Enesco is a world leader in the design, manufacturing and marketing of licensed and proprietary branded giftware, and home and garden décor products to a variety of specialty gift, home décor, mass-market and direct mail retailers. We primarily serve markets in the U.S., Canada and Europe.
Enesco’s product lines include some of the world’s most recognizable brands, including Bratz tm , Border Fine Arts tm , Cherished Teddies ® , Halcyon Days ® , Heartwood Creek tm by Jim Shore, Lilliput Lane tm , Nickelodeon ® , Pooh & Friends ® , Walt Disney Classics Collections ® and Disney ® , among others.
Products include diverse lines of accent furniture, wall décor, garden accessories, frames, desk accessories, figurines, cottages, musicals, music boxes, ornaments, waterballs, candles, tableware, general home accessories and resin figures.
Products
Enesco’s giftware, and home and garden décor products fall under three main categories:
• Proprietary Designs
Enesco offers a line of proprietary branded products that are designed by Enesco’s in-house creative group and certain contracted third-party artists. Our proprietary designs product lines in 2005 included:
• Blooming Wild tm
• Dartington Crystal ® • Growing Up Birthday Girls ®
• Border Fine Arts tm
• Foundations ® • Lilliput Lane tm
• Circle of Love tm
• Gregg Gift tm
• Licensed Brands
Enesco obtains brand name licenses to develop product formats that primarily are sold to mass-market and specialty gift retailers in the U.S. Our licensed product lines in 2005 included:
• Bratz tm
• Halcyon Days ® • Pooh & Friends ®
• Cherished Teddies ®
• Heartwood Creek tm by Jim Shore • Precious Moments ®
• Children of the Inner Light ®
• My Little Kitchen Fairies tm • Rudolph the Red-Nosed Reindeer ®
• John Deere ®
• Marvel ® • Walt Disney Classics Collection ®
• Disney ®
• NASCAR ®
• Mary Engelbreit tm
• Nickelodeon ®
• Third-Party Distribution
Enesco has third-party distribution agreements that allow us to sell other manufacturers’ product lines in our core channels of distribution. These strategic alliances expand the breadth of our product offerings, while minimizing product development costs. In 2005, we had third-party distribution agreements with the following:
• About Face Designs
• Demdaco • Lenox
• Artline
• Franz Porcelain • Publications International
Our product lines consist of approximately 23,000 stock-keeping units (SKUs) worldwide, including approximately 4,000 sold in the U.S. Each year, Enesco undertakes a comprehensive review of all products being sold and developed. Using an analysis based on profitability and management judgment, Enesco discontinues certain SKUs from its product lines where the potential for consumer demand is low.
During the fourth quarter of 2005, as part of our Operating Improvement Plan, we initiated a rationalization of our U.S. product portfolio and found that as our product lines have proliferated, certain
unproductive product lines remained. By the end of 2005, we reduced the number of overall product lines in the U.S. by more than 70%, from 170 to approximately 50, retaining only those lines that met our minimum sales threshold and margin criteria. As a result, we plan to close out the discontinued products throughout 2006 and reduce our inventory levels by approximately $11 million in 2006.
Our continuing product lines are giftable items within four merchandise categories; decorative gift, inspirational, brand enthusiast and occasion-based. We believe that these merchandise categories elicit strong and sustainable market demand and profitability, and leverage our core distribution base. The top 10 product lines in 2005 by merchandise category include: Heartwood Creek tm by Jim Shore and My Little Kitchen Fairies tm in the decorative gift merchandise category; Foundations ® and Gregg Gift tm in the inspirational category; Disney, Cherished Teddies ® and Rudolph the Red-Nosed Reindeer ® in the brand enthusiast category; and Circle of Love tm , Growing Up Birthday Girls ® and Children of the Inner Light ® in the occasion-based merchandise category. These continuing product lines, in total, represent approximately 80% of our U.S. net sales in 2005, excluding Precious Moments ® product sales.
Significant Products
Our most popular product line is Heartwood Creek tm by Jim Shore. This line accounted for approximately $39.6 million, or 16% of our consolidated net revenues in 2005, compared to $35.6 million, or 13% in 2004. This is the fourth consecutive year of increased revenues from this product line. Precious Moments ® product revenues accounted for approximately $32.5 million, or 13% of 2005 consolidated net revenues compared to $55.7 million, or 21% in 2004. Of the $23.2 million decrease in Precious Moments ® product revenues in 2005, $6.3 million occurred in the six months ended June 30, 2005, as compared to revenues for the first six months of 2004. The remaining decrease of $16.9 million, which occurred over the last six months in 2005, resulted from our termination of the PMI license agreement effective June 30, 2005. (See Note 11 of the “Notes to Consolidated Financial Statements” of this Form 10-K.)
Heartwood Creek tm by Jim Shore and Precious Moments ® product lines accounted for 10% or more of our consolidated net revenue in 2005, 2004 and 2003, as shown below:
| 2005 | 2004 | 2003 | ||||||||||
|
Heartwood
Creek tm
by Jim Shore
|
16 | % | 13 | % | 5 | % | ||||||
|
Precious
Moments®
|
13 | % | 21 | % | 32 | % |
No other product lines or brands accounted for more than 10% of consolidated net revenue in the last three years.
Principal Markets
Enesco has a presence and competes in three major geographical markets that include the U.S., Canada and Europe (primarily the U.K., France and Germany). The U.S. market accounted for approximately 55% of our consolidated net revenues in 2005 while Europe accounted for 32%, Canada for 11% and various other countries for 2%. Management expects this geographic mix to remain at these approximate proportions in 2006.
Product Sourcing
Enesco’s product lines are manufactured by independent vendors in the Far East and in the Philippines, Indonesia, Thailand and Europe. Enesco International (H.K.) Limited in Hong Kong provides the overall management of the sourcing and production from our manufacturers in the Far East. Enesco Limited’s U.K. manufacturing plants supply in part the Lilliput Lane tm , Border Fine Arts tm , Halcyon Days ® and Dartington product lines. During 2005, we closed our Lilliput Lane tm Workington facility in the U.K. and consolidated its operations into our Penrith plant. The Workington plant was then sold in September 2005.
The majority of Enesco products are manufactured through third-party vendors in Asia and have suggested retail prices ranging between $5 and $500. During 2005, Enesco’s purchases from its three largest contract manufacturers accounted for approximately 15%, 11% and 9%, respectively, of its total purchases. During 2005, approximately 70% of Enesco’s total product purchases came from manufacturing sources located in the People’s Republic of China, which enjoys most-favored nation trade status with the U.S. Other U.S. products primarily are purchased from Taiwan, Thailand, Germany and Japan, none of which provide more than 10% of our purchase requirements.
Our ability to import products and thereby satisfy customer orders is affected by the availability of, and demand for, quality production capacity abroad. Enesco competes with other importers of specialty giftware products for the limited number of foreign manufacturing sources that can produce detailed, high-quality products at affordable prices. Foreign manufacturing and procurement of imports is subject to the following inherent risks: labor, economic and political instability; cost and capacity fluctuations and delays in transportation, dockage and materials handling; restrictive actions by governments; nationalizations; the laws and policies of the U.S. affecting importation of goods (including duties, quotas and taxes); foreign currency fluctuations, and tax laws. Moreover, we cannot predict what relevant political, legal or regulatory changes may occur, or the type or amount of any financial impact on Enesco such changes may have in the future.
Enesco is dependent upon its ability to continue to conduct business with vendors located in China, which is subject to political uncertainties, the financial impact of which we are unable to estimate. To the extent China may have its exports or transaction of business with U.S. persons subject to political retaliation, the cost of imports from China could increase significantly and/or the ability to import goods may be impaired materially. In such an event, there could be a material adverse effect on Enesco until alternative arrangements for the manufacture of our products are obtained on economic, production and operational terms at least as favorable as those currently in effect.
Our Vendor Certification Program requires all manufacturing sources, whether affiliates or contract manufacturers, to agree to, and comply with, quality compliance and labor standards established and enforced by Enesco and certain of its licensors.
Enesco is certified by the Office of U.S. Customs and Border Protection as a member of the Customs Trade Partnership Against Terrorism (CTPAT). The Department of Homeland Security instituted CTPAT as a means to identify low risk importers and allow the free flow of goods even under heightened security conditions. Enesco’s certification is strategically important since it may reduce the risk of significant delays in the importation of our products. Also, our certification will permit us to become, or continue to be, a vendor for certain U.S. customers who require CTPAT certification as a condition to conducting business.
Marketing and Sales
Enesco markets its product lines primarily through retail promotions, tradeshows, and private shows held in major U.S. and foreign cities, as well as through catalogs, collector clubs, trade advertising and the Enesco website. In 2005, our primary marketing focus was brand building for Enesco’s proprietary product lines, such as Foundations ® and Gregg Gift tm , and for Enesco’s licensed brands, such as Heartwood Creek tm by Jim Shore and Disney related licenses. Each of these product lines experienced revenue growth in 2005 compared to 2004 as shown in the chart below:
| 2005 | 2004 | % Increase | ||||||||||
| ($ in millions) | ||||||||||||
|
Foundations®
|
$ | 5.6 | $ | 4.8 | 17 | % | ||||||
|
Gregg
Gift tm
|
7.6 | 7.2 | 6 | % | ||||||||
|
Heartwood
Creek tm
by Jim Shore
|
39.6 | 35.6 | 11 | % | ||||||||
|
Disney related licenses
|
20.6 | 19.4 | 6 | % |
Our product lines are displayed in our leased showrooms located in the U.S., Canada, England, France and Hong Kong. During the fourth quarter of 2005, we implemented a consolidation strategy for all of our non-essential U.S. showroom locations. This strategy focuses on growing the major market showrooms in Atlanta, Dallas and Los Angeles on a year-round basis. As a result of this consolidation, we negotiated lease buyouts with the landlords of the remaining showrooms that we do not want to occupy on a year round basis. The impact of terminating these showroom leases resulted in a restructuring charge of approximately $0.9 million in the fourth quarter of 2005. The showroom consolidation strategy is expected to result in annual savings of approximately $2.0 million.
Our collectible brand enthusiast product lines are primarily marketed through collector club programs where, for a non-refundable annual fee, consumers may subscribe for exclusive product offerings and newsletters as a member of one of our collector clubs. New items and limited edition pieces are introduced annually to consumers. Every year, a number of existing pieces are retired from these collectible lines to allow for new introductions and to keep each line balanced based on consumer demand. As of December 31, 2005, Enesco had approximately 108,000 active members in its clubs, an 18% decrease from 2004 membership levels, excluding the impact of the July 1, 2005 transfer of Precious Moments ® collector club memberships to PMI as part of our license termination agreement. We believe that the overall reduction in collector club memberships is due to the declining market interest in, and demand for, collectible products.
During the first quarter of 2005, Enesco restructured its U.S. marketing and sales organization areas to enhance the effectiveness of these critical functions and to organize its sales personnel based on whether their customers utilize centralized buying (headquarters-based buying) versus buying on an individual retail outlet basis. As a result, we consolidated our former multiple channel marketing structure into one simplified and focused marketing organization. We organized our sales function under two umbrellas: field sales and headquarters sales. Our field sales group focuses on independent store buying and is comprised of approximately 100 field account executives based throughout the U.S and approximately 15 inside sales account executives who work with their field counterparts. Our headquarters sales group utilizes a team of national account executives and customer service specialists to manage the larger, national and mass-market accounts.
Our operations in the U.K., Canada and France each have their own employee sales organizations. Enesco also sells its products through distributors in approximately 25 countries around the world.
Methods of Distribution
In order to serve customers throughout the U.S., product is shipped from our overseas vendors to Enesco’s warehouse and distribution facility, which is located in Elk Grove Village. In November 2005, we announced the transition of our primary U.S. distribution and warehousing operations to National Distribution Centers (NDC), a third-party logistics company. NDC is operating a leased facility in the Indianapolis metropolitan area, of which our products occupy approximately 150,000 square feet. As part of Enesco’s Operating Improvement Plan, we believe that outsourcing our distribution and warehousing operations to a third-party logistics provider will enable us to improve supply chain efficiencies, improve customer service, consolidate our U.S. distribution operations, improve financial performance and build on our core strengths of new product development and sales.
We began moving all inventory related to our continuing product lines to the NDC facility during late December 2005 in conjunction with the timing of our normal annual physical inventory count. NDC began shipping product to our customers from its facility in January 2006. Our discontinued product lines will continue to be distributed to customers from the EGV distribution facility through 2006.
Enesco also uses third-party warehouse and distribution facilities in Fort Mills, South Carolina, to handle the distribution of certain products to mass merchants, China, to handle large seasonal orders, and Fenton, Missouri, to handle warehouse and distribution of the Walt Disney Classics Collection ® in the U.S. Shipments from Enesco to its customers are handled by United Parcel Service and other commercial
carriers. As a result, we are not dependent on a single carrier and we have several alternatives if one carrier is unable to handle our shipments.
Our subsidiaries in Canada and the U.K. have distribution facilities to service their operations. Enesco Limited’s main distribution facility is located in Carlisle, England. Enesco Limited also utilizes small distribution facilities in Bilston, England for the Halcyon Days ® product line and in Torrington, England for the Dartington line.
Trademarks and Other Intellectual Property
Enesco continuously enters into and renews license agreements relating to trademarks, copyrights, designs and products, which enable us to market new items compatible with our existing product lines, to refresh our product offerings for changing consumer preferences, and to reduce the risk of dependency on one line. Enesco’s licenses are either non-exclusive or exclusive for specific products in specified channels and territories. Royalties are paid on licensed items and, in some cases, advance royalties or minimum guarantees are required by agreements.
Protection of all of Enesco’s intellectual property, whether owned or licensed, is important to our business. Enesco maintains an aggressive and visible program to identify and challenge companies and individuals worldwide who infringe upon its registered trademarks and copyrighted designs.
Enesco owns approximately 300 trademark registrations. The registrations for Enesco’s trademarks are maintained and renewed provided that the trademarks are still in use for the goods covered by such registration. Enesco historically has renewed its registered trademarks and expects to continue to renew them as business needs require.
Seasonality
Consumer interest in our home and garden décor and everyday gift products is seasonal and may vary based on current market demand fluctuations and time of the year. Enesco also produces specially designed product for holiday seasons and gift-giving occasions, including Christmas, Valentine’s Day, Easter, Mother’s Day, Father’s Day, Halloween and Thanksgiving. Quarterly revenues are influenced by the shipment of seasonal merchandise. Historically, revenues peak in the third quarter of each year as merchandise is typically shipped during that time in preparation for the Christmas shopping season.
Working Capital
Enesco attempts to minimize its inventory levels by shortening the period of time from when a product is conceptualized to when it is delivered to our customers. Generally, a product is designed, sculpted, manufactured and marketed to our current or perspective retailers before Enesco begins shipping the product to customers. Since the majority of our products are manufactured through third-party vendors in China and Thailand, with an inherent delayed fulfillment time, it is necessary for us to maintain minimum daily inventory levels to satisfy the needs of our customers.
In 2005, we adjusted our ordering and shipping policies for our seasonal and Christmas products. Rather than shipping seasonal products in April, May and June, we now make products to order, and spread the shipment to our retail customers and payments to our vendors from June through October. Also in 2005, we began shipping products directly to our customers from a third-party logistics provider in China in order to reduce our distribution costs and inventory levels.
In 2005, we implemented a change in our customer everyday payment terms, from 90 days down to 45 days. These initiatives have helped to reduce our days sales outstanding in accounts receivable, from 92 days at December 31, 2004 to 69 days at December 31, 2005. Depending on sales volume and distribution requirements, Enesco offers its retail customers various extended payment terms and special programs. These programs provide retailers the opportunity to sell products prior to paying Enesco. We believe our general terms of sale are competitive in the giftware industry.
Customers
Enesco has over 44,000 customers worldwide. Our core customer base includes independent gift retailers, national gift chains, mass merchants, military post exchanges, club warehouses, home television shopping networks, florists, hospital gift shops, home décor chains and independents, garden stores, jewelry and department stores, and catalog retailers. Some of our major customers during 2005 included: Avon Products, Inc., Carlton Cards Retail, Inc., Hallmark Specialty Retail Group, John Lewis Plc., Kirlin’s, Kohl’s Department Stores, Robinson May, QVC Network, Target, Signet Group, Walgreens Company and Wal-Mart Stores, Inc. No single account represented more than 3% of 2005 consolidated net revenues.
We compete with other designers, manufacturers and distributors of giftware, and home and garden décor to generally target consumers with discretionary income, the amount of which is sensitive to economic shifts.
Open Orders
At December 31, 2005, Enesco had net open orders of approximately $10.4 million, a 62% decrease over the December 31, 2004 level of approximately $26.2 million. The December 31, 2004 amount was unusually large due to distribution disruptions in 2004 as a result of the difficulties we encountered with our Enterprise Resource Planning (ERP) system. The December 31, 2005 net open orders do not include orders for Precious Moments ® products due to the termination of our license agreement with PMI. It is standard practice in the giftware industry, however, that orders are subject to amendment or cancellation prior to shipment for various reasons, including credit considerations and product availability. Due to the many external factors that can impact the status of unshipped orders at any particular time, the comparison of backlog in any given year with those at the same date in a prior year is not necessarily indicative of prospective sales results in future years.
Competition
Competition in the giftware and home and garden décor industry is highly fragmented among a number of companies and product categories. The principal factors affecting success in the marketplace include originality of product design, quality, price, sales coverage, marketing ability, logistics and sourcing. The ability to obtain and renew license agreements for products also is significant.
Enesco competes with domestic and international companies in the industry, such as Hallmark Cards, Inc., Lenox Group, Inc., Roman, Inc., Lladro Commercial S.A., The Boyds Collection, Ltd. and Russ Berrie and Company, Inc., among others. No one competitor is dominant in the industry.
We believe that Enesco’s competitive strengths include our core and well-established distribution base, our extensive knowledge of the marketplace and its demands, our domestic and international employee-based sales force, our ability to secure licenses with popular and established brands, our ability to bring innovative and trend-driven products to the market quickly, our focus on giftable product categories, and the market demand for our proprietary designs, as well as the strength of our supplier relationships. Many of our competitors, however, may have greater financial, marketing, distribution and other resources than Enesco.
Design and Development
Enesco’s in-house creative group provides continuous product design and development of certain of our products. This group’s responsibilities include all creative aspects from concept to prototype, design and enhancement of products. Design and development costs expensed are approximately 1% of sales.
Environmental
Enesco is subject to various federal, state and local laws and regulations governing the use, discharge and disposal of hazardous material. Compliance with current laws and regulations has not had and is not
expected to have a material adverse effect on our financial condition. It is possible, however, that environmental issues may arise in the future that Enesco currently cannot predict.
Employees and Related Matters
As of December 31, 2005, Enesco employed 1,182 employees worldwide, 454 of whom work in our U.S. facilities and 728 in our international facilities.
In the first three quarters of 2005, we implemented several corporate downsizings, which resulted in the termination of 178 employees in our U.S facilities and 83 in our international facilities. In the fourth quarter of 2005, as part of our Operating Improvement Plan initiative to reduce corporate overhead, general and administrative and marketing costs, we eliminated an additional 19 positions in the U.S. and 18 internationally. As announced in the fourth quarter of 2005, the EGV warehouse and distribution facility will close in 2006 as a result of our transition of domestic warehousing and distribution functions to a third-party logistics provider. Employment levels at the EGV facility were reduced by 87 positions in January 2006 and an additional 87 positions will be terminated in 2006 as business needs dictate. Enesco continues to monitor employee-related expenses to identify opportunities based on business operating plans.
Enesco’s EGV warehouse personnel are represented by Local Union No. 781 of the International Brotherhood of Teamsters under a contract that expires on June 30, 2007, and includes 144 union member employees. Employees at our Dartington factory are represented by the General Municipal and Boilermakers Union in the U.K. under a contract that expires on December 31, 2006. During 2005, Enesco did not incur any work stoppages. We believe that our labor relations are good.
Financial Information about Geographic Areas
Information required by this item is set forth in Note 5 of the “Notes to Consolidated Financial Statements” of this Form 10-K.
Available Information
Enesco makes available, without charge, copies of its Proxy Statement, Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, any amendments to those reports and any other of its reports filed with or furnished to the SEC on or through the Investor Relations section of our website, www.enesco.com, as soon as reasonably practicable after they are filed. You may request a paper copy of materials Enesco files with the SEC by writing to Investor Relations, 225 Windsor Drive, Itasca, Illinois 60143 or calling Enesco at (630) 875-5300.
In addition, the following policies and corporate governance documents are available at the Investor Relations section of our website: Enesco Corporate Governance Guidelines, Standards of Business Conduct and Ethics, applicable to all directors and employees, Audit Committee Charter, Human Resource and Compensation Committee Charter, and Nominating and Governance Committee Charter. Paper copies of these documents also are available, free of charge, by calling (630) 875-5300 or by sending a request in writing to Investor Relations, 225 Windsor Drive, Itasca, Illinois 60143.
You may read and copy materials Enesco files with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Our filings with the SEC also are available to you on the SEC’s Internet web site at www.sec.gov.
Information on our website is not incorporated into this Form 10-K or Enesco’s other securities filings and is not a part of them.
Item 1A. Risk Factors
The ownership of our common stock involves a number of risks and uncertainties. Potential investors should carefully consider the risks and uncertainties described below and the other information in this
Form 10-K before deciding whether to invest in our securities. Our business, financial condition or results of operations could be materially adversely affected by any of these risks. The risks described below are not the only ones facing us. Additional risks that are currently unknown to us or that we currently consider to be immaterial may also impair our business or adversely affect our financial condition or results of operations.
We have had a history of losses and may not be profitable in the future.
We have had a history of losses. We had a net loss of $54.0 million in 2005 and a net loss of $45.2 million in 2004. We are in the process of restructuring our operations, including the recently completed upgrading of our information systems, exiting the Precious Moments ® business, reducing SG&A costs, and improving our cash flow management. However, we cannot assure that these efforts will result in our return to profitability. Even if we are able to generate a profit in the future, we may not be able to increase our profits from quarter to quarter. If we are unable to achieve and maintain profitability, the price of our common stock may decline.
Our failure to successfully refinance or amend our current credit facility could cause us to incur significant additional bank fees and would impair our ability to conduct our normal business operations.
On December 21, 2005, we entered into the tenth amendment to our credit facility. This amendment provides for penalty fees if we are unable to pay the outstanding loans and letters of credit under our credit facility prior to certain dates in 2006. In addition, the credit facility requires us to maintain specified financial ratios, and our failure to maintain these ratios would constitute an event of default under the credit facility.
On March 31, 2006, we entered into the eleventh amendment to our existing credit facility. This amendment reset each of Enesco’s 2006 cumulative minimum monthly EBITDA covenants effective January 30, 2006 based on our reforecast. This amendment also reduces the credit facility commitments from $75 million to $70 million and accelerates by one month, the tenth amendment fees. While we have been able to renegotiate these ratios and obtain waivers of specific covenant violations in the past, we cannot assure that we would be able to continue to do so in the future.
We have entered into a commitment letter with LaSalle Business Credit, LLC, an affiliate of one of the lenders under our existing credit facility, to enter into a new $75 million credit facility. This commitment letter initially expired on January 31, 2006 but has been extended monthly through April 30, 2006. However, there can be no assurance that we will be successful in doing so on commercially reasonable terms, or at all. Our failure to refinance our existing credit facility or enter into a new credit facility could severely restrict our ability to carry out our normal business operations, and as a result we may be forced to sell assets, reorganize under an appropriate bankruptcy provision, or liquidate certain strategically selected assets.
Our failure to generate sufficient cash to meet our liquidity needs may affect our ability to service our indebtedness and grow our business.
Our ability to make payments on and to refinance our indebtedness, amounts borrowed under our senior credit facility, and to fund any capital expenditures we may make in the future, if any, will depend on our ability to generate cash in the future. This, to a certain extent, is subject to general economic, financial, competitive and other factors that are beyond our control.
Subject to our ability to either extend our existing credit facility and/or secure replacement financing by January 1, 2007, we believe our cash flow from operations, together with available cash and available borrowings under our credit facility, will be adequate to meet future liquidity needs. However, we cannot assure you that our business will generate sufficient cash flow from operations in the future that our currently anticipated long-term growth in revenues and cash flow will be realized on schedule or in an amount sufficient to enable us to service indebtedness, or that future borrowings will be available to us under the senior credit facility. We may need to refinance all or a portion of our indebtedness, including
our credit facility, on or before maturity. There can be no assurance that we will be able to do so on commercially reasonable terms or at all.
Our existing credit facility contains, and any new credit facility will most likely contain, various covenants which limit our management’s discretion in the operation of our business and the failure to comply with such covenants could have a material adverse effect on our business, financial condition and results of operations.
Our credit facility contains various provisions that limit our management’s discretion by restricting our ability to, among other things:
| • | incur additional indebtedness; | |
| • | pay dividends or distributions on, or redeem or repurchase, our common stock; | |
| • | make investments; | |
| • | incur liens; | |
| • | transfer or sell assets; and | |
| • | consolidate, merge, or transfer all or substantially all of our assets. |
We anticipate that we will be required by lenders to agree to a change in control default covenant in our replacement credit facility if our CEO and President were to resign. Any failure to comply with the restrictions of our credit facility or any other subsequent financing agreements may result in an event of default. An event of default may allow the creditors, if the agreements so provide, to accelerate the related debt as well as any other debt to which a cross-acceleration or cross-default provision applies.
Our indebtedness imposes constraints and requirements on our business and financial performance and our compliance and performance in relationship to these could materially adversely affect our financial condition and operations.
We have a significant amount of indebtedness. Our significant indebtedness could:
| • | require us to dedicate a significant portion of our cash flows from operations to payments on our indebtedness, including penalties, which would reduce the availability of this cash to fund working capital, expansion of our business, and other general corporate purposes; | |
| • | limit our flexibility in planning for, or reacting to, changes in our business and the markets in which we operate; | |
| • | place us at a competitive disadvantage compared to our competitors that have less debt; and | |
| • | limit our ability to obtain additional funds. |
We have received a delisting notice from the New York Stock Exchange, and if we are unable to comply with the conditions of our plan to meet the continued listing standards, we will be delisted, which would result in decreased liquidity and increased volatility for our common stock.
We received notification from the New York Stock Exchange on September 1, 2005 that we are not in compliance with the NYSE’s continued listing standards. As a result, we submitted a plan to the NYSE demonstrating how we intend to comply with these standards over the next 18 months and are subject to quarterly monitoring for compliance with these standards. If we are unable to meet the criteria and are delisted, we may be unable to have our common stock listed on Nasdaq because of minimum stock price and other listing requirements and, as a result, we would likely have our common stock quoted on the Over-the -Counter Bulletin Board, or the OTC BB, which would also require us to delist our common stock from the Pacific Stock Exchange. Securities that trade on the OTC BB generally have less liquidity and greater volatility than securities that trade on the NYSE and Nasdaq. In addition, because issuers whose securities trade on the OTC BB are not subject to the corporate governance and other
standards imposed by the NYSE and Nasdaq, our reputation may suffer, which could result in a decrease in the trading price of our shares.
The market price of our common stock has historically fluctuated and is likely to fluctuate in the future.
The price of our common stock has fluctuated widely. For example, in 2005, the lowest price for our common stock was $1.12 and the highest price for our common stock was $8.70. The market price of our common stock can fluctuate significantly for many reasons, including, but not limited to:
| • | our ability to successfully obtain replacement financing; | |
| • | the success of our efforts to reorganize our operations; | |
| • | our financial performance; | |
| • | our ability to maintain our listing on the NYSE; | |
| • | our ability to successfully introduce new products and the popularity of our existing products; | |
| • | acquisitions, strategic alliances or joint ventures involving us or our competitors; | |
| • | decisions by investors to de-emphasize investment categories, groups or strategies that include our company or industry; and | |
| • | market conditions in the industry, the financial markets, and the economy as a whole. |
It is likely that our operating results in one or more future quarters may be below the expectations of security analysts and investors. In that event, the trading price of our common stock would likely decline. In addition to fluctuations in the market price of our common stock, the stock market has experienced extreme price and volume fluctuations. These market fluctuations can be unrelated to the operating performance of particular companies. Future sales of substantial amounts of our common stock, or the perception that such sales could occur, could adversely affect prevailing market prices for our common stock. Additionally, future stock price volatility for our common stock could provoke the initiation of securities litigation, which may divert substantial management resources and have an adverse effect on our business, operating results and financial condition.
If we undergo a change in control, including the resignation or termination of our CEO and President, we may be unable to maintain our strategic alliance with Jim Shore Designs, Inc.
Our strategic alliance agreement with Jim Shore Designs, Inc. focuses on key gift and seasonal categories that have been very successful for us. This agreement continues through November 22, 2008, and will be extended an additional three years, unless either party decides not to renew. However, if we undergo a “change in control,” which is defined in the agreement as including a change in the CEO and President positions, both of which are held by Cynthia Passmore, Jim Shore Designs, Inc. would be able to terminate the agreement. If the agreement were terminated, we would lose one of our most successful and growing product lines, which would have a material adverse effect on our business, financial condition and results of operations.
We are highly dependent upon the ability of our senior management and Keystone Consulting Group to effectively run our operations.
We have been experiencing changes in our senior management team. For instance, we appointed a Chief Financial Officer in January 2005 who resigned in July 2005. We then appointed a Chief Accounting Officer to handle these functions. In addition, we have eliminated the position of Chief Operating Officer as part of our downsizing efforts. In connection with the development and implementation of our Operating Improvement Plan, we have engaged Keystone Consulting Group (Keystone), a restructuring advisor. Our engagement letter with Keystone is cancelable by either party upon written notice to the other. We are highly dependent on Keystone to assist us in implementing the Operating Improvement Plan.
Our ability to implement our business strategy is dependent upon our senior management’s ability to run our business effectively. We currently have an employment agreement with our CEO and President, but not with our other executive officers. We currently have a consulting agreement with Keystone, which expires March 31, 2006, which we are in the process of extending at least through June 30, 2006. We cannot assure you that we will be able to retain any of our executives or that we will be successful in extending Keystone’s engagement following its expiration on March 31, 2006 on terms favorable to us, or that Keystone will have the resources necessary to assist us in the continued implementation of our Operating Improvement Plan. Our business, results of operations and financial condition could be materially adversely affected by the loss of any of these persons or Keystone and the inability to attract and retain appropriately qualified replacements. In addition, as noted above, if our CEO and President resigns or is terminated, our licensing agreement with Jim Shore Designs, Inc. would be at risk of being terminated.
If we cannot develop products that will appeal to customers and enter into favorable licensing agreements, we may not be able to compete effectively.
We believe that our future success will depend, in part, upon our ability to continue to develop new products that will appeal to consumers. Historically, we have received a substantial portion of our revenues through a small number of very successful licensing agreements. Our success is dependent upon our ability to retain these critical licenses on favorable terms and to enter into new licensing agreements that will result in the introduction of successful product lines. We face significant competition for licenses, which may cause us to pay higher royalty rates and to guarantee minimum annual payments. As our most successful licenses expire, the competition for renewing these licenses could intensify significantly. We cannot assure you that we will be successful in the introduction, manufacturing and marketing of any new products or product innovations, or develop and introduce, in a timely manner, innovations to our existing products that satisfy customer needs or achieve market acceptance. Our failure to develop new products and introduce them successfully and in a timely manner, and at favorable margins, would harm our ability to successfully grow our business and could have a material adverse effect on our business, results of operations and financial condition.
If we fail to adequately protect our intellectual property rights, competitors may manufacture and market products similar to ours, which could adversely affect our market share and results of operations.
Our success with our proprietary products depends, in part, on our ability to defend our intellectual property rights. If we fail to adequately protect our intellectual property rights, competitors may manufacture and market products similar to ours. In addition to our proprietary designs, we obtain brand name licenses to develop product formats. Occasionally, we become involved in litigation with our licensors, such as our recently settled litigation involving Jim Shore Designs, Inc. Enforcing our rights under our licensing agreements in this manner is expensive to us, distracting to management and may strain relationships with our licensors. In addition, our ability to successfully market these products would be adversely affected if competitors were able to develop, use or sell products that are similar to our products.
We have, in the past, experienced problems managing our supply chain and business processes, and our future success is dependent upon our ability to improve these functions.
In 2004, we unsuccessfully attempted to implement a new Enterprise Resource Planning system intended to integrate our supply chain and business processes. As a result, we were unable to ship products, we incurred expenses related to excess inventory, and we experienced record-keeping problems involving freight billing, customer invoicing and inventory management accuracy. To remedy the situation, we were forced to incur costs related to additional personnel and consultants in 2004, which increased our labor and IT costs significantly. Our future success is dependent upon our ability to successfully manage these functions. If we are unable to do so, we would incur increased operating costs and would encounter delays in shipping our products, which would result in a potential loss of revenues and customers and
would therefore have a material adverse effect on our business, financial condition and results of operations.
We are dependent upon the ability of NDC, a third-party logistics company, to manage our U.S. distribution and warehouse operations.
As part of our Operating Improvement Plan, we have hired NDC, a third-party logistics company, to provide storage, handling, inventory management, shipping, receiving, repackaging, order processing and related clerical support for our business. These functions are critical to the success of our business, and we are entirely dependent upon NDC to perform these functions efficiently. In addition, we may incur significant costs under the agreement with NDC. Any problems that we experience in our arrangement with NDC could have a material adverse effect on our business, financial condition and results of operations.
Competition in our markets may hinder our ability to execute our business strategy, achieve profitability, or maintain relationships with existing customers.
The markets for giftware and home and garden décor products are highly competitive. In these industries, we compete against numerous other domestic and foreign companies. Competition in the markets in which we operate is based primarily on originality of product design, quality, price, sales coverage, marketing ability, logistics and sourcing.
Many of our competitors have substantially greater revenue and resources than we do. Our competitors may take actions to match our new product introductions and other initiatives. Because many of our competitors source their products from third parties, our ability to obtain a cost advantage through sourcing is reduced. Certain of our competitors may be willing to reduce prices and accept lower profit margins to compete with us. Further, retailers often demand that suppliers reduce their prices on existing products. Competition could cause price reductions, reduced profits or losses, or loss of market share, any of which could have a material adverse effect on our business, results of operations and financial condition.
To compete effectively in the future in our markets, among other things, we must:
| • | maintain strict quality standards; | |
| • | develop new products that appeal to customers; and | |
| • | deliver products on a reliable basis at competitive prices. |
Our inability to do any of these things well could have a material adverse effect on our business, results of operations and financial condition.
If the trend toward retail store consolidation in the independent gift channel in the U.S. continues, our revenues may decline unless we can grow share in our core gift channel or grow revenues in alternate channels.
In recent years, retail shopping patterns in the U.S. for our products have changed to include stronger sales in the mass, chain drug and grocery channels and over the Internet, while there has been consolidation of retail specialty stores in the card and gift channel. Our business strategy involves aligning our resources and leveraging our core distribution base, to gain share in four merchandise categories: decorative gifts, inspirational gifts, brand enthusiast gifts and occasion-based gifts. If we are unable to grow market share in these merchandise categories or expand in alternative channels at levels that offset the decline in sales due to the consolidation of retail stores in the specialty gift channel in the U.S., our revenues will continue to decline.
Because we do not have long-term commitments from many of our customers, we must estimate customer demand, and errors in our estimates could have negative effects on our inventory levels and revenues.
We have more than 40,000 customers worldwide, and no single customer accounted for more than 3% of our consolidated sales in 2005. Non-seasonal purchase commitments may be made in advance of our receipt of customer orders and are often non-cancelable. It is standard practice in our industry that customer orders are subject to amendment or cancellation prior to shipment for various reasons. Our purchase commitments are made in advance of our receipt of customer orders and are often non-cancelable. As a result, we are required to estimate the inventory levels and enter into purchase commitments necessary to fulfill our orders and maximize sales. On occasion, we have been unable to adequately respond to customer cancellations or unexpected increases in customer orders. Accordingly, we may be faced with excess inventory or the inability to adequately respond to unexpected increases in customer purchase orders, in which case we may incur higher expenses related to excess inventory or, alternatively, we may lose the revenue associated with the additional purchase orders and our customer relationships may suffer.
We are dependent upon third-party suppliers whose failure to perform adequately could disrupt our business operations.
We currently source a significant portion of our products from third parties. Our ability to select and retain reliable vendors who provide timely deliveries of quality products will impact our success in meeting customer demand for timely delivery of quality products. We typically do not enter into long-term contacts with our primary vendors and suppliers. Instead, most of our products are supplied on a “purchase order” basis. As a result, we may be subject to unexpected changes in pricing or supply of products. Any inability of our suppliers to timely deliver quality products or any unanticipated change in supply, quality or pricing of products could be disruptive and costly to us.
Our reliance on manufacturing facilities and suppliers in China could make us vulnerable to supply interruptions related to the political, legal and cultural environment in China.
We do not own any of our manufacturing facilities, except on a limited basis in the United Kingdom. A significant portion of our products are manufactured by third-party suppliers in Asia, primarily the People’s Republic of China. During 2005, approximately 70% of our total product purchases were from manufacturing sources in China. Our ability to continue to select reliable vendors who provide timely deliveries of quality products will impact our success in meeting customer demand for timely delivery of quality products. Furthermore, the ability of these suppliers to timely deliver finished goods and/or raw materials may be affected by events beyond their control, such as inability of shippers to timely deliver merchandise due to work stoppages or slowdowns, or significant weather and health conditions (such as SARS or the avian flu) affecting manufacturers and/or shippers.
There is no assurance that we could quickly or effectively replace any of our suppliers if the need arises. Our dependence on these suppliers could also adversely affect our ability to react quickly and effectively to changes in the market for our products. In addition, international manufacturing is subject to significant risks, including, among other things:
| • | labor unrest; | |
| • | political and economic instability; | |
| • | cost and capacity fluctuations; | |
| • | delays in transportation, dockage and materials handling; | |
| • | restrictive actions by governments, including nationalization of assets; | |
| • | United States laws and policies affecting the importation of goods; | |
| • | international political, military and terrorist developments; and |
• international tax and trade laws.
Labor in China has historically been readily available at relatively low cost as compared to labor costs in North America and Europe. China has experienced rapid social, political and economic change in recent years. A substantial increase in labor costs in China could affect the price that our suppliers charge, which would lower our gross margins and therefore have a material adverse effect on our financial condition and results of operations.
Changes in the cost or availability of raw materials could adversely affect our results of operations.
Pricing and availability of raw materials used in our products can be volatile due to numerous factors beyond our control, including labor costs, production levels, competition, consumer demand, commodity costs (such as oil based resins and pigments), and general economic conditions. This volatility can significantly affect the availability and cost of raw materials to us, and may, therefore, have a material adverse effect on our business, results of operations and financial condition.
If the price of raw materials used in manufacturing our products increases, there can be no assurance that we will be able to pass any portion of such increases on to our customers. Conversely, when raw material prices decline, customer demands for lower prices could result in lower sale prices and, to the extent we have existing inventory, lower margins. As a result, fluctuations in raw material prices could have a material adverse effect on our business, results of operations and financial condition.
We may not be able to sell our non-strategic business assets at favorable prices.
As part of our Operating Improvement Plan, we are attempting to reduce our overall number of product lines and concentrate on products that we believe will have strong and sustainable market demand. As a result, we are currently in the process of attempting to sell some of our assets that we believe are not consistent with our strategy. There is no assurance that we will be able to sell these assets on favorable terms, or at all. If we are unable to do so, we may be forced to wind down these operations, which would impose additional costs and management distraction on us.
Our business is seasonal, which may cause our operating results to vary from quarter to quarter.
Sales of certain of our products are seasonal. For instance, we produce specially designed products for holiday season and gift-giving occasions. Our revenues will typically peak in the third calendar quarter of each year. As a result, comparisons of our results from quarter to quarter may not be meaningful and cannot necessarily be relied on as indicators of future performance. In addition, we may also experience quarterly fluctuations in our sales and income depending on various factors, including, among other things, changes in the ordering patterns of our customers during a particular quarter, and the mix of products sold.
Currency fluctuations may significantly increase our expenses and affect our results of operations.
While we transact business predominantly in U.S. dollars and most of our revenues are collected in U.S. dollars, a portion of our costs, such as for our products, payroll, rent, and indirect operational costs, are denominated in other currencies. Changes in the relation of these and other currencies to the U.S. dollar will affect our sales and profitability and could result in unfavorable foreign currency translations or exchange losses. For instance, if the government of China allowed the Chinese yuan to rise substantially versus the U.S. dollar, the cost of our products produced in China would rise. The impact of future exchange rate fluctuations on our results of operations cannot be accurately predicted. There can be no assurance that the U.S. dollar foreign exchange rates will be stable in the future or that fluctuations in financial markets will not have a material adverse effect on our business, results of operations and financial condition.
Item 1B. Unresolved Staff Comments
Not applicable.
