nursery accessories and décor such as blankets, rugs, mobiles, nightlights, hampers, lamps and wall art, as well as specified kitchen and nursery appliances, diaper bags and spa/bath products. LaJobi ® products, which are marketed primarily under the Babi Italia ® , Europa Baby ® , Bonavita ® , Graco ® and Serta ® brands, consist primarily of cribs, mattresses and other nursery furniture. Sassy ® products, which are marketed primarily under the Sassy ® , Carter’s ® and Garanimals ® brands, consist primarily of developmental toys and feeding, bath and baby care items with features that address the various stages of an infant’s early years.
Design and Production
We maintain a continuing program of new product development. We design most of our own products, although certain products are designed by independent designers or are licensed from other third parties. Items are added to the product line only if we believe that they can be sourced and marketed on a basis that meets our profitability standards.
Generally, a new design is brought to market in less than one year after a decision is made to produce the product. Sales of our products are, in large part, dependent on our ability to anticipate, identify and react quickly to changing consumer preferences and to effectively utilize our sales and distribution systems to bring new products to market.
We occasionally engage in market research and test marketing to evaluate consumer reactions to our products. Research into consumer buying trends often suggests new products. We assemble information from retail stores, our sales force, focus groups, industry experts, vendors and our product development personnel. We continually analyze our products to determine whether they should be adapted into new or different products using elements of the initial design or whether they should be removed from the product line.
Substantially all of our products are produced by independent manufacturers, generally in Eastern Asia, under the quality review of approximately 43 individuals in the PRC, Thailand, Hong Kong and Vietnam who monitor the production process with responsibility for the quality, safety and prompt delivery of our products, as well as certain compliance and product development issues. We have established subsidiaries in the PRC, Hong Kong and Thailand to oversee our quality assurance activities in Asia, and have retained the full-time services of such individuals, either directly through such subsidiaries, or through third party outsource agencies. See the Company’s Quarterly Report on Form 10-Q for the period ended September 30, 2011 (the “September 10-Q”) for a discussion of our East Asia quality control staff, a description of the previous retention of certain of these individuals through a company affiliated with the former President of LaJobi and various members of his family, and the potential impact of such prior staffing and related payment practices. Our products are designed, manufactured, packaged and labeled to conform to all applicable safety requirements under U.S. federal and other applicable laws and regulations, various industry-developed voluntary standards and product-specific standards.
During 2011, we utilized numerous manufacturers in Eastern Asia for our operations, with facilities primarily in the PRC and other Eastern Asia countries. During 2011, approximately 74% of our dollar volume of purchases for our operations was attributable to manufacturing in the PRC. Members of our Eastern Asia and U.S. product development staff make frequent visits to such manufacturers. The PRC currently enjoys “permanent normal trade relations” (“PNTR”) status under U.S. Tariff laws, which generally provides a favorable category of U.S. import duties. The loss of such PNTR status would result in a substantial increase in the import duty for products manufactured for us in the PRC and imported into the United States and would result in an increase in our sourcing costs. In addition, certain categories of wooden bedroom furniture previously imported from the PRC by our LaJobi subsidiary were also subject to anti-dumping duties. For a discussion of charges taken for anticipated anti-dumping duties (and related interest) and other actions resulting from LaJobi’s prior import practices, including a restatement of specified financial statements and a liability in the approximate amount of $11.7 million recorded in connection therewith, see Item 3, “Legal Proceedings”, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, and Notes 4, 17 and 19 of the Notes to Consolidated Financial Statements. We have discontinued the practices that resulted in these anticipated anti-dumping duties and have established alternate vendor arrangements for the relevant product in countries that are not subject to such anti-dumping duties. Also see “Risk Factors- Any failure to fully comply with the laws of various Asian jurisdictions could cause potential liability and have other adverse effects” .
In 2011, the supplier accounting for the greatest dollar volume of the purchases for our operations accounted for approximately 24% of such purchases, and the five largest suppliers accounted for approximately 48% in the aggregate. We believe, however, that there are alternate manufacturers for our products and sources of raw materials. See Item 1A, “Risk Factors – We rely on foreign suppliers, primarily in the PRC, to manufacture most of our products, which subjects us to numerous international business risks that could increase our costs or disrupt the supply of our products ”, as well as Note 16 of Notes to Consolidated Financial Statements for a discussion of risks attendant to our foreign operations.
Marketing and Sales
Our products are marketed through our own direct sales force of full-time employees, as well as through independent manufacturers’ representatives and distributors to retail customers in the United States and certain foreign countries including, but not limited to, mass merchandisers, baby superstores, specialty stores, department stores and boutiques. During 2011, we maintained a direct sales force and distribution network for our operations in the United States, the United Kingdom and Australia. We also maintain relationships with several independent representatives to service select domestic and foreign retail customers, as well as international distributors to service certain retail customers in several foreign countries. Our sales attributable to foreign-based operations were $9.6 million, $9.4 million and $8.5 million for the years ended December 31, 2011, 2010, and 2009, respectively. Our consolidated foreign sales from operations, including export sales from the United States, aggregated $18.9 million, $22.9 million and $19.8 million for the years ended December 31, 2011, 2010, and 2009, respectively. See Note 16 of Notes to Consolidated Financial Statements for information with respect to, among other things, revenues from external customers and total assets for each of the years ending December 2011, 2010, and 2009, respectively, as well as specified geographic information.
During 2011, we sold infant and juvenile products to approximately 2,100 customers worldwide. Toys “R” Us, Inc. and Babies “R” Us, Inc., in the aggregate, accounted for approximately 39.8%; Wal-Mart Stores, Inc. (“Walmart”) accounted for approximately 12.7%; and Target Corporation (“Target”) accounted for approximately 8.8% of our consolidated gross sales during 2011. The loss of any of these customers, the loss of certain other large customers, or a significant reduction in the volume of business conducted with any such customers, could have a material adverse affect on us. See Item 1A, “Risk Factors – Our business is dependent on several large customers” and Note 5 of Notes to Consolidated Financial Statements.
We reinforce the marketing efforts of our sales force through an active promotional program, including showrooms at our principal facilities, participation in trade shows, and trade and consumer advertising, as well as a growing set of internet-based promotional activities. We also seek to further capture synergies between our businesses by cross-marketing products and building upon the strong customer relationships developed by each of our subsidiaries, as well as by consolidating certain operational activities.
Customer service is an essential component of our marketing strategy. We maintain customer service departments that respond to customer inquiries, investigate and resolve issues and generally assist customers and/or consumers.
Our general terms of sale are competitive with others in our industry. Sales are typically made utilizing standard credit terms of 30 to 60 days. However, commencing in late 2011, we occasionally elect to participate in an “auction” program initiated by one of our largest customers, which permits us to offer an additional discount on all or a portion of the outstanding accounts receivable from such customer in return for prompt, accelerated payment of all or the relevant portion of such receivable. The amount of the additional discount is subject to acceptance, is determined in part by the aging of the receivable and is within the range of customary discounts for early payment. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources”. We do not ordinarily sell our products on consignment, and we ordinarily accept returns only for defective merchandise. Notwithstanding the foregoing, in certain instances, where retailers are unable to resell the quantity of products that they have purchased from us, we may, in accordance with industry practice, assist retailers in selling such excess inventory by offering credits and other price concessions or, on occasion, accept returns.
Distribution
Many of our customers, particularly mass merchandisers, pick up their goods at our regional distribution centers, which are located in South Gate, California; Cranbury, New Jersey; and Kentwood, Michigan. We also use common carriers to arrange shipments to customers who request such arrangements, including smaller retailers and specialty stores. CoCaLo distributes its products through a third party logistics provider (unaffiliated since January 1, 2011). LaJobi also utilizes the services of independent third party logistics providers in California for a portion of its distribution requirements, and our subsidiaries in Australia and the U.K. utilize the services of independent third party logistics providers in their respective jurisdictions.
Seasonality
We typically do not experience significant seasonal variations in demand for our products, although we typically do experience slightly higher sales during the second half of the fiscal year. In 2011, approximately 52% of our net sales were made during the second half of the fiscal year. Sales to our retail customers may be higher in periods when retailers take initial shipments of new products, as these orders typically incorporate enough products to fill each store plus additional amounts to be kept at the customer’s distribution center. The timing of these initial shipments varies by customer depending on when they finalize store layouts for the upcoming year and whether there are any mid-year product introductions.
Competition
The infant and juvenile products industry is highly competitive and is characterized by the frequent introduction of new products and includes numerous domestic and foreign competitors, many of which are substantially larger and have financial and other resources greater than ours. We compete with a number of different competitors, depending on the product category, and compete against no single company across all of our product categories. Our competition includes large infant and juvenile product companies and specialty infant and juvenile product manufacturers. We compete principally on the basis of proprietary product design, brand name recognition, product quality, innovation, and relationships with major retailers, customer service and price/value relationship.
In addition, certain of our potential customers, in particular mass merchandisers, have the financial and other resources necessary to buy products similar to those that we sell directly from manufacturers in Eastern Asia and elsewhere, thereby potentially reducing the size of our potential market. See Item 1A, “Risk Factors – Competition in our markets could reduce our net sales and profitability.”
Copyrights, Trademarks, Patents and Licenses
We rely on a combination of trademarks, copyrights, patents, licenses and trade secrets to protect our intellectual property. We believe our intellectual property has significant value, though we do not consider our business to be materially dependent on such intellectual property due to the availability of substitutes and our ability to create new designs, and the variety of products that we sell. Intellectual property protections are limited or even unavailable in some foreign countries and preventing unauthorized use of our intellectual property can be difficult even in countries with substantial legal protection. In addition, the portion of our business that relies on the use of intellectual property is subject to the risk of challenges by third parties claiming infringement of their proprietary rights. See Item 1, “Risk Factors - “Trademark infringement or other intellectual property claims relating to our products could increase our costs.”
We enter into license agreements relating to trademarks, copyrights, patents, designs and products which enable us to market items compatible with our product line. We believe that our license agreements are important assets for our business. We currently maintain license agreements with, among others, The William Carter Company (Carter’s ® ); Disney ® Enterprises, Inc.; Graco ® Children’s Products, Inc.; Serta ® , Inc.; and Garanimals ® . Our license agreements are typically for terms of two to five years with extensions possible if agreed to by both parties. Royalties are paid on licensed products and, in many cases, advance royalties and minimum guarantees are required by these license agreements. Although we do not believe our business is dependent on any single license, the Graco ® license (which expires on December 31, 2013, subject to renewals) and the Carter’s ® license (which expires on December 31, 2012, subject to renewals) are each material to and accounted for a material portion of the net revenues of LaJobi and Kids Line, respectively, as well as a significant percentage of the net revenues of the Company, in each case for each of the last three years. In addition, the Serta ® license (which expires on December 31, 2013, subject to renewals) is material to and accounted for a significant percentage of the net revenues of LaJobi; the Disney ® license (which expires on December 31, 2012, subject to renewals) is material to and accounted for a significant percentage of the net revenues of Kids Line; and the Garanimals ® license (which expires on December 31, 2012) is material to and accounted for a significant percentage of the net revenues of Sassy, in each case (other than Garanimals ® which commenced in 2010) for the last three years ended December 31, 2011. While historically we have been able to renew the license agreements that we wish to continue on terms acceptable to us, the loss of any of the foregoing and/or other significant license agreements could have a material adverse effect on our results of operations, at least until such time, if ever, that appropriate replacements can be secured and related products marketed on commercially acceptable terms. See Item 1A, “Risk Factors - “ Competition for licenses could increase our licensing costs or limit our ability to market products” and “The loss of any significant license could adversely affect our business .”
In connection with the sale of KID’s former gift business to The Russ Companies, Inc. (“TRC”), a limited liability company wholly-owned by KID (the “Licensor”) executed a license agreement (the “License Agreement”) with TRC permitting TRC to use specified intellectual property, consisting generally of the “Russ” and “Applause” trademarks and trade names (the “Retained IP”). Pursuant to the License Agreement, TRC was required to pay the Licensor an annual royalty of $1,150,000. KID received $287,500 in respect of the royalty payment due March 23, 2010 under the License Agreement, which was recorded as other income in the first quarter of 2010, but did not receive any other royalty payments due thereunder. On April 21, 2011, TRC and TRC’s domestic subsidiaries (collectively, the “Debtors”), filed a voluntary petition under Chapter 7 of the United States Bankruptcy Code in the United States Bankruptcy Court for the District of New Jersey (the “Bankruptcy Court”). On June 16, 2011, the Bankruptcy Court entered an order which, among other things, approved a settlement with the secured creditors of the Debtors, including KID (the “Settlement”). Among other things, the Settlement allows us to retain ownership of the Retained IP. See Note 3 of the Notes to Consolidated Financial Statements for more information regarding the Settlement.
Employees
As of December 31, 2011, we employed approximately 320 persons. In addition, we currently utilize the full-time services of approximately 43 individuals in the PRC, Thailand, Hong Kong and Vietnam, a portion of which are employed directly by the Company’s Asian subsidiaries and the remainder of which are employed through third-party outsource agencies. See, “Business – Design and Production”, “Risk Factors – Any failure to fully comply with the laws of various Asian jurisdictions could cause potential liability and have other adverse effects ” and Note 17 of the Notes to Consolidated Financial Statements. We consider our employee relations to be good. Most of our employees are not covered by a collective bargaining agreement, although approximately 25 Sassy employees, representing approximately 8% of our total employees, were represented by a collective bargaining agreement as of December 31, 2011.
Government Regulation
Certain of our products are subject to the provisions of, among other laws, the Federal Hazardous Substances Act, the Federal Consumer Product Safety Act and the Federal Consumer Product Safety Improvement Act. Those laws empower the Consumer Product Safety Commission (the “CPSC”) to protect consumers from certain hazardous articles by regulating their use or excluding them from the market and requiring the recall of products that are found to be potentially hazardous. The CPSC’s determination is subject to judicial review. Similar laws exist in some states and cities in the United States and in certain foreign jurisdictions in which our products are sold. We maintain a quality control program in order to comply with such laws, and we believe we are in substantial compliance with all the foregoing laws. Notwithstanding the foregoing, no assurance can be made that all products are or will be free from hazards or defects, or that rapidly changing safety standards will not render unsaleable products that complied with previously applicable safety standards. See Item 1A, “Risk Factors – Product liability, product recalls and other claims relating to the use of our products could increase our costs. ”
Corporate Governance and Available Information
We make available a wide variety of information free of charge on our website at www.kidbrands.com . Our reports that are filed or furnished with the United States Securities and Exchange Commission (the “SEC”), including our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and any amendments to such reports, are available on our website as soon as reasonably practicable after the reports are electronically filed with or furnished to the SEC. Our website also contains news releases, financial information, company profiles and certain corporate governance information, including current versions of our “Whistleblower Policy”, “Corporate Governance Guidelines”, “Code of Business Conduct and Ethics”, “Code of Ethics for Principal Executive Officer and Senior Financial Officers”, “Criteria and Procedures with respect to Selection and Evaluation of Directors and Communications with the Board of Directors”, and the charters of the Audit Committee, the Compensation Committee and the Nominating/Governance Committee of the Board of Directors. To access our SEC reports or amendments, log onto our website and then click onto “Investor Relations” on the main menu and then onto the “SEC Filings” link near the bottom of the page. Mailed copies of such information can be obtained free of charge by writing to us at Kid Brands, Inc., One Meadowlands Plaza, 8 th Floor, East Rutherford, New Jersey 07073, Attention: Corporate Secretary. The contents of our websites are not incorporated into this filing.
CEO BACKGROUND
Raphael Benaroya (4)
64 1993 Pursuant to an agreement between the Company and RB, Inc., Mr. Benaroya was appointed by the Board as of September 12, 2011 to serve as interim Executive Chairman, acting as the chief executive of the Company during the pendency of the Board’s search for a new chief executive officer. He currently also serves as the Chairman of the Board and is a member of the Board’s Executive Committee, and has been a member of the Board since 1993. Since 2008, Mr. Benaroya has been Managing Director of Biltmore Capital, a privately-held financial company which invests in secured debt. Prior thereto, Mr. Benaroya was Chairman of the Board, President and Chief Executive Officer of United Retail Group, Inc., a Nasdaq-listed company, which operated a chain of retail specialty stores, from 1989 until its sale in October 2007, and continued as President and Chief Executive Officer thereafter until March 2008. Mr. Benaroya currently serves on the board of directors of Aveta Health Care, a privately-held healthcare management company. From April through October 2009, Mr. Benaroya had been retained by the Company to perform an expanded role as Chairman of the Board. From April 2008 until March 2010, Mr. Benaroya had been an advisor for D. E. Shaw & Co., L.P., an affiliate and investment advisor of D. E. Shaw Laminar Portfolios, L.L.C. (“Laminar”), a private investment fund and former 20% stockholder of the Company, relating to certain of Laminar’s portfolio companies.
Mario Ciampi (1)(2)
52 2007 Mr. Ciampi is currently (and has been since 2007) a partner of Prentice (5), a Connecticut-based private investment firm, and he served as a consultant to Prentice from 2006 to 2007. From October 2004 to May 2006, he served as President of Disney Store — North America, a division of The Children’s Place Retail Stores, Inc., a specialty retailer of children’s merchandise. From 1996 to September 2004, he served in various capacities for The Children’s Place, most recently as Senior Vice President — Operations. Mr. Ciampi was elected to the Board of the Company at the 2007 Annual Meeting of Shareholders. Mr. Ciampi has also been a member of the Board of Directors of Bluefly, Inc., an Internet retailer of discounted designer apparel and accessories, and home products and accessories, since 2008, and of Delia’s, Inc., a retailer of apparel for young girls, since March 2011. Mr. Ciampi is a current Prentice Director.
Frederick J. Horowitz (1)(3)
48 2006 Since 2001, Mr. Horowitz has been the Chairman and CEO of A.P. Deauville, a manufacturer and distributor of personal care products, primarily in the value and mass markets. Mr. Horowitz was elected to the Board of the Company on June 29, 2006. Mr. Horowitz is also a managing partner of American Brand Holdings, LLC, the owner of the “Hang Ten” brands, which is exclusively licensed to Kohl’s Corporation, an operator of family-oriented department stores.
Hugh R. Rovit (1)(2)(3)
51 2010 Mr. Rovit has served as the Chief Executive Officer of Sure Fit Inc., a marketer and distributor of home furnishing products, since 2006. From 2001 through 2005, he was a principal at Masson & Company, a turnaround management firm. Previously, Mr. Rovit held the positions of: Chief Financial Officer of Best Manufacturing, Inc., a manufacturer and distributor of institutional service apparel and textiles, from 1998 through 2001; and Chief Financial Officer of Royce Hosiery Mills, Inc., a manufacturer and distributor of men’s and women’s hosiery, from 1991 through 1998. Mr. Rovit currently serves on the Board of Directors of Spectrum Brands Holdings, Inc., a global consumer products company and Nellson Nutraceuticals, Inc., a privately-held manufacturer and marketer of nutritional bars and powders and is director emeritus of Atkins Nutritionals Inc., Oneida, Ltd. and Cosmetic Essence Inc., each privately held. Mr. Rovit was elected to the Board of the Company at the 2010 Annual Meeting of Shareholders.
Salvatore M. Salibello (2)(3)(4)
66 2006 Mr. Salibello has been an Assurance Partner of BDO USA, LLP since January 2012. From 1978 until January 2012, he was the founder and managing partner of Salibello & Broder LLP, a certified public accounting firm, until its acquisition by BDO. He is a Certified Public Accountant and a member of the American Institute of Certified Public Accountants and the New York State Society of Certified Public Accountants. Mr. Salibello currently sits on the Board of Directors of three closed-end mutual funds (Gabelli Dividend and Income Trust Fund, Gabelli Global Utility and Income Trust Fund, and Gabelli Global Gold Natural Resources + Income Trust Fund). Mr. Salibello was elected to the Board of the Company on June 29, 2006.
Michael Zimmerman (4)
42 2006 Mr. Zimmerman founded Prentice (5) in May 2005 and has been its Chief Executive Officer since its inception. Prior thereto, he managed investments in the retail consumer sector for S.A.C. Capital, a Connecticut-based investment fund, from 2000-2005. Mr. Zimmerman currently serves on the Board of Directors of Delia’s, Inc., a retailer of apparel for young girls, and he served as a director of The Wetseal, Inc., a national specialty retailer of contemporary apparel and accessory items, from March 2006 through May 2010. Mr. Zimmerman was elected to the Board of the Company on October 5, 2006. Mr. Zimmerman is a current Prentice Director.
MANAGEMENT DISCUSSION FROM LATEST 10K
Overview
We are a leading designer, importer, marketer and distributor of branded infant and juvenile consumer products. We generated annual net sales of approximately $252.6 million in 2011. We operate in one segment: the infant and juvenile business.
Our infant and juvenile business – which is currently conducted through the following operating subsidiaries: Kids Line, LaJobi, Sassy, and CoCaLo – designs, manufactures through third parties, imports and sells products in a number of complementary categories including, among others, infant bedding and related nursery accessories and décor, kitchen and nursery appliances and food preparation products, diaper bags and bath/spa products (Kids Line ® and CoCaLo ® ); nursery furniture and related products (LaJobi ® ); and developmental toys and feeding, bath and baby care items with features that address the various stages of an infant’s early years (Sassy ® ). In addition to our branded products, we also market certain categories of products under various licenses, including Carter’s ® , Disney ® , Graco ® and Serta ® . Our products are sold primarily to retailers in North America, the United Kingdom and Australia, including large, national retail accounts and independent retailers (including toy, specialty, food, drug, apparel and other retailers). We maintain a direct sales force and distribution network to serve our customers in the United States, the United Kingdom and Australia. We also maintain relationships with several independent representatives to service select domestic and foreign retail customers, as well as international distributors to service certain retail customers in several foreign countries. International sales, defined as sales outside of the United States, including export sales, constituted 7.5%, 8.3% and 8.1% of our net sales for the years ended December 31, 2011, 2010 and 2009, respectively.
Our senior corporate management, together with senior management of our subsidiaries, coordinates the operations of all of our businesses and seeks to identify cross-marketing, procurement and other complementary business opportunities, while maintaining the separate brand identities of each subsidiary.
Aside from funds provided by our senior credit facility, revenues from the sale of products have historically been the major source of cash for the Company, and cost of goods sold and payroll expenses have been the largest uses of cash. As a result, operating cash flows primarily depend on the amount of revenue generated and the timing of collections, as well as the quality of our customer accounts receivable. The timing and level of the payments to suppliers and other vendors also significantly affect operating cash flows. Management views operating cash flows as a good indicator of financial strength. Strong operating cash flows provide opportunities for growth both internally and through acquisitions, and also enable us to pay down debt.
We do not ordinarily sell our products on consignment, although we may do so in limited circumstances, and we ordinarily accept returns only for defective merchandise, although we may in certain cases accept returns as an accommodation to retailers. In the normal course of business, we grant certain accommodations and allowances to certain customers in order to assist these customers with inventory clearance or promotions, and in certain cases we may accept returns. Such amounts, together with discounts, are deducted from gross sales in determining net sales.
Our products are manufactured by third parties, principally located in the PRC and other Eastern Asian countries. Our purchases of finished products from these manufacturers are primarily denominated in U.S. dollars. Expenses incurred by these third party manufacturers are primarily denominated in Chinese Yuan. As a result, any material increase in the value of the Yuan relative to the U.S. dollar, as has occurred in past periods, or higher rates of inflation in the country of origin, would increase our expenses, and therefore, adversely affect our profitability. Conversely, a small portion of our revenues is generated by our subsidiaries in Australia and the United Kingdom and is denominated primarily in those local currencies. Any material increase in the value of the U.S. dollar relative to the value of the Australian dollar or British pound would result in a decrease in the amount of these revenues upon their translation into U.S. dollars for reporting purposes. See Item 1A, Risk Factors – “Currency exchange rate fluctuations could increase our expenses”.
Our gross profit may not be comparable to those of other entities, since some entities include the costs of warehousing, outbound handling costs and outbound shipping costs in their costs of sales. We account for the above expenses as operating expenses and classify them under selling, general and administrative expenses. For the years ended December 31, 2011, 2010 and 2009, the costs of warehousing, outbound handling costs and outbound shipping costs were $7.5 million, $7.2 million, and $7.0 million, respectively. In addition, the majority of outbound shipping costs are paid by our customers, as many of our customers pick up their goods at our distribution centers.
If our suppliers experience increased raw materials, labor or other costs, and pass along such cost increases to us through higher prices for finished goods, our cost of sales would increase. Many of our suppliers are currently experiencing significant cost pressures related to labor rates, raw material costs and currency inflation, which has and, we believe, will continue to put pressure on our gross margins, at least for the foreseeable future. To the extent we are unable to pass such price increases along to our customers or otherwise reduce our cost of goods, our gross profit margins would decrease. Our gross profit margins have also been impacted in recent periods by: (i) an increasing shift in product mix toward lower margin products, including increased sales of licensed products, which typically generate lower margins as a result of required royalty payments (which are recorded in cost of goods sold); (ii) increased pressure from major retailers, largely as a result of prevailing economic conditions, to offer additional mark downs and other pricing accommodations to clear existing inventory and secure new product placements; and (iii) other increased costs of goods. We believe that our future gross margins will continue to be under pressure as a result of the items listed above, and such pressures may be more acute over the next several quarters as a result of anticipated product cost increases. In addition, charges pertaining to anti-dumping duties that we anticipate will be owed by our LaJobi subsidiary to U.S. Customs, and charges pertaining to customs duties we anticipate will be owed by our Kids Line and CoCaLo subsidiaries to U.S. Customs have adversely affected gross margins and net income for specified periods (See the “Explanatory Note” above and Notes 17 and 19 to the Notes to Consolidated Financial Statements). The restatement of the Prior Financial Statements herein, as described in Note 19 to Notes to Consolidated Financial Statements, had a positive impact on previously-reported results of operations for 2010 and 2011, and a negative impact on previously-reported results of operations for prior periods. As the customs matters have not been concluded, however, it is possible that the actual amount of duty owed for the relevant periods will be higher than currently accrued amounts, and in any event, additional interest will continue to accrue until payment is made. In addition, we may be assessed by U.S. Customs a penalty of up to 100% of any customs duty owed, as well as possibly being subject to fines, penalties or other measures from U.S. Customs or other governmental authorities. Any amounts owed in excess of the accruals recorded will adversely affect our gross margin and net income for the period(s) in which such amounts are recorded and could have a material adverse affect on our results of operations. See Note 17 of Notes to Consolidated Financial Statements for a discussion of the LaJobi anti-dumping duty matters and the Kids Line/CoCaLo customs duty matters. We have discontinued the practices that resulted in the charge for anticipated anti-dumping duties, and have established alternate vendor arrangements for the relevant products in countries that are not subject to such anti-dumping duties. We believe that our ability to procure the affected categories of furniture has not been materially adversely affected.
We continue to seek to mitigate margin pressure through the development of new products that can command higher pricing; the identification of alternative, lower-cost sources of supply, re-engineering of certain existing products to reduce manufacturing costs; where possible, price increases; and more aggressive inventory management. Particularly in the mass market, however, our ability to increase prices or resist requests for mark-downs and/or other allowances is limited by market and competitive factors, and, while we have implemented selective price increases and will likely continue to seek to do so, we have not been able to increase prices commensurate with our cost increases and have generally focused on maintaining (or increasing) shelf space at retailers and, as a result, our market share.
Recent Developments
Restatement of Financial Statements
As is described in Note 19 to the Notes to Consolidated Financial Statements, the Company previously recorded charges of approximately $6.86 million (which includes approximately $340,000 of interest) for the quarter and year ended December 31, 2010 (the period of discovery) relating to aggregate anti-dumping duties and interest the Company anticipates will be owed to U.S. Customs by LaJobi for the period commencing in April 2008 (when the Company acquired LaJobi’s assets) through December 31, 2010. In addition, the Company previously recorded charges of approximately $2.4 million (which includes approximately $200,000 of interest) for the quarter ended June 30, 2011 (the period of discovery), relating to aggregate customs duties and interest the Company anticipates will be owed to U.S. Customs by Kids Line and CoCaLo for the years ended 2006 through 2010 and the six months ended June 30, 2011. In each case, the anticipated duties were recorded in costs of sales, and the related interest was recorded in interest expense.
Although it was the initial determination of the Company’s management (a determination in which the Company’s independent auditors concurred) that the impact of the aggregate charges described above was immaterial to prior periods, after various submissions to and discussions with the Staff of the SEC on this matter, and in recognition of the Staff’s position with respect thereto (and not as a result of the discovery of new facts or information), management and the Audit Committee met and determined on February 14, 2012 (which determination was subsequently ratified by the Board), that it was necessary to restate the Company’s audited consolidated financial statements as of December 31, 2010 and 2009, and for the three years ended December 31, 2010 included in the Company’s 2010 10-K, as well as its unaudited interim consolidated financial statements as of and for the quarter and year to date periods ended March 31, 2011, June 30, 2011 and September 30, 2011, and related 2010 comparative prior quarter and year to date periods, as included in its Quarterly Reports on Form 10-Q for the quarters ended March 31, 2011, June 30, 2011, and September 30, 2011 (collectively, the “Prior Financial Statements”). As a result, on February 14, 2012, management and the Audit Committee met and determined that the Prior Financial Statements should no longer be relied upon.
The restatement of the Prior Financial Statements has been implemented as follows. This 2011 10-K restates all periods presented herein, as applicable, to reflect the recording of the anticipated anti-dumping duty (and related interest) payment requirements of the Company’s LaJobi subsidiary and anticipated customs duty (and related interest) payment requirements of the Company’s Kids Line and CoCaLo subsidiaries described above in the respective periods to which such liabilities relate. This 2011 10-K also includes the impact of such adjustments on the unaudited quarterly financial information presented in the Notes to Consolidated Financial Statements herein. In addition, the Company’s Quarterly Reports on Form 10-Q during 2012 will restate applicable 2011 comparable prior quarter and year to date periods.
Previously filed Annual Reports on Form 10-K and quarterly reports on Form 10-Q for quarterly and annual periods ended prior to December 31, 2011 have not been and will not be amended.
The combined impact of the adjustments to (and the addition of) specified line items in the Prior Financial Statements resulting from the restatement is set forth in Note 19 to the Notes to Consolidated Financial Statements. In addition, see Notes 4 and 17 of the Notes to Consolidated Financial Statements for a description of a liability (and corresponding goodwill) recorded in the aggregate amount of approximately $11.7 million with respect to a portion of the LaJobi earnout consideration (and a related finder’s fee) for the year ended December 31, 2010, required by applicable accounting standards as a result of the restatement, and the full impairment of such goodwill as of December 31, 2011. Such liability, and corresponding goodwill, are also reflected in such restatement.
Goodwill and Intangible Assets
Because the restatement of the Prior Financial Statements results in the technical satisfaction of the formulaic provisions for the payment of a portion of the LaJobi earnout under the agreement governing the purchase of the LaJobi assets, applicable accounting standards require that the Company record a liability in the approximate amount of $11.7 million for the year ended December 31, 2010 ($10.6 million in respect of the LaJobi earnout and $1.1 million in respect of the related finder’s fee), which also required an offset in equal amount to goodwill, all of which goodwill was impaired as of December 31, 2011.
With respect to such goodwill, we performed our annual goodwill assessment as of December 31, 2011. The goodwill impairment test is accomplished using a two-step process. The first step compares the fair value of a reporting unit that has goodwill to its carrying value. The fair value of a reporting unit is estimated using a discounted cash flow analysis. If the fair value of the reporting unit is determined to be less than its carrying value, a second step is performed to compute the amount of goodwill impairment, if any. Step two allocates the fair value of the reporting unit to the reporting unit’s net assets other than goodwill. The excess of the fair value of the reporting unit (using fair-value based tests) over the amounts assigned to its net assets other than goodwill is considered the implied fair value of the reporting unit’s goodwill. The implied fair value of the reporting unit’s goodwill is then compared to the carrying value of its goodwill. Any shortfall represents the amount of goodwill impairment.
As of December 31, 2011, after completing the first step of the impairment test, there was indication of impairment because our carrying value exceeded our market capitalization (as a result of the substantial decline of the Company’s stock price during 2011).
Management’s determination of the fair value of the goodwill for the second step in the analysis was performed with the assistance of a public accounting firm, other than the Company’s auditors. The analysis used a variety of testing methods that are judgmental in nature and involve the use of significant estimates and assumptions, including: (i) the Company’s operating forecasts; (ii) revenue growth rates; (iii) risk-commensurate discount rates and costs of capital; and (iv) price or market multiples. The Company’s estimates of revenues and costs are based on historical data, various internal estimates and a variety of external sources, and are developed by the Company’s routine long-range planning process.
In addition to the stock price decline, during the year ended December 31, 2011, net sales and gross margins for LaJobi declined substantially from the previous year, and the margins for Kids Line and CoCaLo declined from the previous year. These adverse conditions led the Company to revise its estimates with respect to net sales and gross margins, which in turn negatively impacted our cash flow forecasts for LaJobi, Kids Line and CoCaLo. These revised cash flows forecasts resulted in the conclusion in the second step of the analysis that the Company’s goodwill was fully impaired (it was determined to have no implied value), and as a result, the Company recorded a goodwill impairment charge in the amount of $11.7 million for the year ended December 31, 2011, representing the shortfall between the fair value of its operations for which goodwill had been allocated and its carrying value.
In addition, in connection with our annual assessment of indefinite-lived and definite-lived intangible assets (discussed in Note 4 to the Notes to Consolidated Financial Statements), we recorded, in our consolidated financial statements for the fourth quarter and fiscal year ended December 31, 2011, non-cash impairment charges: (i) to our LaJobi trade name in the amount of $9.9 million; and (ii) to our Kids Line customer relationships in the amount of $19.0 million. There was no impairment of the Company’s other intangible assets (either definite-lived or indefinite-lived) during 2011.
See “Critical Accounting Policies” below, and Notes 2 and 4 to the Notes to Consolidated Financial Statements.
Interim Executive Chairman
Effective September 12, 2011, Bruce G. Crain resigned as President and Chief Executive Officer of the Company. In connection therewith, Mr. Crain also resigned his position as a member of the Board and all other positions with the Company and its subsidiaries. In addition, as of September 12, 2011, Raphael Benaroya was appointed by the Board to the position of interim Executive Chairman, to serve as the chief executive of the Company during the pendency of the Board’s search for a new chief executive officer until the earlier of: (i) December 31, 2011; and (ii) the appointment of a new chief executive officer or written notice from the Company. On February 14, 2012, this agreement was modified and extended on a month-to-month basis, effective as of January 1, 2012, subject to termination by either the Company or RB, Inc. at any time upon ten days written notice to the other party.
The Board’s Search Committee is continuing to oversee the process for the selection of a new chief executive officer with the assistance of the executive search firm retained by the Board for such purpose.
Details with respect to these events are set forth in the Company’s Current Report on Form 8-K filed on February 17, 2012.
LaJobi Matters
See Notes 4 and 17 of the Notes to Consolidated Financial Statements for a description of: (i) a demand for arbitration initiated by Mr. Bivona with respect to the LaJobi earnout and matters under his employment agreement, as well as the related required recording of a liability in the approximate amount of $11.7 million for the year ended December 31, 2010 ($10.6 million in respect of the LaJobi earnout and $1.1 million in respect of the related finder’s fee), with a required offset in equal amount to goodwill, all of which goodwill was impaired as of December 31, 2011; (ii) the “Focused Assessment” of our LaJobi subsidiary’s import practices and procedures by U.S. Customs, charges recorded in connection therewith, including the recordation of an additional aggregate amount of $314,000 in the periods to which such amounts relate based on current assumptions and information, and actions taken by the Company as a result of such matters, including the restatement of the Prior Financial Statements herein; (iii) a discussion of certain corrective payment practices established with respect to individuals providing quality control, compliance and certain other services in the PRC, Hong Kong, Vietnam and Thailand; and (iv) a description of an informal investigation by the SEC and a document request by the United States Attorney’s Office for the District of New Jersey into these matters. Also see “Goodwill and Intangible Assets” above and Item 3, “Legal Proceedings.”
Share Repurchase Program
On November 8, 2011, the Board approved a share repurchase program. Under the share repurchase program, the Company is authorized to purchase up to $10.0 million of its outstanding shares of common stock (and in connection therewith, the Board terminated the repurchase program authorized in March of 1990). The purchases may be made from time to time on the open market or in negotiated transactions. The timing and extent to which the Company repurchases its shares will depend on market conditions and other corporate considerations as may be considered in the Company’s sole discretion, including limitations in our current credit agreement, which, in addition to limits on revolver availability and a stricter Consolidated Leverage Ratio for this purpose (0.25x less than the maximum then permitted), limits the aggregate amount that can be expended on share repurchases and dividends to $5.0 million until the LaJobi Focused Assessment has been concluded and all duty amounts required thereby have been paid. The share repurchase program may be suspended or discontinued at any time without prior notice. The Company intends to finance the share repurchase program from available cash and/or proceeds under its current revolving credit facility (to the extent available therefor).
Putative Class Action and Derivative Litigations
See Part I, Item 3 “Legal Proceedings”, for a discussion of recent developments with respect to the putative class action proceeding and shareholder derivative proceeding instituted against the Company and various of its officers and directors, including the dismissal without prejudice of each such proceeding with leave for the plaintiffs to amend the respective complaints, as well as a related books and records inspection initiated by the derivative proceeding plaintiff.
Refinancing of Senior Indebtedness
KID and specified domestic subsidiaries executed a Second Amended and Restated Credit Agreement as of August 8, 2011, with certain financial institutions, including Bank of America, N.A., among other things, as Administrative Agent. This amendment and restatement represents a refinancing of the Company’s previous senior secured debt facility, and provides for an aggregate $175.0 million revolving credit facility (without borrowing base limitations), with a $25.0 million sub-facility for letters of credit, and a $5.0 million sub-facility for swing-line loans. KID is entitled to increase the amount of this new revolver by up to an additional $35.0 million, provided that, among other things, no defaults have occurred and are continuing and commitments are received for such increase (from existing lenders or certain third party financial institutions). The refinancing, among other things, increases borrowing capacity previously available (which provided for a $50.0 million revolver based on eligible receivables and inventory, with a $5.0 million sub-facility for letters of credit, and an $80.0 million term loan), lowers minimum and maximum interest rate margins and is described in detail under “Liquidity and Capital Resources” below under the section captioned “Debt Financing.”
Customs Compliance Investigation
See Note 17 of Notes to Consolidated Financial Statements for a description of a review authorized by the Board of Directors customs compliance practices at the Company’s non-LaJobi subsidiaries, charges recorded in connection therewith, including the recordation of an additional aggregate amount of $461,000 in the periods to which such amounts relate based on current assumptions and information, a related investigation initiated by the Board with respect to such review and other actions taken by the Company as a result thereof.
TRC Matters
See Note 3 of the Notes to Consolidated Financial Statements for a discussion of the bankruptcy filing of TRC and its domestic subsidiaries, and a settlement agreement approved by the Bankruptcy Court with the secured creditors of the debtors, including KID.
See Note 17 of the Notes to Consolidated Financial Statements for a discussion of a General Release and Settlement Agreement entered into as of January 20, 2012 between the Company and the TRC Landlord with respect to which the Company had previously accrued $1.1 million for potential contingent liabilities.
Inventory
Inventory, which consists of finished goods, is carried on our balance sheet at the lower of cost or market. Cost is determined using the weighted average cost method and includes all costs necessary to bring inventory to its existing condition and location. Market represents the lower of replacement cost or estimated net realizable value of such inventory. Inventory reserves are recorded for damaged, obsolete, excess and slow-moving inventory if management determines that the ultimate expected proceeds from the disposal of such inventory will be less than its carrying cost as described above. Management uses estimates to determine the necessity of recording these reserves based on periodic reviews of each product category, based primarily on the following factors: length of time on hand, historical sales, sales projections (including expected sales prices), order bookings, anticipated demand, market trends, product obsolescence, the effect new products may have on the sale of existing products and other factors. Risks and exposures in making these estimates include changes in public and consumer preferences and demand for products, changes in customer buying patterns, competitor activities, our effectiveness in inventory management, as well as discontinuance of products or product lines. In addition, estimating sales prices, establishing markdown percentages and evaluating the condition of our inventories all require judgments and estimates, which may also impact the inventory valuation. However, we believe that, based on our prior experience of managing and evaluating the recoverability of our slow moving, excess, damaged and obsolete inventory in response to market conditions, including decreased sales in specific product lines, our established reserves are materially adequate. If actual market conditions and product sales were less favorable than we have projected, however, additional inventory reserves may be necessary in future periods.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
OVERVIEW
We are a leading designer, importer, marketer and distributor of branded infant and juvenile consumer products. Through our four wholly-owned operating subsidiaries – Kids Line, LLC (“Kids Line”); LaJobi, Inc. (“LaJobi”); Sassy, Inc. (“Sassy”); and CoCaLo, Inc. (“CoCaLo”) – we design, manufacture through third parties, and market branded infant and juvenile products in a number of complementary categories including, among others: infant bedding and related nursery accessories and décor, kitchen and nursery appliances and food preparation products, bath/spa products and diaper bags (Kids Line ® and CoCaLo ® ); nursery furniture and related products (LaJobi ® ); and developmental toys and feeding, bath and baby care items with features that address the various stages of an infant’s early years (Sassy ® ). In addition to our branded products, we also market certain categories of products under various licenses, including Carter’s ® , Disney ® , Graco ® and Serta ® . Our products are sold primarily to retailers in North America, the United Kingdom (“U.K.”) and Australia, including large, national retail accounts and independent retailers (including toy, specialty, food, drug, apparel and other retailers). We maintain a direct sales force and distribution network to serve our customers in the United States, the U. K. and Australia. We also maintain relationships with several independent representatives to service select domestic and foreign retail customers, as well as international distributors to service certain retail customers in several foreign countries.
We generated net sales of approximately $55.2 million in the three months ended March 31, 2012. International sales, defined as sales outside of the United States, including export sales, constituted 11.9% and 9.8% of our net sales for the three months ended March 31, 2012 and 2011, respectively.
We operate in one segment: the infant and juvenile business. Our senior corporate management, together with senior management of our subsidiaries, coordinates the operations of all of our businesses and seeks to identify cross-marketing, procurement and other complementary business opportunities, while maintaining the separate brand identities of each subsidiary.
Aside from funds provided by our senior credit facility, revenues from the sale of products have historically been the major source of cash for the Company, and cost of goods sold and payroll expenses have been the largest uses of cash. As a result, operating cash flows primarily depend on the amount of revenue generated and the timing of collections, as well as the quality of customer accounts receivable. The timing and level of the payments to suppliers and other vendors also significantly affect operating cash flows. Management views operating cash flows as a good indicator of financial strength. Strong operating cash flows provide opportunities for growth both internally and through acquisitions, and also enable us to pay down debt.
We do not ordinarily sell our products on consignment (although we may do so in limited circumstances), and we ordinarily accept returns only for defective merchandise, although we may in certain cases accept returns as an accommodation to retailers. In the normal course of business, we grant certain accommodations and allowances to certain customers in order to assist these customers with inventory clearance or promotions. Such amounts, together with discounts, are deducted from gross sales in determining net sales.
Our products are manufactured by third parties, principally located in the PRC and other Eastern Asian countries. Our purchases of finished products from these manufacturers are primarily denominated in U.S. dollars. Expenses for these manufacturers are primarily denominated in Chinese Yuan. As a result, any material increase in the value of the Yuan relative to the U.S. dollar, as occurred in past periods, or higher rates of inflation in the country of origin, would increase our expenses, and therefore, adversely affects our profitability. Conversely, a small portion of our revenues are generated by our subsidiaries in Australia and the U.K. and are denominated primarily in their local currencies. Any material increase in the value of the U.S. dollar relative to the value of the Australian dollar or British pound would result in a decrease in the amount of these revenues upon their translation into U.S. dollars for reporting purposes. See Item 1A, Risk Factors — “Currency exchange rate fluctuations could increase our expenses” , of the 2011 10-K .
Our gross profit may not be comparable to those of other entities, since some entities include the costs of warehousing, outbound handling costs and outbound shipping costs in their costs of sales. We account for the above expenses as operating expenses and classify them under selling, general and administrative expenses. The costs of warehousing, outbound handling costs and outbound shipping costs were $1.7 million and $2.1 million, for the three months ended March 31, 2012 and 2011, respectively. In addition, the majority of outbound shipping costs are paid by our customers, as many of our customers pick up their goods at our distribution centers.
If our suppliers experience increased raw materials, labor or other costs, and pass along such cost increases to us through higher prices for finished goods, our cost of sales would increase. Many of our suppliers are currently experiencing significant cost pressures related to labor rates, raw material costs and currency inflation, which has and, we believe, will continue to put pressure on our gross margins, at least for the foreseeable future. To the extent we are unable to pass such price increases along to our customers or otherwise reduce our cost of goods, our gross profit margins would decrease. Our gross profit margins have also been impacted in recent periods by: (i) an increasing shift in product mix toward lower margin products, including increased sales of licensed products, which typically generate lower margins as a result of required royalty payments (which are recorded in cost of goods sold); (ii) increased pressure from major retailers, largely as a result of prevailing economic conditions, to offer additional mark downs and other pricing accommodations to clear existing inventory, secure new product placements and/or to improve the gross margins of such retailers; and (iii) other increased costs of goods. We believe that our future gross margins will continue to be under pressure as a result of the items listed above, and such pressures may be more acute over the next several quarters as a result of anticipated product cost increases. In addition, charges pertaining to anti-dumping duties that we anticipate will be owed by our LaJobi subsidiary to U.S. Customs, and charges pertaining to customs duties we anticipate will be owed by our Kids Line and CoCaLo subsidiaries to U.S. Customs have adversely affected gross margins and net income for specified periods (See Notes 9 and 12 to the Notes to Unaudited Consolidated Financial Statements). The restatement of the Prior Financial Statements, as described in Note 12 to Notes to Unaudited Consolidated Financial Statements, had a negative impact on previously-reported results of operations for the period ended March 31, 2011. As the customs matters have not been concluded, however, it is possible that the actual amount of duty owed for the relevant periods will be higher than currently accrued amounts, and in any event, additional interest will continue to accrue until payment is made. In addition, we may be assessed by U.S. Customs a penalty of up to 100% of any customs duty owed, as well as possibly being subject to fines, penalties or other measures from U.S. Customs or other governmental authorities. Any amounts owed in excess of the accruals recorded will adversely affect our gross margin and net income for the period(s) in which such amounts are recorded and could have a material adverse affect on our results of operations. See Note 9 of Notes to the Unaudited Consolidated Financial Statements for a discussion of the LaJobi anti-dumping duty matters and the Kids Line/CoCaLo customs duty matters. We have discontinued the practices that resulted in the charge for anticipated anti-dumping duties, and have established alternate vendor arrangements for the relevant products in countries that are not subject to such anti-dumping duties. We believe that our ability to procure the affected categories of furniture has not been materially adversely affected.
We continue to seek to mitigate margin pressure through the development of new products that can command higher pricing, the identification of alternative, lower-cost sources of supply, re-engineering of certain existing products to reduce manufacturing cost, where possible, price increases, and more aggressive inventory management. Particularly in the mass market, our ability to increase prices or resist requests for mark-downs and/or other allowances is limited by market and competitive factors, and, while we have implemented selective price increases and will likely continue to seek to do so, we have not been able to increase prices commensurate with our cost increases and have generally focused on maintaining (or increasing) shelf space at retailers and, as a result, our market share.
Recent Developments
Restatement of Financial Statements
See Note 12 of the Notes to Unaudited Consolidated Financial Statements for a description of: (i) a restatement in the 2011 10-K of the Company’s financial statements previously included in its Annual Report on Form 10-K for the year ended December 31, 2010 to reflect the recording of specified anticipated anti-dumping and customs duty (and related interest) payment requirements of LaJobi, Kids Line and CoCaLo in the respective periods to which such liabilities relate; and (ii) the impact of such restatement on the applicable unaudited quarterly financial information for the quarter ended March 31, 2011 presented in this Quarterly Report on Form 10-Q for the quarter ended March 31, 2012 (the “Q1 10-Q”). The Company’s Quarterly Reports on Form 10-Q for subsequent periods during 2012 will restate applicable 2011 comparable prior quarter and year to date periods.
Goodwill and Intangible Assets
Because the restatement of the Prior Financial Statements results in the technical satisfaction of the formulaic provisions for the payment of a portion of the LaJobi earnout under the agreement governing the purchase of the LaJobi assets, applicable accounting standards required that the Company record a liability in the approximate amount of $11.7 million for the year ended December 31, 2010 ($10.6 million in respect of the LaJobi earnout and $1.1 million in respect of the related finder’s fee), which also required an offset in equal amount to goodwill, all of which goodwill was impaired as of December 31, 2011.
With respect to such goodwill, we performed our annual goodwill assessment as of December 31, 2011. The goodwill impairment test is accomplished using a two-step process. The first step compares the fair value of a reporting unit that has goodwill to its carrying value. The fair value of a reporting unit is estimated using a discounted cash flow analysis. If the fair value of the reporting unit is determined to be less than its carrying value, a second step is performed to compute the amount of goodwill impairment, if any. Step two allocates the fair value of the reporting unit to the reporting unit’s net assets other than goodwill. The excess of the fair value of the reporting unit (using fair-value based tests) over the amounts assigned to its net assets other than goodwill is considered the implied fair value of the reporting unit’s goodwill. The implied fair value of the reporting unit’s goodwill is then compared to the carrying value of its goodwill. Any shortfall represents the amount of goodwill impairment.
As of December 31, 2011, after completing the first step of the impairment test, there was indication of impairment because our carrying value exceeded our market capitalization (as a result of the substantial decline of the Company’s stock price during 2011).
Management’s determination of the fair value of the goodwill for the second step in the analysis was performed with the assistance of a public accounting firm, other than the Company’s auditors. The analysis used a variety of testing methods that are judgmental in nature and involve the use of significant estimates and assumptions, including: (i) the Company’s operating forecasts; (ii) revenue growth rates; (iii) risk-commensurate discount rates and costs of capital; and (iv) price or market multiples. The Company’s estimates of revenues and costs are based on historical data, various internal estimates and a variety of external sources, and are developed by the Company’s routine long-range planning process.
In addition to the stock price decline, during the year ended December 31, 2011, net sales and gross margins for LaJobi declined substantially from the previous year, and the margins for Kids Line and CoCaLo declined from the previous year. These adverse conditions led the Company to revise its estimates with respect to net sales and gross margins, which in turn negatively impacted our cash flow forecasts for LaJobi, Kids Line and CoCaLo. These revised cash flows forecasts resulted in the conclusion in the second step of the analysis that the Company’s goodwill was fully impaired (it was determined to have no implied value), and as a result, the Company recorded a goodwill impairment charge in the amount of $11.7 million for the year ended December 31, 2011, representing the shortfall between the fair value of its operations for which goodwill had been allocated and its carrying value.
In addition, in connection with our annual assessment of indefinite-lived and definite-lived intangible assets (discussed in Note 4 to the Notes to Consolidated Financial Statements of the 2011 10-K), we recorded, in our consolidated financial statements for the fourth quarter and fiscal year ended December 31, 2011, non-cash impairment charges: (i) to our LaJobi trade name in the amount of $9.9 million; and (ii) to our Kids Line customer relationships in the amount of $19.0 million.
Testing for impairment of indefinite-lived trade names is based on whether the fair value of such trade names exceeds their carrying value. The Company determines fair value by performing a projected discounted cash flow analysis based on the Relief-From-Royalty Method for all indefinite-lived trade names. In the Company’s analysis for 2011, it used a five-year projection period, which has been its prior practice, and projected for each business unit the long-term growth rate of each business, as well as the assumed royalty rate that could be obtained by each such business by licensing out each intangible. For 2011, the Company kept its long-term growth rate at 2.5% for all of its business units, but used assumed royalty rates of 3%, 2.6%, 2.5% and 4% for Kids Line, Sassy, LaJobi and CoCaLo, respectively. Assumed royalty rates decreased with respect to Kids Line and LaJobi from the 2010 rates of 5% and 4%, respectively, as a result of reduced profitability for each such business unit in 2011. With respect to LaJobi, the difference between fair value and the carrying value of the relevant trade names resulted in an impairment charge in the amount of $9.9 million. No other trade names were impaired during 2011.
The Company’s other intangible assets with definite lives (consisting primarily of customer lists) are amortized over their estimated useful lives and are tested if events or changes in circumstances indicate that an asset may be impaired. In testing for impairment, the Company compares the carrying value of such assets to the estimated undiscounted future cash flows anticipated from the use of the assets and their eventual disposition. When the estimated undiscounted future cash flows are less than their carrying amount, an impairment charge is recognized in an amount equal to the difference between the asset’s fair value and its carrying value. The fair value of the Kids Line customer relationships was lower than the carrying value due to revised undiscounted future cash flow projections resulting from meaningfully lower sales to one of its major customers and reduced profitability in 2011. This resulted in a $19.0 million impairment which was recorded in cost of sales. While LaJobi sales also decreased during 2011, the fair value of its customer lists continued to exceed its carrying value as of December 31, 2011.
There was no impairment of the Company’s other intangible assets (either definite-lived or indefinite-lived) during 2011. There was no impairment of any of the Company’s intangible assets (either definite-lived or indefinite-lived) during the quarter ended March 31, 2012.
Interim Executive Chairman
Effective September 12, 2011, Bruce G. Crain resigned as President and Chief Executive Officer of the Company. In connection therewith, Mr. Crain also resigned his position as a member of the Board and all other positions with the Company and its subsidiaries. In addition, as of September 12, 2011, Raphael Benaroya was appointed by the Board to the position of interim Executive Chairman, to serve as the chief executive of the Company during the pendency of the Board’s search for a new chief executive officer until the earlier of: (i) December 31, 2011; and (ii) the appointment of a new chief executive officer or written notice from the Company. On February 14, 2012, this agreement was modified and extended on a month-to-month basis, effective as of January 1, 2012, subject to termination by either the Company or RB, Inc. at any time upon ten days written notice to the other party.
The Board’s Search Committee is continuing to oversee the process for the selection of a new chief executive officer with the assistance of the executive search firm retained by the Board for such purpose.
Details with respect to these events are set forth in the Company’s Current Report on Form 8-K filed on February 17, 2012.
TRC Matters
See Note 11 of the Unaudited Notes to Consolidated Financial Statements for a discussion of the bankruptcy filing of TRC and its domestic subsidiaries, and a settlement agreement approved by the Bankruptcy Court with the secured creditors of the debtors, including KID.
See Part II, Item 1 “Legal Proceedings” for a discussion of a General Release and Settlement Agreement entered into as of January 20, 2012 between the Company and the TRC Landlord (as defined therein) with respect to which the Company had previously accrued $1.1 million for potential contingent liabilities.
LaJobi Matters
See Notes 9 and 12 of the Notes to Unaudited Consolidated Financial Statements for a description of: (i) a demand for arbitration initiated by Mr. Bivona with respect to the LaJobi earnout and matters under his employment agreement, as well as the related required recording of a liability in the approximate amount of $11.7 million for the year ended December 31, 2010 ($10.6 million in respect of the LaJobi earnout and $1.1 million in respect of the related finder’s fee), with a required offset in equal amount to goodwill, all of which goodwill was impaired as of December 31, 2011; (ii) the “Focused Assessment” of our LaJobi subsidiary’s import practices and procedures by U.S. Customs, charges recorded in connection therewith based on current assumptions and information, and actions taken by the Company as a result of such matters, including the restatement of the Prior Financial Statements; (iii) a discussion of certain corrective payment practices established with respect to individuals providing quality control, compliance and certain other services in the PRC, Hong Kong, Vietnam and Thailand; and (iv) a description of an informal investigation by the SEC and a document request by the United States Attorney’s Office for the District of New Jersey into these matters. Also see “Goodwill and Intangible Assets” above and Item 3, “Legal Proceedings.”
Putative Class Action and Derivative Litigations
See Part II, Item 1 “Legal Proceedings”, for a discussion of recent developments with respect to the putative class action proceeding and shareholder derivative proceeding instituted against the Company and various of its officers and directors, including the dismissal without prejudice of each such proceeding with leave for the plaintiffs to amend the respective complaints, a second amended complaint filed by the plaintiff on May 7, 2012 in the putative class action proceeding, and a motion to compel the inspection of documents filed by the plaintiff in the putative derivative proceeding on April 28, 2012 (with a related extension of time to amend the complaint).
Customs Compliance Investigation
See Notes 9 and 12 of the Notes to Unaudited Consolidated Financial Statements for a description of a review authorized by the Board of Directors of the customs compliance practices at the Company’s non-LaJobi subsidiaries, charges recorded in connection therewith based on current assumptions and information, a related investigation initiated by the Board with respect to such review and other actions taken by the Company as a result thereof.
CONF CALL
Erica Pettit
Thank you, Chris. Good morning everyone and welcome to Russ Berrie’s third quarter 2008 conference call. If you have not viewed the press release issued this morning and would like to receive one by email or fax, please call Financial Dynamics at 212-850-5600 and someone will send you one immediately.
As stated in the company’s earnings release, this call is being webcast and can be accessed on the company’s website at www.russberrie.com. The webcast of the call will be archived online shortly after the conference call for 90 days. We will begin the call with comments from management and then we will open up the line for questions.
Before we begin we would like to remind everyone of the cautionary language regarding forward-looking statements contained in the press release. That same language applies to comments made on this morning’s conference call.
Now I’d like to turn the call over to Bruce Crain, Chief Executive Officer and President of Russ Berrie.
Bruce G. Crain
Good morning everybody. Thanks Erica and thanks everybody for joining us. I’ll start with a review of our recent performance then Tony Cappiello, our Chief Administrative Officer and Interim Chief Financial Officer will provide a more detailed discussion of our financial results. Later I’ll come back and briefly discuss our plans going forward.
Let me discuss some general trends that are affecting our businesses before diving into specifics on the I&J area or infant and juvenile business and then our gift business. We delivered consolidated top line growth and profitability during the quarter due to growth in our infant and juvenile segment, despite the extremely volatile and uncertain retailer and consumer environment that we have all been witnessing over the last months.
Our recent acquisitions of LaJobi and CoCaLo collectively performed well and were accretive to our results. Kids Line and Sassy together delivered solid organic growth for the nine months ended September 30, 2008. That said, our gift segment continued to experience sales challenges as we cycled very strong performance from last year driven by Shining Star sales in particular and the weak demand trends that persist in the gift channel.
Our gross margins are under pressure in both segments as they have been impacted by both supplier costs and a consumer environment that is straining retailer price points. Some of these margin adjustments are structural and longer term for us and some we believe are shorter term pressures that can be addressed.
Let me briefly describe a couple of the factors that have continued to impact our margin performance. First, higher cost of goods, particularly in our infant and juvenile business, persisted as raw material costs, labor and freight costs, all remained elevated. All of these are affected by the current state of the Asian supplier market that continues to be under significant costing pressures with many factories going out of business over the last year, although we are fortunate that our principal factory partners are still operating.
This sourcing environment has been further exacerbated by the ongoing unfavorable currency trends as the US dollar and Chinese Yuan exchange rate continues to weaken. Given that we source the vast majority of our products from Asia, all our product development and sourcing teams are regularly in Asia both managing costs and sourcing new programs. Recent discussions with vendors provide us with cautious optimism for managing margins in 2009 as recent tax rebates for Chinese factories have improved and declines in commodities such as oil and cotton have begun to help offset some of the margin pressures. However, ongoing concern that currency and cost uncertainties and the escalating costs of quality assurance and testing are continuing to pressure margins.
Separately, our gross margin in the gift segment was negatively impacted as a result of the mix of products sold, de-leveraging of fixed costs due to lower sales, and an additional inventory reserve that Tony will discuss later.
Now, specifically turning to a few things I wanted to discuss about our infant and juvenile area. First, we believe that the infant and juvenile industry has historically demonstrated that consumers typically cut back in other purchases before pulling back in purchases of most infant and juvenile products. We believe this fundamental has helped insulate our business during the economic downturn, although we have recently entered into unprecedented times that make it difficult to predict how the consumer will react on a go-forward basis.
For example, retailers are bracing for one of the weakest holiday seasons in years and are managing their inventories accordingly. We are seeing this even in every day product areas that are not necessarily typically associated with holiday shopping. To that end, some retailers have pulled back on certain orders, including reducing product inflows at least temporarily. While this has resulted in some sales postponements, our businesses continue to focus on maximizing market share and shelf space.
While we are shipping some important reorders and new programs in the fourth quarter, our principal focus is now on executing our new product launches and sales plans for 2009. Second, our strategy of building a confederation of businesses is taking shape nicely. While we are maintaining independent efforts to build our brands and focus our product focus leadership positions, we are also collaborating to identify broader operational efficiencies.
We also believe our ongoing focus on quality assurance processes and quality controls will continue to be a strength for us. We continue to work on being in the front of these issues, especially given the rapidly evolving global regulatory environment. Third, for all of our businesses, the key driver remains developing product consumers want and all the Russ businesses showed their upcoming lines at the ABC Juvenile Product Show in September in Las Vegas, which many of you know is now the largest infant and juvenile trade show event in the US.
Our businesses each had distinctive locations on the trade show floors where they previewed new products and product line extensions to retailers. Examples from each business included Kids Line who showcased their largest collection ever of Carter’s licensed products and several new blanket programs. In addition they presented more than ten new designs of bedding collections including a new organic cotton line.
Sassy showed its Hispanic focused line called BeBe, introduced new paint-free attachable and developmental toys, and debuted a web-based monitor. LaJobi launched a new Graco branded crib line and their first eco-friendly Serta branded crib mattress for specialty stores. Additionally, they brought to market a new in-house brand called Nursery 101 which provides access to opening price points.
CoCaLo featured a large line of design led and CoCaLo branded bedding separates and an extensive blanket and gift program. They also introduced CoCaLo Naturals, which is a new offering of organic products. While not a traditional show for Russ Gift, this segment was also represented at the ABC show. They showcased Sea Pals and a new licensed line of Peeps based plush for the 2009 spring and Easter season, among other offerings.
Before moving on to discussing our gift segment, I’d like to remind everyone that we are exiting our MAM distribution agreement at the end of this year. While MAM products have been an important part of our Sassy business for many years, [inaudible] recently due to currency and other issues. Even more importantly, our distribution agreement restricted us strategically from competing in certain categories and will continue to do so throughout 2009. As we build our plan for 2009, we recognize we will need to address the loss of approximately $20 million to $25 million in MAM related sales.
Now turning to the gift segment, as we stated throughout the year, we continue to experience significant sales challenges in our gift business globally and especially in our US gift business. Overall the traditional gift industry is still large but the trends remain weak as we have discussed on past calls. The independent retailer remains particularly challenged, consumer gift product preferences are evolving, retailer competition is shifting, and sourcing costs are all escalating.
While out gift team continues to make progress, the recent results are clearly inadequate. However, we have been focused on recovering sales and managing costs. Let me discuss certain areas in which we have been investing in that we believe will help Russ Gift maintain its traditional role as an industry leader, but one with improved financial performance.
First, we continue to believe in the importance of maintaining a new product pipeline through a combination of in-house creative development and leveraging select licenses that utilize our product development resources and our global supply chain, including our Asian sourcing team. In the licensed product area, Russ Gift continues to focus on developing product for and expanding the distribution of Evergreen and Iconic brands that include Curious George, Raggedy Ann and Andy, Pound Puppies, Peep, Applause, Necco candies, and Corduroy. All of these products have rich brand histories with cost-effective licenses that when co-branded with Russ or Applause can have meaningful market presence.
Russ also has tremendous product development talent that has developed in-house and inspired Russ and Applause branded lines such as Sea Pals, Yamiko Plush, Bright Beginnings Baby, and many seasonal and occasion specific plush and non-plush gift offerings.
During the fourth quarter we are preparing for the January 2009 gift trade shows that will take place in all of our global markets. We will be showcasing broad product lines that are fresh and creative as well as priced correctly and right. Second we plan to continue shifting sales resources to where they will most effectively drive sales and channels, where gift product is really sold today, and where it will be shopped by the trade and consumers in the future. To that end we are continuing to develop our multi-channel selling approach to the market including a cost-effective field sales organization, key account teams, B to B and telesales resources, and web-based selling tools.
We also continue investing in enhancing our selling organization’s effectiveness by getting them the right tools and systems to strengthen our relationships and sales productivity with customers. Third, we believe our presence in the international gift sales channels will continue to have a helpful and diversified influence on our gift business.
It’s also clear that we need to continue our efforts to better manage our cost structures, especially given our reduced sales levels. On a positive note we have taken costs out and managed the cash utilization of the gift business which Tony will discuss later. However, it is critical that we continue to work on aggressive cost management and reduction initiatives to address the continued weakness of our business model and the trends in the gift industry. We will be addressing this over the next few months as we plan and enter 2009.
Finally, let me take a moment to discuss Shining Stars. Sales year-to-date have been substantially lower than 2007 and lower than originally planned for 2008, particularly in the third quarter. This relative weakness is further amplified when comparing year-over-year gift results due to the very strong results in this product line in the third quarter of 2007.
We expect out gift business will continue to experience the Shining Stars headwind in the fourth quarter as well. However, we are cautiously optimistic that sales from a broader core range in many new products will set the stage for improved performance. While Shining Star sales are down significantly, we will continue to work with our license partners as they continue to invest in the franchise and the website.
Before I turn the call over to Tony to discuss our third quarter financial performance, I’d like to say that while we continue to work on many sales, profit, and working capital improvement initiatives, we are also operating our businesses very pragmatically and carefully so we can be nimble and react as needed in this unprecedented environment.
I’ll now turn the call over to Tony to talk about our recent results. Following Tony I’ll return briefly to review some of our core strategic business fundamentals that we believe will drive our business going forward.
Bruce G. Crain
Thanks, Bruce. As you all know, the details of our results are available on our recently filed 10-Q for the third quarter as well as the press release we put out this morning, so I’ll keep my remarks relatively short. Consolidated net sales for the third quarter increased 7.1% to $108.1 million compared to $100.9 million for the third quarter of 2007. This was primarily driven by sales of $24.4 million from our LaJobi and CoCaLo acquisitions partially offset by a 31.4% decrease in the gift segment net sales.
Consolidated gross profit in the third quarter was $39 million or 36.1% of net sales compared to $40.4 million or 40% of net sales for the third quarter of 2007. Although reported infant and juvenile segment margins were favorable compared to the third quarter of 2007, after adjusting for a $3.6 million impairment charge in the third quarter of 2007 related to the MAM distribution agreement, our margins were lower due to competitive pricing constraints, increased work material costs, and the shift in product mix.
While the product mix has led to lower gross margins, some of this in part our strategy to drive sales growth in new categories that have inherently but still attractive margins and appealing return on investments. Our plan is to grow our placement and shelf position. Declining gift segment margin was primarily attributable to higher margins achieved in the prior year quarter due to favorable Shining Star margins, the de-leveraging of the fixed cost embedded in gross margins due to lower sales volume for the third quarter of 2008, and additional inventory reserve of $600 million booked during the quarter.
Consolidated SG&A expenses for the third quarter was $29 million or 26.8% of net sales compared to $27.1 million or 26.9% of net sales in the third quarter of 2007. The primary reason for this increase in absolute terms was from adding the LaJobi and CoCaLo businesses to the infant and juvenile segment. This was somewhat offset by over $3 million of lower SG&A expenses in the gift segment as we controlled and reduced costs where we could.
SG&A in the infant and juvenile segment increased from $6.7 million or 14.8% of net sales during the fourth quarter of 2007 to $11.9 million or 17% of sales in the third quarter of 2008. This increase is primarily attributable to the acquisition of LaJobi and CoCaLo, a higher allocation of corporate costs, increased product development costs and advertising expenses incurred to support our growth in the infant and juvenile segment.
SG&A in the gift segment was $17.1 million or 44.7% of net sales in the third quarter of 2008 as compared to $20.5 million or 36.7% of net sales in the prior year period. The decrease was primarily due to a reduction in selling and shipping expenses related to lower gift segment sales volume and the elimination in 2008 of advertising expenses incurred during the roll out of the Shining Star products during the third quarter of 2007.
Consolidated net income was $8.2 million or $0.39 per diluted share for the third quarter compared to consolidated income of $14.3 million or $0.67 per diluted share for the same period in 2007.
Turning to the balance sheet, we believe our capital structure is solid and we continue to plan prudently for future working capital needs and capital expenditures. Consolidated net inventories totaled $65 million for the third quarter which included the acquisitions of LaJobi and CoCaLo. Importantly, our inventory for the quarter was in line with our overall sales performance and sales outlook with higher infant and juvenile inventories that reflect the acquisitions and lower gift inventories that reflect lower sales levels. The increase in good will in tangible assets and debt reflect the acquisitions of LaJobi and CoCaLo.
Now let me turn the call back to Bruce for his closing remarks.
Bruce G. Crain
Thanks Tony. Just for everybody listening, Tony mentioned that the inventory reserve in our gift business of $600 million, that would be $600,000 of reserve there. But thanks Tony for the numbers.
Let me talk about a few fundamentals. Despite the weak current consumer and retailer environment, we believe we have tactics and strategies in place to maximize the opportunities available in today’s environment and management team approaches that will allow Russ to weather this tough economic times that likely lay ahead while also best position ourselves for the future.
Let me briefly remind everyone of the fundamental drivers of our businesses that we believe will support our companies even during difficult times. In our infant and juvenile segment, we enjoyed many favorable dynamics and attractive financial metrics even though product cost increases remain challenging. For example, we’re experiencing the strongest birth rate period since the early 1960s in the US with over 4.3 million being born annually.
As I mentioned earlier, we believe parents typically resist compromising spending on their children even in tough times and hope that this will continue to serve us well. We believe we have some of the strongest and deepest retailer relationships across the I&J industry. We also believe that we have particularly strong entrepreneurial management teams across our confederation of design and brand-led I&J businesses.
For the gift segment, results are very challenged, but we believe we are making progress and we have several significant asses we are working with including the Russ brand, the most extensive and one of the most experienced international sales and product organizations in the gift industry, some of the deepest customer relationships around the world, and we have scale advantages.
Finally, and especially given the difficult consumer markets, we’re taking what we think is a cautious and prudent approach to managing our financial position in both segments and at our corporate level during these uncertain times. In addition, we believe our financial partners and banking relationships are strong and we’re also working carefully to control expenses and guarding against deferrable operating or capital expenses.
This is an unprecedented time in recent history and despite the current challenges we are facing, we’re determined to advance our businesses and position the company and for many of you on the phone today, your company, for long term success.
In closing, I’d like to thank our employees in particular that are working hard around the world to drive our businesses as well as our supplier and retailer partners.
Now we’ll turn the call over to your questions.
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