UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the Quarterly Period Ended February 27, 2005
OR
Commission file number: 002-90139
LEVI STRAUSS & CO.
(Exact Name of Registrant as Specified in Its Charter)
1155 Battery Street, San Francisco, California 94111
(Address of Principal Executive Offices)
(415) 501-6000
(Registrant’s Telephone Number, Including Area Code)
None
(Former Name, Former Address, and Former Fiscal Year, if Changed Since Last Report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes ¨ No x
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Common Stock $.01 par value—37,278,238 shares outstanding on April 6, 2005
INDEX TO FORM 10-Q
February 27, 2005
PART I—FINANCIAL INFORMATION
Item 1.
Consolidated Financial Statements (unaudited):
Consolidated Balance Sheets as of February 27, 2005 and November 28, 2004
Consolidated Statements of Operations for the Three Months Ended February 27, 2005 and February 29, 2004
Consolidated Statements of Cash Flows for the Three Months Ended February 27, 2005 and February 29, 2004
Notes to Consolidated Financial Statements
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
Item 4.
Controls and Procedures
PART II—OTHER INFORMATION
Legal Proceedings
Unregistered Sales of Equity Securities and Use of Proceeds.
Defaults Upon Senior Securities.
Submission of Matters to a Vote of Security Holders.
Item 5.
Other Information.
Item 6.
Exhibits.
SIGNATURE
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Item 1. Consolidated Financial Statements
LEVI STRAUSS & CO. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in Thousands)
(Unaudited)
Current Assets:
Cash and cash equivalents
Restricted cash
Trade receivables, net of allowance for doubtful accounts of $28,726 and $29,002
Inventories:
Raw materials
Work-in-process
Finished goods
Total inventories
Deferred tax assets, net of valuation allowance of $26,364 and $26,364
Other current assets
Total current assets
Property, plant and equipment, net of accumulated depreciation of $484,708 and $486,439
Goodwill
Other intangible assets, net of accumulated amortization of $740 and $720
Non-current deferred tax assets, net of valuation allowance of $360,319 and $360,319
Other assets
Total assets
Current Liabilities:
Current maturities of long-term debt and short-term borrowings
Current maturities of capital lease obligations
Accounts payable
Restructuring reserves
Accrued liabilities
Accrued salaries, wages and employee benefits
Accrued income taxes
Total current liabilities
Long-term debt, less current maturities
Long-term capital lease, less current maturities
Post-retirement medical benefits
Pension liability
Long-term employee related benefits
Long-term income tax liabilities
Other long-term liabilities
Minority interest
Total liabilities
Commitments and contingencies (Note 7)
Stockholders’ Deficit:
Common stock—$.01 par value; 270,000,000 shares authorized; 37,278,238 shares issued and outstanding
Additional paid-in capital
Accumulated deficit
Accumulated other comprehensive loss
Stockholders’ deficit
Total liabilities and stockholders’ deficit
The accompanying notes are an integral part of these financial statements.
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CONSOLIDATED STATEMENTS OF OPERATIONS
Net sales
Cost of goods sold
Gross profit
Selling, general and administrative expenses
Long-term incentive compensation expense
(Gain) loss on disposal of assets
Other operating income
Restructuring charges, net of reversals
Operating income
Interest expense
Loss on early extinguishment of debt
Other income, net
Income (loss) before taxes
Income tax expense (benefit)
Net income (loss)
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CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash Flows from Operating Activities:
Adjustments to reconcile net income (loss) to net cash (used in) provided by operating activities:
Depreciation and amortization
Non-cash asset write-offs associated with reorganization initiatives
Unrealized foreign exchange gains
Decrease in trade receivables
(Increase) decrease in inventories
(Increase) decrease in other current assets
Decrease in other non-current assets
Decrease in accounts payable and accrued liabilities
Decrease in deferred income taxes
Decrease in restructuring reserves
(Decrease) increase in accrued salaries, wages and employee benefits
Increase (decrease) in current income tax liabilities
Increase in long-term income tax liabilities
Decrease in long-term employee related benefits
(Decrease) increase in other long-term liabilities
Other, net
Net cash (used in) provided by operating activities
Cash Flows from Investing Activities:
Purchases of property, plant and equipment
Proceeds from sale of property, plant and equipment
Cash outflow from net investment hedges
Net cash used in investing activities
Cash Flows from Financing Activities:
Proceeds from issuance of long-term debt
Repayments of long-term debt
Net increase (decrease) in short-term borrowings
Debt issuance costs
Increase in restricted cash
Net cash provided by (used in) financing activities
Effect of exchange rate changes on cash
Net decrease in cash and cash equivalents
Beginning cash and cash equivalents
Ending cash and cash equivalents
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest
Income taxes
Restructuring initiatives
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NOTE 1: PREPARATION OF FINANCIAL STATEMENTS
Basis of Presentation and Principles of Consolidation
The unaudited consolidated financial statements of Levi Strauss & Co. and its wholly-owned and majority-owned foreign and domestic subsidiaries (“LS&CO.” or the “Company”) are prepared in conformity with generally accepted accounting principles in the United States (“U.S.”) for interim financial information. In the opinion of management, all adjustments necessary for a fair presentation of the financial position and the results of operations for the periods presented have been included. These unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements of LS&CO. for the year ended November 28, 2004 included in the annual report on Form 10-K filed by LS&CO. with the Securities and Exchange Commission on February 17, 2005.
The unaudited consolidated financial statements include the accounts of Levi Strauss & Co. and its subsidiaries. All intercompany transactions have been eliminated. Management believes that the disclosures are adequate to make the information presented herein not misleading. Certain prior year amounts have been reclassified to conform to the current presentation. The results of operations for the three months ended February 27, 2005 may not be indicative of the results to be expected for any other interim period or the year ending November 27, 2005.
The Company’s fiscal year consists of 52 or 53 weeks, ending on the last Sunday of November in each year. The 2005 fiscal year consists of 52 weeks ending November 27, 2005. Each quarter of fiscal year 2005 consists of 13 weeks. The 2004 fiscal year consisted of 52 weeks ended November 28, 2004 with all four quarters consisting of 13 weeks.
Restricted Cash
Restricted cash as of February 27, 2005 and November 28, 2004 was $4.7 million and $1.9 million, respectively, and primarily relates to required cash deposits for customs and rental guarantees in Europe. The 2005 amount includes approximately $2.9 million of restricted cash for dividends declared but unpaid for the minority shareholders of the Company’s subsidiary in Japan.
Reclassification of Outstanding Checks
The Company included approximately $14.3 million of outstanding checks in “accounts payable” in its statement of cash flows for the three months ended February 29, 2004. Outstanding checks represent checks that have been issued by the Company but have not been processed against the Company’s bank accounts as of the balance sheet date. As of November 28, 2004, the Company has reported outstanding checks as a reduction in “cash and cash equivalents” in the consolidated balance sheet and statement of cash flows, and the prior year amount in the statement of cash flows has been reclassified to reflect this presentation.
Long-lived Assets Held for Sale
At February 27, 2005 and November 28, 2004, the Company had approximately $2.4 million and $2.3 million, respectively, of long-lived assets held for sale. Such assets are recorded in “Property, plant and equipment.” Long-lived assets held for sale as of February 27, 2005 primarily relate to closed manufacturing plants in San Antonio, Texas and San Francisco, CA.
Loss on Early Extinguishment of Debt
During the three months ended February 27, 2005, the Company recorded a $23.0 million loss on early extinguishment of debt as a result of its debt refinancing activities during the period. The loss was comprised of a tender offer premium and other fees and expenses approximating $19.7 million incurred in conjunction with the Company’s completion in January 2005 of a tender offer to repurchase $372.1 million of its 2006 notes and the write-off of approximately $3.3 million of unamortized debt discount and capitalized costs related to such notes (See also Note 5 to the Consolidated Financial Statements).
New Accounting Standards
In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment” (“SFAS 123(R)”). Under this standard, all forms of share-based payment to employees, including stock options, would be treated as compensation and recognized in the income statement. This statement will be effective for awards granted, modified or settled in interim periods or fiscal years beginning after June 15, 2005. The Company does not believe that the adoption of SFAS 123(R) will have a significant effect on its financial statements.
NOTE 2: RESTRUCTURING RESERVES
Summary
The following describes the activities associated with the Company’s reorganization initiatives. Severance and employee benefits relate to items such as severance packages, out-placement services and career counseling for employees affected by the plant closures and reorganization initiatives. Reductions consist of payments for severance and employee benefits, other restructuring costs, and foreign exchange differences. The balance of severance and employee benefits and other restructuring costs are included in restructuring reserves on the balance sheet.
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The total balance of the reserves at February 27, 2005 and November 28, 2004 was $35.2 million and $50.8 million, respectively. The current and long-term portion of the reserve at February 27, 2005 was $26.8 million and $8.4 million, respectively. The current and long-term portion of the reserve at November 28, 2004 was $42.0 million and $8.8 million, respectively. For the three months ended February 27, 2005 and February 29, 2004, the Company recognized restructuring charges, net of reversals, of $3.2 million and $54.4 million, respectively. Charges in the three months ended February 27, 2005 relate primarily to additional severance and benefit expenses related to the 2004 U.S. and European organizational changes. Charges in the three months ended February 29, 2004 relate primarily to the indefinite suspension of an enterprise resource planning system installation and additional charges related to the Company’s 2003 organizational changes and plant closures. The Company expects to utilize a significant portion of its restructuring reserves during fiscal year 2005.
The following table summarizes the 2005 activity, and the reserve balances as of November 28, 2004 and as of February 27, 2005, associated with the Company’s plant closures and reorganization initiatives:
2004 Reorganization Initiatives
2003 U.S. Organizational Changes
2003 North America Plant Closures
2003 Europe Organizational Changes
2002 Europe Reorganization Initiative
Total
The Company commenced the following reorganization initiatives in 2004.
2004 Spain Plant Closures
During the year ended November 28, 2004, the Company closed its two owned and operated manufacturing plants in Spain and recorded a charge of $27.3 million for severance and benefits related to the displacement of approximately 450 employees and other restructuring costs associated with this initiative. The amount of the charge was determined based upon the severance benefits for this action, as negotiated with local representatives for the employees. The plant ceased operations in the fourth quarter of 2004. The Company recorded additional charges during the quarter ended February 27, 2005 of $0.3 million for additional severance and employee benefits and facility closure costs. As of February 27, 2005, all of the employees associated with this initiative had been displaced. Current appraised values indicate that there does not appear to be an impairment issue relating to the carrying amounts of the plants’ property, plant and equipment. The Company expects to incur no additional restructuring costs in connection with this action.
2004 Australia Plant Closure
During the year ended November 28, 2004, the Company closed its owned and operated manufacturing plant in Adelaide, Australia and recorded severance costs of approximately $2.6 million related to the displacement of approximately 90 employees. The amount of the charge was determined based upon severance benefits. The Company did not record any additional charges during the quarter ended February 27, 2005. As of February 27, 2005, approximately 85 employees had been displaced. Current appraised values indicate that there does not appear to be an impairment issue relating to the carrying amounts of the plant’s property, plant and equipment. The Company expects to incur no additional restructuring costs in connection with this action.
2004 U.S. Organizational Changes
During the year ended November 28, 2004, the Company reduced resources associated with the Company’s corporate support functions by eliminating staff, not filling certain open positions and outsourcing most of the transaction activities in the U.S. human resources function. The Company expects this initiative will result in the displacement of approximately 200 employees. As of February 27, 2005, approximately 180 individuals had been displaced. During the three months ended February 27, 2005 and the year ended November 28, 2004, the Company recorded charges, net of reversals, related to this initiative of approximately $1.8 million and $26.2 million, respectively. The Company estimates that it will incur future additional restructuring charges related to this initiative, principally in the form of severance and employee benefits payments, of approximately $2.0 million, which will be recorded as they become estimable and probable.
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2004 Europe Organizational Changes
During the year ended November 28, 2004, the Company commenced additional reorganization actions relative to its European operations which it expects will result in the displacement of approximately 210 employees. As of February 27, 2005, approximately 125 employees had been displaced. During the three months ended February 27, 2005 and the year ended November 28, 2004, the Company recorded charges, net of reversals, for severance and lease termination costs related to these actions of approximately $1.8 million and $15.2 million, respectively. The Company estimates that it will incur additional restructuring charges of approximately $12.8 million relating to these actions, principally in the form of severance and employee benefits payments for the displacement of approximately 85 additional employees, which will be recorded as they become probable and estimable.
2004 Dockers® Europe Organizational Changes
During 2004, the Company commenced the process of changing its Dockers® business model in Europe. The Company plans to transfer and consolidate Dockers® Europe’s operations in Brussels, which is the European headquarters of Levi Strauss & Co. The Company anticipates that the move will take place in the third quarter of 2005, resulting in the closure of its Amsterdam office and the displacement of approximately 65 employees based there. In November 2004, the president of the Dockers® business in Europe, along with the leaders of the marketing and merchandising functions, left employment with the Company. During the year ended November 28, 2004, the Company recorded a charge of approximately $1.3 million, primarily related to severance and related benefits resulting from the termination of the three executives. The Company did not record any additional charges during the quarter ended February 27, 2005. During the third quarter of 2005, the Company expects to incur additional restructuring costs of approximately $7.7 million relating to this initiative in the form of severance and employee benefits payments, contract termination costs and asset disposals, which will be recorded as they become estimable and probable, or in the case of contract termination costs, when the related contracts are terminated.
2004 Indefinite Suspension of Enterprise Resource Planning System Installation
In December 2003, the Company indefinitely suspended the installation of a worldwide enterprise resource planning system in order to reduce costs and prioritize work and resource use, and as a result the Company recorded a charge of approximately $42.8 million during fiscal 2004. The charge was comprised of approximately $2.7 million related to the displacement of approximately 40 employees, $6.7 million for other restructuring costs primarily related to non-cancelable project contractual commitments and $33.4 million to write-off capitalized costs related to the project. During the three months ended February 27, 2005, the Company recorded a charge of $0.1 million. As of February 27, 2005, all the employees had been displaced. The Company expects to incur no additional restructuring costs in connection with this action.
In August 2004 the Company decided to implement a new enterprise resource planning system for its Asia Pacific region. This decision will likely result in the utilization of certain of the previously written off assets described above, primarily software and licenses with an original cost of approximately $4.0 to $5.0 million. Under the provisions of Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-lived Assets”, previously written down assets are not reversed, and accordingly, there will be no adjustment to write-up the assets identified for use in this initiative. However, upon quantification of the actual assets utilized, the Company will disclose in the notes to the financial statements the original cost and pro forma depreciation expense related to such assets for the applicable periods to provide data regarding the benefit associated with their utilization.
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The table below displays the restructuring activity for the three months ended February 27, 2005, and the balance of the restructuring reserves as of February 27, 2005, for the 2004 reorganization initiatives discussed above.
Severance and employee benefits
Other restructuring costs
Subtotal- Spain Plant Closures
Subtotal-Australia Plant Closure
Subtotal-U.S. Organizational Changes
Subtotal-Europe Organizational Changes
Subtotal-Dockers® Europe Organizational Changes
2004 Indefinite Suspension of ERP Installation
Subtotal-ERP Indefinite Suspension
Total - 2004 Reorganizational Changes
On September 10, 2003, the Company announced a reorganization of its U.S. business to further reduce the time it takes from initial product concept to placement of the product on the retailer’s shelf and to reduce costs. During the fourth quarter of fiscal 2003, the Company recorded an initial charge of $22.4 million in connection with this initiative, reflecting the displacement of approximately 350 salaried employees in various U.S. locations. As a result of these initiatives, the Company recorded charges during the year ended November 28, 2004 of $7.3 million, net of reversals for additional severance and benefits related to the displacement of 189 employees, and $0.9 million, respectively, for other restructuring costs. During the three month period ended February 27, 2005, the Company reversed approximately $0.8 million of charges primarily related to revised COBRA and annual incentive plan liabilities related to the displaced employees. As of February 27, 2005, all employees had been displaced.
During fiscal year 2005, the Company expects to incur an insignificant amount of additional employee-related restructuring costs related to this initiative for termination benefits and other restructuring costs, which will be recorded as they become estimable and probable.
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The table below displays the activity and liability balance of the reserve for the 2003 U.S. organizational changes.
The Company closed its sewing and finishing operations in San Antonio, Texas in January 2004. The Company’s three Canadian facilities, two sewing plants in Edmonton, Alberta and Stoney Creek, Ontario, and a finishing center in Brantford, Ontario, closed in March 2004, displacing approximately 2,050 employees. Production from the San Antonio and Canadian facilities has been shifted to third-party contractors located primarily outside the U.S. and Canada. During the third quarter of 2003, the Company recorded a charge of approximately $11.0 million for asset write-offs associated with the U.S. and Canadian plant closures. During the fourth quarter of 2003, the Company recorded a charge of $42.1 million consisting of $41.3 million for severance and employee benefits and $0.8 million for other restructuring costs. The Company recorded additional charges during the year ended November 28, 2004 of $12.9 million, net of reversals, for additional severance and employee benefits, facility closure costs and asset write-offs. During the three months ended February 27, 2005, the Company recorded an equal amount of charges and reversals (approximately $0.3 million) related to this initiative. As of February 27, 2005, all of the employees had been displaced in connection with these plant closures.
During fiscal year 2005, the Company expects to incur an insignificant amount of additional employee-related restructuring and asset disposal costs, which will be recorded as they become estimable and probable, or in the case of contract termination costs, when the related contracts are terminated.
The table below displays the restructuring activity and liability balance of the reserve for the 2003 North American plant closures.
During the fourth quarter of 2003, the Company announced reorganization actions to consolidate and streamline operations in its European headquarters in Belgium and in various field offices. As a result, the Company recorded a charge of $28.9 million consisting of $28.1 million for severance and employee benefits and $0.8 million for other restructuring costs. The charge reflected the estimated displacement of approximately 330 employees. During 2004, the Company recorded a net reversal of approximately $0.6 million as a result of lower than anticipated severance and employee benefits related to this initiative. In addition, the Company recorded a charge of approximately $0.8 million, net of reversals, primarily for legal fees associated with severance negotiations. During the three months ended February 27, 2005, the Company recorded an insignificant amount of charges related to this initiative and reversed approximately $0.1 million of charges related to lower than expected severance costs. As of February 27, 2005, substantially all of the employees had been displaced. The Company expects to incur no additional restructuring costs in connection with this action.
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The table below displays the activity and liability balance of the reserve for this initiative.
(Dollars in thousands)
2002 Europe Reorganization Initiatives
In November 2002, the Company initiated the first of a series of reorganization initiatives affecting several countries to realign its resources with its European sales strategy to improve customer service, reduce operating costs and streamline product distribution activities. These actions included the closures of the leased distribution centers in Belgium, France and Holland during the first half of 2004. During the year ended November 28, 2004, the Company recorded a net reversal of approximately $0.4 million as a result of lower than anticipated severance and employee benefits related to this initiative. As of February 27, 2005, all of the employees had been displaced. The Company expects to incur no additional restructuring costs in connection with this initiative.
NOTE 3: GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill was $199.9 million as of February 27, 2005 and November 28, 2004. Other intangible assets were as follows:
Amortized intangible assets:
Other intangible assets
Unamortized intangible assets:
Trademarks
Amortization expense for the quarter ended February 27, 2005 and February 29, 2004 was approximately $0.3 million and $0.03 million, respectively. Future amortization expense for the next five fiscal years with respect to the Company’s finite lived intangible assets is estimated at approximately $0.5 million per year.
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NOTE 4: INCOME TAXES
The Company’s income tax provision for the three months ended February 27, 2005 was approximately $49.1 million, which includes $48.4 million of expense related to current year operations and approximately $0.7 million of period expense related to an increase in the Company’s contingent tax liabilities.
The effective income tax rate for the three months ended February 27, 2005 was 50.9%. It differs from the Company’s estimated annual effective income tax rate of 55.4% described below, due primarily to losses in certain foreign jurisdictions for which no tax benefit can be recognized for the full year. In accordance with FASB Interpretation No. 18, the Company adjusts its annual estimated effective tax rate to exclude the impact of these foreign losses. The adjusted estimated annual effective income tax rate is applied to the year-to-date pre-tax operating results, exclusive of the results in these foreign jurisdictions, to compute income tax expense for the three months ended February 27, 2005.
Estimated Annual Effective Income Tax Rate. The estimated annual effective income tax rate for 2005 differs from the U.S. federal statutory income tax rate of 35% as follows:
Income tax expense at U.S. federal statutory rate
State income taxes, net of U.S. federal impact
Impact of foreign operations
Reassessment of reserves due to change in estimate
Other, including non-deductible expenses
The “State income taxes, net of U.S. federal impact” item above primarily reflects franchise tax and minimum tax expense, net of related federal benefit, which the Company expects for the year. The Company currently has a full valuation allowance against state net operating loss carryforwards. The annual estimated effective tax rate for 2005 does not include any anticipated benefit from additional current year state tax losses.
The “Impact of foreign operations” item above reflects changes in the residual U.S. tax on unremitted foreign earnings and the Company’s expectation that foreign income taxes will be deducted rather than claimed as a credit for U.S. federal income tax purposes. Additionally, this item includes the impact of foreign income and losses incurred in jurisdictions with tax rates that are different from the U.S. federal statutory rate.
The “Reassessment of reserves due to change in estimate” item above relates primarily to changes in the Company’s estimate of its contingent tax losses. The 3.8% increase in the annual estimated effective tax rate for 2005 relates primarily to additional interest for the 2005 fiscal year of approximately $7.9 million and the accrual of an additional prior year tax liability of approximately $0.5 million. For 2004, the 6.7% increase relates to projected interest expense on the Company’s income tax reserves.
The “Other, including non-deductible expenses” item above relates primarily to items that are expensed for determining book income but that will not be deductible in determining U.S. federal taxable income.
Examination of Tax Returns. The Company has unresolved issues in its consolidated U.S. federal corporate income tax returns for the prior 19 years. A number of these tax returns and certain other state and foreign tax returns are under examination by various regulatory authorities. The Company continuously reviews issues raised in connection with these on-going examinations to evaluate the adequacy of its reserves.
During 2004, the Company reached a partial agreement with the Internal Revenue Service for the years 1990 to 1994 and paid $42.0 million in tax and interest in November 2004. The Company also received a Revenue Agent’s Report during the year for additional issues related to the 1990 to 1994 tax years. The most significant unresolved issue relating to these tax years was the subject of an unfavorable Technical Advice Memorandum from the National Office of the Internal Revenue Service with regard to certain positions taken by the Company on prior returns. The Company filed a protest with the Appeals Division of the Internal Revenue Service relating to the remaining unresolved items for these years.
During the three months ended February 27, 2005, the case has been returned by the Appeals Division to the Internal Revenue Service exam team. The Company and the Internal Revenue Service exam team have begun detailed settlement discussions for the open items included in this exam cycle as well as for all remaining items from the 1995 to 1999 audit cycle.
The Company believes that is accrued tax liabilities are adequate to cover all probable U.S. federal, state, and foreign income tax loss contingencies at February 27, 2005. However, it is reasonably possible the Company may also incur additional income tax liabilities related to prior years. The Company estimates this additional potential exposure to be approximately $23.9 million. Should the Company’s view as to the likelihood of incurring these additional liabilities change, additional income tax expense may be accrued in future periods. This $23.9 million amount has not been accrued because it currently does not meet the recognition criteria for liabilities generally accepted accounting principles in the United States.
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Reclassifications. During the three months ended February 27, 2005, the Company reclassified approximately $26.8 million of contingent tax liabilities from current to non-current. The reclassification is due in part to a decision to appeal a foreign tax ruling the Company previously expected to settle during 2005.
NOTE 5: LONG-TERM DEBT
Long-term debt is summarized below:
Long-term debt:
Secured:
Term loan
Revolving credit facility
Customer service center equipment financing (1)
Notes payable, at various rates
Subtotal
Unsecured:
Notes:
7.00%, due 2006
11.625% Dollar denominated, due 2008 (2)
11.625% Euro denominated, due 2008 (2)
12.25% Senior Notes, due 2012
9.75% Senior Notes, due 2015
Yen-denominated Eurobond 4.25%, due 2016
Current maturities
Total long-term debt
Short-term debt:
Short-term borrowings
Current maturities of long-term debt
Total short-term debt
Total long-term and short-term debt
Issuance of Senior Notes Due 2015
Principal, Interest and Maturity. On December 22, 2004, the Company issued $450.0 million in notes to qualified institutional buyers. These notes are unsecured obligations that rank equally with all of the Company’s other existing and future unsecured and unsubordinated debt. They are 10-year notes maturing on January 15, 2015 and bear interest at 9.75% per annum, payable semi-annually in arrears on January 15 and July 15, commencing on July 15, 2005. The Company may redeem some or all of the notes prior to January 15, 2010 at a price equal to 100% of the principal amount plus accrued and unpaid interest and a “make-whole” premium. Thereafter, the Company may redeem all or any portion of the notes, at once or over time, at redemption prices specified in
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the indenture governing the notes, after giving the required notice under the indenture. In addition, at any time prior to January 15, 2008, the Company may redeem up to a maximum of 33 1/3% of the original aggregate principal amount of the notes with the proceeds of one or more public equity offerings at a redemption price of 109.75% of the principal amount plus accrued and unpaid interest, if any, to the date of redemption. Costs representing underwriting fees and other expenses of approximately $10.0 million are amortized over the term of the notes to interest expense.
Use of Proceeds — Repurchase of Senior Notes Due 2006. The Company used approximately $372.1 million of the $450.0 million of gross proceeds from the notes offering to purchase approximately $372.1 million in aggregate principal amount of its 2006 notes through a tender offer. As a result, the Company has not yet met its 2006 refinancing condition contained in its senior secured term loan and senior secured revolving credit facility. The Company intends to use the remaining proceeds to repay outstanding debt (which may include any remaining 2006 notes), or for the payment of premiums, fees and expenses relating to the offering and tender offer. The Company may also elect to use these remaining proceeds for other corporate purposes consistent with the requirements of the Company’s credit agreements, indentures and other agreements.
Covenants. The indenture governing these notes contains covenants that limit the Company’s and its subsidiaries’ ability to incur additional debt; pay dividends or make other restricted payments; consummate specified asset sales; enter into transactions with affiliates; incur liens; impose restrictions on the ability of a subsidiary to pay dividends or make payments to the Company and its subsidiaries; merge or consolidate with any other person; and sell, assign, transfer, lease, convey or otherwise dispose of all or substantially all of the Company’s assets or its subsidiaries’ assets. Subsidiaries of the Company that are not wholly-owned subsidiaries, for example Japan, are permitted to pay dividends to all stockholders under these credit agreements and indentures either on a pro rata basis or on a basis that results in the receipt by the Company of dividends or distributions of greater value than it would receive on a pro rata basis.
Asset Sales. The indenture governing these notes provides that the Company’s asset sales must be at fair market value and the consideration must consist of at least 75% cash or cash equivalents or the assumption of liabilities. The Company must use the net proceeds from the asset sale within 360 days after receipt either to repay bank debt, with an equivalent permanent reduction in the available commitment in the case of a repayment under its revolving credit facility, or to invest in additional assets in a business related to its business. To the extent proceeds not so used within the time period exceed $10.0 million, the Company is required to make an offer to purchase outstanding notes at par plus accrued and unpaid interest, if any, to the date of repurchase. Any purchase or prepayment of these notes requires consent of the lenders under the Company’s senior secured term loan and senior secured revolving credit facility.
Change in Control. If the Company experiences a change in control as defined in the indenture governing the notes, then it will be required under the indenture to make an offer to repurchase the notes at a price equal to 101% of the principal amount plus accrued and unpaid interest, if any, to the date of repurchase. Any purchase or prepayment of these notes requires consent of the lenders under the Company’s senior secured term loan and senior secured revolving credit facility.
Events of Default. The indenture governing these notes contains customary events of default, including failure to pay principal, failure to pay interest after a 30-day grace period, failure to comply with the merger, consolidation and sale of property covenant, failure to comply with other covenants in the indenture for a period of 30 days after notice given to the Company, failure to satisfy certain judgments in excess of $25.0 million after a 30-day grace period, and certain events involving bankruptcy, insolvency or reorganization. The indenture also contains a cross-acceleration event of default that applies if debt of Levi Strauss & Co. or any restricted subsidiary in excess of $25.0 million is accelerated or is not paid when due at final maturity.
Covenant Suspension. If these notes receive and maintain an investment grade rating by both Standard and Poor’s and Moody’s and the Company and its subsidiaries are and remain in compliance with the indenture, then the Company and its subsidiaries will not be required to comply with specified covenants contained in the indenture.
The covenants, events of default, asset sale, change of control, covenant suspension and other terms of the notes are comparable to those contained in the indentures governing the Company’s 2012 notes, 2012 floating rate notes and 2013 Euro notes.
Subsequent Event — Issuance of 2012 Floating Rate Notes and 2013 Euro Notes and Repurchase and Redemption of Senior Notes due 2008
Floating Rate Notes Due 2012. On March 11, 2005, the Company issued $380.0 million in notes to qualified institutional buyers. These notes are unsecured obligations that rank equally with all of the Company’s other existing and future unsecured and unsubordinated debt. They are 7-year notes maturing on April 1, 2012 and bear interest at a rate per annum, reset quarterly, equal to LIBOR plus 4.75%, payable quarterly in arrears on January 1, April 1, July 1, and October 1, commencing on July 1, 2005. Starting on April 1, 2007, the Company may redeem all or any portion of the notes, at once or over time, at redemption prices specified in the indenture governing the notes, after giving the required notice under the indenture. In addition, at any time prior to April 1, 2007, the Company may redeem up to and including 100% of the original aggregate principal amount of the notes with the proceeds of one or
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more public equity offerings at a redemption price of 104% of the principal amount plus accrued and unpaid interest, if any, to the date of redemption, provided that after giving effect to any redemption of less than 100% of the notes then outstanding, at least $150.0 million aggregate principal amount of the notes remains outstanding. These notes were offered at par. Costs representing underwriting fees and other expenses of approximately $9.6 million are amortized over the term of the notes to interest expense.
The covenants, events of default, asset sale, change of control, covenant suspension and other terms of the notes are comparable to those contained in the indentures governing the Company’s 2012 notes, 2013 Euro notes and 2015 notes.
Euro Notes Due 2013. On March 11, 2005, the Company issued €150.0 million in notes to qualified institutional buyers. These notes are unsecured obligations that rank equally with all of the Company’s other existing and future unsecured and unsubordinated debt. They are 8-year notes maturing on April 1, 2013 and bear interest at 8.625% per annum, payable semi-annually in arrears on April 1 and October 1, commencing on October 1, 2005. Starting on April 1, 2009, the Company may redeem all or any portion of the notes, at once or over time, at redemption prices specified in the indenture governing the notes, after giving the required notice under the indenture. In addition, at any time prior to April 1, 2008, the Company may redeem up to a maximum of 35% of the original aggregate principal amount of the notes with the proceeds of one or more public equity offerings at a redemption price of 108.625% of the principal amount plus accrued and unpaid interest, if any, to the date of redemption. These notes were offered at par. Costs representing underwriting fees and other expenses of approximately $6.0 million are amortized over the term of the notes to interest expense.
The covenants, events of default, asset sale, change of control, covenant suspension and other terms of the notes are comparable to those contained in the indentures governing the Company’s 2012 notes, 2012 floating rate notes and 2015 notes.
Use of Proceeds — Tender Offer and Redemption of 2008 Notes. In March 2005, the Company commenced a cash tender offer for the outstanding principal amount of its senior unsecured notes due 2008. The tender offer expired March 23, 2005. The Company purchased pursuant to the tender offer $270.0 million and €89.0 million in principal amount tendered of the 2008 notes. The Company subsequently redeemed all remaining 2008 notes on April 11, 2005. Both the tender offer and redemption were funded with the proceeds from the issuance of the 2012 floating rate notes and the 2013 Euro notes. As a result, the Company believes it has met its 2008 notes refinancing condition contained in its senior secured term loan. The remaining proceeds of approximately $33.5 million and use of $16.9 million of the Company’s existing cash and cash equivalents were used to pay the fees, expenses and premiums payable in connection with the March 2005 offering, the tender offer and the redemption. The Company paid approximately $34.8 million in tender premiums and other fees and expenses and wrote off approximately $9.8 million of unamortized debt discount and issuance costs related to this tender offer and redemption.
Credit Agreement Ratios
Term Loan Leverage Ratio. The Company’s senior secured term loan contains a consolidated senior secured leverage ratio of 3.5 to 1.0, which is measured as of the end of each fiscal quarter. As of February 27, 2005, the Company was in compliance with this ratio.
Revolving Credit Facility Fixed Charge Coverage Ratio. The Company’s senior secured revolving credit facility contains a fixed charge coverage ratio of 1.0 to 1.0. The ratio is measured only if certain availability thresholds are not met. As of February 27, 2005, the Company was not required to perform this calculation.
Other Debt Matters
Debt Issuance Costs. The Company capitalizes debt issuance costs, which are included in other assets in the accompanying consolidated balance sheet. These costs were amortized using the straight-line method of amortization for all debt issuances prior to 2005. Beginning in 2005, all new debt issuance costs will be amortized using the effective interest method. Unamortized debt issuance costs at February 27, 2005 and November 28, 2004 were $61.8 million and $54.8 million, respectively. Amortization of debt issuance costs, which is included in interest expense, was $3.3 million and $2.6 million for the three months ended February 27, 2005 and February 29, 2004, respectively.
Accrued Interest. At February 27, 2005 and November 28, 2004, accrued interest was $39.7 million and $65.6 million, respectively, and is included in accrued liabilities.
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Principal Short-term and Long-term Debt Payments
The table below sets forth, as of February 27, 2005, the Company’s required aggregate short-term and long-term debt principal payments for the next five fiscal years and thereafter, after giving effect to the issuance in March 2005 of $380.0 million of 2012 floating rate notes and €150.0 million of 2013 Euro notes and the subsequent repurchase and redemption of all outstanding 2008 notes. The table also gives effect to the satisfaction of the 2008 notes refinancing condition and gives effect to the two different 2006 notes refinancing condition scenarios under the senior secured term loan:
Fiscal year
2005 (remaining nine months) (1)
2006(2)
2007
2008
2009
Thereafter
Short-term Credit Lines and Stand-by Letters of Credit
The Company’s total unused lines of credit were approximately $306.4 million at February 27, 2005.
At February 27, 2005, the Company had unsecured and uncommitted short-term credit lines available totaling approximately $13.0 million at various rates. These credit arrangements may be canceled by the bank lenders upon notice and generally have no compensating balance requirements or commitment fees.
As of February 27, 2005, the Company’s total availability of $411.0 million under its senior secured revolving credit facility was reduced by $117.6 million of letters of credit and other credit usage allocated under the Company’s senior secured revolving credit facility, yielding a net availability of $293.4 million. Included in the $117.6 million of letters of credit and other credit usage at February 27, 2005 were $11.8 million of trade letters of credit, $6.0 million of other credit usage and $99.8 million of stand-by letters of credit with various international banks, of which $80.2 million serve as guarantees by the creditor banks to cover U.S. workers compensation claims and customs bonds. The Company pays fees on the standby letters of credit, and borrowings against the letters of credit are subject to interest at various rates.
Interest Rates on Borrowings
The Company’s weighted average interest rate on average borrowings outstanding during the first quarter of 2005 and 2004, including the amortization of capitalized bank fees, interest rate swap cancellations and underwriting fees, was 10.72% and 10.63%, respectively. The weighted average interest rate on average borrowings outstanding excludes interest payable to participants under deferred compensation plans and other miscellaneous items.
Dividends and Restrictions
Under the terms of the Company’s senior secured term loan and senior secured revolving credit facility, the Company is prohibited from paying dividends to its stockholders. In addition, the terms of certain of the indentures relating to the Company’s unsecured senior notes limit the Company’s ability to pay dividends. Subsidiaries of the Company that are not wholly-owned subsidiaries, for example Japan, are permitted under these credit agreements and indentures to pay dividends to all stockholders either on a pro rata basis or on a basis that results in the receipt by the Company of dividends or distributions of greater value than it would receive on a pro rata basis. There are no restrictions under the Company’s term loan and revolving credit facility or its indentures on the transfer of the assets of the Company’s subsidiaries to the Company in the form of loans, advances or cash dividends without the consent of a third party.
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NOTE 6: FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amount and estimated fair value (in each case including accrued interest) of the Company’s financial instrument assets and liabilities at February 27, 2005 and November 28, 2004 are as follows:
Debt Instruments:
U.S. dollar notes offerings (3)
Euro notes offering (3)
Yen-denominated Eurobond placement
Customer service center equipment financing
Short-term and other borrowings
Foreign Exchange Contracts:
Foreign exchange forward contracts
Foreign exchange option contracts
The Company’s financial instruments are reflected on its books at the carrying values noted above. The fair values of the Company’s financial instruments reflect the amounts at which the instruments could be exchanged in a current transaction between willing parties, other than in a forced liquidation sale (i.e. quoted market prices). The increase in the estimated fair value of the Company’s total debt at February 27, 2005 as compared to the estimated fair value at November 28, 2004 was due primarily to higher trading prices for the Company’s publicly traded U.S. dollar notes offerings at February 27, 2005.
The Company has determined the estimated fair value of certain financial instruments using available market information and valuation methodologies. However, this determination involves application of judgment in interpreting market data, as such, the estimates presented herein are not necessarily indicative of the amounts that the Company could realize in a current market exchange. The Company uses widely accepted valuation models that incorporate quoted market prices or dealer quotes to determine the estimated fair value of its foreign exchange and option contracts. Dealer quotes and other valuation methods, such as the discounted value of future cash flows, replacement cost and termination cost have been used to determine the estimated fair value for long-term debt and the remaining financial instruments. The carrying values of cash and cash equivalents, trade receivables and short-term borrowings approximate fair value. The fair value estimates presented herein are based on information available to the Company as of February 27, 2005 and November 28, 2004.
NOTE 7: COMMITMENTS AND CONTINGENCIES
Foreign Exchange Contracts
At February 27, 2005, the Company had U.S. dollar spot and forward currency contracts to buy $619.7 million and to sell $341.0 million against various foreign currencies. These contracts are at various exchange rates and expire at various dates through July 2005. The Company has no option contracts outstanding at February 27, 2005.
The Company is exposed to credit loss in the event of nonperformance by the counterparties to the foreign exchange contracts. However, the Company believes these counterparties are creditworthy financial institutions and does not anticipate nonperformance.
Other Contingencies
Wrongful Termination Litigation. There have been no material developments in this litigation since the Company filed its 2004 Annual Report on Form 10-K on February 17, 2005. For information about the litigation, see Note 9 to the consolidated financial statements contained in such Annual Report on Form 10-K.
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Class Actions Securities Litigation. There have been no material developments in this litigation since the Company filed its 2004 Annual Report on Form 10-K on February 17, 2005. For information about the litigation, see Note 9 to the consolidated financial statements contained in such Annual Report on Form 10-K.
Comexma Litigation. On March 3, 2005, the Civil Court in the Federal District in Mexico City, Mexico entered a judgment against Levi Strauss & Co. in favor of a former contract manufacturer who had brought suit alleging that its business had suffered direct damages and harm to its reputation from an unauthorized anti-counterfeiting raid on its Mexico City facilities in June 2001.
The lawsuit, Compania Exportadora de Maquila, Comexma v. Levi Strauss & Co., et al, was brought following a raid on Comexma’s Mexico City facilities that was conducted by local police and accompanied by local media upon the initiation of the Company’s outside Mexican brand protection counsel. The local counsel failed to follow our pre-approval procedures for initiating such a raid, which required such counsel to check with the Company before going forward to confirm that the target was not an authorized contractor. No counterfeiting activity was uncovered, and the raid was terminated upon confirmation from the Company that Comexma was an authorized manufacturer. The raid occurred within a few months after the Company had notified Comexma that it was terminating its contract manufacturing relationship.
The court awarded Comexma approximately $24.5 million in direct damages and lost income, and an additional approximately $20.5 million in damages for harm to its reputation. The Company strongly disagrees with the court’s decision and has filed an appeal of the Civil Court’s judgment. On appeal, the Company seeks to have the judgment reversed or remanded for further proceedings, and, if the appellate court affirms the lower court on the issue of liability, to have the amount of the direct and additional damages reduced substantially. Based upon advice of external legal counsel in regards to the probable range of loss in the event the Company loses on appeal or otherwise does not prevail, the Company has recorded a provision during the three months ended February 27, 2005 related to this litigation that is reflected in selling, general and administrative expenses. A decision by the appellate court could be rendered as early as the next two to four months.
Other Litigation. In the ordinary course of business, the Company has various other pending cases involving contractual matters, employee-related matters, distribution questions, product liability claims, trademark infringement and other matters. The Company does not believe there are any pending legal proceedings that will have a material impact on its financial condition or results of operations.
NOTE 8: DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
The global scope of the Company’s business operations exposes it to the risk of fluctuations in foreign currency markets. The Company’s exposure results from certain product sourcing activities, some inter-company sales, foreign subsidiaries’ royalty payments, net investment in foreign operations and funding activities. The Company’s foreign currency management objective is to mitigate the potential impact of currency fluctuations on the value of its U.S. dollar cash flows. The Company typically takes a long-term view of managing exposures, using forecasts to develop exposure positions and engaging in their active management.
The Company operates a centralized currency management operation to take advantage of potential opportunities to naturally offset exposures against each other. For any residual exposures, the Company enters into spot exchange, forward exchange, cross-currency swaps and option contracts to hedge certain anticipated transactions as well as certain firm commitments, including third party and inter-company transactions. The Company manages the currency risk as of the inception of the exposure. The Company does not currently manage the timing mismatch between its forecasted exposures and the related financial instruments used to mitigate the currency risk.
The Company does not apply hedge accounting to its foreign currency derivative transactions, except for certain net investment hedging activities.
The Company primarily uses foreign exchange currency swaps to hedge the net investment in its European operations. For the contracts that qualify for hedge accounting, the related gains and losses are consequently included as cumulative translation adjustments in the “Accumulated other comprehensive loss” section of Stockholders’ Deficit. At February 27, 2005, the fair value of qualifying net investment hedges was a $2.6 million net liability with the corresponding unrealized loss recorded as a cumulative translation adjustment in the “Accumulated other comprehensive loss” section of Stockholders’ Deficit. At February 27, 2005, a $0.4 million realized loss has been excluded from hedge effectiveness testing and therefore is included in “Other income, net” in the Company’s statement of operations.
The Company designates a portion of its outstanding yen-denominated Eurobond as a net investment hedge. As of February 27, 2005, a $7.7 million unrealized loss related to the translation effects of the yen-denominated Eurobond was recorded as a cumulative translation adjustment in the “Accumulated other comprehensive loss” section of Stockholders’ Deficit.
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The table below provides data about the realized and unrealized gains and losses associated with foreign exchange management activities reported in “Other income, net.”
Foreign exchange management
The table below gives an overview of the realized and unrealized gains and losses associated with foreign exchange management activities that are reported as cumulative translation adjustments in the “Accumulated other comprehensive loss” (“Accumulated OCI”) section of Stockholders’ Deficit.
Accumulated OCI
gain (loss)
Net investment hedges
Derivative instruments
Yen Bond
Cumulative income taxes
The table below gives an overview of the fair values of derivative instruments associated with the Company’s foreign exchange management activities that are reported as an asset or (liability).
Fair value asset
(liability)
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NOTE 9: OTHER INCOME, NET
The following table summarizes significant components of other income, net:
Three months endedFebruary 27.
2005
Three months endedFebruary 29,
2004
Foreign exchange management contracts (income) losses
Foreign currency transaction gains
Interest income
Minority interest - Levi Strauss Japan K.K.
Minority interest - Levi Strauss Istanbul Konfeksiyon (1)
Other
The Company uses foreign exchange management contracts such as forward, swap and option contracts, to manage foreign currency exposures. These derivative instruments are recorded at fair value and the changes in fair value are recorded in other expense, net.
Foreign currency transactions are transactions denominated in a currency other than the entity’s functional currency. At the date the foreign currency transaction is recognized, each asset, liability, revenue, expense, gain or loss arising from the transaction is measured and recorded in the functional currency of the recording entity using the exchange rate in effect at that date. At each balance sheet date for each entity, recorded balances denominated in a foreign currency are adjusted, or remeasured, to reflect the current exchange rate. The changes in the recorded balances caused by remeasurement at the exchange rate are recorded in other expense, net.
The Company’s interest income primarily relates to investments in certificates of deposit, time deposits and commercial paper with original maturities of three months or less. The increase in interest income in 2005 as compared to 2004 was primarily due to a higher average investment balance in the first three months of 2005 compared to the first three months of 2004.
NOTE 10: EMPLOYEE BENEFIT PLANS
Pension and Post-retirement Plans. The following table summarizes the components of net periodic benefit cost (income) for the Company’s defined benefit pension plans and post-retirement benefit plans for the three months ended February 27, 2005 and February 29, 2004:
Service cost
Interest cost
Expected return on plan assets
Amortization of prior service cost (gain)
Amortization of transition asset
Amortization of actuarial loss
Net curtailment loss (gain)
Net periodic benefit cost (income)
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Senior Executive Long-Term Incentive Plan. The Company established a new executive compensation plan at the beginning of fiscal 2005. The plan is intended to provide long-term incentive compensation for the Company’s senior management. The Company’s executive officers and non-employee members of the board are eligible to participate in the plan.
Key elements of the plan include the following:
On March 9, 2005, the Human Resources Committee approved target awards under the plan for the first performance cycle. A total of 215,587 shares were granted at a strike price of $54.00 per share. The three year expected appreciation is $60.00 per share, or $12.9 million.
NOTE 11: COMPREHENSIVE INCOME (LOSS)
The following is a summary of the components of total comprehensive income (loss), net of related income taxes:
Other comprehensive income (loss):
Net investment hedge gains (losses)
Foreign currency translation (losses) gains
Decrease in minimum pension liability
Total other comprehensive income (loss)
The following is a summary of the components of accumulated other comprehensive income (loss), net of related income taxes:
Net investment hedge losses
Foreign currency translation losses
Additional minimum pension liability
Accumulated other comprehensive loss, net of income taxes
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NOTE 12: BUSINESS SEGMENT INFORMATION
During 2004, the Company changed the structure of its U.S. business operations as a result of its reorganization initiatives. The Company’s business operations in the United States are now organized and managed principally through Levi’s®, Dockers® and Levi Strauss Signature™ commercial business units. The Company’s operations in Canada and Mexico are included in its North America region along with its U.S. commercial business units. The structure of its international business operations have not changed. They are organized and managed through its Europe and Asia Pacific regions. The Company’s Europe region includes Eastern and Western Europe; Asia Pacific includes Asia, the Middle East, Africa and Central and South America. Each of the business segments is managed by a senior executive who reports directly to the Company’s chief executive officer. The Company manages its business operations, evaluates performance and allocates resources based on the operating income of its segments, excluding restructuring charges, net of reversals, and excluding depreciation and amortization. Corporate expense is comprised of long-term incentive compensation expense, restructuring charges, net of reversals, and other corporate expenses, including corporate staff costs.
As a result of the changes in the Company’s reportable segments, the information for prior year has been revised to conform to the current presentation. No single country other than the United States had net sales exceeding 10.0% of consolidated net sales for any of the periods presented. The Company does not report assets by segment because assets are not allocated to its segments for purposes of measurement by the Company’s chief operating decision maker.
Business segment information for the Company is as follows:
Net sales:
U.S. Levi’s® brand
U.S. Dockers® brand
U.S. Levi Strauss Signature™ brand
Canada and Mexico
Total North America
Europe
Asia Pacific
Consolidated net sales
Operating income:
Regional operating income
Corporate:
Other corporate expense
Total corporate expense
Consolidated operating income
Income (loss) before income taxes
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NOTE 13: SUBSEQUENT EVENTS
Issuance of Floating Rate Notes Due 2012 and Euro Notes Due 2013. On March 11, 2005, the Company issued $380.0 million of 2012 floating rate notes and €150.0 million of 2013 Euro notes to qualified institutional buyers and subsequently repurchased or redeemed all outstanding 2008 notes (See also Note 5 to the consolidated financial statements).
Acquisition of Minority Interest in Turkey Joint Venture. On March 31, 2005, the Company acquired the 49% minority interest of its joint venture in Turkey for cash. The Company will account for the acquisition in its second quarter of fiscal 2005 using the purchase method, as prescribed by Financial Accounting Standards Board Statement No. 141, “Business Combinations”. The Company is currently assessing the impact of applying the purchase method to this acquisition. However, because the Company has been accounting for the joint venture using the consolidation method, the Company does not believe that the acquisition will have a material impact on its financial condition or results of operations.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Introduction
Overview. We are one of the world’s leading branded apparel companies, with sales in more than 110 countries. We design and market jeans and jeans-related pants, casual and dress pants, tops, jackets and related accessories for men, women and children under our Levi’s®, Dockers® and Levi Strauss Signature™ brands. We also license our trademarks in various countries throughout the world for accessories, pants, tops, footwear, home and other products.
Our net sales for the three months ended February 27, 2005 were $1.0 billion. Net sales for the quarter by region and by brand were as follows:
We distribute our Levi’s® and Dockers® products primarily through chain retailers and department stores in the U.S. and primarily through department stores and specialty retailers abroad. We also distribute Levi’s® and Dockers® products through independently-owned franchised stores outside the U.S. and through a small number of company-owned stores located in the U.S., Europe and Asia. We distribute our Levi Strauss Signature™ products through mass channel retailers worldwide including Wal-mart, Kmart and Target Stores in the United States and Carrefour and ASDA-Wal-Mart abroad.
Our business is organized into three geographic regions. The following tables provide net sales and operating income for those regions and for our corporate group for the three months ended February 27, 2005:
Region and Geographies
North America (U.S., Canada and Mexico)
Asia Pacific (Asia, Middle East, Africa and South America)
Corporate
Our Results. Results of operations for the three months ended February 27, 2005 are summarized as follows:
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Going into the balance of the year, we expect challenging business conditions in the United States in view of an uncertain and uneven retail environment, continued retailer consolidation (such as the recent Sears Roebuck & Co/Kmart Corporation merger and the proposed Federated Department Stores, Inc./May Department Stores Co. merger) and the impact of rising gasoline prices and interest rates on consumer demand.
Our Directors and Senior Management. On February 3, 2005, we elected Leon J. Level to our board of directors, effective as of April 1, 2005. Mr. Level serves on our audit and finance committees. On March 7, 2005, Hans Ploos van Amstel replaced James P. Fogarty as our senior vice president and chief financial officer.
Comexma Litigation. On March 3, 2005, the Civil Court in the Federal District in Mexico City, Mexico entered a judgment against us in favor of a former contract manufacturer who had brought suit alleging that its business had suffered direct damages and harm to its reputation from an unauthorized anti-counterfeiting raid on its Mexico City facilities in June 2001. The court awarded Comexma approximately $24.5 million in direct damages and lost income, and an additional approximately $20.5 million in damages for harm to its reputation. We strongly disagree with the court’s decision and have filed an appeal seeking to have the judgment reversed or remanded for further proceedings, and, if the appellate court affirms the lower court on the issue of liability, to have the amount of the direct and additional damages reduced substantially. For more information, see “Part II – Other Information - Item I - Legal Proceedings”.
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Our Financing Arrangements. During fiscal 2005 we made several significant changes in our financing arrangements:
For more information regarding our financing activities, please see “Indebtedness.”
Our Liquidity. As of April 3, 2005, our total availability under our amended senior secured revolving credit facility was approximately $413.1 million. We had no outstanding borrowings under this facility, but had utilization of other credit-related instruments such as documentary and standby letters of credit. Our unused availability was approximately $299.7 million. In addition, we had liquid short-term investments in the United States totaling approximately $77.6, resulting in a net liquidity position (availability and liquid short-term investments) of $377.3 million in the United States.
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Results of Operations
Three Months Ended February 27, 2005 as Compared to Same Period in 2004
The following table summarizes, for the periods indicated, items in our consolidated statements of operations, the changes in these items period to period and these items expressed as a percentage of net sales.
Consolidated net sales increased 4.5% and, on a constant currency basis, increased 2.4%.
The following table shows our net sales for our North America, Europe and Asia Pacific businesses and the changes in these results period to period.
North America
Total net sales
North America net sales decreased 1.2%.
The following table presents our net sales in our North America region broken out for our U.S. brands and for Canada and Mexico, including changes in these results period to period.
U.S. Levi Strauss Signature ™ brand
Total North America net sales
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The following discussion summarizes net sales performance during the first three months of 2005 of our U.S. brands. In these sections, the tables showing net sales for the Levi’s® and Dockers® brands break out net sales between “Licensed Categories” and “Continuing Categories.”
We believe this presentation is useful to the reader because it shows the impact of product category licensing on our net sales. We expect our revenues from “licensed categories” to decrease and our revenues from royalty payments to increase. We present this data only for our U.S. Levi’s® and Dockers® brands because there has been no significant licensing of product categories that we have marketed and sold ourselves in our U.S. Levi Strauss Signature™ brand or in our Europe and Asia Pacific businesses.
Levi’s® Brand. The following table shows net sales of our U.S. Levi’s® brand, including the changes in these results period to period.
U.S. Levi’s® brand - Continuing categories
U.S. Levi’s® brand - Licensed categories
Total U.S. Levi’s ® brand net sales
Net sales in our U.S. Levi’s® brand for the three months ended February 27, 2005 decreased 5.4% as compared to the same period in 2004. The decrease was driven by our product rationalization actions and the related decisions to license certain product categories and discontinue underperforming categories. These actions were initiated in fiscal 2004 in line with our strategy to focus the brand on more category competitive products in our core channels of distribution and improve our profitability. Our decision to license certain products resulted in an approximately $17.1 million decrease in net sales in the 2005 period, while net sales for our continuing categories increased approximately $1.2 million or 0.4%.
Key operational results for the three months ended February 27, 2005 were as follows:
We continue to focus on increasing sales and profits in our core jeans business, including young men’s products such as workwear, low-rise and boot-cut fits with premium finishes, and in driving consumer awareness and demand in a challenging and uneven retail environment with our marketing campaigns.
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Dockers® Brand. The following table shows net sales of our U.S. Dockers® brand, including changes in these results for the three months ended February 27, 2005 compared to the same period in 2004.
U.S. Dockers® brand - Continuing categories
U.S. Dockers® brand - Licensed categories
U.S. Dockers® brand - Discontinued Slates® pants
Total U.S. Dockers ® brand net sales
Net sales in our U.S. Dockers® brand for the first three months of 2005 increased 3.8% as compared to the same period in 2004. The increase was primarily due to the following factors:
Partially offsetting these factors were continued weakness in our women’s business, which continues to reflect the impact from a consumer shift to products featuring more fashion and style. Also offsetting these factors was the impact of our product rationalization efforts initiated in early 2004 which led to a number of strategic actions, including licensing of our women’s tops and boys businesses, and exiting our Slates® dress pants business. This is the last period for which we expect there to be a material impact from these actions in our year-over-year comparisons.
Levi Strauss Signature™ Brand. Net sales in our U.S. Levi Strauss Signature™ brand for the first three months of 2005 increased 1.0% as compared to the same period in 2004. The increase was primarily driven by our addition of the Kmart, Shopko, Meijer and Pamida accounts in the second half of 2004, partially offset by a retail fixture fill for the Target account launch in the first quarter of 2004.
We continue to focus on delivering our core and trend core products to support the remainder of the Spring selling season, and maintaining proper in-stock inventory levels at retail.
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Europe net sales increased 9.8% and, on a constant currency basis, increased 4.5%.
The following table presents our net sales in our Europe region broken out for our brands including changes in these results for the three months ended February 27, 2005 compared to the same period in 2004.
Europe Levi’s® brand
Europe Dockers® brand
Europe Levi Strauss Signature ™ brand
Total Europe net sales
Levi’s® Brand. Net sales for our Levi’s® brand in Europe for the three months ended February 27, 2005 increased 9.2% on a constant currency basis. The increase was driven primarily by our repositioning of the brand across Europe and a change in our spring/summer sell-in calendar. The repositioning consisted of the development of a new Levi’s® brand architecture, with a more premium priced and focused product line, and the elimination of lower price point and unprofitable products. We plan to drive the repositioning through a major advertising campaign which began in February 2005 consisting of cinema, television, print and outdoor advertising. In addition, our net sales were favorably affected by our implementation of a new sell-in calendar which resulted in earlier shipments of our Spring/Summer products in 2005 as compared to 2004.
Dockers® Brand. Net sales for our Dockers® brand in Europe for the three months ended February 27, 2005 decreased 23.6% on a constant currency basis. The decrease was driven by weak demand in the retail replenishment business due to soft consumer demand, poor customer service and order fulfillment performance and the impact of our reorganization of the Dockers® business in Europe. As previously disclosed, we are in the process of developing a new business model and marketing program for the brand, including closing down our former headquarters in Amsterdam and consolidating operations in our offices in Brussels, rationalizing our product lines, focusing on improving the profitability of the brand and developing actions to improve our customer service performance.
Levi Strauss Signature™ Brand. Net sales for our Levi Strauss Signature ™ brand in Europe for the three months ended February 27, 2005 decreased 27.3% on a constant currency basis. The decrease reflects the impact of the volume shipped in the first quarter of 2004 when we filled retail fixtures for the initial launch of the Levi Strauss Signature™ brand in the United Kingdom, Germany and France. In addition, net sales of the brand have been impacted by weak demand in the retail replenishment business as major retailers are in the process of more tightly managing their inventory positions. We expect to continue to introduce our brand to other countries in Europe in late 2005.
Asia Pacific net sales increased 18.1% and, on a constant currency basis, increased 13.7%.
The following table presents our net sales in our Asia Pacific region broken out for our brands, including changes in these results for the three months ended February 27, 2005 compared to the same period in 2004.
Asia Pacific Levi’s® brand
Asia Pacific Dockers® brand
Asia Pacific Levi Strauss Signature ™ brand
Total Asia Pacific net sales
Our Asia Pacific region realized a 13.7% increase in net sales on a constant currency basis for the three months ended February 27, 2005, compared with the same period in 2004. The net sales increase was driven by a 15.4% increase in net sales on a constant currency basis for our Levi’s® brand products, which represent 95% of our business in our Asia Pacific region. A key driver of the increase was a more favorable mix of higher priced premium Levi’s® brand products and the sales performance of our Levi’s® LadyStyle products. Net sales increased in most countries in the region, with the exception of Australia, Indonesia, Philippines and Singapore, which were affected by soft retail conditions in those countries. Japan, which represents our largest business in Asia Pacific with approximately 41% of regional net sales for the first three months of 2005, had a 4.0% increase in net sales as compared to the same period in 2004 on a constant currency basis.
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Gross profit increased 19.2%. Gross margin was 48.4%, reflecting an increase of 6.0 percentage points.
Factors that increased our gross profit included:
Our gross margin increased primarily due to a favorable mix of more profitable first quality products and sales in our core channels of distribution, higher sales from our international businesses, lower returns and sales allowances, lower sourcing costs reflecting the closure of our remaining North America manufacturing plants and the shift of production to lower cost sources, and a lower proportion of sales of marked-down obsolete and excess products, particularly in the United States. The increase was partially offset by the lower gross margin on Levi Strauss Signature™ products.
Our cost of goods sold is primarily comprised of cost of materials, labor and manufacturing overhead and also includes the cost of inbound freight, internal transfers, and receiving and inspection at manufacturing facilities as these costs vary with product volume. We include substantially all the costs related to receiving and inspection at distribution centers, warehousing and other activities associated with our distribution network in selling, general and administrative expenses. Our gross margins may not be comparable to those of other companies in our industry, since some companies may include costs related to their distribution network in cost of goods sold.
Our 48.4% gross margin in the current period is not necessarily indicative of our expected gross margin percentage for the year. We currently expect our full-year gross margin to be in the mid-40% range.
Selling, general and administrative expenses increased 6.7%. As a percentage of net sales, selling, general and administrative expenses were 30.7% of sales, reflecting an increase of 0.6 percentage points.
Various factors contributed to the increase in our selling, general and administrative expenses:
In addition, we recorded a charge during the period related to the establishment of a reserve for litigation which also contributed to the increase.
These increases were partially offset by lower salaries and wages and related expenses due to the impact of reduced headcount resulting from our reorganization initiatives in the United States and Europe and the effect of general cost controls.
Selling, general and administrative expenses also include distribution costs, such as costs related to receiving and inspection at distribution centers, warehousing, shipping, handling and certain other activities associated with our distribution network. These expenses totaled $54.0 million (5.4% of consolidated net sales) in the three-month period ended February 27, 2005 as compared to
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$55.3 million (5.7% of consolidated net sales) in the three-month period ended February 29, 2004. U.S. distribution expenses totaled $31.6 million (6.2% of net sales in the United States) and $32.3 million (6.2% of net sales in the United States) for the first three months of 2005 and 2004, respectively.
Long-term incentive compensation expense was $5.6 million as compared to $12.2 million in 2004.
The $6.6 million decrease in our long-term incentive compensation expense relates primarily to the adoption in 2005 of new long-term incentive compensation plans for which the performance measurement period is three years as compared to eighteen months for our 2004 interim plan.
Other operating income increased $5.1 million, or 59.6% as compared to 2004.
Other operating income is comprised of royalty income we generate through licensing our trademarks in connection with the manufacturing, advertising, distribution and sale of products by third-party licensees. During the three months ended February 27, 2005, royalty income increased $5.1 million as compared to the three month period ended February 29, 2004. The increase was attributable primarily to our decision to license additional Levi’s® and Dockers® brand product categories, an increase in the number of licensees, and increased sales by licensees of accessories and sportswear, partially offset by decreased sales by licensees of footwear and the termination of a license in Europe.
Restructuring charges, net of reversals, were $3.2 million as compared to $54.4 million in 2004.
We recorded net restructuring charges of $3.2 million in the three months ended February 27, 2005. These charges relate to current period activities associated with our 2004 U.S. and Europe reorganization initiatives. Restructuring charges, net of reversals, in the prior comparable period were $54.4 million, of which $42.8 million represented costs associated with the indefinite suspension of an enterprise resource planning system installation and $11.6 million represented additional charges related to our 2003 U.S. and Europe organizational changes and North American sewing and finishing plant closures.
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Operating income increased 203.0%. Operating margin was 18.3%, reflecting an increase of 12.0 percentage points.
The following table shows our operating income by brand in the United States and in total for our North America, Europe and Asia Pacific regions, the changes in results from the three month period ended February 29, 2004 to the three month period ended February 27, 2005 and results presented as a percentage of net sales:
$ Increase
(Decrease)
February 27,2005
% of Region Net
Sales
February 29,
Canada, Mexico and Latin America (all brands)
North America (all brands)
Europe (all brands)
Asia Pacific (all brands)
Depreciation and amortization expense
Total operating income
The increase in operating income period to period is primarily attributable to higher regional operating income, lower long-term incentive compensation expense and lower restructuring charges, net of reversals.
Regional Summaries. The following summarizes the changes in operating income by region:
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Other corporate expense. We reflect annual incentive compensation plan costs for corporate employees, post-retirement medical benefit plan curtailment gains, and corporate staff costs in other corporate expense. Other corporate expense was relatively flat compared to the prior period. Lower corporate staff costs that were attributable to our restructuring and cost cutting initiatives were offset by higher annual incentive costs, the prior period $16.4 million curtailment gain related to our post-retirement medical plan and a charge related to the establishment of a reserve for our litigation. The increase in our annual incentive costs are primarily due to the fact that, in the current period, we accrued at a higher rate relative to expected company performance compared to the same period in the prior year. In addition, we incurred approximately $0.8 million of corporate charges in 2005 related to the 2004 plan payout.
The following table summarizes significant components of other corporate expense:
Annual incentive compensation plan - corporate employees
Post-retirement medical benefit plan curtailment gain
Corporate staff costs and other expense
Total other corporate expense
Interest expense was relatively flat.
Interest expense for the three months ended February 27, 2005 was relatively flat compared to the first three months ended February 29, 2004. Higher average debt balances and higher average borrowing rates in the current period were offset by approximately $2.8 million of interest on customs and duties recorded in the prior comparable period. The weighted average interest rate on average borrowings outstanding during the first three months of 2005 and 2004, including the amortization of debt issuance costs and interest rate swap cancellations, was 10.72% and 10.63%, respectively.
Loss on early extinguishment of debt was $23.0 million in 2005.
During the three months ended February 27, 2005, we recorded a $23.0 million loss on early extinguishment of debt as a result of our debt refinancing activities during the period. The loss was comprised of a tender offer premium and other fees and expenses approximating $19.7 million incurred in conjunction with our completion in January 2005 of a tender offer to repurchase $372.1 million of our 2006 notes and the write-off of approximately $3.3 million of unamortized debt discount and capitalized costs related to such notes.
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Other income, net was $4.0 million as compared to $1.6 million in 2004.
Foreign exchange management contracts (gains) losses
We use foreign exchange management contracts such as forward, swap and option contracts, to manage foreign currency exposures. Outstanding derivative instruments are recorded at fair value and the changes in fair value are recorded in “other expense, net”. At contract maturity, the realized gain or loss related to derivative instruments is also recorded in “other expense, net”. The decrease in foreign exchange management contract losses was due to changes in outstanding exposures under management and changes in foreign currency exchange rates.
Foreign currency transactions are transactions denominated in a currency other than the recording entity’s functional currency. At the date the foreign currency transaction is recognized, each asset, liability, revenue, expense, gain or loss arising from the transaction is measured and recorded in the functional currency of the recording entity using the exchange rate in effect at that date. At each balance sheet date for each entity, recorded balances denominated in a foreign currency are adjusted, or remeasured, to reflect the current exchange rate. The changes in the recorded balances caused by remeasurement at the exchange rate are recorded in “other expense, net”. For 2005 and 2004, the net gains, were caused by remeasurement of foreign currency denominated balances at the exchange rates existing at the balance sheet dates. For more information, see “Item 3 – Quantitative and Qualitative Disclosures About Market Risk”.
The increase in interest income was primarily due to a higher average cash investment balance in the first three months of 2005 compared to the first three months of 2004.
Income tax expense increased by $52.7 million.
Income tax expense was $49.1 million for the first three months of 2005 compared to an income tax benefit of $3.6 million for the same period in 2004. The increase was driven primarily by $96.4 million in income before taxes in 2005 as compared to a $5.9 million loss before taxes in 2004.
The effective tax rate for the three months ended February 27, 2005 is 50.9%. It differs from the estimated annual effective tax rate of 55.4% due primarily to losses in certain foreign jurisdictions for which no tax benefit can be recognized for the full year and certain period costs. In accordance with FASB Interpretation No. 18, we adjust our annual estimated effective tax rate of 55.4% to eliminate the impact of these foreign losses. Our estimated effective tax rate for 2005 is based on current full-year forecasts of income or losses in domestic and foreign jurisdictions. To the extent the forecasts change in total, or by taxing jurisdiction, the effective tax rate may be subject to change.
We have unresolved issues in our consolidated U.S. federal corporate income tax returns for the prior 19 years. A number of these tax returns and certain other state and foreign tax returns are under examination by various regulatory authorities. We continuously review issues raised in connection with these on-going examinations to evaluate the adequacy of our reserves.
During 2004, we reached a partial agreement with the Internal Revenue Service for the years 1990 to 1994 and paid $42.0 million in tax and interest in November 2004. We also received a Revenue Agent’s Report during the year for additional issues related to the 1990 to 1994 tax years. The most significant unresolved issue relating to these tax years was the subject of an unfavorable Technical Advice Memorandum from the National Office of the Internal Revenue Service with regard to certain positions taken by us on prior returns. We filed a protest with the Appeals Division of the Internal Revenue Service relating to the remaining unresolved items for these years.
During the three months ended February 27, 2005, the case has been returned by the Appeals Division to the Internal Revenue Service exam team. We and the Internal Revenue Service exam team have begun detailed settlement discussions for the open items included in this exam cycle as well as for all remaining items from the 1995 to 1999 audit cycle.
We believe that our accrued tax liabilities are adequate to cover all probable U.S. federal, state, and foreign income tax loss contingencies at February 27, 2005. However, it is reasonably possible we may also incur additional income tax liabilities related to prior years. We estimate this additional potential exposure to be approximately $23.9 million. Should our view as to the likelihood of incurring these additional liabilities change, additional income tax expense may be accrued in future periods. This $23.9 million amount has not been accrued because it currently does not meet the recognition criteria for liabilities generally accepted accounting principles in the United States.
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During the three months ended February 27, 2005, we reclassified approximately $26.8 million of contingent tax liabilities from current to non-current. The reclassification is due in part to a decision to appeal a foreign tax ruling we previously expected to settle during 2005.
Net income was $47.3 million, compared to a net loss of $2.4 million in 2004.
The increase in net income in the three months ended February 27, 2005 was due primarily to higher gross profit, increased royalty income, lower restructuring costs and the realization of a $3.0 million gain on foreign exchange management contracts compared to a $14.4 million loss in the prior comparable period. These increases were partially offset by higher selling, general and administrative expenses and a $23.0 million loss on early extinguishment of debt related to our refinancing activities.
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Liquidity and Capital Resources
Liquidity Outlook
We believe we will have adequate liquidity in 2005 to operate our business and to meet our cash requirements. We believe that we will be in compliance with the financial covenants contained in our senior secured term loan and our senior secured revolving credit facility.
Cash Sources
Our key sources of cash include earnings from operations and borrowing availability under our senior secured revolving credit facility. As of February 27, 2005, we had total cash and cash equivalents of approximately $223.1 million, a $76.5 million decrease from the $299.6 million cash balance as of November 28, 2004. The decrease was primarily driven by a change in certain working capital accounts and the impact of the December 2004 and January 2005 refinancing actions and interest payments, partially offset by higher operating income and reduced trade receivables.
As of February 27, 2005, our total availability under our amended senior secured revolving credit facility was approximately $411.0 million. We had no outstanding borrowings under this facility, but had utilization of other credit-related instruments such as documentary and standby letters of credit. Our unused availability was approximately $293.4 million. In addition, we had liquid short-term investments in the United States totaling approximately $80.1 million, resulting in a net liquidity position (availability and liquid short-term investments) of $373.5 million in the United States.
As of April 3, 2005, our total availability under our amended senior secured revolving credit facility was approximately $413.1 million. We had no outstanding borrowings under this facility, but had utilization of other credit-related instruments such as documentary and standby letters of credit. Our unused availability was approximately $299.7 million. In addition, we had liquid short-term investments in the United States totaling approximately $77.6 million, resulting in a net liquidity position (availability and liquid short-term investments) of $377.3 million in the United States.
Cash Uses
Our principal cash requirements include working capital, payments of interest on our debt, payments of taxes, payments for U.S. pension and post-retirement health benefit plans, capital expenditures and cash restructuring costs. We expect to have the following selected cash requirements in the remainder of 2005 and first three months of fiscal 2006:
Selected Cash Requirements
Projected
for first three
months of fiscal2006
Restructuring activities
Federal, foreign and state taxes (net of refunds) (1)
Prior years’ income tax liabilities, net (2)
Post-retirement health benefit plans
Capital expenditures
Pension plans
Total selected cash requirements
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The information in the table above reflects our estimates of future cash payments. These estimates and projections are based upon assumptions that are inherently subject to significant economic, competitive, legislative and other uncertainties and contingencies, many of which are beyond our control. Accordingly, our actual expenditures and liabilities may be materially higher or lower than the estimates and projections reflected in this table. The inclusion of these projections and estimates should not be regarded as a representation by us that the estimates will prove to be correct.
Off-Balance Sheet Arrangements, Guarantees and Other Contingent Obligations
Off-Balance Sheet Arrangements. We have no material off-balance sheet debt obligations or unconditional purchase commitments other than operating lease commitments.
Indemnification Agreements. In the ordinary course of our business, we enter into agreements containing indemnification provisions under which we agree to indemnify the other party for specified claims and losses. For example, our trademark license agreements, real estate leases, consulting agreements, logistics outsourcing agreements, securities purchase agreements and credit agreements typically contain these provisions. This type of indemnification provision obligates us to pay certain amounts associated with claims brought against the other party as the result of trademark infringement, negligence or willful misconduct of our employees, breach of contract by us including inaccuracy of representations and warranties, specified lawsuits in which we and the other party are co-defendants, product claims and other matters. These amounts are generally not readily quantifiable: the maximum possible liability or amount of potential payments that could arise out of an indemnification claim depends entirely on the specific facts and circumstances associated with the claim. We have insurance coverage that minimizes the potential exposure to certain of these claims. We also believe that the likelihood of substantial payment obligations under these agreements to third parties is low and that any such amounts would be immaterial.
Cash Flows
The following table summarizes, for the three months ended February 27, 2005 and February 29, 2004, selected items in our consolidated statements of cash flows:
Cash (used for) provided by operating activities
Cash used for investing activities
Cash provided by (used for) financing activities
Cash used for operating activities was $80.6 million for the three months ended February 27, 2005 compared to cash provided by operating activities of $11.5 million for the same period in 2004.
The increase in cash used for operating activities was primarily due to the following factors:
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Factors that partially offset these increases were as follows:
Cash used for investing activities was $4.7 million for the three months ended February 27, 2005, compared to $10.0 million for the same period in 2004.
The decrease resulted primarily from lower realized losses on net investment hedges and was partially offset by an increase in investments in information technology systems, due in part to our decision to build an internal infrastructure in Asia with the installation of a worldwide enterprise resource planning system.
Cash provided by financing activities was $8.5 million for the three months ended February 27, 2005 compared to cash used for financing activities of $5.4 million for the same period in 2004.
Cash provided by financing activities primarily reflected our issuance of $450.0 million in 9.75% unsecured notes due 2015. The increase was largely offset by the repayment of $372.1 million in aggregate principal amount of our 2006 notes, the payment of debt issuance costs of approximately $10.4 million and the full repayment of the remaining principal outstanding under our customer service center equipment financing agreement of $55.9 million. Cash used for financing activities of $5.4 million in the prior comparable period primarily reflected required payments on the equipment financing and senior secured term loan as well as repayments on short-term borrowings.
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Indebtedness
Overview
The following table shows our debt and cash and cash equivalents as of February 27, 2005, and after giving effect to our issuance in March 2005 of $380.0 million floating rate notes due 2012 and €150.0 million Euro notes due 2013, our subsequent repurchase and redemption of all outstanding senior notes due 2008 and our payment of tender offer and redemption premiums of approximately $34.0 million. After giving effect to these items, our debt, net of cash on hand, was $2.2 billion as of February 27, 2005, compared with $2.0 billion as of November 28, 2004:
Dollars in thousands
Long-Term Debt:
11.625% Dollar denominated, due 2008
11.625% Euro denominated, due 2008
12.25% senior notes, due 2012
9.75% senior notes, due 2015
Floating rate notes due 2012
8.625% Euro notes, due 2013
Short-Term Debt:
As of February 27, 2005, we had fixed rate debt of approximately $2.0 billion (87% of total debt) and variable rate debt of approximately $0.3 billion (13% of total debt). As of February 27, 2005, after giving effect to our March and April 2005 financing actions, our fixed rate debt would have been approximately $1.7 billion (72% of debt) and our variable rate debt would have been approximately $0.7 billion (28% of debt). The borrower of substantially all of our debt is Levi Strauss & Co., our parent and U.S. operating company.
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Principal Payments
The table below sets forth, as of February 27, 2005, the required aggregate short-term and long-term debt principal payments for the next five fiscal years and thereafter, giving effect to our issuance in March 2005 of $380.0 million floating rate notes due 2012 and €150.0 million Euro notes due 2013 and our subsequent repurchase and redemption of all outstanding senior notes due 2008. The table also gives effect to the satisfaction of the 2008 notes refinancing condition and the different 2006 notes refinancing condition scenarios under our senior secured term loan.
Term Loan Leverage Ratio. Our senior secured term loan contains a consolidated senior secured leverage ratio of 3.5 to 1.0, which is measured as of the end of each fiscal quarter. As of February 27, 2005, we were in compliance with this ratio.
Revolving Credit Facility Fixed Charge Coverage Ratio. Our senior secured revolving credit facility contains a fixed charge coverage ratio of 1.0 to 1.0. The ratio is measured only if certain availability thresholds are not met. As of February 27, 2005, we were not required to perform this calculation.
See Note 5 to our consolidated financial statements for further discussion of our indebtedness as of February 27, 2005 and our refinancing activities during and subsequent to the three months ended February 27, 2005.
Other Sources of Financing
We are a privately held corporation. Historically, we have primarily relied on cash flow from operations, borrowings under our credit facilities, issuances of notes and other forms of debt financing. We regularly explore our financing and debt reduction alternatives, including new credit agreements, equipment and real estate financing, equity financing, securitizations and unsecured and secured note issuances.
Effects of Inflation
We believe that inflation in the regions where most of our sales occur has not had a significant effect on our net sales or profitability.
Foreign Currency Translation
The functional currency for most of our foreign operations is the applicable local currency. For those operations, assets and liabilities are translated into U.S. dollars using period-end exchange rates and income and expense accounts are translated at average monthly exchange rates. The U.S. dollar is the functional currency for foreign operations in countries with highly inflationary economies and certain other subsidiaries. The translation adjustments for these entities are included in “Other income, net.”
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Critical Accounting Policies and Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and the related notes. We believe that the following discussion addresses our critical accounting policies, which are those that are most important to the portrayal of our financial condition and results and require management’s most difficult, subjective and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Changes in such estimates, based on more accurate future information, or different assumptions or conditions, may affect amounts reported in future periods.
We summarize our critical accounting policies below.
Revenue recognition. We recognize revenue on sale of product when the goods are shipped and title passes to the customer provided that: there are no uncertainties regarding customer acceptance; persuasive evidence of an arrangement exists; the sales price is fixed or determinable; and collectibility is probable. Revenue is recognized when the sale is recorded net of an allowance for estimated returns, discounts and retailer promotions and incentives.
We recognize allowances for estimated returns, discounts and retailer promotions and incentives in the period when the sale is recorded. Allowances principally relate to U.S. operations and primarily reflect price discounts, non-volume-based incentives and other returns and discounts. We estimate non-volume-based allowances by considering customer and product-specific circumstances and commitments, as well as historical customer claim rates. Actual allowances may differ from estimates due to changes in sales volume based on retailer or consumer demand and changes in customer and product-specific circumstances.
Inventory valuation. We value inventories at the lower of cost or market value. Inventory costs are based on standard costs on a first-in first-out basis, which are updated periodically and supported by actual cost data. We include materials, labor and manufacturing overhead in the cost of inventories. In determining inventory market values, substantial consideration is given to the expected product selling price. We consider various factors, including estimated quantities of slow-moving and obsolete inventory, by reviewing on-hand quantities, outstanding purchase obligations and forecasted sales. We then estimate expected selling prices based on our historical recovery rates for sale of slow-moving and obsolete inventory and other factors, such as market conditions and current consumer preferences. Estimates may differ from actual results due to the quantity, quality and mix of products in inventory, consumer and retailer preferences and economic conditions.
Restructuring reserves. Upon approval of a restructuring plan by management with the appropriate level of authority, we record restructuring reserves for certain costs associated with plant closures and business reorganization activities as they are incurred or when they become probable and estimable. Restructuring costs associated with initiatives commenced prior to January 1, 2003 were recorded in compliance with Emerging Issues Task Force No. 94-3 and primarily include employee severance, certain employee termination benefits, such as outplacement services and career counseling, and resolution of contractual obligations.
For initiatives commenced after December 31, 2002, we recorded restructuring reserves in compliance with Statement of Financial Accounting Standards No. (“SFAS”) 112, “Employers’ Accounting for Postemployment Benefits,” and SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities,” resulting in the recognition of employee severance and related termination benefits for recurring arrangements when they become probable and estimable and on the accrual basis for one-time benefit arrangements. We record other costs associated with exit activities as they are incurred. Employee severance and termination benefit costs reflect estimates based on agreements with the relevant union representatives or plans adopted by us that are applicable to employees not affiliated with unions. These costs are not associated with nor do they benefit continuing activities. Changing business conditions may affect the assumptions related to the timing and extent of facility closure activities. We review the status of restructuring activities on a quarterly basis and, if appropriate, record changes based on updated estimates.
Income tax assets and liabilities. We provide for income taxes in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“SFAS 109”). SFAS 109 requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the financial statement carrying amounts and the tax bases of assets and liabilities. We maintain valuation allowances where it is more likely than not all or a portion of a deferred tax asset will not be realized. Changes in valuation allowances from period to period are included in our tax provision in the period of change. In determining whether a valuation allowance is warranted, we take into account such factors as prior earnings history, expected future earnings, carryback and carryforward periods, and tax strategies that could potentially enhance the likelihood of realization of a deferred tax asset. We are also subject to examination of our income tax returns for multiple years by the Internal Revenue Service and other tax authorities. We periodically assess the likelihood of adverse outcomes resulting from these examinations to determine the impact on our deferred taxes and income tax liabilities and the adequacy of our provision for income taxes.
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Derivative and foreign exchange management activities. We recognize all derivatives as assets and liabilities at their fair values. The fair values are determined using widely accepted valuation models that incorporate quoted market prices and dealer quotes and reflect assumptions about currency fluctuations based on current market conditions. The aggregate fair values of derivative instruments used to manage currency exposures are sensitive to changes in market conditions and to changes in the timing and amounts of forecasted exposures.
Not all exposure management activities and foreign currency derivative instruments will qualify for hedge accounting treatment. Changes in the fair values of those derivative instruments that do not qualify for hedge accounting are recorded in “Other (income) expense, net” in the Statements of Operations. As a result, net income may be subject to volatility. The derivative instruments that qualify for hedge accounting currently hedge our net investment position in certain of our subsidiaries. For these instruments, we document the hedge designation by identifying the hedging instrument, the nature of the risk being hedged and the approach for measuring hedge effectiveness. Changes in fair values of derivative instruments that qualify for hedge accounting are recorded as cumulative translation adjustments in the “Accumulated other comprehensive loss” section of Stockholders’ Deficit.
Employee benefits
Pension and Post-retirement Benefits. We have several non-contributory defined benefit retirement plans covering substantially all employees. We also provide certain health care benefits for employees who meet age, participation and length of service requirements at retirement. In addition, we sponsor other retirement plans for our foreign employees in accordance with local government programs and requirements. We retain the right to amend, curtail or discontinue any aspect of the plans at any time. Any of these actions (including changes in actuarial assumptions and estimates), either individually or in combination, could have a material impact on our consolidated financial statements and on our future financial performance.
We account for our U.S. and certain foreign defined benefit pension plans and our post-retirement benefit plans using actuarial models in accordance with SFAS 87, “Employers’ Accounting for Pension Plans,” and SFAS 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions.” These models use an attribution approach that generally spreads individual events over the estimated service lives of the employees in the plan. The attribution approach assumes that employees render service over their service lives on a relatively smooth basis and as such, presumes that the income statement effects of pension or post-retirement benefit plans should follow the same pattern. Our policy is to fund our retirement plans based upon actuarial recommendations and in accordance with applicable laws and income tax regulations, as well as in accordance with our credit agreements.
Net pension income or expense is determined using assumptions as of the beginning of each fiscal year. These assumptions are established at the end of the prior fiscal year and include expected long-term rates of return on plan assets, discount rates, compensation rate increases and medical trend rates. We use a mix of actual historical rates, expected rates and external data to determine the assumptions used in the actuarial models.
Employee Incentive Compensation. We maintain short-term and long-term employee incentive compensation plans. These plans are intended to reward eligible employees for their contributions to our short-term and long-term success. Provisions for employee incentive compensation are recorded in accrued salaries, wages and employee benefits and long-term employee related benefits. Changes in the liabilities for these incentive plans generally correlate with our financial results and projected future financial performance and could have a material impact on our consolidated financial statements and on future financial performance.
In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment,” (“SFAS 123(R)”). Under this standard, all forms of share-based payment to employees, including stock options, would be treated as compensation and recognized in the income statement. This statement is effective for awards granted, modified or settled in interim periods or fiscal years beginning after June 15, 2005. We do not believe that the adoption of SFAS 123(R) will have a significant effect on our financial statements.
FORWARD-LOOKING STATEMENTS
Except for the historical information contained in this report, certain matters discussed in this report, including (without limitation) statements under “Business” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Although we believe that, in making any such statements, our expectations are based on reasonable assumptions, any such statement may be influenced by factors that could cause actual outcomes and results to be materially different from those projected.
These forward-looking statements include statements relating to our anticipated financial performance and business prospects and/or statements preceded by, followed by or that include the words “believe,” “anticipate,” “intend,” “estimate,” “expect,”
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“project,” “could,” “plans,” “seeks” and similar expressions. These forward-looking statements speak only as of the date stated and we do not undertake any obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise, even if experience or future events make it clear that any expected results expressed or implied by these forward-looking statements will not be realized. Although we believe that the expectations reflected in these forward-looking statements are reasonable, these expectations may not prove to be correct or we may not achieve the financial results, savings or other benefits anticipated in the forward-looking statements. These forward-looking statements are necessarily estimates reflecting the best judgment of our senior management and involve a number of risks and uncertainties, some of which may be beyond our control, that could cause actual results to differ materially from those suggested by the forward-looking statements, including, without limitation:
Our actual results might differ materially from historical performance or current expectations. We do not undertake any obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise.
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Item 3. Quantitative and Qualitative Disclosures about Market Risk
DERIVATIVE FINANCIAL INSTRUMENTS
We are exposed to market risk primarily related to foreign currencies and interest rates. We actively manage foreign currency risks with the objective of maximizing our U.S. dollar value. We hold derivative positions only in currencies to which we have exposure. We currently do not hold any interest rate derivatives.
We are exposed to credit loss in the event of nonperformance by the counterparties to the foreign exchange contracts. However, we believe these counterparties are creditworthy financial institutions and do not anticipate nonperformance. We monitor the creditworthiness of our counterparties in accordance with our foreign exchange and investment policies. In addition, we have International Swaps and Derivatives Association, Inc. (ISDA) master agreements in place with our counterparties to mitigate the credit risk related to the outstanding derivatives. These agreements provide the legal basis for over-the-counter transactions in many of the world’s commodity and financial markets.
FOREIGN EXCHANGE RISK
The global scope of our business operations exposes us to the risk of fluctuations in foreign currency markets. This exposure is the result of certain product sourcing activities, some inter-company sales, foreign subsidiaries’ royalty payments, net investment in foreign operations and funding activities. Our foreign currency management objective is to mitigate the potential impact of currency fluctuations on the value of our cash flows. We typically take a long-term view of managing exposures, using forecasts to develop exposure positions and engaging in their active management.
We operate a centralized currency management operation to take advantage of potential opportunities to naturally offset exposures against each other. For any residual exposures, we enter into spot exchange, forward exchange, cross-currency swaps and option contracts to hedge certain anticipated transactions as well as certain firm commitments, including third party and inter-company transactions. We manage the currency risk as of the inception of the exposure. We do not currently manage the timing mismatch between our forecasted exposures and the related financial instruments used to mitigate the currency risk.
Our foreign exchange risk management activities are governed by a foreign exchange risk management policy approved by our board of directors. Our foreign exchange committee, comprised of a group of our senior financial executives, reviews our foreign exchange activities to ensure compliance with our policies. The operating policies and guidelines outlined in the foreign exchange risk management policy provide a framework that allows for an active approach to the management of currency exposures while ensuring the activities are conducted within established parameters. Our policy includes guidelines for the organizational structure of our risk management function and for internal controls over foreign exchange risk management activities, including various measurements for monitoring compliance. We monitor foreign exchange risk, interest rate risk and related derivatives using different techniques including a review of market value, sensitivity analysis and a Value-at-Risk model.
At February 27, 2005, we had U.S. dollar spot and forward currency contracts to buy $619.7 million and to sell $341.0 million against various foreign currencies. These contracts are at various exchange rates and expire at various dates through July 2005. We have no option contracts outstanding at February 27, 2005.
At the respective maturity dates of the outstanding spot, forward and option currency contracts, we expect to enter into various derivative transactions in accordance with our currency risk management policy.
Item 4. Controls and Procedures
In conjunction with their audit of our financial statements for the year ended November 28, 2004, our independent registered public accounting firm identified three significant deficiencies in our internal control. These significant deficiencies and the actions we have taken to address them are summarized as follows:
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As of February 27, 2005, we updated our evaluation of the effectiveness of the design and operation of our disclosure controls and procedures for purposes of filing reports under the Securities and Exchange Act of 1934. This controls evaluation was done under the supervision and with the participation of management, including our chief executive officer and our chief financial officer, and took into account the actions we have taken during 2005 in response to the communication of the significant deficiencies from our independent registered public accounting firm in conjunction with their 2004 audit. Our chief executive officer and our chief financial officer have concluded that our disclosure controls and procedures (as defined in Rule13(a)-15(e) and 15(d)-15(e) under the Exchange Act) are effective to provide reasonable assurance that information relating to us and our subsidiaries that we are required to disclose in the reports that we file or submit to the SEC is recorded, processed, summarized and reported with the time periods specified in the SEC’s rules and forms.
As a result of the SEC’s deferral of the deadline for foreign and non-accelerated filers’ compliance with the internal control requirements of Section 404 of the Sarbanes-Oxley Act of 2002, we will not be subject to the requirements until our annual report on Form 10-K for fiscal year 2006.
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Item 1. Legal Proceedings
The lawsuit, Compania Exportadora de Maquila, Comexma v. Levi Strauss & Co., et al, was brought following a raid on Comexma’s Mexico City facilities that was conducted by local police and accompanied by local media upon the initiation of our outside Mexican brand protection counsel. The local counsel failed to follow our pre-approval procedures for initiating such a raid, which required such counsel to check with us before going forward to confirm that the target was not an authorized contractor. No counterfeiting activity was uncovered, and the raid was terminated upon confirmation from us that Comexma was an authorized manufacturer. The raid occurred within a few months after we had notified Comexma that we were terminating our contract manufacturing relationship, and during the period in which we believe Comexma was in the process of negotiating with its employees and others to shut down its facility.
The court awarded Comexma approximately $24.5 million in direct damages and lost income, and an additional approximately $20.5 million in damages for harm to its reputation. We strongly disagree with the court’s decision and have filed an appeal of the Civil Court’s judgment. On appeal, we seek to have the judgment reversed or remanded for further proceedings, and, if the appellate court affirms the lower court on the issue of liability, to have the amount of the direct and additional damages reduced substantially. Based upon advice of legal counsel in regards to the probable range of loss in the event we lose on appeal or otherwise do not prevail, we have recorded a provision during the three months ended February 27, 2005 related to this litigation that is included in our selling, general and administrative expenses. A decision by the appellate court could be rendered as early as the next two to four months.
Other Litigation. In the ordinary course of business, we have various other pending cases involving contractual matters, employee-related matters, distribution questions, product liability claims, trademark infringement and other matters. We do not believe there are any pending legal proceedings that will have a material impact on our financial condition or results of operations.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
None.
Item 3. Defaults Upon Senior Securities.
Item 4. Submission of Matters to a Vote of Security Holders.
Item 5. Other Information.
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Item 6. Exhibits
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
/S/ GARY W. GRELLMAN
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