UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTIONS 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
or
[ ] TRANSITION REPORT PURSUANT TO SECTIONS 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ________________________ to ________________________
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
[X] Yes [ ] No
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
At March 31, 2005, there were 34,907,998 sharesof Class A Common Stock, par value $.01, outstanding.
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(In thousands, except share data)
See accompanying notes to consolidated financial statements.
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(In thousands, except per share data)
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(In thousands)
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(1) As restated, see note 3
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See footnotes on following page.
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The following discussion of financial condition and results of operations should be read in conjunction with (i) the Consolidated Financial Statements of the Company, and notes thereto, as set forth in this Form 10-Q and (ii) the Company’s Annual Report on Form 10-K for the year ended June 30, 2004, including any amendments thereto.
Management’s discussion and analysis of financial condition and results of operations and other sections of this Quarterly Report contain forward-looking statements relating to future results of the Company. Such forward-looking statements are identified by use of forward-looking words such as “anticipates”, “believes”, “plans”, “estimates”, “expects”, and “intends” or words or phrases of similar expression. These forward-looking statements are subject to management decisions and various assumptions, risks and uncertainties, including, but not limited to: changes in political and economic conditions; changes in demand for the Company’s products; acceptance of new products; changes in conditions in the various geographic markets where the Company does business; technology developments affecting the Company’s products; changes in laws and regulations; and those matters discussed in the Company’s filings with the Securities and Exchange Commission (“SEC”). Accordingly, actual circumstances and results could differ materially from those contemplated by the forward-looking statements.
On February 7, 2005, the Office of the Chief Accountant of the SEC issued a letter to the American Institute of Certified Public Accountants expressing its views regarding certain operating lease accounting issues and their application under accounting principles generally accepted in the United States of America. The Company’s management subsequently initiated a review of its lease-related accounting practices and determined that the manner in which it accounted for (i) the amortization of leasehold improvements, (ii) landlord/tenant incentives (specifically, construction allowances), and (iii) the recognition of rent expense (income) when the lease term in an operating lease contains periods of free or reduced rents (i.e. “rent holidays” and/or rent escalation provisions) were not consistent with the views expressed by the SEC and/or the applicable accounting guidance.
Adjustments related to the Company’s accounting for leases (collectively, the “restatement adjustments”) do not materially impact the Company’s historical or future cash flows or the timing or amount of its lease payments, as they represent non-cash changes in accounting treatment. Furthermore, the restatement adjustments have no impact on previously reported revenue, same store sales, cash balances, inventory, or compliance with any of the Company’s debt covenants, and such adjustments are not expected to have any material impact on future earnings.
A discussion of each of the aforementioned lease accounting matters is presented below:
Amortization of Leasehold Improvements – The Company’s long-standing policy with respect to the amortization of leasehold improvements is to assign depreciable lives based on the underlying lease term, or the asset’s estimated useful life, whichever is shorter. As a result of its review, however, the Company identified several leasehold improvements (dating back as far as 1991) which were, at the time they were initially recorded, inappropriately assigned depreciable lives in excess of the underlying lease term, effectively serving to understate previously recorded depreciation expense. The leasehold improvement restatement adjustments have been recorded as depreciation expense in the Consolidated Statements of Operations and accumulated depreciation in the Consolidated Balance Sheets. These adjustments have no impact on “net cash provided by operating activities” during any of the periods restated.
Landlord/Tenant Incentives – The Company determined that the manner in which it accounted for construction allowances was not in accordance with Financial Accounting
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Standards Board Technical Bulletin No. 88-1, “Issues Relating to Accounting for Leases” (“FTB No. 88-1”), which states that lease incentives should be treated by the lessee as a reduction of rental expense and amortized on a straight-line basis over the term of the lease in accordance with FTB No. 85-3, “Accounting for Operating Leases with Scheduled Rent Increases”. Accordingly, in connection with the restatement adjustments, the Company has reflected a liability in its Consolidated Balance Sheets for the unamortized portion of construction allowances (deferred lease incentives) which are to be amortized over the lease term on a straight-line basis as a reduction of rent expense. The Company had previously recorded these allowances as a reduction of the related fixed assets within property, plant and equipment, amortizing them over the lease term as a reduction of depreciation expense.
The restatement adjustments arising as a result of the Company’s past accounting for construction allowances do not affect the income statement classification of related amounts as both depreciation and rent expense are presented within general and administrative expenses in the Consolidated Statements of Operations. Cash receipts associated with construction allowances, which were previously reflected in the Company’s Consolidated Statements of Cash Flows as a reduction of the related capital expenditures within investing activities, have, instead, been appropriately reflected within operating activities.
Periods of Free/Reduced Rents – The Company also determined that its past practice of recognizing rent expense (income) was not in accordance with generally accepted accounting principles. When the terms of an operating lease provide for free rent periods and/or rent escalation provisions, the lessee (lessor) is required to record straight-line rent expense (income) beginning on the date when the lessee takes (relinquishes) possession or control of the property. Previously, the Company recorded rent expense (income) based on the contractual terms of the underlying lease agreement, beginning on the rent commencement date, without considering the free rent period and/or future rent escalations, if any. The Company now records straight-line rent expense (income) when it takes (relinquishes) possession or control of the leased space, which may begin as many as twelve months before the rent commencement date.
The restatement adjustments related to periods of free/reduced rents have been recorded as rent expense (income) in the Company’s Consolidated Statements of Operations and deferred rent credits (expense) in the Consolidated Balance Sheets. These adjustments have no impact on “net cash provided by operating activities” during any of the periods restated.
For all periods restated, investments in auction rate securities have been reclassified from cash and cash equivalents to short-term investments in the Company’s Consolidated Balance Sheets. The reclassification was effected as the securities had stated maturities beyond three months but are priced and traded as short-term instruments due to the liquidity provided through the interest rate reset mechanism of 28 or 35 days. The Company held no auction rate securities as of March 31, 2005 or June 30, 2004. The reclassification also resulted in changes in the Company’s Consolidated Statements of Cash Flows as the purchase and sale of short-term investments previously presented as cash and cash equivalents have been reclassified to investing activities.
See Note 3 to the Company’s Consolidated Financial Statements for the three months ended March 31, 2005 and 2004 for a summary of the effects of the restatement adjustments on the Company’s Consolidated Statements of Operations for the three and nine months ended March 31, 2004, Consolidated Balance Sheet as of June 30, 2004, and Consolidated Statement of Cash Flows for the nine months ended March 31, 2004. The information provided in the accompanying Management’s Discussion and Analysis of Financial Condition and Results of Operations reflects the effect of the restatement adjustments.
The Company’s consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America which require, in some cases, that certain estimates and assumptions be made that affect the amounts and disclosures reported in those financial statements and the related
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accompanying notes. Estimates are based on currently known facts and circumstances, prior experience and other assumptions believed to be reasonable. Management uses its best judgment in valuing these estimates and may, as warranted, solicit external advice. Actual results could differ from these estimates, assumptions and judgments and these differences could be material. The following critical accounting policies, some of which are impacted significantly by estimates, assumptions and judgments, affect the Company’s consolidated financial statements.
Inventories– Inventories (finished goods, work in process and raw materials) are stated at the lower of cost, determined on a first-in, first-out basis, or market. Cost is determined based solely on those charges incurred in the acquisition and production of the related inventory (i.e. material, labor and manufacturing overhead costs). The Company estimates an inventory reserve for excess quantities and obsolete items based on specific identification and historical write-offs, taking into account future demand and market conditions. If actual demand or market conditions in the future are less favorable than those estimated, additional inventory write-downs may be required.
Revenue Recognition – Revenue is recognized when all of the following have occurred: persuasive evidence of a sales arrangement exists (e.g. a wholesale purchase order or retail sales invoice); the sales arrangement specifies a fixed or determinable sales price; product is shipped or services are provided to the customer; and collectibility is reasonably assured. This occurs upon the shipment of goods to independent retailers or, in the case of Ethan Allen-owned retail stores, upon delivery to the customer. Recorded sales provide for estimated returns and allowances. The Company permits retail customers to return defective products and incorrect shipments, and terms offered by the Company are standard for the industry.
Allowance for Doubtful Accounts – The Company maintains an allowance for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. The allowance for doubtful accounts is based on a review of specifically identified accounts in addition to an overall aging analysis. Judgments are made with respect to the collectibility of accounts receivable based on historical experience and current economic trends. Actual losses could differ from those estimates.
Retail Store Acquisitions — The Company accounts for the acquisition of retail stores and related assets in accordance with SFAS No. 141, Business Combinations, which requires application of the purchase method for all business combinations initiated after June 30, 2001. Accounting for these transactions as purchase business combinations requires the allocation of purchase price paid to the assets acquired and liabilities assumed based on their fair values as of the date of the acquisition. The amount paid in excess of the fair value of net assets acquired is accounted for as goodwill.
Impairment of Long-Lived Assets and Goodwill — The Company periodically evaluates whether events or circumstances have occurred that indicate that long-lived assets may not be recoverable or that the remaining useful life may warrant revision. When such events or circumstances are present, the Company assesses the recoverability of long-lived assets by determining whether the carrying value will be recovered through the expected undiscounted future cash flows resulting from the use of the asset. In the event the sum of the expected undiscounted future cash flows is less than the carrying value of the asset, an impairment loss equal to the excess of the asset’s carrying value over its fair value is recorded. The long-term nature of these assets requires the estimation of its cash inflows and outflows several years into the future and only takes into consideration technological advances known at the time of the impairment test.
In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, goodwill and other intangible assets are to be evaluated for impairment on an annual basis and between annual tests whenever events or circumstances indicate that the carrying value of the goodwill or other intangible asset may exceed its fair value. The Company conducts its required annual impairment test during the fourth quarter of each fiscal year. The impairment test uses a discounted cash flow model to estimate fair value. This model requires the use of long-term planning forecasts and
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assumptions regarding industry-specific economic conditions that are outside the control of the Company.
Business Insurance Reserves – The Company has insurance programs in place to cover workers’ compensation and property/casualty claims. The insurance programs, which are funded through self-insured retention, are subject to various stop-loss limitations. The Company accrues estimated losses using actuarial models and assumptions based on historical loss experience. Although management believes that the insurance reserves are adequate, the reserve estimates are based on historical experience, which may not be indicative of current and future losses. In addition, the actuarial calculations used to estimate insurance reserves are based on numerous assumptions, some of which are subjective. The Company adjusts insurance reserves, as needed, in the event that future loss experience differs from historical loss patterns.
Other Loss Reserves – The Company has a number of other potential loss exposures incurred in the ordinary course of business such as environmental claims, product liability, litigation, tax liabilities, restructuring charges, and the recoverability of deferred income tax benefits. Establishing loss reserves for these matters requires management’s estimate and judgment with regard to maximum risk exposure and ultimate liability or realization. As a result, these estimates are often developed with the Company’s counsel, or other appropriate advisors, and are based on management’s current understanding of the underlying facts and circumstances. Because of uncertainties related to the ultimate outcome of these issues or the possibilities of changes in the underlying facts and circumstances, additional charges (or credits) related to these matters could be required in the future.
Ethan Allen’s revenues are comprised of (i) wholesale sales to independently-owned and Company-owned retail stores and (ii) retail sales of Company-owned stores. See Note 12 to the Company’s Consolidated Financial Statements for the three and nine months ended March 31, 2005 and 2004.
The components of consolidated revenue and operating income were as follows (in millions):
Consolidated revenue for the three months ended March 31, 2005 decreased by $13.4 million, or 5.5%, to $231.2 million, from $244.6 million for the three months ended March 31, 2004. Net sales for the period reflect the delivery of product associated with booked orders and related backlog existing as of the end of the preceding quarter. The decrease in net sales for the period was due to a decline in the incoming order rate as a result of (i) softening consumer confidence, likely attributable to the threat of further interest
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rate increases, a decline in the stock markets, and rising fuel prices, (ii) the Company’s current year transition to everyday pricing from periodic sale events conducted in the prior year, and, to a lesser extent, (iii) the Easter holiday falling in March in fiscal 2005 as compared to April in fiscal 2004. Partially offsetting these declines was increased sales activity resulting from the continued re-positioning of the Company’s retail stores to larger and more prominent locations.
Total wholesale revenue for the third quarter of fiscal 2005 decreased by $10.1 million, or 5.6%, to $168.8 million from $178.9 million in the third quarter of fiscal 2004. The decrease was attributable to the decline in the incoming order rate noted during the prior quarter, particularly within the Company’s case goods operations, as compared to the same period in the prior year. This decrease was partially offset by increased revenue attributable to increased throughput within the Company’s upholstery operations and improved service position, resulting in shorter delivery cycle times, within certain imported product lines.
Total retail revenue from Ethan Allen-owned stores for the three months ended March 31, 2005 decreased by $6.8 million, or 4.7%, to $137.3 million from $144.1 million for the three months ended March 31, 2004. The decrease in retail sales by Ethan Allen-owned stores was attributable to a decrease in comparable store delivered sales of $8.1 million, or 6.0%, and a decrease resulting from sold and closed stores, which generated $4.7 million fewer sales in the third quarter of fiscal 2005 as compared to the same period in fiscal 2004, partially offset by sales generated by newly opened (including relocated) or acquired stores of $6.0 million. The number of Ethan Allen-owned stores decreased to 123 as of March 31, 2005 as compared to 124 as of March 31, 2004. During the twelve months ended March 31, 2005, the Company acquired 6 stores from, and sold 3 stores to, independent retailers, closed 5 stores, and opened 1 store. The Company-owned store count at March 31, 2005 also reflects the net addition of 3 stores stemming from Ethan Allen’s acquisition of the 25% minority interest in a joint venture previously established in 1998 between the Company and an independent retailer. While the operations of these stores have been reflected in the Company’s consolidated financial statements since inception of the joint venture as a result of the Company’s 75% majority ownership, the stores were not previously included in the Company’s store count due to the fact that they were independently managed.
Comparable stores are those which have been operating for at least 15 months. Minimal net sales, derived from the delivery of customer ordered product, are generated during the first three months of operations of newly opened stores. Stores acquired from retailers by Ethan Allen are included in comparable store sales in their 13th full month of Ethan Allen-owned operations.
Total booked orders, which include wholesale orders and written business of Ethan Allen-owned retail stores, decreased 8.1% from the prior year quarter. Quarter-over-quarter, wholesale orders decreased 10.0% while Ethan Allen-owned store written business decreased 3.3% and comparable store written business decreased 4.5%. The decrease in retail written sales during the current quarter was likely attributable to softening consumer confidence, the Company’s current year transition to everyday pricing from periodic sale events conducted in the prior year, and the current year timing of the Easter holiday. Partially offsetting these factors were the positive effects of the continued re-positioning of the Company’s retail stores to larger and more prominent locations and increased distribution of the “Furnishing Solutions by Ethan Allen” direct mail magazine. During the quarter, the Company distributed approximately 20 million copies of the magazine, representing a 33% increase over historical levels for the period.
Gross profit decreased during the quarter to $110.5 million from $119.3 million in the prior year comparable quarter. The $8.8 million, or 7.4%, decrease in gross profit was primarily attributable to (i) a decrease in total sales volume, (ii) increased costs associated with ordinary inefficiencies experienced within the Company’s case goods operations related to the production of first cuts for new collections, and (iii) price increases within selected raw material categories, namely lumber, foam, and steel components. Consolidated gross margin decreased to 47.8% in the third quarter of fiscal
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2005 from 48.8% in the prior year quarter as a result, primarily, of the factors identified previously.
Operating expenses decreased $0.5 million, or 0.6%, to $81.2 million, or 35.1% of net sales, in the current year quarter from $81.7 million, or 33.4% of net sales, in the prior year quarter. This decrease was primarily attributable to a decrease in advertising costs within the wholesale segment stemming from increased distribution of the Company’s direct mail magazine in lieu of more costly national television advertising, as well as cost savings attributable to the closure of selected plant locations in recent periods. These favorable variances were partially offset by the continued re-positioning of the Company’s retail stores to larger and more prominent locations. This initiative has resulted in higher costs associated with managerial salaries and benefits, occupancy, credit card fees, advertising, and delivery and warehousing.
Operating income for the three months ended March 31, 2005 was $29.3 million, or 12.7% of net sales, compared to $37.6 million, or 15.4% of net sales, for the three months ended March 31, 2004. This represents a decrease of $8.3 million, and was attributable to the overall decrease in gross profit noted during the period, partially offset by slightly lower operating expenses as referred to previously.
Total wholesale operating income for the third quarter of fiscal 2005 was $31.5 million, or 18.7% of net sales, as compared to $34.1 million, or 19.0% of net sales, in the comparable prior year quarter. The decrease of $2.4 million, or 7.4%, was primarily attributable to (i) the decrease in wholesale sales volume, (ii) ordinary inefficiencies experienced within the Company’s case goods operations associated with the production of first cuts for new collections, and (iii) price increases within selected raw material categories, namely lumber, foam, and steel components. These decreases were partially offset by a reduction in operating expenses as a result of the Company’s decision to increase distribution of its direct mail magazine in lieu of more costly national television advertising, as well as cost savings attributable to the closure of selected plant locations in recent periods.
The retail segment incurred an operating loss of $0.9 million ((0.7%) of net sales) for the third quarter of fiscal 2005, representing a decrease of $4.6 million from reported operating profit of $3.7 million (2.5% of net sales) in the prior year period. The decrease in retail operating profitability generated by Ethan Allen-owned stores was attributable to a decrease in sales volume coupled with higher operating expenses related to the continued re-positioning of the retail store network.
Interest and other miscellaneous income, net for the current quarter remained unchanged from the prior year quarter at $0.2 million, and represents, primarily, gains (losses) related to the sale of real estate, interest income earned on the Company’s cash balances, and the Company’s pro-rata share of income (losses) related to its United Kingdom joint venture with MFI Furniture Group Plc.
Income tax expense for the three months ended March 31, 2005 was $11.3 million as compared to $14.5 million for the three months ended March 31, 2004. The Company’s effective tax rate for the current quarter was 38.7%, up from 38.5% in the prior year quarter. The slightly higher effective tax rate is the result of recently-enacted changes within certain state tax legislation, and increased state income tax liability arising in connection with the operation of a greater number of Company-owned stores, some of which are located in new jurisdictions.
The Company recorded net income of $17.9 million for the quarter ended March 31, 2005, as compared to $23.1 million in the prior year quarter. Net income per diluted share for the current quarter totaled $0.50, down from $0.60 per diluted share in the prior year quarter.
Nine Months Ended March 31, 2005 Compared to Nine Months Ended March 31, 2004
Consolidated revenue for the nine months ended March 31, 2005 decreased by $1.7 million, or 0.2%, to $706.8 million, from $708.5 million for the nine months ended March
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31, 2004. Net sales for the period reflect the delivery of product associated with booked orders and related backlog existing as of the beginning of the period. The modest decrease in net sales for the period was due, primarily, to inconsistent consumer spending habits noted throughout the first nine months of the year likely attributable to ongoing economic uncertainty and the Company’s current year transition to everyday pricing from periodic sale events conducted in the prior year. These factors were partially offset by the continued re-positioning of the Company’s retail stores to larger and more prominent locations and the impact of recent product introductions.
Total wholesale revenue for the first nine months of fiscal 2005 decreased $10.1 million, or 2.0%, from $501.5 million in the prior year comparable period. The year-over-year decrease is attributable to a decline in case goods sales volume, offset by increased throughput within the Company’s upholstery operations, and improved service position, resulting in shorter delivery cycle times, within certain imported product lines.
Total retail revenue from Ethan Allen-owned stores for the nine months ended March 31, 2005 increased $8.5 million, or 2.0%, to $434.8 million from $426.3 million for the nine months ended March 31, 2004. The increase in retail sales by Ethan Allen-owned stores was attributable to an increase in sales generated by newly opened (including relocated) or acquired stores of $17.0 million, and an increase in comparable store delivered sales of $0.6 million, or 0.2%, partially offset by a decrease resulting from sold and closed stores, which generated $9.1 million fewer sales during the first nine months of fiscal 2005 as compared to the same period in fiscal 2004.
Total booked orders for the first nine months of the current fiscal year, which include wholesale orders and written business of Ethan Allen-owned retail stores, decreased 4.2% from the prior year period. Year-over-year, wholesale orders decreased 6.1% while Ethan Allen-owned store written business increased 1.2% and comparable store written business decreased 0.5%. The modest increase in retail written sales was likely attributable to the continued re-positioning of the Company’s retail stores to larger and more prominent locations, and increased distribution of the “Furnishing Solutions by Ethan Allen” direct mail magazine, offset, to some degree, by the current year transition to everyday pricing from periodic sale events conducted in the prior year.
Gross profit decreased during the nine month period ended March 31, 2005 to $340.3 million from $344.0 million in the prior year comparable period. The $3.7 million, or 1.1%, decrease in gross profit was primarily attributable to (i) ordinary inefficiencies experienced within the Company’s case goods operations associated with the production of first cuts for new collections, (ii) price increases within selected raw material categories, namely lumber, foam, plywood, and steel, and (iii) full implementation of the Company’s everyday pricing program. These unfavorable variances were partially offset by a reduction in costs associated with excess capacity at the Company’s manufacturing facilities, and a higher proportionate share of retail sales to total sales (62% in the current period compared to 60% in the prior year period). Consolidated gross margin decreased to 48.1% in the first nine months of fiscal 2005 from 48.5% in the prior year comparable period as a result, primarily, of the factors identified previously.
Operating expenses increased $4.0 million, or 1.7%, to $243.4 million, or 34.4% of net sales, in the current year period from $239.4 million, or 33.8% of net sales, in the prior year period. This increase was primarily attributable to the continued re-positioning of the Company’s retail stores to larger and more prominent locations and the higher proportionate share of retail sales to total sales in the current period as compared to the prior year period. These factors have resulted in higher costs associated with designer salaries and commissions, credit card fees, occupancy, managerial salaries and benefits, and delivery and warehousing. In addition, advertising costs within the wholesale segment increased during the period, primarily related to the increased distribution of the Company’s direct mail magazine. These increases were partially offset by lower expenditures related to national television advertising, and cost savings attributable to the closure of selected plant locations in recent periods.
Operating income for the nine months ended March 31, 2005 was $96.8 million, or 13.7% of net sales, compared to $104.5 million, or 14.8% of net sales, for the nine months
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ended March 31, 2004. This represents a decrease of $7.7 million, and was attributable to the decrease in gross profit noted during the period, coupled with the higher operating expenses as referred to previously.
Total wholesale operating income for the first nine months of fiscal 2005 was $86.6 million, or 17.6% of net sales, as compared to $91.3 million, or 18.2% of net sales, in the comparable prior year period. The decrease of $4.7 million, or 5.2%, was primarily attributable to (i) the decrease in wholesale sales volume, (ii) ordinary inefficiencies experienced within the Company’s case goods operations associated with the production of first cuts for new collections, (iii) price increases within selected raw material categories, namely lumber, foam, plywood, and steel, (iv) an increase in selling expenses, primarily related to the increased distribution of the Company’s direct mail magazine, and (v) full implementation of the Company’s everyday pricing program. These factors were partially offset by lower expenditures related to national television advertising, a reduction in excess capacity at the Company’s manufacturing facilities, and cost savings attributable to the closure of selected plant locations in recent periods.
Operating income for the retail segment decreased $1.1 million to $8.0 million, or 1.8% of net sales, for the first nine months of fiscal 2005, as compared to $9.1 million, or 2.1% of net sales, in the prior year period. The decrease in retail operating income generated by Ethan Allen-owned stores was primarily attributable to higher operating expenses related to the continued re-positioning of the retail store network, partially offset by increased sales volume.
Interest and other miscellaneous income, net for the current nine month period decreased $1.8 million, to $1.4 million, from $3.2 million in the prior year period. The decrease was the result of (i) the favorable settlement of an outstanding legal matter recorded during the prior year period, (ii) a decrease in interest income associated with the lower cash balances maintained during the current period, and (iii) an increase in the Company’s share of losses incurred in connection with its United Kingdom joint venture with MFI Furniture Group Plc.
Income tax expense for the nine months ended March 31, 2005 was $37.9 million as compared to $41.2 million for the nine months ended March 31, 2004. The Company’s effective tax rate for the current period was 38.8%, up from 38.4% in the prior year comparable period. The higher effective tax rate is the result of recently-enacted changes within certain state tax legislation, and increased state income tax liability arising in connection with the operation of a greater number of Company-owned stores, some of which are located in new jurisdictions.
The Company recorded net income of $59.8 million for the first nine months of fiscal 2005 as compared to $66.0 million in the prior year comparable period. Net income per diluted share totaled $1.63 for the current period and $1.72 per diluted share in the prior year period.
The Company’s principal sources of liquidity include cash and cash equivalents, cash flow from operations and borrowing capacity under a $100.0 million revolving credit facility. In addition to the $100.0 million revolving credit component, the facility includes an accordion feature which provides for an additional $50.0 million of liquidity if needed, as well as sub-facilities for trade and standby letters of credit of $50.0 million and swing-line loans of $3.0 million. The Company does, from time to time, hold investments in auction rate securities which have stated maturities beyond three months but are priced and traded as short-term investments due to the liquidity provided through the interest rate reset mechanism of 28 or 35 days. These auction rate securities are classified as short-term investments in the Company’s Consolidated Balance Sheets.
As of March 31, 2005 the Company maintained cash and short-term investments totaling $10.9 million and outstanding debt and capital lease obligations totaling $4.5 million. The current and long-term portions of the Company’s outstanding debt and capital lease obligations totaled $0.1 million and $4.4 million, respectively, at that date. The Company
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had no revolving loans outstanding under the credit facility as of March 31, 2005, and trade and standby letters of credit outstanding under the facility at that date totaled $15.6 million. Remaining available borrowing capacity under the facility was $84.4 million at March 31, 2005.
In April 2005, the Company borrowed $12.5 million under its revolving credit facility to fund working capital needs. The borrowings, which are short-term in nature, bear interest at a rate of 6.125%.
Net cash provided by operating activities totaled $79.2 million for the first nine months of fiscal 2005 as compared to $113.0 million for the first nine months of fiscal 2004. The current period decrease of $33.8 million was principally the result of (i) changes in inventories ($7.4 million effect), (ii) changes in accounts payable ($6.4 million effect) resulting from the ordinary timing of related cash disbursements, including estimated quarterly income tax payments and treasury stock repurchases, (iii) a decrease in net income ($6.2 million effect), (iv) changes in customer deposits ($5.8 million effect) reflecting the period-to-period change in the level of written and delivered sales, and (v) changes in prepaid expenses and other current assets ($3.0 million effect), deferred income taxes ($2.6 million effect), and accrued expenses ($1.7 million effect), all as a result of normal business activity.
The decrease in inventory levels since June 2004 was the result, primarily, of a decline in finished goods and work-in-process inventories. The decrease in finished goods inventories was related, in part, to better Company-wide management of inventories, a decline in the wholesale incoming order rate, and an increase in retail sales volume. The decline in work-in-process inventories is attributable to the consolidation of two manufacturing facilities, announced in April 2004, and the related phase-out of those plants’ production during the current period. These decreases were partially offset by an increase in raw material inventories resulting from the purchase of lumber, fabric, and purchased frames in anticipation of future production needs.
Net cash used in investing activities totaled $18.2 million for the current nine month period compared to $24.5 million in the prior year period. The current period decrease of $6.3 million was due, primarily, to a $15.5 million net decrease in cash utilized to fund short-term investment activity and a $2.1 million increase in proceeds related to the sale of three Company-owned stores to independent Ethan Allen retailers. These favorable variances were partially offset by (i) a $9.7 million increase in capital spending, exclusive of acquisitions, to $24.2 million from $14.5 million in the prior year period, (ii) a $1.4 million decline in proceeds from the disposal of certain property, plant and equipment, and (iii) a $1.0 million increase in cash utilized to fund acquisition activity (2 retail stores were acquired in the current period as compared to no stores acquired in the prior year period). The current level of capital spending is principally attributable to (i) new store development and renovation, (ii) Company-wide technology initiatives, and (iii) improvements within the Company’s remaining manufacturing facilities. The Company anticipates that cash from operations will be sufficient to fund future capital expenditures.
Net cash used in financing activities totaled $77.7 million for the nine months ended March 31, 2005 as compared to $8.9 million in the prior year period. The current period increase of $68.8 million was the result, primarily, of (i) an increase of $59.6 million in payments related to the acquisition of treasury stock, (ii) a $4.1 million increase in cash utilized in the payment of dividends, and (iii) an increase in cash utilized to repay outstanding debt of $3.7 million.
On January 25, 2005 the Company declared a dividend of $0.15 per common share, payable on April 25, 2005, to shareholders of record as of April 11, 2005. The Company expects to continue to declare quarterly dividends for the foreseeable future.
In addition to using available cash to fund changes in working capital, necessary capital expenditures, acquisition activity, the repayment of debt, and the payment of dividends, the Company has been authorized by its Board of Directors to repurchase its common stock, from time to time, either directly or through agents, in the open market at
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prices and on terms satisfactory to the Company. The Company also retires shares of unvested restricted stock and, prior to June 30, 2002, repurchased shares of common stock from terminated or retiring employee’s accounts in the Ethan Allen Retirement Savings Plan. All of the Company’s common stock repurchases and retirements are recorded as treasury stock and result in a reduction of shareholders’ equity.
During the nine months ended March 31, 2005 and 2004, the Company repurchased and/or retired the following shares of its common stock:
For each of the periods presented above, the Company funded its purchases of treasury stock with existing cash on hand and cash generated through current period operations. On November 16, 2004, the Board of Directors increased the share purchase authorization to 2.0 million shares, of which 1.4 million shares remained as of March 31, 2005.
Subsequent to March 31, 2005 and through May 9, 2005, the Company repurchased, in nine separate open market transactions, an additional 716,900 shares of its common stock at a total cost of $22.6 million, representing an average price per share of $31.47. On April 26, 2005, the Board of Directors increased the remaining authorization of 691,100 shares to 2.0 million shares.
As of March 31, 2005, aggregate scheduled maturities of long-term debt, including capital lease obligations, for each of the next five fiscal years are: $0.2 million in fiscal 2006; $0.1 million in fiscal 2007; $0.1 million in fiscal 2008; $0.1 million in fiscal 2009; and $0.1 million in fiscal 2010. The balance of the Company’s long-term debt and capital lease obligations ($3.8 million) matures in fiscal years 2011 and thereafter. The Company believes that its cash flow from operations, together with its other available sources of liquidity, will be adequate to make all required payments of principal and interest on its debt, to permit anticipated capital expenditures and to fund working capital and other cash requirements. As of March 31, 2005, the Company had working capital of $148.6 million and a current ratio of 2.15 to 1.
Except as indicated below, the Company does not utilize or employ any off-balance sheet arrangements, including special-purpose entities, in operating its business. As such, the Company does not maintain any (i) retained or contingent interests, (ii) derivative instruments, or (iii) variable interests which could serve as a source of potential risk to its future liquidity, capital resources and results of operations.
The Company, or its consolidated subsidiaries, may, from time to time in the ordinary course of business, provide guarantees on behalf of selected affiliated entities or become contractually obligated to perform in accordance with the terms and conditions of certain business agreements. The nature and extent of these guarantees and obligations may vary based on the underlying relationship of the benefiting party to the Company and the business purpose for which the guarantee or obligation is being provided. Details of those arrangements for which the Company, or any of its wholly-owned subsidiaries, act as guarantor or obligor are provided below.
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Retailer-Related Guarantees
Ethan Allen Inc. has obligated itself, on behalf of one of its independent retailers, with respect to a $1.5 million credit facility (the “Credit Facility”) comprised of a $1.1 million revolving line of credit and a $0.4 million term loan. This obligation requires the Company, in the event of the retailer’s default under the Credit Facility, to repurchase the retailer’s inventory, applying such purchase price to the retailer’s outstanding indebtedness under the Credit Facility. The Company’s obligation remains in effect for the life of the term loan which expires in April 2008. The maximum potential amount of future payments (undiscounted) that the Company could be required to make under this obligation is limited to the amount outstanding under the Credit Facility at the time of default (subject to pre-determined lending limits based on the value of the underlying inventory) and, as such, is not an estimate of future cash flows. No specific recourse or collateral provisions exist that would enable recovery of any portion of amounts paid under this obligation, except to the extent that the Company maintains the right to take title to the repurchased inventory. Management anticipates that the repurchased inventory could subsequently be sold through the Company’s retail store network. As of March 31, 2005, the amount outstanding under the Credit Facility totaled approximately $1.1 million, of which $0.9 million was outstanding under the revolving credit line. Management expects that, based on the underlying creditworthiness of the respective retailer, this obligation will expire without requiring funding by the Company. However, in accordance with the provisions of FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, a liability has been established to reflect the Company’s non-contingent obligation under this arrangement as a result of modifications made to the Credit Facility subsequent to January 1, 2003. As of March 31, 2005, the carrying amount of such liability is less than $50,000.
Indemnification Agreement
In connection with the Company’s joint venture arrangement with United Kingdom-based MFI Furniture Group Plc., Ethan Allen Inc. has entered into a tax cross-indemnification agreement with the joint venture partner. The indemnification agreement stipulates that both parties agree to pay fifty percent of the amount of any tax liability arising as a result of (i) an adverse tax judgment or (ii) the imposition of additional taxes against either partner, and attributable to the operations of the joint venture. The indemnification agreement is effective until such time that the joint venture is terminated. At the present time, management anticipates that the joint venture will continue to operate for the foreseeable future.
The maximum potential amount of future payments (undiscounted) that the Company could be required to make under this indemnification agreement is indeterminable as no such tax liability currently exists. Further, the nature, extent and magnitude of any such tax liability arising in the future as a result of an adverse tax judgment or change in applicable tax law cannot be estimated with any reasonable certainty. It should be further noted that no recourse or collateral provisions exist that would enable recovery of any portion of amounts paid under this indemnification agreement. Management expects, based on its current understanding of the applicable tax laws and the existing legal structure of the joint venture, subject to future changes in applicable laws and regulations, this cross-indemnity agreement will expire without requiring funding by the Company. Accordingly, as of March 31, 2005, the carrying amount of the liability related to this indemnification agreement is zero.
Product Warranties
The Company’s products, including its case goods, upholstery and home accents, generally carry explicit product warranties that extend from three to five years and are provided based on terms that are generally accepted in the industry. All of the Company’s domestic independent retailers are required to enter into, and perform in accordance with the terms and conditions of, a warranty service agreement. The Company records provisions for estimated warranty and other related costs at time of sale based on historical
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warranty loss experience and makes periodic adjustments to those provisions to reflect actual experience. On rare occasion, certain warranty and other related claims involve matters of dispute that ultimately are resolved by negotiation, arbitration or litigation. In certain cases, a material warranty issue may arise which is beyond the scope of the Company’s historical experience. The Company provides for such warranty issues as they become known and are deemed to be both probable and estimable. It is reasonably possible that, from time to time, additional warranty and other related claims could arise from disputes or other matters beyond the scope of the Company’s historical experience. As of March 31, 2005, the Company’s product warranty liability totaled $1.3 million.
The Company has experienced inconsistent business activity throughout the last nine to twelve months. During that time, macro-economic factors such as the ongoing war in Iraq, rising fuel prices, the threat of further interest rate increases, and recent declines in the stock markets, appear to have contributed to lower levels of consumer confidence and discretionary spending. In addition, the Company’s current year transition to everyday pricing in lieu of its historical periodic sale events, likely also had some effect on order trends as compared to prior periods. Despite these challenges, the Company believes it is well-positioned for the next phase of economic growth as a result of (i) its established brand, (ii) its comprehensive complement of home decorating solutions, and (iii) its vertically-integrated business model.
Should the economy strengthen, however, it is also possible that costs associated with production (including raw materials and labor), distribution (including freight and fuel charges), and retail operations (including compensation, delivery and warehousing, occupancy and advertising expenses) may continue to increase. Similarly, continued increases in interest rates and crude oil prices could serve to further adversely impact the level of discretionary spending on the part of consumers. We cannot reasonably predict when, or to what extent, such events may occur or what effect, if any, such events may have on the Company’s consolidated financial condition or results of operations.
The industry remains extremely competitive with domestic manufacturers facing increased pricing pressure as a result of the continued development of manufacturing capabilities in other countries, specifically within Asia. In response to these pressures, a large number of U.S. furniture manufacturers and retailers, including Ethan Allen, have increased their overseas sourcing activities in an attempt to maintain a competitive advantage and retain market share. At the present time, the Company manufactures and/or assembles approximately 70% of its products. Management of the Company continues to believe that a balanced approach to product sourcing, which includes the domestic manufacture of certain product offerings coupled with the import of other selected products, provides the greatest degree of flexibility and is the most effective approach to ensuring that acceptable levels of quality, service and value are attained.
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The Company is exposed to interest rate risk primarily through its borrowing activities. The Company’s policy has been to utilize United States dollar denominated borrowings to fund its working capital and investment needs. Short-term debt, if required, is used to meet working capital requirements and long-term debt is generally used to finance long-term investments. There is inherent rollover risk for borrowings as they mature and are renewed at current market rates. The extent of this risk is not quantifiable or predictable because of the variability of future interest rates and the Company’s future financing requirements. As of March 31, 2005, the Company had no debt instruments outstanding with variable interest rates.
The Company’s exposure to foreign currency exchange risk is primarily limited to its operation of five Ethan Allen-owned retail stores located in Canada as substantially all purchases of imported parts and finished goods are denominated in United States dollars. As such, gains or losses resulting from market changes in the value of foreign currencies have not had, nor are they expected to have, a material effect on the Company’s consolidated results of operations.
Currently, the Company does not enter into financial instrument transactions for trading or other speculative purposes or to manage interest rate or currency exposure.
Ethan Allen’s management, including the Chairman of the Board and Chief Executive Officer (“CEO”) and the Vice President-Finance (“VPF”), conducted an evaluation of the effectiveness of disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report.
As was disclosed in the Company’s Current Report on Form 8-K dated April 20, 2005, management, in consultation with the Audit Committee of the Company’s Board of Directors, concluded that it was necessary to restate certain previously issued financial statements. This conclusion was reached in light of the views expressed by the Office of the Chief Accountant of the Securities and Exchange Commission in their letter to the American Institute of Certified Public Accountants, dated February 7, 2005, with respect to certain operating lease accounting issues and their application under accounting principles generally accepted in the United States of America. As a result of the need to restate previously issued financial statements, management, including the CEO and VPF, has concluded that, as of March 31, 2005, the Company’s disclosure controls and procedures were not effective in ensuring that material information relating to the Company (including its consolidated subsidiaries), which is required to be included in the Company’s periodic filings under the Exchange Act, had been made known to them in a timely manner.
There have been no changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended March 31, 2005 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. However, prior to the filing of this report, management has implemented necessary changes to the Company’s internal controls in order to address the lease accounting matters referred to above.
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There has been no material change to the matters discussed in Part I, Item 3 — Legal Proceedings in the Company’s Annual Report on Form 10-K as filed with the Securities and Exchange Commission as of September 10, 2004.
Issuer Purchases of Equity Securities
Certain information regarding purchases made by or on behalf of the Company or any affiliated purchaser (as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934, as amended) of our common stock during the three months ended March 31, 2005 is provided below:
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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.
ETHAN ALLEN INTERIORS INC.(Registrant)
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