ITEM 1. BUSINESS - -----------------
HCI Direct, Inc. (formerly, Hosiery Corporation of America, Inc.) (the "Company"), is a corporation organized in 1975 under the laws of the state of Delaware.
The Company is engaged in the direct mail marketing, manufacturing and distribution of quality women's sheer hosiery products to consumers throughout North America and the United Kingdom. The Company has recently begun to expand its operations into France and Germany. (See Note 3 to the Consolidated Financial Statements of the Company in Item 8 hereof.) The Company markets women's sheer hosiery through a continuous product shipment or "continuity" program. The Company's continuity program involves mailing to customers a free offer or a specially priced introductory hosiery offer, the acceptance of which enrolls customers in the program and results in additional shipments of hose on a regular and continuous basis upon payment of a prior hose shipment. The Company's hosiery production was approximately 57 million pairs in 1999, primarily marketed under the Silkies(R) brand name. The Company's manufacturing operations supplied 69% of all the hosiery required by the Company's continuity program during 1999 with the balance being outsourced.
The Company markets its hosiery products primarily through its direct mail marketing continuity program. The success of this program depends on targeting likely customers and on retaining customers by delivering quality hosiery products directly to the home on a regular basis. Drawing on its customer list of over 82 million individuals and on certain rented customer lists, the Company has developed sophisticated statistical, regression, segmentation and other financial analyses to accurately target, test and acquire first-time (and previously inactive) "front end" customers through direct mail solicitation. The Company has designed an initial direct mail solicitation offer which has attracted front end customers and reactivated previous customers. During 1999, the Company established an Internet presence with a website enabling customers to enroll on-line into the continuity program.
In order to induce customers to participate in the Company's continuity program, the introductory hosiery offer is a "loss leader". The introductory offer is either one pair free or one pair free plus two pair at a discounted price plus shipping and handling.
Front end customers who continue to participate in the Company's continuity program become part of the Company's repeat or "back end" customer base. After responding to the front end solicitation and receiving their first shipment, customers can elect to continue in the program, receiving either four or six pairs of hose with each subsequent shipment. A customer who chooses to participate in the continuity program by making regular purchases pursuant thereto is an active back end customer. Upon payment for each shipment, customers are sent another shipment of regularly priced hose, typically every four to six weeks. The Company has established a consistent and predictable back end customer base by providing customers with quality hosiery products on a regular basis. As of December 1999, the Company had approximately 1.7 million back end customers. Such "active back end customers" exclude customers receiving their first shipment.
Marketing Strategy - ------------------
The Company has created a marketing strategy which combines direct mail marketing techniques with its continuity program. The Company's marketing efforts focus on targeting and acquiring front end customers, as well as maintaining a strong relationship with continuity or back end customers through efficient fulfillment of quality products, customer service, creative new product introductions and unique marketing strategies. These direct mail marketing initiatives, refined by advanced statistical and regression analyses, have increased the size and quality of its customer base.
The Continuity Program. The Company's current initial direct mail solicitation offers its customers either a one pair free offer or the opportunity to receive one free pair of hosiery with the purchase of two additional pairs at $1.00 per pair. The customer is able to choose the size and color for this initial shipment.
For those customers that receive only the one pair free offer, the first shipment that they must pay, to stay in the program, is the second shipment (four pair at the regular price). Whereas the one pair free plus two pair at $1.00 per pair customer must pay for the first shipment to stay in the program.
By paying for the product and ordering another shipment of hosiery, the customer joins the Company's continuity program and becomes a repeat or back end customer. Upon payment for each shipment, customers are sent a subsequent shipment of regularly priced hose, typically every four to six weeks, with some customers electing a bi-monthly shipment option. With each shipment, customers may change the selection of styles, colors and sizes. Back end shipments contain either four or six pairs of hosiery which vary in price according to style. All shipments are made on credit, but the Company's exposure to any one customer is limited to the cost of one shipment. Customers are not required to commit to a minimum purchase amount and can cancel the program at any time, for any reason.
Acquiring Front End Customers. Direct mail marketing has become the Company's primary means of attracting new front end customers and reactivating previous customers. Four major solicitations featuring the Company's introductory offer are mailed each year (January, March, June, September). There is no significant seasonality in the mailings.
The Company employs, whenever possible, advanced statistical and regression analyses in conjunction with each of its solicitation promotions. The Company utilizes its proprietary in-house database of over 82 million customers, as well as lists rented from other direct marketing firms, and analyzes information concerning customer buying habits and payment records in order to determine which potential customers are likely to purchase hosiery from the Company on a regular and long-term basis. During each major solicitation, all chosen customer lists are ranked by potential realizable profit. The mailing cut off is then matched to budgeted production. This process ensures that anticipated profit is maximized from each of the four mailings.
Retention of Back End Customers. The Company seeks to retain its continuity or back end customers by providing high quality hosiery on a regular basis and at competitive prices. In addition, as members of the continuity program, customers receive gift certificates with each shipment of hosiery which can be redeemed for a wide array of merchandise. The Company also offers a women's wear catalog featuring branded and private label lingerie and intimate apparel products in conjunction with outside manufacturers. Through these means the Company believes it has been able to establish a predictable base of back end customers without significant losses of customers over time. Whilst constantly developing new means of increasing the retention of back end customers, the Company inevitably loses a proportion of these customers due to such factors as competition (e.g. retail), fashion change, customer having too much hosiery, quality and garment fit.
Through its data processing capabilities, the Company tracks a customer's order history from the initial order through each subsequent purchase, whether the purchase is a hosiery product, merchandise from the women's wear merchandise catalog, or other consumer products received through gift redemptions. Each of the Company's customer service representatives has on-line capabilities to retrieve customer specific queries and purchasing history.
Customer Testing. All aspects of the Company's direct mail marketing program typically result from specific customer testing which the Company conducts continuously. Such testing enables the Company to (i) project the profitability of certain in-house and outside customer lists; (ii) maximize response rates to front end solicitations; (iii) determine the profitability of the product mix offered to back end customers; (iv) determine optimal pricing strategy; and (v) increase payment and retention rates. Constant refinement of test programs through creative design, offer upgrades, new hosiery products and referrals are conducted throughout various mailings with the objective of increasing response rates or reducing cost, without negatively impacting continuation or retention. The time from test to application can take between three and twelve months depending on the testing employed. Historically, the Company's actual results have generally been similar to its test results.
Customer Profile. Management believes that the Company's average customer is a working woman between age 30 and 55. The Company estimates that its average customer buys approximately 60% of her sheer hosiery products from the Company, and many of such customers purchase hosiery for other household members.
Product and Development - -----------------------
The Company manufactures competitively priced, quality women's sheer hosiery under the Silkies(R) brand name. The Company's product line is designed to include the more popular product styles and colors for which most customers have the greatest demand and, effective January 2000, includes ten styles of sheer hosiery, in ten different colors and six sizes, as well as knee-hi's and two opaque styles in six different colors. The Company's elastomer products (compression garments containing spandex) include Control Top, Total Leg Control, Sheer Charm, Opaque, Shapely Perfection, Trouser Socks, Ultra Control Top, Ultra Total Leg Control and Ultra Shapely Perfection. The Company's elastomer products currently represent approximately 93% of its total production. The remainder of the Company's production consists of its non-elastomer products including Panty 'n Hose, Sheer to Waist and Knee-Hi styles. As of January 2000, the styles range in price from $2.47 to $5.99 per pair. The Company performs extensive consumer research and product testing to: (i) ensure product quality, (ii) service all significant markets and (iii) convert existing compression hose customers to higher margin, sheer compression hosiery products such as Shapely Perfection.
Data Processing and Management Information Systems - --------------------------------------------------
The Company has computer and data processing capabilities which are adequate for its current level of operations. The Company has a full back up and disaster recovery program for its data processing and order processing systems which enables operation at an outside facility within twelve hours of the onset of such need.
The Company provides data processing services, including proprietary software programs, to its marketing operations that manage the flow of all hosiery products from solicitation to customer fulfillment. These services include direct mail solicitations, customer list management and customer service operations, including order input, billing, collection, printing and tracking of customers ordering history. Through its database capabilities, the Company is also able to store and manage a proprietary database of customer purchasing habits gathered from the Company's hosiery sales history in addition to customer gift redemptions and women's wear merchandise catalogs. This historical database of customer purchasing habits covers current and past hosiery shipments, customers' credit statistics, buying patterns and purchasing records.
Manufacturing and Distribution - ------------------------------
The Company manages all phases of the manufacturing, outsourcing, procurement and fulfillment of hosiery products, including planning, purchasing, production, packaging and distribution. The Company's direct mail marketing program is vertically integrated into its manufacturing and production operations, the latter providing the Company's marketing operations with approximately 69% of the Company's hosiery needs. By spreading the volume of yearly orders over four major solicitation dates, manufacturing and fulfillment are able to avoid extreme variations, and thereby ensure higher efficiency and better product quality. Additionally, the results of the Company's direct mail marketing program allow the Company quickly to adjust its manufacturing output accordingly.
Production Process. Once front end and back end orders have been received, the shipment information is communicated via computer to the Company's facilities at Newland, North Carolina. The Company's ability to schedule its annual output allows the Company to practice "Just In Time" inventory management techniques. The primary raw materials utilized by the Company are nylon and spandex yarn, dye and chemicals, and are readily available. Such raw materials are purchased directly from suppliers who provide the Company with technical support. Most knitting and sewing operations, including toe closing, line seaming and gusset seaming, are located at the Company's facilities in Newland, North Carolina. Once the hosiery products have been manufactured, they are transported to the Company's Lancaster, South Carolina, facility where the products are dyed, packaged and then to the Heath Springs, South Carolina, facility where they are prepared for delivery. In Europe, approximately 75% of the product is purchased from an outside supplier in Italy with the balance being produced in the United States.
Suppliers. The primary raw materials utilized in the Company's manufacturing operations are nylon and spandex yarn, dye and chemicals. The Company purchases a majority of its yarn under 6-month fixed-price contracts from various domestic and international suppliers. Although the Company generally stocks only a two to three week supply of raw materials in order to manage inventory efficiently, the predictable nature of the Company's shipments generally allows it to order raw materials up to a year in advance and secure an adequate supply at prearranged costs, as well as purchased hosiery.
Packaging and Distribution. The Company operates fully automated, high speed packaging machines and distributes its products through the postal service directly to the customer's home. The Company's use of standardized and fully automated packaging allows the Company to achieve significant efficiencies. The Company uses the postal service and has been able to control delivery costs by passing on to its customers any increases in postal rates. However, there can be no assurance that in the future the Company will be able to pass on increased shipping costs to its customers. The Company also tries to minimize postal costs through the use of pre-sorting, utilizing nine digit zip codes and co-mingling of mail. In Europe, the Company has recently consolidated fulfillment centers in the United Kingdom and France to a fulfillment center in Switzerland. This consolidation allows for greater efficiency in servicing the customers of the United Kingdom, Germany and France.
Capital Investment. During the past ten years, the Company has spent approximately $32 million replacing the majority of its knitting and sewing capacity with advanced robotics, installing automatic packaging equipment for more timely response through efficient fulfillment, building a new dye house and distribution facility and upgrading its computer facilities. The Company maintains relationships with its machinery producers in order to keep up-to-date on changing manufacturing methods. The Company's current manufacturing operations have the capacity to produce approximately 67 million pairs annually. Additional requirements are being outsourced in Mexico and Italy.
Growth Strategy - ---------------
Management believes that the Company's ability to analyze and manage a large customer base, combined with its knowledge of customer buying profiles, provides strong potential for future growth through the direct mail marketing channel and the Internet. The Company has formed a committee to develop and oversee the Internet strategy. The Company's strategy for additional growth primarily involves expanding its current operations in Germany, France and the United Kingdom, and to begin mailing in Japan. The Company believes, based in part on management's significant experience with international operations, test marketing during 1997 and 1998 in France and Germany, test marketing in 1998 and 1999 in Japan, and the introduction of new styles, that the international markets provide significant opportunities for growth. Additionally, during 1999, the Company successfully mailed and fulfilled a new program "Little Silkies" that targets children through the age of twelve, as well as other new products.
Competition and Industry - ------------------------
The Company operates exclusively in the women's sheer hosiery industry, targeting adult females as customers. Management believes that the women's sheer hosiery market is declining partly as a result of changes in women's choices in business and leisure wear. Despite this apparent overall market decline, the Company has been able to increase its sales from $178.7 million in 1997 to $259.9 million in 1999.
Women's sheer hosiery is sold through a variety of distribution channels, including discount stores, grocery and drug stores, specialty stores, national chains and direct marketing. The Company is the only organization which focuses solely on distributing women's sheer hosiery through a direct mail marketing continuity program. Although several competitors have sold their hosiery products via mail order for many years, this distribution has concentrated on the large quantity sale of irregulars, as opposed to the Company's direct mail marketing of high quality women's hosiery products in a continuity program. Because the Company sells women's sheer hosiery, it competes indirectly with major manufacturers and distributors of women's sheer hosiery who primarily sell through the retail channel and some of whom are larger and better capitalized than the Company, and may have greater brand recognition than the Company.
The major United States hosiery manufacturers include Sara Lee Hosiery, a division of Sara Lee Corporation, Kayser-Roth, a subsidiary of Italian-based Golden Lady, the Company and Americal, a privately held U.S. concern. Sara Lee Hosiery and Kayser-Roth are believed to account for more than 70% of the women's sheer hosiery market. Over 60 other smaller manufacturers also produce women's sheer hosiery primarily for sale under private labels. Sara Lee Hosiery and Golden Lady are also significant competitors in Europe. Competition in the women's sheer hosiery market is generally based on price, quality and customer service.
In addition, the Company competes, and faces potential competition, with other direct marketing and Internet companies. Such competitors include businesses which engage in direct mail, catalog sales, telemarketing and other methods of sale which compete for the attention and spending dollars of consumers in the home. There are numerous direct marketing companies that are larger and better capitalized than the Company and that offer more varied product assortments. The Company believes, however, that it is the only significant direct marketing company to focus exclusively on women's sheer hosiery.
Employees - ---------
As of December 31, 1999, the Company had 1,077 employees, 204 of whom were located at its headquarters and operations center in Bensalem, Pennsylvania, 313 of whom were located at its manufacturing facility in Newland, North Carolina, 237 of whom were located at its manufacturing, and packaging facility in Lancaster, South Carolina, and 267 of whom were located at its sewing and fulfillment operations facility in Heath Springs, South Carolina. Additionally, 56 employees are currently employed in Canada and Europe. Of the total number of employees, 167 are salaried. The remaining 910 are non-salaried employees, the majority of whom are paid an hourly wage plus incentive compensation based on productivity measures. The Company's hourly workforce is not affiliated with any unions. The Company has not experienced any work stoppages and believes its relations with its employees are good.
Recapitalization - ----------------
On October 17, 1994, the Company effected the recapitalization of its capital stock (the "Recapitalization"). As a result of the substantial indebtedness incurred in connection with the Recapitalization, the Company has significant debt service obligations. At December 31, 1999, the outstanding amount of the Company's indebtedness (other than trade payables and accrued expenses) is $141.4 million, including $67.3 million of senior secured debt and $69.1 million of senior subordinated debt (the "Notes"). (See Items 7 and 13 and Note 15 to Consolidated Financial Statements of the Company in Item 8 hereof).
ITEM 2.
ITEM 2. PROPERTIES - -------------------
The Company owns or leases facilities at nine principal locations. The following sets forth the general location of each, its size, whether the facility is owned or leased and the principal function of each.
Size in Owned/ Location Square Feet Leased Function - ----------------------- ----------- ------ ----------------------------- Headquarters; Administration; Marketing; Data Processing; Bensalem, Pennsylvania 60,000 Leased Customer Service
Newland, North Carolina 138,000 Owned Knitting; Sewing
Lancaster, South Carolina 142,000 Owned Dyeing; Packaging
Heath Springs, South Fulfillment Operations, Carolina 143,000 Owned United States
Fulfillment Operations, Liestal, Switzerland 69,000 Leased Europe
Liverpool, United Kingdom 15,000 Leased Headquarters; United Kingdom
Ettligen, Germany 3,000 Leased Office
Markham, Ontario Canada 6,000 Leased Office
Tokyo, Japan 600 Leased Office
The owned facilities are subject to mortgages and security interests granted to secure payment of the Company's debt. See Note 10 to the Consolidated Financial Statements of HCI Direct, Inc. (formerly, Hosiery Corporation of America, Inc.) in Item 8 hereof.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS - --------------------------
As a result of a lawsuit brought by the Federal Trade Commission ("FTC"), the Federal District Court for the Eastern District of Pennsylvania issued a consent injunction in 1984, which specifies rules the Company must follow in conducting its mail order business. The consent injunction permanently enjoins the Company from violating various FTC and Postal Service laws and regulations. As a result of these inquiries, in 1984 the Company adopted revised promotional materials. The Company believes but cannot assure that these modifications and its current and future promotional materials will meet the concerns expressed by the FTC or be deemed to be in compliance with the consent injunction.
In 1997, the Company reached an agreement with an 11-state group that imposes specific disclosure requirements on the Company's promotional materials and specifies rules the Company must follow in its promotional materials and in conducting its mail order business. The modifications the Company made to its solicitation materials had a material adverse effect on its U.S. response rates in 1997 and 1998. The Company does not believe that these modifications will have a further significant negative impact on its response rates in the future, although the Company cannot guarantee that this will be the case. In addition, while the Company believes the modifications to its promotional materials meet the concerns expressed by the 11-state group and comply with the terms of that agreement, the Company cannot assure that these modifications will be deemed to be in compliance with the 11-state agreement.
Under the terms of the 11-state agreement, the Company paid $0.3 million in administrative expenses and fees during 1997. The agreement also required that the Company pay refunds to customers under certain circumstances for a six-month period. These refunds were not material to the Company's business, financial condition or results of operations.
Beginning in early 1999, the Company introduced a new promotional offer in North America whereby the customer has the opportunity to receive one free pair of hosiery when the customer responds to the Company's initial solicitation. Under this offer, if the customer does not elect to cancel future shipments, the customer automatically becomes a participant in the Company's continuity program. While the Company believes that this new promotional offer complies with the terms of its agreement with the 11-state group, the Company cannot assure this. Accordingly, there may be some additional modifications that the Company may need to make to its promotional materials to fully satisfy the terms of the agreement.
In 1997 and 1998, the Company received inquiries from the Direct Marketing Association and the National Advertising Division of the Better Business Bureau concerning whether the terms of its promotional offers are sufficiently disclosed in its promotional materials. These inquiries were resolved without any future modifications to the Company's promotional materials.
The Company received formal inquiries from 2 states which were not part of the 11-state group. The Company had reached an agreement in principle with one of the 2 states. However, the state never finalized this agreement and the Company has not heard further from the state in over a year. The Company is in discussions with the other state and is seeking to settle the inquiry. The Company does not believe that the amount of any settlement of either inquiry will be significant. While the Company believes that it will be able to resolve these inquiries and other future inquiries, it cannot assure this, nor can it assure that these or other regulators or trade associations will not require or seek to impose additional changes to the Company's promotional materials or billing practices. In addition, the Company cannot assure that these additional changes to its materials or billing practices, if any, will not be significant or will not have a material adverse effect on its business, financial condition or results of operations.
The direct mail marketing industry is subject to ongoing and changing federal, state, local and foreign consumer protection, mail order and other laws and regulations. Accordingly, it is possible that new or additional laws or regulations could be passed at any time. While the Company's management believes that its promotional materials are in substantial compliance with applicable laws and regulations, the Company cannot give any assurance in that regard nor can it assure that additional laws or regulations will not be passed which could have a material adverse effect on the Company's ability to rent customer lists from third parties, or on its future response rates, business, financial condition or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - --------------------------------------------------------------
On October 20, 1999, a majority of the Stockholders of the Company approved by written consent the reversal of the 8.6976942 to 1 stock split effective June 24, 1999 (the "reverse stock split"). The reverse stock split was previously approved by the Board of Directors on September 1, 1999. The reverse stock split was effective on October 27, 1999 when the Restated Articles of Incorporation of the Company were filed with the State of Delaware.
PART II -------
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS - ------------------------------------------------------------
There is no established public trading market for any class of common equity of the Company.
As of March 30, 2000, the Company had approximately 41 holders of record of its common stock.
Dividend Policy - ---------------
The Company has not paid cash dividends on its common stock since 1992 and does not anticipate paying such dividends in the foreseeable future. The Company intends to retain any future earnings for reinvestment in the Company. In addition, the Bank Credit Agreement and the indenture pursuant to which the Notes were issued place limitations on the Company's ability to pay dividends or make certain other distributions in respect of its common stock. The Company is not permitted to declare or pay any dividend or make any distribution in respect of the Company's or any of its Restricted Subsidiaries' Equity Interests other than dividends or distributions payable solely in shares of its Capital Stock. Any future determination as to the payment of dividends will be subject to such prohibitions and limitations, will be at the discretion of the Company's Board of Directors and will depend on the Company's results of operations, financial condition, capital requirements and other factors deemed relevant by the Board of Directors, including the General Corporation Law of the State of Delaware (the "DGCL") which provides that dividends are only payable out of the Company's surplus or current net profits.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA - ----------------------------------
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 - ----------------------------------------------------------------------------
Results of Operations - ---------------------
The following table sets forth certain income statement data for the Company expressed as a percentage of net revenues.
Fiscal 1999 Compared to Fiscal 1998 - -----------------------------------
Net revenues increased by 30.8% to $259.9 million in fiscal 1999 from $198.7 million in 1998. North America contributed $42.2 million and Europe $19.0 million of the increase, respectively. In Europe, the UK was up $10.9 million, Germany $6.1 million and France was reinitiated again in 1999 and contributed $2.1 million of the increase. The increase in North America was primarily due to a new offer that dramatically increases the number of customers who receive the second and third shipments.
Cost of sales increased from $91.4 million in 1998 to $117.8 million in 1999, an increase of 29.0%. As a percentage of net revenues, cost of sales declined to 45.3% in 1999 from 46.0% in 1998. The improvement in the cost of sales percentage from year to year is primarily due to the new offer in the United States, as this offer increased back end shipments which have a higher margin than new customer shipments.
Administrative and general expenses increased 9.2% to $15.0 million in 1999 from $13.7 million in 1998. New start ups for the Internet, Japan, Little Silkies and the reinitiation of France account for $0.7 million of the increase with the balance caused primarily by higher wages and increased personnel. As a percentage of net revenues, administrative and general expenses declined to 5.7% in 1999 compared to 6.9% in 1998.
Provision for doubtful accounts increased to $28.6 million in 1999 from $11.5 million in 1998, an increase of 147.5%. This increase was primarily driven by the new offer in the United States, where the first shipment is totally free and the second shipment is four pair at full price. This offer generates substantially more back end shipments but is offset to a certain extent by the cost of bad debts. North America accounted for $15.8 million of the increase with the balance related to the growth in Europe. As a percentage of net revenues, bad debts were 11.0% for 1999 compared to 5.8% for 1998.
Marketing costs increased 39.8% to $51.1 million from $36.6 million for the years ended December 31, 1999 and 1998, respectively. The increase in marketing costs was due to the increased number and volume of mailing campaigns in 1999 versus 1998 and the increased number and volume of mailing campaigns in 1998 versus 1997. These costs are deferred and amortized over a 42-month period with the greatest amortization in the first 24 months. Expansion in the United Kingdom and Germany plus entering France and Japan, developing an Internet business and starting a "Little Silkies" line for young girls contributed to the increase in marketing costs in 1999 over 1998. As a percentage of net revenues, marketing costs were 19.7% in 1999 versus 18.4% in 1998.
Coupon redemption costs decreased to $3.3 million for 1999 from $3.8 million for 1998. As a percentage of net revenues, redemption costs were 1.3% in 1999 versus 1.9% for 1998.
Operating income increased to $39.9 million in 1999 from $38.1 million in 1998, an increase of 4.8%. The increase in operating income was primarily the result of increased revenue offset by higher cost of sales, provision for doubtful accounts and marketing costs. As a percentage of net revenues, operating income was 15.3% in 1999 versus 19.2% for 1998.
The Company had net income of $12.2 million in 1999 as compared to net income of $13.5 million in 1998. As a percentage of net revenues, net income was 4.7% in 1999 versus 6.8% for 1998.
Fiscal 1998 Compared to Fiscal 1997 - -----------------------------------
Net revenues increased by 11.2% to $198.7 million in fiscal 1998 from $178.7 million in 1997. The increase in net revenue was attributable to North America $13.6 million and Europe $6.4 million. The increase in Europe was primarily attributable to increased solicitations in Germany. The increase in North America was the result of stronger sales to existing customers and the acquisition of Enchantress ($2.2 million). Enchantress, a Canadian Company, was acquired in 1998. (See Note 4 to the Consolidated Financial Statements of the Company in Item 8 hereof.)
Cost of sales increased 11.3% to $91.4 million in fiscal 1998 from $82.1 million for fiscal 1997. As a percentage of net revenues, cost of sales increased to 46.0% in 1998 versus 45.9% for the same period in 1997. The absolute increase in cost of sales is related to increased shipments in the United States, Germany and Canada.
Administrative and general expenses increased 13.0% to $13.7 million in fiscal 1998 from $12.1 million for 1997. Included in 1998 was severance of $0.5 million compared to none in 1997. The balance of the increase was caused by increased personnel and higher wages. As a percentage of net revenues, administrative and general expenses were 6.9% in 1998 versus 6.8% in 1997.
Provision for doubtful accounts increased $0.7 million or 6.9% to $11.5 million in fiscal 1998 from $10.8 million for the same period of 1997. This increase was caused by growing the business in Germany, the Canadian acquisition and an increase in the United States offset by lower experience in the United Kingdom. As a percentage of net revenues, bad debts were 5.8% for 1998 versus 6.0% for 1997.
Marketing costs increased 19.8% to $36.6 million from $30.5 million for the years ended December 31, 1998 and 1997, respectively. This increase was partially attributable to higher amortization of prior years' deferred marketing costs in 1998 compared to 1997, related to the substantial increase (43.6%) in solicitations in 1997 versus 1996. In 1997, 75.6 million solicitations were mailed as compared to 52.6 million in 1996. These costs are amortized over 42 months with the greatest amortization in the first 24 months. Additionally, a substantial portion of this increase was attributable to higher front end solicitations, in the current year, as 16.6 million additional solicitations were mailed in 1998 compared to 1997 (up 22.0%). As a percentage of net revenues, marketing costs were 18.4% in 1998 versus 17.1% for 1997.
Coupon redemption costs increased slightly to $3.8 million for fiscal 1998 from $3.7 million for fiscal 1997. As a percentage of net revenues, redemption costs were 1.9% in 1998 versus 2.1% for 1997.
Interest expense decreased to $16.6 million for fiscal 1998 from $18.1 million for 1997. This decrease in interest expense was primarily due to less debt and lower rates. As a percentage of net revenues, interest expense was 8.4% in 1998 versus 10.1% for 1997.
Operating income increased to $38.1 million in 1998 from $35.9 million in 1997, an increase of 6.2%. The increase in operating income was primarily the result of increased revenue and lower interest rates offset by higher marketing costs. As a percentage of net revenues, operating income was 19.2% for 1998 versus 20.1% for 1997.
The Company had net income of $13.5 million in 1998 as compared to a net income of $11.6 million in 1997. As a percentage of net revenues, net income was 6.8% in 1998 versus 6.5% for 1997.
Liquidity and Capital Resources - -------------------------------
The Company's cash requirements arise principally from the need to finance new front end solicitations (customers), capital expenditures, debt repayment and other working capital requirements. The Company financed these requirements and expects to finance future requirements for 2000 (including $13.0 million of debt repayments) from internally generated funds and/or its Credit Facility.
In fiscal 1999, 1998 and 1997, capital expenditures were $1.9 million, $3.6 million and $2.6 million, respectively. The majority of the expenditures were for the purchase of knitting, sewing and dyeing equipment and facility acquisition and enhancements. These expenditures were financed substantially through the assumption of capital leases. Also, the Company expects to expend approximately $2.0 million in 2000 for additional equipment. These capital expenditures will be financed through internal sources or the assumption of capital leases.
Net cash provided by operating activities was $0.1 million in 1999 as compared to $4.6 million in 1998 and $11.2 million in 1997. The decrease from 1998 to 1999 was caused by the increase in accounts receivable, lower net income and increase in accounts payable, offset by lower inventories. The decrease from 1997 to 1998 was caused by the increase in the payments for deferred marketing offset by higher amortization of these costs and the increase in prepaid costs for future marketing (January 1999).
Net cash used in investing activities was $1.0 million in 1999, $5.1 million in 1998 and $0.9 million in 1997. In 1998, a Canadian hosiery company was acquired.
Net cash provided by (used in) financing activities was $0.9 million, ($3.8) million and ($7.9) million, respectively. During 1997, a new credit agreement was reached with the Company's bank lenders which provided $65 million in term debt at a substantially lower interest rate (7.5% versus 8.8%) an increase in its line of credit from $15 million to $20 million and a change in the covenants relating to the credit agreement. In 1999, the line of credit was increased to $25 million and the covenants were also changed. Net payments on bank and other financing, including capital lease obligations and excluding the termination of the prior term debt, totaled $9.4 million, $5.3 million and $7.3 million in 1999, 1998 and 1997, respectively.
The Recapitalization and Line of Credit - ---------------------------------------
On October 17, 1994, the Company effected the recapitalization of its capital stock (the "Recapitalization"). As a result of the substantial indebtedness incurred in connection with the Recapitalization, the Company has significant debt service obligations. In November 1997, the Company amended and restructured its credit agreement. This change resulted in lower interest rates, an increase in the revolving credit facility from $15 million to $20 million, a substantial change in the timing of principal payments and changes to the debt covenants. At December 31, 1999, the outstanding amount of the Company's indebtedness (other than trade payables and accrued expenses) is $141.4 million, including $67.3 million of senior secured debt and $69.1 million of senior subordinated debt (the "Notes"). Since consummation of the Recapitalization, the Company's ongoing cash requirements through January 2002 will consist primarily of interest payments and required amortization payments under the Credit Agreement, interest payments on the Notes, payments of capital lease obligations, front end marketing expenditures, working capital, capital expenditures and taxes. The required amortization payments under the Credit Agreement will be: $13.0 million in 2000, $20.0 million in 2001 and $19.0 million in 2002. Other than upon a change of control (as defined) or as a result of certain asset sales, the Company will not be required to make any principal payments in respect of the Notes until maturity, August 2002. The Company's primary source of liquidity will be cash flow from operations and funds available to it under a revolving credit facility. The revolving credit facility provides for maximum borrowings of $20.0 million, $5.5 million of which was available at December 31, 1999.
In March 1999, the Company amended its Credit Agreement to include an Incremental Revolving Loan of $5.0 million. This loan can be made from time to time after the existing revolving credit facility equals $20.0 million. In December 1999, this loan was extended until March 2000 at which time $4.0 million of the Incremental Revolving Loan was extended through the life of the Credit Agreement. At December 31, 1999 all $5.0 million was available to the Company giving it $10,533 in total credit facilities. Additionally, certain of the Company's covenants were waived for the December quarter and amended for 2000 and subsequent years.
Legal Proceedings - -----------------
As a result of a lawsuit brought by the FTC, the Federal District Court for the Eastern District of Pennsylvania issued a consent injunction in 1984, which specifies rules the Company must follow in conducting its mail order business. The consent injunction permanently enjoins the Company from violating various FTC and Postal Service laws and regulations. As a result of these inquiries, in 1984 the Company adopted revised promotional materials. The Company believes but cannot assure that these modifications and its current and future promotional materials will meet the concerns expressed by the FTC or be deemed to be in compliance with the consent injunction.
In 1997, the Company reached an agreement with an 11-state group that imposes specific disclosure requirements on the Company's promotional materials and specifies rules the Company must follow in its promotional materials and in conducting its mail order business. The modifications the Company made to its solicitation materials had a material adverse effect on its U.S. response rates in 1997 and 1998. The Company does not believe that these modifications will have a further significant negative impact on its response rates in the future, although the Company cannot guarantee that this will be the case. In addition, while the Company believes the modifications to its promotional materials meet the concerns expressed by the 11-state group and comply with the terms of that agreement, the Company cannot assure that these modifications will be deemed to be in compliance with the 11-state agreement.
Under the terms of the 11-state agreement, the Company paid $0.3 million in administrative expenses and fees during 1997. The agreement also required that the Company pay refunds to customers under certain circumstances for a six-month period. These refunds were not material to the Company's business, financial condition or results of operations.
Beginning in early 1999, the Company introduced a new promotional offer in North America whereby the customer has the opportunity to receive one free pair of hosiery when the customer responds to the Company's initial solicitation. Under this offer, if the customer does not elect to cancel future shipments, the customer automatically becomes a participant in the Company's continuity program. While the Company believes that this new promotional offer complies with the terms of its agreement with the 11-state group, the Company cannot assure this. Accordingly, there may be some additional modifications that the Company may need to make to its promotional materials to fully satisfy the terms of the agreement.
In 1997 and 1998, the Company received inquiries from the Direct Marketing Association and the National Advertising Division of the Better Business Bureau concerning whether the terms of its promotional offers are sufficiently disclosed in its promotional materials. These inquiries were resolved without any future modifications to the Company's promotional materials.
The Company received formal inquiries from 2 states which were not part of the 11-state group. The Company had reached an agreement in principle with one of the 2 states. However, the state never finalized this agreement and the Company has not heard further from the state in over a year. The Company is in discussions with the other state and is seeking to settle the inquiry. The Company does not believe that the amount of any settlement of either inquiry will be significant. While the Company believes that it will be able to resolve these inquiries and other future inquiries, it cannot assure this, nor can it assure that these or other regulators or trade associations will not require or seek to impose additional changes to the Company's promotional materials or billing practices. In addition, the Company cannot assure that these additional changes to its materials or billing practices, if any, will not be significant or will not have a material adverse effect on its business, financial condition or results of operations.
The direct mail marketing industry is subject to ongoing and changing federal, state, local and foreign consumer protection, mail order and other laws and regulations. Accordingly, it is possible that new or additional laws or regulations could be passed at any time. While the Company's management believes that its promotional materials are in substantial compliance with applicable laws and regulations, the Company cannot give any assurance in that regard nor can it assure that additional laws or regulations will not be passed which could have a material adverse effect on the Company's ability to rent customer lists from third parties, or on its future response rates, business, financial condition or results of operations.
Year 2000 - ---------
The Company adopted a five-phase Year 2000 program consisting of Phase I - identification and ranking of the components of the Company's systems, equipment and suppliers that may be vulnerable to Year 2000 problems; Phase II - assessment of items identified in Phase I; Phase III - remediation or replacement of non-compliant systems and components and determination of solutions for non-compliant suppliers; Phase IV - testing of systems and components following remediation; and Phase V - developing contingency plans to address the most reasonably likely worst case Year 2000 scenarios. The Company successfully completed all phases of its Year 2000 program and was Year 2000 compliant as of November 1999. The Company spent approximately $0.4 million on internal manpower costs during 1997 and 1998 related to the Year 2000 issue, representing approximately 4% of the information systems budget. The Company spent approximately $0.1 million in 1999 to complete the project. The Company had a limited contingency plan that addressed the possible impact of Year 2000 problems on mission critical systems but believes that the risk of such problems has passed.
The Company's use of its own information technology personnel to make the business systems Year 2000 compliant did delay some other strategic information systems development and implementation which would have otherwise benefited the Company in various ways and to varying extents. The Company does not believe that it will be at a competitive disadvantage as a result of these delays.
The Company's vendors are all Year 2000 compliant including the U.S. Postal Service which is the only significant vendor which could have adversely affected the Company's operations.
Inflation - ---------
Over the past three years, which has been a period of low inflation, the Company has been able to increase sales volume to compensate for increases in operating expenses. The Company has historically been able to increase its selling prices as the cost of sales and related operating expenses have increased and, therefore, inflation has not had a significant effect on operations.
Accounting Statements Not Yet Adopted - -------------------------------------
New Accounting Standards - In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. As issued, SFAS No. 133 was effective for fiscal years beginning after June 15, 1999. In June 1999, the FASB issued SFAS No. 137, Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133. SFAS No. 137 defers the effective date of SFAS No. 133 for one year to fiscal years beginning after June 15, 2000. The Company has not yet assessed what the impact of the SFAS will be on the Company's future earnings or financial position.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK - --------------------------------------------------------------------
The Company uses its revolving credit facility, term loan, senior subordinated notes and bonds to finance a significant portion of its operations. These on-balance sheet financial instruments, to the extent they provide for variable rates of interest, expose the Company to interest rate risk resulting from changes in the Eurodollar Rate, Federal Funds Rate or the prime rate. Also, the Company sources hosiery at prices denominated in foreign currency and also sells products in Canada, United Kingdom, France and Germany at prices denominated in local currency.
To the extent that the Company's financial instruments expose the Company to interest rate risk and market risk, they are presented in the table below. The table presents principal cash flows and related interest rates by year of maturity for the Company's revolving credit facility, term loan, senior subordinated notes and bonds in effect at December 31, 1999. Note 19 to the consolidated financial statements should be read in conjunction with the table below (dollar amount in thousands).
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - ----------------------------------------------------
Schedules other than those listed above are omitted because they are either not applicable or not required or the information required is included in the consolidated financial statements or notes thereto.
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of HCI Direct, Inc. Bensalem, Pennsylvania
We have audited the accompanying consolidated balance sheets of HCI Direct, Inc. (formerly, Hosiery Corporation of America, Inc.) and subsidiaries (the "Company") as of December 31, 1999 and 1998, and the related consolidated statements of income, stockholders' deficiency and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with auditing standards generally accepted in the United States of America.
Deloitte & Touche LLP Philadelphia, Pennsylvania
March 30, 2000
See notes to consolidated financial statements.
HCI DIRECT, INC. (FORMERLY, HOSIERY CORPORATION OF AMERICA, INC.) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (Dollars in thousands, except per share data)
1. ORGANIZATION
HCI Direct, Inc. (formerly, Hosiery Corporation of America, Inc.) and subsidiaries is a company incorporated in the State of Delaware and is engaged in the direct mail marketing, manufacturing and distribution of quality women's sheer hosiery products to consumers throughout North America, the United Kingdom, France and Germany. On June 24, 1999, the Company name was changed to HCI Direct, Inc. (see Note 14). The Company markets women's sheer hosiery through a continuous product shipment or "continuity" program. The Company's continuity program involves mailing to customers a specially priced introductory hosiery offer, the acceptance of which enrolls customers in the program and results in additional shipments of hose on a regular and continuous basis upon payment of a prior hose shipment. The Company's manufacturing operations supply approximately 69% of all the hosiery required by the Company's continuity program.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation - The consolidated financial statements include the accounts of HCI Direct, Inc. (formerly, Hosiery Corporation of America, Inc.) (the "Company") and its subsidiaries. All significant intercompany accounts and transactions have been eliminated.
Revenue Recognition - Revenue less allowance for returns is recognized when merchandise is shipped. The Company provides for returns at the time of shipment based upon historical experience.
Cash and Cash Equivalents - Cash and cash equivalents consist of cash and other short-term securities purchased with maturities of less than three months.
Inventories - Inventories are stated at the lower of cost (first-in, first-out) or market.
Property and Equipment - Property and equipment are stated at cost less accumulated depreciation. Depreciation is provided on a straight-line basis using estimated lives of 31 years for buildings, 5 to 10 years for machinery and equipment, 5 to 7 years for furniture and fixtures and 3 to 5 years for automobiles. Leasehold improvements are amortized over the shorter of the estimated useful life or the lease periods which are generally 15 to 18 years.
Deferred Customer Acquisition Costs - Deferred customer acquisition costs consist of marketing costs (postage, printed material, customer list rentals, etc.) of the initial shipment to a customer and similar costs associated with the resolicitation of previously canceled customers. These costs are aggregated by promo- tional program and are amortized on an accelerated basis based upon the estimated current year revenue in proportion to the expected future revenue generated by these customers. Approximately 58% of these costs are amortized in the first 12 months, 71% within 18 months, and 80% within 24 months. The loss incurred on front end shipments to customers is charged to operations at the time of the front end shipment.
Software Costs - Software costs, principally internally developed, consist of the expenses associated with the development (computer time, license, programming time) of material software projects with a long-term benefit and are included in the consolidated balance sheet as Other Assets. The Company amortizes these assets on a straight-line basis over 7 years.
Goodwill - Goodwill (the excess of cost over fair value of the underlying assets at the date of acquisition) is being amortized on a straight-line basis over 30 years.
HCI DIRECT, INC. (FORMERLY, HOSIERY CORPORATION OF AMERICA, INC.) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (Dollars in thousands, except per share data)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (continued)
Derivative Financial Instruments - The Company enters into interest rate caps to manage exposure to fluctuations in interest rates. Premiums paid on caps are amortized to interest expense over the term of the cap. The interest rate caps were fully amortized at December 31, 1997.
Deferred Debt Issuance Costs - Debt issuance costs represent costs associated with bank borrowings and notes and are amortized using the straight-line method over the terms of the related borrowings. The effect of utilizing the straight-line method instead of the effective-interest method is not material to the financial statements.
Income Taxes - The Company uses the liability method of accounting for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes. Under the liability method, deferred income taxes are determined based upon enacted tax laws and rates applied to the differences between the financial statement and tax basis of assets and liabilities.
Impairment of Long-Lived Assets - Long-lived assets and certain identifiable intangibles are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability is assessed based on the future cash flows expected to result from the use of the asset and its eventual disposition. If the sum of the undiscounted cash flows is less than the carrying value of the asset, an impairment loss is recognized. Any impairment loss, if indicated, is measured as the amount by which the carrying amount of the asset exceeds the estimated fair value of the asset.
Accounting for Stock-Based Compensation - As permitted by Statement of Financial Accounting Standard ("SFAS") No. 123, Accounting for Stock-Based Compensation, the Company has chosen to measure stock-based compensation expense in accordance with the method prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees.
Foreign Currency Translation - Foreign entities translate monetary assets and liabilities at year-end exchange rates while non-monetary items are translated at historical rates. Income and expense accounts are translated at the average rates in effect during the year, except for depreciation and certain marketing expenses which are translated at historical rates. Gains or losses from changes in exchange rates are recognized in income in the year of occurrence. The effect of recording translation adjustments in income instead of equity for the Company's Canadian operations is not material to the financial statements.
Use of Estimates - The preparation of the Company's consolidated financial statements in conformity with generally accepted accounting principles necessarily requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Examples of such estimates and assumptions that could affect the reported amounts of assets and liabilities include, inter alia, provisions for sales returns and bad debts, provisions for coupon redemption and currency exchange rates. Actual results could differ from those estimates.
HCI DIRECT, INC. (FORMERLY, HOSIERY CORPORATION OF AMERICA, INC.) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (Dollars in thousands, except per share data)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - (continued)
New Accounting Standards - In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. As issued, SFAS No. 133 was effective for fiscal years beginning after June 15, 1999. In June 1999, the FASB issued SFAS No. 137, Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133. SFAS No. 137 defers the effective date of SFAS No. 133 for one year to fiscal years beginning after June 15, 2000. The Company has not yet assessed what the impact of the SFAS will be on the Company's future earnings or financial position.
Reclassifications - Certain reclassifications were made to the prior year's consolidated financial statements to conform to classifications used in the current period.
3. OPERATING SEGMENTS
The Company organizes its business units into two geographic segments: North America and International. The President of HCI Direct, Inc., is responsible for North America, and the President of Hosiery Corporation International is responsible for all International locations. The business is basically the same in both segments in that the bulk of the pantyhose is self-manufactured and sold directly to the end user via mail order. The business is a continuity business, and the goal of the program is to maintain customers in the program receiving full-priced shipments. Since North America is the established business (24 years) as compared to International (4 years), this explains the difference in profitability.
HCI DIRECT, INC. (FORMERLY, HOSIERY CORPORATION OF AMERICA, INC.) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (Dollars in thousands, except per share data)
3. OPERATING SEGMENTS (continued)
The segment's accounting policies are the same as those described in the summary of significant accounting policies.
HCI DIRECT, INC. (FORMERLY, HOSIERY CORPORATION OF AMERICA, INC.) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (Dollars in thousands, except per share data)
4. ACQUISITION
On June 10, 1998, the Company acquired substantially all of the assets and assumed certain liabilities of Enchantress Hosiery Corporation of Canada Ltd. ("EHC") for approximately $3,900 which was funded through a borrowing under the Company's revolving credit facility. EHC is engaged in the direct mail marketing and distribution of quality sheer hosiery products to consumers throughout Canada. The acquisition was accounted for using the purchase method of accounting. Accordingly, a portion of the purchase price was allocated to the net assets acquired based on estimated fair values at date of acquisition. The fair value of assets acquired and liabilities assumed was approximately $100. The excess of the purchase price over the estimated fair value of the net assets acquired of approximately $3,800 is amortized over a period of 30 years using the straight-line method.
5. PROVISION FOR COUPON REDEMPTION
As part of the marketing program, the Company issues coupons to program participants based upon the products purchased or the referral of new customers to the Company. Customers may redeem coupons for free gifts from a program catalog once they have collected the required number of coupons. During 1999, customers with an average of 34 coupons redeemed for a free gift after a collection period of approximately four years. The estimated future costs for this program have been determined based on historical customer redemption patterns applicable to outstanding coupons and average gift costs.
6. INVENTORIES
1999 1998 ---- ----
Raw materials.................................... $ 859 $ 909 Work-in-process.................................. 2,984 3,023 Finished goods................................... 7,658 13,500 Promotional and packing material................. 2,747 2,576 ------- ------- $14,248 $20,008 ======= =======
7. PROPERTY AND EQUIPMENT
1999 1998 ---- ----
Land and buildings.............................. $ 7,125 $ 7,125 Machinery and equipment......................... 23,688 22,658 Furniture and fixtures.......................... 2,249 2,322 Leasehold improvements.......................... 3,839 3,781 Automobiles..................................... 523 642 ------- ------- 37,424 36,528 Less accumulated depreciation and amortization.. 20,962 18,622 ------- ------- $16,462 $17,906 ======= =======
Included in the above amounts are machinery and equipment operated under agreements which have been recorded as capital leases having a carrying value of $5,801 and $7,252 as of December 31, 1999 and 1998, respectively (net of accumulated depreciation of $6,293 and $7,801 as of December 31, 1999 and 1998, respectively). Depreciation and amortization expense for capital lease assets for 1999, 1998 and 1997 was $1,658, $1,738 and $1,542, respectively.
HCI DIRECT, INC. (FORMERLY, HOSIERY CORPORATION OF AMERICA, INC.) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (Dollars in thousands, except per share data)
8. OTHER ASSETS 1999 1998 ---- ----
Software, net of accumulated amortization of approximately $6,316 and $6,190, respectively.. $831 $444 Deposits......................................... 13 176 Miscellaneous other............................... 82 87 ---- ---- $926 $707 ==== ====
9. OTHER EXPENSES
Included in other expenses are the following: 1999 1998 1997 ---- ---- ----
Loss on foreign exchange.................. $634 $194 $225 Multistate group administrative expenses.. -- -- 300 Miscellaneous expenses (income)........... (1) (8) 4 ---- ---- ---- $633 $186 $529 ==== ==== ====
10. LINE OF CREDIT AND LONG-TERM DEBT
HCI DIRECT, INC. (FORMERLY, HOSIERY CORPORATION OF AMERICA, INC.) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (Dollars in thousands, except per share data)
10. LONG-TERM DEBT (continued)
On October 17, 1994, the Company entered into a revolving credit and term loan agreement (the "Agreement") with a group of banks which was restructured on November 20, 1997 and amended on March 26, 1999 and March 29, 2000. Outstanding borrowings at December 31, 1999 and 1998 are $52,000 and $59,500, respectively. The facility is secured by substantially all of the assets of HCI Direct, Inc. The facility is also subject to the continuing guarantees of the subsidiaries of HCI Direct, Inc. The revolving credit and term loan portions of the facility have maximum borrowings of $25,000 and $65,000, respectively. The revolving credit facility expires on February 1, 2002. The Company can borrow based on a formula which comprises the sum of 80% of accounts receivable and 50% of inventory. Interest under the revolving credit facility is payable at the banks' prime lending rate plus 0.5% (9.00% at December 31, 1999). There were borrowings outstanding under the revolving credit facility at December 31, 1999 of $13,750 and $3,400 in 1998. The amount available under the revolving credit facility at December 31 was $10,533 and $15,800 in 1999 and 1998, respectively. The term loan is payable in quarterly installments ranging from $750 to $5,000, with a final payment due February 1, 2002. Interest under the term loan is generally payable quarterly and is charged at a premium of 0.5% over the Base Rate or 1.5% over the Eurodollar Rate as defined in the Agreement. The rate in effect at December 31, 1999 ranged from 6.94% to 7.9375%. Additionally, fees are charged on the average daily amount of unused commitment and are payable quarterly. Under the terms of the Agreement, certain restrictions are placed on additional borrowings, the purchase of property and equipment, the payment of cash dividends and the disposition of assets. The Company has also agreed to maintain certain financial ratios as defined in the Agreement.
In March 1999, the Company amended the Agreement to include an Incremental Revolving Loan of $5.0 million. This loan can be made from time to time after the existing revolving credit facility equals $20.0 million. In December 1999, this loan was extended until March 2000. Effective March 30, 2000, $4.0 million of this loan was extended through the life of the Agreement (see Note 24).
During 1994, the Company issued the 13.75% Senior Subordinated Notes, with a principal amount of $70,000, at a discount, which discount is being amortized using the interest method over the life of the notes at an effective interest rate of 14.38%. Interest is payable semi-annually. The Notes were issued in denominations of one thousand dollars, each of which contained one share (collectively the "Shares") of the Company's Class A Non Voting Common Stock, par value $.01 per share. The Notes and the Shares were immediately detachable. Beginning October 1, 1997, the Notes, or a portion thereof, are subject to redemption at the option of the Company at specified redemption prices ranging from 100% to 112% of the aggregate principal amounts of Notes so redeemed. Upon the occurrence of a Change of Control, as defined, each holder of the Notes shall have the right to require the Company to repurchase such holder's Notes at a purchase price equal to 101% of the aggregate principal amount thereof. Under the terms of the agreement, certain restrictions are placed on additional borrowings, the purchase of property and equipment, the payment of cash dividends and the disposition of assets.
In accordance with the Agreement and Notes, the Company is not permitted to declare or pay any dividend or make any distribution in respect of the Company's or any of its Restricted Subsidiaries' Equity Interests other than dividends or distributions payable solely in shares of its Capital Stock. The Company was in compliance with all debt covenants noted above as of December 31, 1999 except minimum EBITDA and leverage ratios. On December 29, 1999, the group of banks amended the Agreement which included waivers of certain financial covenants as of December 31, 1999. Effective March 30, 2000, the group of banks amended the agreement (see Note 24) which included the amendments of certain financial covenants for 2000 and subsequent years. Under the amended agreement, the Company is in compliance with all debt covenants at December 31, 1999.
The Company was contingently liable for outstanding letters of credit in the amount of approximately $717 as of December 31, 1999.
The Company expects to finance debt repayment requirements from internally generated funds and/or its Credit Facility.
HCI DIRECT, INC. (FORMERLY, HOSIERY CORPORATION OF AMERICA, INC.) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (Dollars in thousands, except per share data)
10. LONG-TERM DEBT (continued)
Maturities of long-term debt consisted of the following as of December 31, 1999:
2000....................................... 13,117 2001....................................... 20,117 2002....................................... 88,186 2003....................................... 117 2004....................................... 117 Thereafter................................. 29 -------- $121,683 ======== 11. INCOME TAXES
The domestic and foreign components of pre-tax income consisted of the following:
1999 1998 1997 ---- ---- ----
United States.................... $20,479 $21,110 $17,835 Foreign.......................... 511 409 -- ------- ------- ------- 20,990 21,519 17,835 ======= ======= =======
The provision for income taxes (benefit) consisted of the following:
1999 1998 1997 ---- ---- ---- Federal: Current.......................... $ (887) $ 468 $2,640 Deferred......................... 8,073 6,701 3,297 ------- ------ ------ 7,186 7,169 5,937 ------- ------ ------ States: Current.......................... 138 (31) 451 Deferred......................... 818 728 (146) ------- ------ ------ 956 697 305 ------- ------ ------ Foreign: Current.......................... 378 -- -- Deferred......................... 242 189 -- ------- ------ ------ 620 189 -- ------- ------ ------ $ 8,762 $8,055 $6,242 ======= ====== ======
HCI DIRECT, INC. (FORMERLY, HOSIERY CORPORATION OF AMERICA, INC.) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (Dollars in thousands, except per share data)
11. INCOME TAXES (continued)
The components of net deferred tax liabilities consisted of the following:
1999 1998 -------- -------- Deferred tax liabilities: Deferred customer acquisition costs........ $ 17,782 $ 12,129 Accounts receivable........................ 11,922 7,309 Prepaid assets............................. 2,951 3,642 Property and equipment..................... 448 508 Other assets............................... 705 802 Other current assets....................... -- 161 Accrued coupon redemption costs............ 366 368 State deferred taxes....................... 2,425 1,885 Other...................................... (38) 199 -------- -------- 36,561 27,003 -------- -------- Deferred tax assets: Accrued expenses........................... (1,268) (868) Stock option............................... (7,121) (7,121) Foreign Tax Credit......................... (361) -- Other...................................... (40) (15) -------- -------- (8,790) (8,004) Valuation Allowance 361 -- -------- -------- (8,429) (8,004) -------- -------- $28,132 $18,999 ======== ========
The Company has recorded a Deferred Tax Asset for Foreign Tax Credits of $358 for 1999 which will expire in 2005. A full valuation allowance of $358 has been established due to the uncertainty of its usage during the 5-year carryforward period.
HCI DIRECT, INC. (FORMERLY, HOSIERY CORPORATION OF AMERICA, INC.) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (Dollars in thousands, except per share data)
12. REDEEMABLE EQUITY SECURITIES
In connection with the Recapitalization, the Company issued 2,826 shares of voting common stock, $.01 par value, to management stockholders for cash. The Company is obligated to redeem these shares from the management stockholders upon the death, disability or termination of employment of the holder. The redeemable common stock was recorded at fair value on the date of issuance, less issuance costs, totaling $45. During 1995, the Company issued an additional 4,048 shares of voting common stock, $.01 par value, for cash under the same basic terms. The redeemable common stock was recorded at fair value on the date of issuance, less issuance costs, totaling $63. In connection with the issuance of redeemable common shares in 1995, certain agreements were amended and executed in order that 14,643 shares of preferred stock issued for cash in 1995 and 10,218 shares of preferred stock issued for cash in October 1994 would be redeemable under the same basic terms of the redeemable common stock. Each preferred share has a $.01 par value, a stated value at liquidation of $10 and cumulative dividends of 25% of additional shares of PIK preferred stock or fractions thereof. The redeemable preferred stock was recorded at fair value on the date of issuance or amendment providing for their redemption, less issuance costs, totaling $224. The excess of the preference value over the carrying value is being accreted by periodic charges to Additional Paid-In Capital over the life of the issue. The redemption provisions were due to expire the earlier of the fifth anniversary of the October 17, 1994 Recapitalization or the closing of an initial public offering for the Company's common stock. These provisions expired in October of 1999. Accordingly, the redeemable equity securities were reclassified to stockholders' deficiency.
In 1996, two officers of the Company were granted 4,434 shares of voting common stock, $.01 par value, as additional compensation. The Company was obligated to redeem these shares under the same basic terms as previously issued redeemable stock. The redeemable common stock was recorded at fair value on the date of issuance. This resulted in an increase in redeemable equity securities of approximately $300.
13. TREASURY STOCK
Pursuant to the Recapitalization Agreement (see Note 15), the Company repurchased from the Stockholder for approximately $199.0 million, which includes approximately $0.9 million in post-closing adjustments, all of its then outstanding shares of Preferred Stock (5,460 Class A shares and 9,425 Class B shares) and 17,337 shares of its then outstanding Common Stock. These shares along with all previously acquired shares of Preferred and Common Stock were then retired. During 1995, additional post closing adjustments totaling $88 were made to the purchase price relating to the retired treasury shares. During 1998, the Company repurchased from two officers of the Company a total of 18,600 shares of common stock and 8,715 shares of preferred stock for a total value of $1,556.
HCI DIRECT, INC. (FORMERLY, HOSIERY CORPORATION OF AMERICA, INC.) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (Dollars in thousands, except per share data)
14. STOCKHOLDERS' EQUITY
On June 24, 1999, the Board of Directors and Stockholders approved the Company's filing of a Restated Certificate of Incorporation that was amended to (i) change the name of the Company to HCI Direct, Inc., (ii) increase the number of shares of capital stock which the Company is authorized to issue to 73 million shares, consisting of (a) 60 million shares of Common Stock, par value $.01 per share, (b) 1 million shares of Class A Common Stock, par value $.01 per share and (c) 12 million shares of Preferred Stock, par value $.01 per share, which includes 4 million shares of Payment-in-kind Preferred Stock, par value $.01 per share, having the powers, preferences, and rights and qualifications, limitations and restrictions set forth in the Company's Restated Certificate of Incorporation.
On June 24, 1999, the Board of Directors and Stockholders approved an 8.6976942 to 1 stock split, effective June 24, 1999.
On October 20, 1999, a majority of the Stockholders of the Company approved by written consent the reversal of the 8.6976942 to 1 stock split effective June 24, 1999 (the "reverse stock split"). The reverse stock split was previously approved by the Board of Directors on September 1, 1999. The reverse stock split was effective on October 27, 1999 when the Restated Articles of Incorporation of the Company were filed with the State of Delaware.
Redeemable equity securities were reclassified into stockholders' deficiency due to redemption provisions that expired on October 17, 1999 (see Note 12).
15. RECAPITALIZATION
On July 19, 1994, an affiliate of Kelso & Company, Inc. ("Kelso"), the Company and Joseph A. Murphy, the sole stockholder of the Company (the "Stockholder"), entered into a Recapitalization and Stock Purchase Agreement (the "Recapitalization Agreement"). Pursuant to the Recapitalization Agreement, the Company repurchased from the Stockholder (the "Repurchase") for approximately $191,200, which includes approximately $900 in post-closing adjustments (net of $7,800 received from the Stockholder for the purchase of certain assets (see below)), all of its then outstanding shares of preferred stock and a substantial portion of its then outstanding shares of common stock. On October 17, 1994, the Company effected the recapitalization of its capital stock (the "Recapitalization"), pursuant to which certain affiliates and designees of Kelso and certain members of operating management of the Company (collectively, the "Investor Group"), purchased a controlling equity interest in the Company. The Company effected the Repurchase with the proceeds of the Financing (as defined below). Following the consummation of the Repurchase (and after giving effect to the purchase of common stock by the Investor Group pursuant to the Financing), the Investor Group owned approximately 74% of the Company's common stock, with the Stockholder retaining approximately 21% of the Company's common stock.
The Company obtained the funds necessary to effect the Repurchase, repay certain existing indebtedness of the Company and pay the fees and expenses incurred in connection with the Recapitalization primarily from the proceeds of a financing (the "Financing") which included (i) borrowings of $80,000 under a credit agreement, consisting of $80,000 of term loan facilities (the "Term Loan Facilities") and a $15,000 revolving credit facility, entered into among the Company, Bankers Trust Company, and the banks signatory thereto, (ii) gross proceeds of approximately $69,100 from the issuance and sale of the Units (each unit consisting of one Senior Subordinated Note and one share of Class A Common Stock), (iii) gross proceeds of approximately $36.5 million from the sale to the Investor Group of shares of a new class of pay-in-kind preferred stock of the Company for cash, and (iv) gross proceeds of approximately $17,100 from the sale to the Investor Group of shares of Common Stock for cash. The Company also utilized working capital of approximately $2,000 to pay fees and expenses incurred in connection with the Recapitalization. In addition, certain members of the Company's management were granted restricted pay-in-kind preferred stock and restricted common stock of $1,022 and $478, respectively (see Note 20).
HCI DIRECT, INC. (FORMERLY, HOSIERY CORPORATION OF AMERICA, INC.) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (Dollars in thousands, except per share data)
15. RECAPITALIZATION (continued)
The Recapitalization and Stock Purchase Agreement contained customary representations, warranties and conditions. The Recapitalization and Stock Purchase Agreement also provided that, at or prior to the consummation of the Acquisition, the Stockholder and the Company enter into an Escrow agreement pursuant to which, among other things, $10,000 of the aggregate purchase price paid by the Company to the Stockholder pursuant to the Repurchase be held in escrow to provide a source of payment to satisfy the Stockholder's indemnification obligations under the Recapitalization and Stock Purchase Agreement.
Prior to the Recapitalization, the Company had authorized classes of voting and non-voting common stock, with shares of voting stock issued and outstanding. As part of the Recapitalization, such non-voting stock was retired and such voting stock was changed and reclassified from Class A Common Stock, par value $1.00 per share, into one share of Common Stock, par value $.01 per share. In addition, in connection with the Recapitalization, the Company issued and sold shares of non-voting Class A Common Stock, a small number of which was purchased by certain designees of Kelso, and the remainder of which was sold in the form of Shares as part of the Units. Upon the occurrence of any Conversion Event (as defined, e.g., any transfer of shares of Class A Common Stock to any persons who are not affiliates of the transferor), each share of Class A Common Stock shall be convertible into one share of the Company's Common Stock. Subsequent to the Recapitalization, the Company effected a stock split of its Common Stock on approximately a 62.22-to-1 basis.
On November 20, 1997, the Company amended and restructured its credit agreement. This change resulted in lower interest rates, an increase in the revolving credit facility from $15,000 to $20,000, a substantial change in the timing of principal payments and changes to the debt covenants.
16. LEASE COMMITMENTS
The Company leases premises under cancelable and noncancelable operating leases with lease terms expiring through 2007. Future minimum payments by year and in the aggregate under all noncancelable capital and operating leases having initial or remaining terms of one year or more consisted of the following at December 31, 1999:
Year ending Capital Operating December 31, Leases Leases ------------ ------- --------- 2000..................................... 1,723 2,789 2001..................................... 1,601 1,148 2002..................................... 1,277 1,027 2003..................................... 779 989 2004..................................... 516 973 Thereafter........... ................... 535 2,356 ----- ----- 6,431 9,282 Amount representing imputed interest..... 506 ===== ----- Present value of net minimum lease payments 5,925 Less current portion 1,526 ----- 4,399 =====
Rental expense under all operating leases for the years ended December 31, 1999, 1998 and 1997, was approximately $2,495, $2,094 and $1,887, respectively.
HCI DIRECT, INC. (FORMERLY, HOSIERY CORPORATION OF AMERICA, INC.) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (Dollars in thousands, except per share data)
17. COMMITMENTS AND CONTINGENCIES
The Company has entered into employment agreements with certain members of management.
The Company has agreed to pay Kelso an annual fee of $263 each year for financial advisory services and to reimburse Kelso for out-of-pocket expenses incurred. Non-officer directors of the Company, other than those directors who are affiliated with Kelso, will be paid an annual retainer of $20. In addition, all out-of-pocket expenses of non-officer directors, including those directors who are affiliated with Kelso, related to meetings attended, will be reimbursed by the Company. Non-officer directors, including those directors affiliated with Kelso, will receive no additional compensation for their services as directors of the Company except as described above.
As a result of a lawsuit brought by the FTC, the Federal District Court for the Eastern District of Pennsylvania issued a consent injunction in 1984, which specifies rules the Company must follow in conducting its mail order business. The consent injunction permanently enjoins the Company from violating various FTC and Postal Service laws and regulations. As a result of these inquiries, in 1984 the Company adopted revised promotional materials. The Company believes but cannot assure that these modifications and its current and future promotional materials will meet the concerns expressed by the FTC or be deemed to be in compliance with the consent injunction.
In 1997, the Company reached an agreement with an 11-state group that imposes specific disclosure requirements on the Company's promotional materials and specifies rules the Company must follow in its promotional materials and in conducting its mail order business. The modifications the Company made to its solicitation materials had a material adverse effect on its U.S. response rates in 1997 and 1998. The Company does not believe that these modifications will have a further significant negative impact on its response rates in the future, although the Company cannot guarantee that this will be the case. In addition, while the Company believes the modifications to its promotional materials meet the concerns expressed by the 11-state group and comply with the terms of that agreement, the Company cannot assure that these modifications will be deemed to be in compliance with the 11-state agreement.
Under the terms of the 11-state agreement, the Company paid $0.3 million in administrative expenses and fees during 1997. The agreement also required that the Company pay refunds to customers under certain circumstances for a six-month period. These refunds were not material to the Company's business, financial condition or results of operations.
Beginning in early 1999, the Company introduced a new promotional offer in North America whereby the customer has the opportunity to receive one free pair of hosiery when the customer responds to the Company's initial solicitation. Under this offer, if the customer does not elect to cancel future shipments, the customer automatically becomes a participant in the Company's continuity program. While the Company believes that this new promotional offer complies with the terms of its agreement with the 11-state group, the Company cannot assure this. Accordingly, there may be some additional modifications that the Company may need to make to its promotional materials to fully satisfy the terms of the agreement.
In 1997 and 1998, the Company received inquiries from the Direct Marketing Association and the National Advertising Division of the Better Business Bureau concerning whether the terms of its promotional offers are sufficiently disclosed in its promotional materials. These inquiries were resolved without any future modifications to the Company's promotional materials.
HCI DIRECT, INC. (FORMERLY, HOSIERY CORPORATION OF AMERICA, INC.) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (Dollars in thousands, except per share data)
17. COMMITMENTS AND CONTINGENCIES (continued)
The Company received formal inquiries from 2 states which were not part of the 11-state group. The Company had reached an agreement in principle with one of the 2 states. However, the state never finalized this agreement and the Company has not heard further from the state in over a year. The Company is in discussions with the other state and is seeking to settle the inquiry. The Company does not believe that the amount of any settlement of either inquiry will be significant. While the Company believes that it will be able to resolve these inquiries and other future inquiries, it cannot assure this, nor can it assure that these or other regulators or trade associations will not require or seek to impose additional changes to the Company's promotional materials or billing practices. In addition, the Company cannot assure that these additional changes to its materials or billing practices, if any, will not be significant or will not have a material adverse effect on its business, financial condition or results of operations.
The direct mail marketing industry is subject to ongoing and changing federal, state, local and foreign consumer protection, mail order and other laws and regulations. Accordingly, it is possible that new or additional laws or regulations could be passed at any time. While the Company's management believes that its promotional materials are in substantial compliance with applicable laws and regulations, the Company cannot give any assurance in that regard nor can it assure that additional laws or regulations will not be passed which could have a material adverse effect on the Company's ability to rent customer lists from third parties, or on its future response rates, business, financial condition or results of operations.
On January 6, 2000, the Internal Revenue Service issued notice of a Tax Deficiency for the years ended December 31, 1993 and 1994 of $638,909 and $2,336,346, respectively plus accrued interest of $410,666 for 1993 and $1,200,939 for 1994. The total assessment for both tax and interest for these years is $4,586,860. The deficiency being assessed is for a corporate-owned life insurance (COLI) plan. This plan was discontinued when the Company was sold in 1994 and the policies were transferred to the former owner at that time. As part of the acquisition agreement, the former owner is responsible for any tax deficiencies related to the COLI and the monies being assessed by the Internal Revenue Service are currently being held in an escrow account.
18. PROFIT SHARING PLAN
The Company has a profit sharing plan covering all employees and those of its subsidiaries. Eligible employees can participate as of January 1 and July 1 after twelve months of service. Employee contributions are made on a pretax basis under Section 401(k) of the Internal Revenue Code. The Company's contribution is at the discretion of the Board of Directors. The expense associated with the employer contribution was approximately $560, $550, and $514 in 1999, 1998, and 1997, respectively.
All contributions and investments are held in a trust for the benefit of plan participants. All employees are 100% vested in their pretax contributions and earnings thereon, but become vested in the Company contributions and earnings at a rate based on years of service, with full vesting after five years.
19. FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company values the financial instruments as required by SFAS No. 107, Disclosures about Fair Value of Financial Instruments. The following methods and assumptions were used to estimate the fair value of each class of financial instrument:
HCI DIRECT, INC. (FORMERLY, HOSIERY CORPORATION OF AMERICA, INC.) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (Dollars in thousands, except per share data)
19. FAIR VALUE OF FINANCIAL INSTRUMENTS (continued)
Cash and Cash Equivalents, Accounts Receivable, Accounts Payable and Accrued Expenses. The carrying amount of these items are a reasonable estimate of their fair values because of the short maturity of these instruments.
Long-term Debt including Current Maturities. The fair value of the Company's long-term debt is based on the quoted market price on the subordinated notes and on current interest rates that are available to the Company for debt not quoted on an exchange. At December 31, 1999 and 1998, the Company had a carrying amount of long-term debt of $121,683 and $129,050, respectively and an estimated fair value of $125,412 and $132,358, respectively.
20. STOCK OPTION PLAN
On June 28, 1996, the Board of Directors approved and adopted a stock option plan (the "Option Plan"), providing for the grant to certain employees of the Company and its subsidiaries of options to purchase up to 215,369 shares of Common Stock. On June 28, 1996, the Board of Directors granted options to purchase an aggregate of 215,369 shares of Common Stock. The exercise price with respect to 199,458 shares is $30.00 per share. The exercise price with respect to 15,911 shares will be the price per share obtained in an initial public offering. All options vested on the date of such grant and are exercisable at the earlier of ten years from the date of grant or upon an initial public offering of the Common Stock or certain change of control events. Options expire 10 years from the date of the grant of such option, subject to earlier termination by the Board of Directors. Compensation expense of $22,938 was recorded in the Company's financial statements for the year ending December 31, 1996. On June 24, 1999, the Board of Directors approved that the Company's 1996 Stock Option Plan be amended to, among other things, increase from 215,369 to 321,369, the number of shares of Common Stock authorized for issuance under the plan.
On July 29, 1998, the Company entered into an agreement with an executive who terminated his employment with the Company (the "Agreement"). In connection with the Agreement, the executive was granted the right to exercise his options at the option price of $30 per share, and simultaneously, the Company reacquired these shares at a fair value of $107 per share.
On June 24, 1999, the Board of Directors approved the Company's 1999 Stock Option Plan providing for the grant of Awards (as defined in the Plan) to certain employees, consultants and directors of the Company of up to 600,000 shares of Common Stock under the terms and conditions set forth in the 1999 Stock Option Plan.
On June 24, 1999 the Board of Directors approved the grant of options to purchase an aggregate of 106,000 shares of common stock to Messrs. Whalen (53,000 shares) and Pearson (53,000 shares) under the 1996 Stock Option Plan. The exercise price for Mr. Whalen's shares and 26,500 of Mr. Pearson's shares is $130.75 per share. These options will have vested on the date of their grant (except for 26,500 of Mr. Pearson's shares which will vest upon the culmination of an initial public offering) and will be exercisable at the earlier of seven years from the date of the grant or upon completion of an initial public offering of common stock. Mr. Pearson is no longer employed by the Company but will retain his options for 90 days after ending his relationship with the Company.
HCI DIRECT, INC. (FORMERLY, HOSIERY CORPORATION OF AMERICA, INC.) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (Dollars in thousands, except per share data)
20. STOCK OPTION PLAN (continued)
A summary of the status of the Company's stock option plan as of December 31, 1999 and changes during the year ending on that date is presented below:
At December 31, 1999, there were 600,000 options available for future grants under the Option Plan.
(1) Exercise price to be determined at the time of the Company's initial public offering.
(2) There were 79,500 shares outstanding at a weighted average price of $130.75; 42,411 shares outstanding at an exercise price to be determined at the time of the Company's initial public offering.
HCI DIRECT, INC. (FORMERLY, HOSIERY CORPORATION OF AMERICA, INC.) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (Dollars in thousands, except per share data)
20. STOCK OPTION PLAN (continued)
The following table summarizes information about stock options outstanding at December 31, 1999:
Options Outstanding ----------------------------------------------- Weighted Average Weighted Number Remaining Average Exercise Outstanding Contractual Exercise Prices at 12/31/99 Life Price -------- ----------- ----------- --------
$ 30.00 182,114 6.5 years $ 30.00 130.75 79,500 6.5 years 130.75 (1) 42,411 6.5 years (1)
The Company applies Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," in accounting for its plan. As there is no difference between the fair market value of the Common Stock, which for financial reporting purposes was based on the estimated fair value at the date of grant, and the exercise price of such options, no compensation expense has been recorded in the Company's financial statements for the year ending December 31, 1999. Had compensation cost for the Company's stock option plan been determined based on the fair value at the grant dates, consistent with the method of SFAS No. 123, "Accounting for Stock-Based Compensation," the Company's net income for the year ending December 31, 1999, would have been decreased to the pro forma amounts indicated below:
Net income:
As reported $12,228 =======
Pro forma $ 8,939 =======
The fair value of each option granted during 1999 is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions: (i) no dividend yield, (ii) no expected volatility as the Company's stock is not publicly traded, (iii) risk-free interest rate of 6.0%, and (iv) expected life of 5.5 years.
21. RELATED PARTIES TRANSACTIONS
In connection with the Recapitalization, certain members of the Company's management were granted restricted pay-in-kind preferred stock and restricted common stock of $1,022 and $478, respectively. Compensation associated with the grant of these shares was measured by the difference between the aggregate price of the restricted shares and the aggregate fair value of the shares on the measurement date. Such compensation is being recognized ratably over the six-year period for which services must be performed in order for these individuals to receive the shares without restriction. The Company is recognizing compensation expense over six years commencing October 17, 1994, which is the date the Company effected the Recapitalization and granted the restricted shares. Compensation expense related to these shares for the period ended December 31, 1999 and 1998 totaled $250 in each year.
HCI DIRECT, INC. (FORMERLY, HOSIERY CORPORATION OF AMERICA, INC.) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (Dollars in thousands, except per share data)
21. RELATED PARTIES TRANSACTIONS (continued)
In connection with the Recapitalization, on October 17, 1994, certain designees of Kelso acquired shares of the Company's Common Stock. The proceeds from the sale of these shares were received subsequent to December 31, 1994.
In 1996, two officers of the Company were granted shares of common stock as additional compensation totaling approximately $300. These shares are included in the accompanying balance sheets as redeemable equity securities.
Kelso provides financial advisory services to the Company for an annual fee. Payment for these services and reimbursement of expenses totaled $293 in 1999, $294 in 1998 and $270 in 1997.
22. PREFERRED STOCK
The PIK Preferred Stock is entitled to cumulative dividends, payable solely in additional shares of PIK Preferred Stock, at an estimated rate of 25% per annum when, as and if declared by the Board of Directors of the Company. Cumulative dividends on preferred shares that have not been declared since the Recapitalization total approximately 9.0 million shares of preferred stock. The PIK Preferred Stock has an aggregate liquidation preference of approximately $37.4 million plus the liquidation preference of additional shares of PIK Preferred Stock issued in payment of dividends on the PIK Preferred Stock and the liquidation preference in respect of accumulated and unpaid dividends, whether or not declared. The PIK Preferred Stock is redeemable at the option of the Company in whole or in part at any time for a redemption price equal to the liquidation preference thereof plus all accumulated and unpaid dividends, whether or not declared, to the date of redemption. In addition, the PIK Preferred Stock has no voting rights, except that the PIK Preferred Stock is entitled to vote, as a separate class, in the event of any merger, consolidation, or sale of all or substantially all of the Company's assets, any amendment to the Company's Restated Certificate of Incorporation or any authorization or issuance by the Company of capital stock ranking senior to or pari passu with the PIK Preferred Stock with respect to dividends or liquidation preference or securities convertible into or exchangeable or exercisable for such capital stock.
Redeemable equity PIK Preferred Stock was reclassified into Preferred Stock due to redemption provisions that expired on October 17, 1999 (see Note 12).
23. QUARTERLY INFORMATION (UNAUDITED)
HCI DIRECT, INC. (FORMERLY, HOSIERY CORPORATION OF AMERICA, INC.) AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 (Dollars in thousands, except per share data)
24. SUBSEQUENT EVENTS
Effective March 30, 2000, the Company amended its Credit Agreement to extend $4,000 of the Incremental Revolving Loan through the life of the Credit Agreement. This loan can be made from time to time after the existing revolving credit facility equals $20,000. Also, the Company amended certain financial ratios as defined in the Agreement for 2000 and subsequent years (see Note 10).
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE - ----------------------------------------------------------------- None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - ---------------------------------------------------------------
The Company's executive officers and directors, as well as additional information with respect to those persons, are set forth in the table below.
Name Age Position - ---- --- -------- John F. Biagini 56 Chairman and Chief Executive Officer Philip G. Whalen 54 President and Chief Operations Officer Michael D. Rowley 50 Vice President and Chief Financial Officer Hans Lengers 54 Director of the Board and President, U.S. Textile Corporation Darrell Edwards 41 Vice President and Director of Marketing William J. Kelly 50 Director, International Operations Arthur Hughes 58 Senior Vice President, Finance Martin J. Pearson 53 President, International Operations Frank K. Bynum, Jr. 37 Director Michael B. Goldberg 53 Director
Directors shall be elected by a plurality of the votes cast at annual meetings of stockholders (except in the case of vacancies on the Board of Directors). All directors of the Company serve for the term for which they are elected or until their successors are duly elected and qualified or until death, retirement, resignation, or removal. All executive officers hold office at the pleasure of the Board of Directors. See "--Stockholders Agreement" and Item 11
ITEM 11. EXECUTIVE COMPENSATION - --------------------------------
The following table sets forth the total compensation earned by the Chief Executive Officer and the six most highly compensated executive officers of the Company for the fiscal year ended December 31, 1999, as well as the total compensation earned by such individuals for the two previous fiscal years.
SUMMARY COMPENSATION TABLE - --------------------------
Long-Term Compensation - ----------------------
Management Stock Purchase and Restricted Stock Award Agreements - ---------------------------------------------------------------
Prior to the closing of the Recapitalization, Mr. Biagini and Mr. Lengers entered into Management Stock Purchase and Restricted Stock Award Agreements with the Company (the "Management Stock Agreements"), pursuant to which Mr. Biagini was granted 18,841 restricted shares of Common Stock and 68,120 restricted shares of PIK Preferred Stock, and Mr. Lengers was granted 9,421 restricted shares of Common Stock and 34,060 restricted shares of PIK Preferred Stock in addition to the shares of Common Stock and PIK Preferred Stock granted to Mr. Biagini and Mr. Lengers is $1,000,000 and $500,000, respectively. The Common Stock was sold at $16.92 per share and the PIK Preferred Stock at $10.00 per share to the original investor group. Compensation with respect to the grant of shares will be recognized ratably over the six-year period for which services must be performed in order for Messrs. Biagini and Lengers to receive the shares without restriction. No dividends will be paid on any restricted stock. Additionally, in 1995 the management group was offered limited opportunities to purchase stock at the same price as Messrs. Biagini and Lengers which resulted in net proceeds to the Company of $190,000.
(1) Options exercisable at a price per share to be obtained in an initial public offering. There is no current public market for these securities.
FISCAL YEAR-END OPTION VALUES -----------------------------
Number of Securities Underlying Unexercised Value of Unexercised Options at In-the-Money Options December 31, 1999 (#) at December 31, 1999 ($) ----------------------- ------------------------
Name Exercisable/Unexercisable Exercisable/Unexercisable - ---- ------------------------- ------------------------- John F. Biagini 0/94,676 0/8,737,040 Hans Lengers 0/47,339 0/4,368,621 Philip G. Whalen 0/53,000 0/0 Arthur Hughes 0/21,322 0/1,747,408 William J. Kelly 0/17,344 0/1,747,408 Martin Pearson 0/53,000 0/0
There is no public market for the common stock of the Company. The value utilized for the In-the-Money Options as of December 31, 1999 was based on a valuation completed by an independent appraiser and reviewed by management for reasonableness.
Options granted in 1999 were 106,000.
Employment Agreements - ---------------------
In August 1980, Hans Lengers entered into an Employment Agreement with the Company's manufacturing subsidiary, U.S. Textile Corporation ("U.S. Textile"), pursuant to which he is employed as President and Chief Executive Officer of U.S. Textile and to manage and operate its business and affairs for his lifetime, such agreement having been amended on September 12, 1994. Mr. Lengers is not entitled to receive compensation upon the voluntary termination of his employment with U.S. Textile. In addition, the Company may abrogate the terms and conditions of the Employment Agreement for good cause as defined by the law of North Carolina, and in any event, the Employment Agreement will terminate upon Mr. Lengers' death, adjudicated incompetency, bankruptcy or physical or mental inability to perform his duties thereunder. The agreement provides for a base salary of $5,000 per month and additional compensation in the amount that 25.0% of the U.S. Textile net profits exceed such base compensation, such that the sum of the base compensation and this additional compensation does not exceed $250,000 per annum, adjusted each year for cost of living increases. The Consumer Price Index for Urban Wage Earners and clerical workers is used as the index to compute cost of living increases. The ceiling for Mr. Lengers' salary in 1998 was $439,000. In addition, Mr. Lengers has agreed during the time of his employment not to devote any of his time and efforts to the affairs of any other business in direct competition with U.S. Textile.
The aforementioned employment agreements require a successor to the employer thereunder to assume the respective obligations of such employer under the applicable agreement.
Compensation Committee Interlocks and Insider Participations in Compensation Decisions - -----------------------------------------------------------------------------
Mr. Biagini was the Chairman and Chief Executive Officer of the Company during the last fiscal year. Messrs. Goldberg and Bynum are both general partners of the general partner of KIAV, general partners of KEPV and are Managing Directors of Kelso.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - ------------------------------------------------------------
The following table sets forth information as of March 29, 1999 with respect to the beneficial ownership of shares of Common Stock of all stockholders of the Company who are known by the Company to beneficially own more than 5% of any such class, by each director, by each executive officer of the Company named in the summary compensation table and by all directors and executive officers of the Company as a group, as determined in accordance with Rule 13d-3(i) under the Securities Exchange Act of 1934, as amended. The Common Stock set forth in the following table includes voting Common Stock and non-voting Class A Common Stock. Except as indicated in the footnotes below, all shares of Common Stock are voting Common Stock. Prior to the consummation of the Recapitalization, all of the issued and outstanding shares of Common Stock and Old Preferred Stock were owned by the Stockholder.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - --------------------------------------------------------
Set forth below is a summary of certain agreements and arrangements entered into by the Company and related parties in connection with the Recapitalization.
Investor Relationships - ----------------------
Kelso affiliates beneficially own 70.8% of the shares of common equity of the Company as described under "Security Ownership of Certain Beneficial Owners and Management". The Company has agreed to indemnify Kelso and its affiliates against certain claims, losses, damages, liabilities and expenses which may arise in connection with the transactions contemplated by the Recapitalization Agreement. The Company has also agreed to pay Kelso an annual fee of $262,500 each year for financial advisory services and to reimburse it for out-of-pocket expenses incurred, and to indemnify it against certain claims, losses, damages, liabilities and expenses which may arise, in connection with rendering such services. Kelso's out-of-pocket expenses in connection with its services rendered during 1999 and 1998 were approximately $30,000 and $32,000, respectively.
Certain Kelso affiliates are parties to a stockholders agreement. In addition, certain affiliates of Kelso, the Company and certain investors in the Company's stock who are designees of Kelso entered into Letter Agreements (collectively, the "Letter Agreements"), each of which, among other things, provides for certain restrictions on the transfer of stock by such investors. The Company has a stockholders agreement which provides, among other things, for certain restrictions on the transfer of the Company's stock.
The Recapitalization and Related Transactions - ---------------------------------------------
The Recapitalization Agreement contains customary representations, warranties, indemnities and conditions. In addition, the Recapitalization Agreement provides that the Stockholder, on the one hand, and Company, on the other, will, subject to certain limitations set forth therein, indemnify each other and their respective stockholders, subsidiaries, affiliates, officers and directors and their respective successors and assigns, from, against and in respect of any damages, losses, deficiencies, liabilities, costs and expenses, incurred as a result of any (i) misrepresentations or breaches of warranties set forth in the Recapitalization Agreement or in any certificate delivered pursuant thereto and (ii) non-fulfillment of certain agreements or covenants set forth in the Recapitalization Agreement. The representations and warranties and covenants and agreements to which such indemnification relates are standard and include representations and warranties with respect to ownership of stock, capitalization, financial statements, absence of defaults under agreements and violations of law and similar matters. In addition, the Recapitalization Agreement provides for similar indemnification by the Stockholder with respect to certain other matters, including, among other things, claims by third parties resulting from or arising out of certain activities in connection with the Stockholder's auction and sale of the Company and certain liabilities incurred as a result of the operations (or relating to the assets) which were transferred to the Stockholder prior to the Recapitalization (as described below) or arising out of such transfer. Under the Recapitalization Agreement, such indemnification is subject to certain baskets and deductibles and, in general, has an aggregate limit of $15 million.
The Recapitalization Agreement also provided for the Stockholder and the Company to enter into an Escrow Agreement pursuant to which, among other things, $10 million of the aggregate purchase price paid by the Company to the Stockholder pursuant to the Repurchase is held in escrow to provide a source of payment to satisfy the Stockholder's indemnification obligations under the Recapitalization Agreement. In addition, the Stockholder has pledged to the Company the shares of Common Stock which were not purchased by the Company pursuant to the Repurchase and which the Stockholder continues to own following the consummation of the Recapitalization (such shares represent approximately 21% of the Company's Common Stock outstanding following the consummation of the Recapitalization).
In connection with the Recapitalization, the Company transferred to the Stockholder certain assets consisting primarily of the stock of all of its non-hosiery related subsidiaries, some of which are inactive businesses, certain receivables, equipment leased to one of the non-hosiery subsidiaries, certain life insurance policies, four owned or leased automobiles and three owned or leased personal computers. None of the assets transferred to the Stockholder, except the life insurance policies and loans thereon, automobiles and computers, were used in the Company's hosiery business.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULE, AND REPORTS ON FORM 8-K - -------------------------------------------------------------------------
A. The following documents are filed as a part of this Report:
(1) and (2) Financial Statements and Financial Statement Schedule--see Index to Financial Statements and Financial Statement Schedule appearing on Page 18.
(3) Exhibits, including those incorporated by reference. The following is a list of exhibits filed as part of this Annual Report on Form 10-K. Where so indicated by footnote, exhibits which were previously filed are incorporated by reference. For exhibits incorporated by reference, the location of the exhibit in the previous filing is indicated.
* Filed herewith.
B. Reports on Form 8-K filed during the quarter ended December 31, 1999:
None.
SIGNATURES - ----------
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on the 30th day of March, 2000.
HCI DIRECT, INC.
/s/ MICHAEL D. ROWLEY BY: ______________________________ Michael D. Rowley Vice President and Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on the 30th day of March, 2000.
Signatures Title - ---------- -----
/s/ JOHN F. BIAGINI _____________________________ Chairman of the Board John F. Biagini
/s/ PHILIP G. WHALEN _____________________________ President and Chief Executive Officer Philip G. Whalen
_____________________________ President, U.S. Textile Corporation Hans Lengers and Director
/s/ MICHAEL D. ROWLEY _____________________________ Vice President and Chief Financial Officer Michael D. Rowley (Principal Financial and Accounting Officer)
/s/ FRANK K. BYNUM, JR. _____________________________ Director Frank K. Bynum, Jr.
/s/ MICHAEL B. GOLDBERG _____________________________ Director Michael B. Goldberg
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of HCI Direct, Inc. Bensalem, Pennsylvania
We have audited the consolidated financial statements of HCI Direct, Inc. (formerly Hosiery Corporation of America, Inc.) and subsidiaries (the "Company") as of December 31, 1999 and 1998, and for each of the three years in the period ended December 31, 1999, and have issued our report thereon dated March 30, 2000, such report is included elsewhere in this Form 10-K. Our audits also included the consolidated financial statement schedule of the Company referred to in Item 8. This consolidated financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such consolidated financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
Deloitte & Touche LLP Philadelphia, Pennsylvania
March 30, 2000
S-1
SCHEDULE I
S-2
EXHIBIT INDEX
EXHIBITS --------
3.7 Form of Restated Certificate of Incorporation of the Company filed with the Secretary of State of the State of Delaware on October 20, 1999
4.5 Amendment and Waiver to the Credit Agreement dated as of December 29, 1999 among the Company; various lending institutions and Bankers Trust Company, as Agent
10.13 Executive Employment Agreement between the Company and Michael D. Rowley, dated as of October 4, 1999
21.1 Subsidiaries of the Registrant
27.0 Financial Data Schedule