UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the Quarterly Period Ended August 28, 2005
OR
Commission file number: 002-90139
LEVI STRAUSS & CO.
(Exact Name of Registrant as Specified in Its Charter)
(State or Other Jurisdiction of
Incorporation or Organization)
(I.R.S. Employer
Identification No.)
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 October 5, 2005
LEVI STRAUSS & CO. AND SUBSIDIARIES
INDEX TO FORM 10-Q
FOR THE THREE AND NINE MONTHS ENDED AUGUST 28, 2005
Page
Number
Consolidated Financial Statements (unaudited):
Consolidated Balance Sheets as of August 28, 2005 and November 28, 2004
Consolidated Statements of Operations for the Three and Nine Months Ended August 28, 2005 and August 29, 2004
Consolidated Statements of Cash Flows for the Nine Months Ended August 28, 2005 and August 29, 2004
Notes to Consolidated Financial Statements
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Quantitative and Qualitative Disclosures About Market Risk
Controls and Procedures
Legal Proceedings
Unregistered Sales of Equity Securities and Use of Proceeds.
Defaults Upon Senior Securities.
Submission of Matters to a Vote of Security Holders.
Other Information.
Exhibits.
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Item 1. Consolidated Financial Statements
CONSOLIDATED BALANCE SHEETS
(Dollars in Thousands)
(Unaudited)
Current Assets:
Cash and cash equivalents
Restricted cash
Trade receivables, net of allowance for doubtful accounts of $33,030 and $29,002
Inventories:
Raw materials
Work-in-process
Finished goods
Total inventories
Deferred tax assets, net of valuation allowance of $26,364
Other current assets
Total current assets
Property, plant and equipment, net of accumulated depreciation of $478,731 and $486,439
Goodwill
Other intangible assets, net of accumulated amortization of $1,063 and $720
Non-current deferred tax assets, net of valuation allowance of $360,319
Other assets
Total assets
Current Liabilities:
Current maturities of long-term debt and short-term borrowings
Current maturities of capital lease obligations
Accounts payable
Restructuring reserves
Accrued liabilities
Accrued salaries, wages and employee benefits
Accrued income taxes
Total current liabilities
Long-term debt, less current maturities
Long-term capital lease obligations, less current maturities
Post-retirement medical benefits
Pension liability
Long-term employee related benefits
Long-term income tax liabilities
Other long-term liabilities
Minority interest
Total liabilities
Commitments and contingencies (Note 7)
Stockholders’ deficit:
Common stock—$.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.
3
CONSOLIDATED STATEMENTS OF OPERATIONS
August 28,
2005
August 29,
2004
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) expense, net
Income before taxes
Income tax expense
Net income
4
CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash Flows from Operating Activities:
Adjustments to reconcile net income to net cash (used for) provided by operating activities:
Depreciation and amortization
Non-cash asset write-offs associated with reorganization initiatives
Gain on disposal of assets
Unrealized foreign exchange gains
Write-off of unamortized costs associated with early extinguishment of debt
Decrease (increase) 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 restructuring reserves
(Decrease) increase in accrued salaries, wages and employee benefits
Increase (decrease) in income tax liabilities
Decrease in long-term employee related benefits
(Decrease) increase in other long-term liabilities
Other, net
Net cash (used for) provided by operating activities
Cash Flows from Investing Activities:
Purchases of property, plant and equipment
Proceeds from sale of property, plant and equipment
Cash inflow from net investment hedges
Acquisition of Turkey minority interest
Net cash used for investing activities
Cash Flows from Financing Activities:
Proceeds from issuance of long-term debt
Repayments of long-term debt
Net decrease in short-term borrowings
Debt issuance costs
Increase in restricted cash
Net cash provided by (used for) financing activities
Effect of exchange rate changes on cash
Net (decrease) increase 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
5
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1: PREPARATION OF FINANCIAL STATEMENTS
Basis of Presentation and Principles of Consolidation
The unaudited consolidated financial statements of Levi Strauss & Co. and its 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 significant 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 and nine months ended August 28, 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 August 28, 2005 and November 28, 2004 was $2.9 million and $1.9 million, respectively, and primarily relates to required cash deposits for customs and rental guarantees to support the Company’s international operations.
Reclassification of Outstanding Checks
The Company included approximately $14.0 million of outstanding checks in “accounts payable” in its previously filed consolidated balance sheet as of August 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 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, for the nine months ended August 29, 2004, has been reclassified to reflect this presentation.
Long-lived Assets Held for Sale
At August 28, 2005 and November 28, 2004, the Company had approximately $0.07 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 August 28, 2005 primarily relate to a closed manufacturing plant in Spain.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(continued)
During the three months ended August 28, 2005, the Company sold its idle manufacturing plant in San Francisco, California, for approximately $3.5 million, and recognized a $3.0 million gain on the disposal. The carrying value of the manufacturing plant was included in the November 28, 2004 assets held for sale balance discussed above. The Company has pledged to contribute $2.0 million of the proceeds from the sale to the Levi Strauss Foundation, a Company-sponsored charitable foundation that supports various global giving programs. As of August 28, 2005, approximately $0.7 million in cash was contributed to the Foundation with approximately $1.3 million recorded as a liability. The charge for the contribution was recorded in selling, general and administrative expenses.
Acquisition of Retail Stores
On August 26, 2005, the Company’s U.K. subsidiary signed an agreement to purchase seven Levi’s® stores and five factory outlets from one of its retail customers in the U.K. for approximately $4.1 million. The sale is expected to close in the fourth quarter of 2005. The acquisition is not expected to have a material impact on the Company’s financial condition or its results of operations.
Loss on Early Extinguishment of Debt
During the three and nine months ended August 28, 2005, the Company recorded a $0.04 million and $66.1 million loss, respectively, on early extinguishment of debt as a result of its debt refinancing activities during the periods. The loss for the nine months ended August 28, 2005 was comprised of tender offer and redemption premiums and other fees and expenses approximating $53.6 million and the write-off of approximately $12.5 million of unamortized debt discount and capitalized costs. Such costs were incurred in conjunction with the Company’s completion in January 2005 of a tender offer to repurchase $372.1 million of its $450.0 million principal amount 2006 notes, and completion in March and April 2005 of the tender offers and redemptions of its $380.0 million and €125.0 million 2008 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 applies to all awards granted after the required effective date and to awards modified, repurchased or cancelled after that date. For nonpublic entities, this statement is effective as of the beginning of the first annual reporting period that begins after December 15, 2005, which for the Company will be as of the beginning of fiscal 2007. Early adoption is permitted. The Company is currently evaluating the impact that the adoption of SFAS 123(R) will have on its financial statements.
In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154, “Accounting Changes and Error Corrections—A Replacement of APB Opinion No. 20 and FASB Statement No. 3.” SFAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.
In June 2005, the FASB’s Emerging Issues Task Force reached a consensus on Issue No. 05-6, “Determining the Amortization Period for Leasehold Improvements” (“EITF 05-6”). The guidance requires that leasehold improvements acquired in a business combination or purchased subsequent to the inception of a lease be amortized over the lesser of the useful life of the assets or a term that includes renewals that are reasonably
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assured at the date of the business combination or purchase. The guidance is effective for periods beginning after June 29, 2005. The Company does not believe that the adoption of EITF 05-6 will have a significant effect on its financial statements.
NOTE 2: RESTRUCTURING RESERVES
Summary
The following describes the activities associated with the Company’s business transformation initiatives, including manufacturing plant closures and organizational changes. 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 other reorganization initiatives. Other restructuring costs primarily relate to lease liability and facility closure costs. Reductions consist of payments for severance, employee benefits, and other restructuring costs, and foreign exchange differences.
The total balance of the reserves at August 28, 2005 and November 28, 2004 was $29.4 million and $50.8 million, respectively. For the three and nine months ended August 28, 2005, the Company recognized restructuring charges, net of reversals, of $5.0 million and $13.4 million, respectively. For the three and nine months ended August 29, 2004, the Company recognized restructuring charges, net of reversals, of $28.1 million and $108.2 million, respectively. Charges in the three and nine months ended August 28, 2005 relate primarily to additional severance and benefit expenses and lease liability costs related to the 2004 U.S. and European organizational changes described below. Charges in the three and nine months ended August 29, 2004 relate primarily to the indefinite suspension of an enterprise resource planning system installation in December 2003, the 2004 organizational changes commenced in the three months ended August 29, 2004 and additional charges related to the Company’s 2003 organizational changes and plant closures described below. The Company expects to utilize a significant portion of its restructuring reserves during the next 12 months.
The following table summarizes the 2005 activity, and the reserve balances as of November 28, 2004 and as of August 28, 2005, associated with the Company’s reorganization initiatives:
November 28,
Restructuring
Charges
Reductions
Reversals
2004 Reorganization Initiatives
2003 and 2002 Reorganization Initiatives
Total
Current portion of restructuring reserves
Non-current portion of restructuring reserves (1)
The table below displays, for the 2004 reorganization initiatives, the restructuring activity for the nine months ended August 28, 2005, the balance of the restructuring reserves as of August 28, 2005 and cumulative charges to date.
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Reductions (7)
Reversals (8)
Cumulative
to date (9)
2004 Spain Plant Closures (1)
Severance and employee benefits
Other restructuring costs
2004 Australia Plant Closure (2)
2004 U.S. OrganizationalChanges (3)
Asset write-off
2004 Europe Organizational Changes (4)
2004 Dockers ® Europe Organizational Changes (5)
2004 Indefinite Suspension of ERP Installation (6)
Total—2004 Reorganization
Initiatives
9
10
The table below displays, for the 2003 and 2002 reorganization initiatives, the restructuring activity for the nine months ended August 28, 2005, the balance of the restructuring reserves as of August 28, 2005 and the cumulative charges to date.
RestructuringCharges
to date (6)
2003 U.S. Organizational Changes (1)
2003 North America Plant Closures (2)
2003 Europe Organizational Changes (3)
2002 Europe Reorganization Initiatives (4)
Total 2003 and Prior Reorganization Initiatives
During the fourth quarter of 2003, the Company commenced reorganization actions to consolidate and streamline operations in its European headquarters in Belgium and in various field offices. Charges in the current period relate primarily to additional severance and employee benefit costs. During the nine-month
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period ended August 28, 2005, the Company reversed approximately $0.3 million of charges related to severance agreements that had been finalized during the period. The remaining liability of $0.9 million relates primarily to salary and benefit payments. The Company expects to incur no additional restructuring charges in connection with this action.
NOTE 3: GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill was $199.9 million as of both August 28, 2005 and November 28, 2004. Other intangible assets were as follows:
August 28, 2005
Gross
Carrying Value
Accumulated
Amortization
Amortized intangible assets:
Other intangible assets
Unamortized intangible assets:
Trademarks
On March 31, 2005, the Company acquired the remaining 49% minority interest of its joint venture in Turkey for approximately $3.8 million in cash and obtained 100% ownership of the venture. The Company accounted for the acquisition using the purchase method, as prescribed by Financial Accounting Standards Board Statement No. 141, “Business Combinations”. As a result of the purchase, the Company recognized approximately $0.3 million related to acquired sales backlog, which is included in other intangible assets at August 28, 2005.
The Company had previously consolidated the results of operations and financial position of the joint venture. As a result, the acquisition did not have a material impact on the Company’s financial condition as of August 28, 2005 or its results of operations for the three and nine months ended August 28, 2005. The order backlog is being amortized over a six-month period.
Amortization expense for the three and nine months ended August 28, 2005 was $0.2 million and $0.6 million, respectively. Amortization expense for the three and nine months ended August 29, 2004 was $0.03 million and $0.09 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 and nine months ended August 28, 2005 was approximately $39.8 million and $98.1 million, respectively. Those amounts include approximately $41.1 million and $106.6 million, respectively, of expense relating to current year operations, reduced by approximately $1.3 million and $8.5 million, respectively, of discrete benefits relating primarily to a decrease in the Company’s contingent tax liabilities.
The effective income tax rate for the nine months ended August 28, 2005 was 46.6%. This differs from the Company’s estimated annual effective income tax rate 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, and then adjusted by discrete items to compute income tax expense for the nine month period ended August 28, 2005.
Estimated Annual Effective Income Tax Rate. The estimated annual effective income tax rate for the full year 2005 and 2004 differs from the U.S. federal statutory income tax rate of 35% as follows:
Fiscal Year
2005 (1)
2004 (2)
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
Provision to return reconciliation
Other, including non-deductible expenses
The “State income taxes, net of U.S. federal impact” item above primarily reflects changes in state apportionment ratios and 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 the periods presented 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. In addition, 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 and foreign losses for which no tax benefit can be recognized. For 2004, the 22.5% decrease reflects additional benefit generated by foreign losses incurred in jurisdictions with rates in excess of the U.S. federal statutory rate. Additionally, changes in the mix of our cumulative earnings and profits by jurisdiction resulted in a reduction in the residual U.S. tax on unremitted foreign earnings.
The “Reassessment of reserves due to change in estimate” item above relates primarily to changes in the Company’s estimate of its contingent tax liabilities. The 2.0 percentage point decrease in the annual estimated
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effective tax rate for 2005 relates primarily to the reversal of prior year tax liabilities of approximately $10.7 million, partially offset by additional interest for the 2005 fiscal year of approximately $5.4 million. Approximately $8.3 million of the $10.7 million reversal of prior year tax liabilities is attributable to the Company’s settlements with the Internal Revenue Service (inclusive of the state tax effects of such settlements) for the years 1986 – 1999 as described more fully below. The remaining $2.4 million reversal reflects changes in estimates attributable to foreign and state income tax exposures not related to the Company’s settlements with the Internal Revenue Service. For 2004, the 10.2 percentage point increase in the effective tax rate relates to a $3.0 million increase in the Company’s accrual for contingent tax losses and the related accrual of interest expense on the Company’s contingent income tax liabilities.
The “Provision to return reconciliation” item above relates primarily to the reconciliation of the Company’s annual tax provision to its annual U.S. federal and foreign corporate income tax returns. The projection of taxable income relied upon in connection with the preparation of the 2004 financial statements was refined during the preparation of the fiscal year 2004 income tax returns filed during the three months ended August 28, 2005. The net impact of the reconciliation of taxable income is an increase to income tax expense of approximately $1.2 million, which has been recorded during the three months ended August 28, 2005. For 2004, this item related to the reconciliation of the Company’s fiscal year 2003 tax provision to its fiscal year 2003 U.S. Federal corporate income tax return. The net impact of the reconciliation of taxable income was an increase to income tax expense of approximately $6.2 million for the three months ended August 29, 2004.
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. In 2004, a lower pre-tax operating result coupled with increased non-deductible expenses accounted for the greater relative percentage of the reconciling items from the U.S. federal statutory rate.
Examination of Tax Returns. During the nine months ended August 28, 2005, the Company reached agreement with the Internal Revenue Service to close a total of 14 open tax years.
In June 2005, the Company reached an agreement with the Appeals division of the Internal Revenue Service regarding the examination of the Company’s consolidated U.S. federal income tax returns for the years 1986-1989. As a result of that agreement, the examination of the Company’s income tax returns for those periods is now closed and the Company reduced its contingent tax liabilities by approximately $4.2 million during the three months ended May 29, 2005.
In August 2005, the Company completed settlement discussions with the Internal Revenue Service relating to the Company’s consolidated U.S. federal income tax returns for the years 1990-1999. As a result of this settlement agreement, the examination of the Company’s income tax returns for those periods is now closed and the Company reduced income tax expense by approximately $4.1 million during the three months ended August 28, 2005. This $4.1 million reduction in income tax expense reflects a net decrease in federal income tax expense of approximately $6.5 million and an increase to state income tax expense, net of federal tax benefits, of approximately $2.4 million. The net decrease to federal income tax expense of $6.5 million relates primarily to a decrease in the Company’s liability associated with its unremitted foreign earnings of approximately $12.3 million, partially offset by $5.8 million of additional net federal income tax expense relating to an increase in taxes payable and changes in other tax attributes.
In connection with the 1990 – 1999 settlement, the Company expects to make total payments to the Internal Revenue Service of approximately $100.0 million in the fourth quarter of 2005. These projected payments are included in the Company’s accrued income taxes as of August 28, 2005.
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The Internal Revenue Service has not yet begun an examination of the Company’s 2000-2004 U.S. federal corporate income tax returns.
Certain state and foreign tax returns are under examination by various regulatory authorities. The Company continuously reviews issues raised in connection with all on-going examinations and open tax years to evaluate the adequacy of its reserves. The Company believes that its accrued tax liabilities are adequate to cover all probable U.S. federal, state, and foreign income tax loss contingencies at August 28, 2005. However, it is possible the Company may also incur additional income tax liabilities related to prior years. The Company estimates this additional potential exposure to be approximately $18.9 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 $18.9 million amount has not been accrued because it currently does not meet the recognition criteria for liabilities under generally accepted accounting principles in the United States.
Reclassifications. During fiscal 2005, the Company reclassified approximately $23.4 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.
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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 (2)
11.625% Dollar denominated, due 2008 (3)
11.625% Euro denominated, due 2008 (3)
12.25% Senior Notes, due 2012
9.75% Senior Notes, due 2015 (2)
Floating rate notes due 2012 (3)
8.625% Euro notes, due 2013 (3)
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
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Issuance of Senior Notes Due 2015 and Partial Repurchase of Senior Notes due 2006
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 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 $10.3 million are amortized over the term of the notes to interest expense.
Use of Proceeds—Tender Offer and Repurchase of Senior Notes Due 2006. In December 2004, the Company commenced a cash tender offer for the outstanding principal amount of all of its senior unsecured notes due 2006. The tender offer expired January 12, 2005. The Company purchased pursuant to the tender offer $372.1 million in principal amount of its $450.0 million principal amount 2006 notes, using $372.1 million of the gross proceeds of the issuance of the 2015 notes. As a result, the Company has not yet met its 2006 notes 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). 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. The Company paid approximately $19.7 million in tender premiums and other fees and expenses with the Company’s existing cash and cash equivalents and wrote off approximately $3.3 million of unamortized debt discount and issuance costs related to this tender offer.
Exchange Offer. In June 2005, after a required exchange offer, all but $50,000 of the $450.0 million aggregate principal amount of the notes were exchanged for new notes on identical terms, except that the new notes are registered under the Securities Act of 1933 (the “Securities Act”).
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
17
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.
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 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 $8.6 million are amortized over the term of the notes to interest expense.
Exchange Offer. In June 2005, after a required exchange offer, all of the $380.0 million aggregate principal amount of the notes were exchanged for new notes on identical terms, except that the new notes are registered under the Securities Act.
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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 $5.3 million are amortized over the term of the notes to interest expense.
Exchange Offer. In June 2005, after a required exchange offer, all but €2.0 million of the €150.0 million aggregate principal amount of the notes were exchanged for new notes on identical terms, except that the new notes are registered under the Securities Act.
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 February 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 in April 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 $35.2 million and use of $12.6 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 $33.9 million in tender premiums and other fees and expenses and wrote off approximately $9.2 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 the fiscal quarter. At August 28, 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. At August 28, 2005, the Company was not required to perform this calculation.
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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, which approximates the effective interest method. New debt issuance costs are amortized using the effective interest method. Unamortized debt issuance costs at August 28, 2005 and November 28, 2004 were $62.1 million and $54.8 million, respectively. Amortization of debt issuance costs, which is included in interest expense, was $3.0 million and $2.7 million for the three months ended August 28, 2005 and August 29, 2004, respectively, and $9.1 million and $7.9 million for the nine months ended August 28, 2005 and August 29, 2004, respectively.
Accrued Interest. At August 28, 2005 and November 28, 2004, accrued interest was $41.9 million and $65.6 million, respectively, and is included in accrued liabilities.
Principal Short-term and Long-term Debt Payments
The table below sets forth, as of August 28, 2005, the Company’s required aggregate short-term and long-term debt principal payments for the next five fiscal years and thereafter. 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 three months) (1)
2006(2)(3)
2007
2008
2009
Thereafter
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Short-term Credit Lines and Stand-by Letters of Credit
The Company’s total unused lines of credit were approximately $387.3 million at August 28, 2005.
At August 28, 2005, the Company had unsecured and uncommitted short-term credit lines available totaling approximately $10.5 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 August 28, 2005, the Company’s total availability of $480.8 million under its senior secured revolving credit facility was reduced by $104.0 million of letters of credit and other credit usage allocated under the Company’s senior secured revolving credit facility, yielding a net availability of $376.8 million. Included in the $104.0 million of letters of credit and other credit usage at August 28, 2005 were $14.6 million of trade letters of credit, $7.8 million of other credit usage and $81.6 million of stand-by letters of credit with various international banks, of which $63.2 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 three months ended August 28, 2005 and August 29, 2004, including the amortization of capitalized bank fees, underwriting fees and interest rate swap cancellations was 10.30% and 10.54%, respectively. The Company’s weighted average interest rate on average borrowings outstanding during the nine months ended August 28, 2005 and August 29, 2004, including the amortization of capitalized bank fees, underwriting fees and interest rate swap cancellations was 10.47% and 10.61%, 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 August 28, 2005 and November 28, 2004 are as follows:
Debt Instruments:
U.S. dollar notes offerings
Euro notes offering
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 change in the estimated fair value of the Company’s total debt at August 28, 2005 as compared to the estimated fair value at November 28, 2004 was primarily due to the refinancing activities during the first half of 2005 and changes in debt, credit and foreign exchange markets.
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 August 28, 2005 and November 28, 2004.
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NOTE 7: COMMITMENTS AND CONTINGENCIES
Foreign Exchange Contracts
At August 28, 2005, the Company had U.S. dollar spot and forward currency contracts to buy $299.2 million and to sell $222.9 million against various foreign currencies. These contracts are at various exchange rates and expire at various dates through November 2005.
The Company has entered into option contracts to manage its exposure to foreign currencies. At August 28, 2005, the Company had bought U.S. dollar option contracts resulting in a net purchase of $58.2 million against various foreign currencies should the options be exercised. To finance the premium related to bought options, the Company sold U.S. dollar options resulting in a net purchase of $75.9 million against various currencies should the options be exercised. The option contracts are at various strike prices and expire at various dates through February 2006.
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 Quarterly Report on Form 10-Q for the period ended May 29, 2005. For more information about the litigation, see Note 7 to the consolidated financial statements contained in the Company’s Quarterly Report on Form 10-Q filed on July 12, 2005 and Note 9 to the consolidated financial statements contained in the Company’s 2004 Annual Report on Form 10-K filed on February 17, 2005.
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. For information about the litigation, see Note 9 to the consolidated financial statements contained in such Annual Report on Form 10-K.
Comexma Litigation. There have been no material developments in this litigation since the Company filed its Quarterly Report on Form 10-Q for the period ended May 29, 2005. For more information about the litigation, see Note 7 to the consolidated financial statements contained in the Company’s Quarterly Report on Form 10-Q filed on July 12, 2005.
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, patent and 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.
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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 under management, 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 has not applied hedge accounting to its foreign currency derivative transactions, except for certain net investment hedging activities. During the nine months ended August 28, 2005, the Company used foreign exchange currency swaps to hedge the net investment in its foreign 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. For the nine months ended August 28, 2005 and August 29, 2004, realized losses of $0.5 million and $4.2 million, respectively, have been excluded from hedge effectiveness testing and therefore were included in “Other (income) expense, net” in the Company’s statement of operations. For the three months ended August 28, 2005 and August 29, 2004, such amounts were immaterial. As of August 28, 2005, the Company had no foreign currency derivatives outstanding hedging the net investment in its foreign operations.
The Company designates a portion of its outstanding yen-denominated Eurobond as a net investment hedge. As of August 28, 2005 and November 28, 2004, unrealized losses of $4.2 million and $10.1 million related to the translation effects of the yen-denominated Eurobond were recorded as cumulative translation adjustments in the “Accumulated other comprehensive loss” section of Stockholders’ Deficit.
On May 19, 2005, the Company designated its outstanding euro-denominated Eurobond as a net investment hedge. As of August 28, 2005, a $4.5 million unrealized gain related to the translation effects of the euro-denominated Eurobond was recorded as a cumulative translation adjustment in the “Accumulated other comprehensive loss” section of Stockholders’ Deficit.
The table below provides data about the realized and unrealized gains and losses associated with foreign exchange management activities reported in “Other (income) expense, net.”
Other (income)
expense, net
August 29, 2004
Foreign exchange management
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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.
Net investment hedges
Derivative instruments
Euro Bond
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).
NOTE 9: OTHER (INCOME) EXPENSE, NET
The following table summarizes significant components of other (income) expense, net:
Foreign exchange management losses
Foreign currency transaction (gains) losses
Interest income
Minority interest—Levi Strauss Japan K.K.
Minority interest—Levi Strauss Istanbul Konfeksiyon (1)
Other
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The Company’s foreign exchange risk management activities include the use of instruments 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 (income) expense, net. At contract maturity, the realized gain or loss related to derivative instruments is also recorded in other (income) 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 (income) expense, net. In addition, at the settlement date of foreign currency transactions, foreign currency (gains) losses are recorded in “other (income) expense, net” to reflect the difference between the spot rate effective at the settlement date and the historical rate at which the transaction was originally recorded.
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 for both periods of 2005, as compared to 2004, was primarily due to higher effective interest rates on the Company’s investments. Also contributing to the increase in the current nine-month period was a higher average investment balance as compared to 2004.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
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 and nine months ended August 28, 2005 and August 29, 2004:
Three Months
Ended August 28,
Ended August 29,
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 gain
Net periodic benefit cost (income)
Net curtailment loss (gain)
Reclassification. The current portion of the Company’s pension liabilities, included in “Accrued salaries, wages and employee benefits” on the consolidated balance sheet, increased by approximately $6.6 million from November 28, 2004 primarily as a result of a change in the Company’s estimate of required cash contributions for the next twelve months to its U.S. Home Office Pension Plan. This change was primarily driven by lower than projected investment returns on the plans’ assets. The revised total cash contributions in fiscal 2005 for the Company’s pension plans are estimated to be approximately $36.0 million, which includes cash contributions of approximately $14.0 million paid through August 28, 2005.
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NOTE 11: COMPREHENSIVE INCOME
The following is a summary of the components of total comprehensive income, net of related income taxes:
Other comprehensive income (loss):
Net investment hedge gains
Foreign currency translation losses
Decrease in minimum pension liability
The following is a summary of the components of accumulated other comprehensive loss, net of related income taxes:
Net investment hedge gains (losses)
Additional minimum pension liability
Accumulated other comprehensive loss, net of income taxes
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 did not change. They are organized and managed through the Company’s 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.
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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 before income taxes
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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.
We distribute our Levi’s® and Dockers® products primarily through chain retailers and department stores in the United States and primarily through department stores, specialty stores and franchised stores abroad. We also distribute Levi’s® and Dockers® products through company-owned stores located in the United States, Europe and Japan. We distribute our Levi Strauss Signature® products through mass channel retailers in the United States and abroad.
The following tables provide net sales and operating income for our business segments and for our corporate group for the three and nine months ended August 28, 2005:
Region and Geographies
Canada and Mexico (all brands)
Europe (all brands)
Asia Pacific (all brands)
Corporate
Our Results. Key financial results for the three and nine months ended August 28, 2005 were as follows:
Our consolidated net sales for the three months ended August 28, 2005 were $1.0 billion, an increase of 2.4% compared to the same period in the prior year, and an increase of 1.8% on a constant currency
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basis. Our consolidated net sales for the nine months ended August 28, 2005 were $3.0 billion, an increase of 1.8% compared to the same period in the prior year, and relatively flat on a constant currency basis. Our net sales increase for the three-month period was primarily driven by increased net sales in our Asia Pacific region, our U.S. Levi’s® brand and our U.S. Levi Strauss Signature® brand, partially offset by decreased net sales in our Europe region and our U.S. Dockers® business. Our net sales increase for the nine-month period was primarily driven by increased net sales in our Asia Pacific region, our U.S. Levi Strauss Signature® brand business and our Mexico business. These increases were partially offset by decreased net sales in our Europe region and our U.S. Levi’s® and U.S. Dockers® brands.
Our gross profit improvement for the nine-month period was primarily driven by net sales growth in our Asia Pacific region, improved profitability of our Levi’s® brand in our Europe region, a favorable mix of more profitable first-quality products, improved management of returns, allowances and product transition costs, particularly in our U.S. Dockers® business, lower sourcing costs, lower inventory markdowns, particularly in Europe and the favorable translation impact of foreign currencies. These factors were partially offset by the impact on our gross profit of the decrease in net sales in our U.S. Levi’s® and U.S. Dockers® brands and the decrease in net sales in our Europe region.
Our third quarter performance reflected continuing improvement in our business. Our net sales and operating income increased compared with the same period in the prior year. We had net sales growth in our U.S. Levi’s® brand, our U.S. Levi Strauss Signature® business and our Asia Pacific business, we grew our royalty income by 39.6%, we increased our operating margin to 13.7% from 12.9% in the comparable period of 2004 and we again delivered a solid gross margin of 44.6%, although slightly lower than during the second quarter of 2005. We also increased our advertising and promotion as part of our efforts to build our brands. We had lower restructuring expenses and we reached an agreement with the Internal Revenue Service to close our open 1990—1999 tax years.
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We are cautious about our sales outlook in the United States and Europe going forward in view of:
We remain focused on our key priorities of driving growth in the Levi’s® and Levi Strauss Signature® businesses, revitalizing our Dockers® brand, including our Dockers® women’s business, and delivering solid and sustainable profitability by continuing to improve our performance and contain costs.
Our Financing Arrangements. During the first nine months of fiscal 2005, we made several significant changes in our financing arrangements:
For more information regarding our financing activities, please see “Indebtedness.”
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Results of Operations
Three and Nine Months Ended August 28, 2005 as Compared to Same Periods in 2004
The following tables summarize, for the periods indicated, items in our consolidated statements of operations, the changes in these items from period to period and these items expressed as a percentage of net sales.
$
Increase(Decrease)
August 28,2005
% of NetSales
August 29,2004
%
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The following tables present our net sales for our North America, Europe and Asia Pacific businesses and the changes in these results period to period.
(Dollars in thousands)
North America
Total consolidated net sales
North America net sales
The following tables present 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.
Total North America net sales
The following discussion summarizes net sales performance during the three and nine months ended August 28, 2005 for 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.”
The “Licensed Categories” line shows our net sales attributable to product categories that we marketed and sold ourselves during the relevant period for which we have also entered into licensing agreements
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as of August 28, 2005. Royalty payments received from licensees appear in the “Other operating income” line item in our statement of operations.
We believe this presentation is useful to the reader because it shows the impact of product category licensing on our net sales. 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 tables present net sales of our U.S. Levi’s® brand, including changes in these results for the three and nine months ended August 28, 2005 compared to the same periods in 2004.
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 increased 4.4% in the three months ended August 28, 2005 as compared to the same period in 2004. The increase in the three-month period was primarily driven by increased sales unit volume. Long bottoms with premium finishing and destructed looks contributed to the increase. In addition, in the current year we have not experienced the supply constraints that we had in the second half of 2004 that resulted in our missing orders and losing sales during that period.
The net sales increase in our continuing categories was partially offset 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 $8.0 million decrease in our net sales for the three months ended August 28, 2005.
Net sales in our U.S. Levi’s® brand for the nine months ended August 28, 2005 were down 1.6% as compared to the same period in 2004. This decrease was driven by our product rationalization actions and the related decisions to license certain product categories and discontinue underperforming categories as described above. Our decision to license certain products resulted in an approximately $37.6 million decrease in our net sales for the nine months ended August 28, 2005.
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Dockers® Brand. The following tables present net sales of our U.S. Dockers® brand, including changes in these results for the three and nine months ended August 28, 2005, compared to the same periods 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 three and nine months ended August 28, 2005 decreased 2.4% and 3.7%, respectively, as compared to the same periods in 2004. The decrease for the three months ended August 28, 2005 was primarily driven by the following:
Partially offsetting the decrease was the net sales growth in our men’s premium pants business, led by our Never Iron™ Cotton Khaki pant and our Essential Dress pant. We also had net sales growth in our shorts and tops businesses, and experienced lower returns and allowances as compared to the same period in the prior year. The lower returns and allowances were driven by improved product performance at retail and fewer sales at discounted prices that occurred in the prior year as a result of our decision in 2004 to discontinue certain product lines.
The decrease in our U.S. Dockers® net sales for the nine months ended August 28, 2005 resulted primarily from weakness in our women’s business, our product rationalization efforts, lower volume of close-out products and our decision to downsize our women’s shorts business. The decrease was partially offset by lower returns and allowances (including the reversal during the period of approximately $4.0 million in unclaimed deductions which had been previously accrued during fiscal 2004), sales growth of our men’s premium pants and shorts businesses, and an improvement in our sales mix.
Levi Strauss Signature® Brand. Net sales in our U.S. Levi Strauss Signature® brand for the three and nine months ended August 28, 2005 increased 17.8% and 7.5%, respectively, as compared to the same periods in 2004. The increase for the three months ended August 28, 2005 was primarily driven by expansion into additional Kmart stores. In addition, we had increased net sales to Wal-Mart and Target resulting from new product introductions, product line extensions and an increase in the number of stores that carry our product.
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The increase in our U.S. Levi Strauss Signature® brand net sales for the nine months ended August 28, 2005 resulted primarily from the factors noted above and lower returns and allowances as compared to the same period in the prior year, partially offset by the impact of increased sales for the initial retail fixture fill in connection with our launch into Target stores and other new accounts in the first quarter of 2004.
Europe net sales
The following tables present our net sales in our Europe region broken out for our brands including changes in these results for the three and nine months ended August 28, 2005 compared to the same periods 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 and nine months ended August 28, 2005 decreased 8.3% and 4.0%, respectively, on a constant currency basis. The decrease in net sales for both periods was driven by a decrease in volume, resulting from soft consumer demand in a challenging retail environment throughout Europe, which has unfavorably impacted our replenishment business. The decrease was partially offset by an increase in average selling price as a result of our ongoing repositioning of the Levi’s® brand in Europe as a premium product.
Dockers® Brand. Net sales for our Dockers® brand in Europe for the three and nine months ended August 28, 2005 decreased 18.9% and 20.6%, respectively, on a constant currency basis. The decrease for both the three and nine month periods was driven by the combination of soft consumer demand and the impact of changes we are implementing in our Dockers® business in Europe. We have developed a new business model and marketing program for the brand. We are also rationalizing our product lines, focusing on improving the profitability of the brand and working to improve our customer service performance.
Levi Strauss Signature® Brand. Net sales for our Levi Strauss Signature® brand in Europe for the three and nine months ended August 28, 2005 decreased 10.1% and 14.4%, respectively, on a constant currency basis. The decrease in both periods is primarily attributable to the weak economic environment discussed above.
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Asia Pacific net sales
The following tables present our net sales in our Asia Pacific region broken out for our brands, including changes in these results for the three and nine months ended August 28, 2005 compared to the same periods in 2004.
Asia Pacific Levi’s® brand
Asia Pacific Dockers® brand
Asia Pacific Levi Strauss Signature™ brand
Total Asia Pacific net sales
We had a 14.2% and 13.2% increase in net sales for our Asia Pacific region on a constant currency basis for the three and nine months ended August 28, 2005, respectively, compared with the same periods in 2004. The net sales increase was driven by a 17.0% and 15.4% increase for the three and nine months, respectively, in net sales on a constant currency basis for our Levi’s® brand products, which represent approximately 96% of our business in the region. Net sales increased in most countries during the three and nine month periods. Japan, which represents our largest business in Asia Pacific with approximately 46% and 43%, respectively, of regional net sales for the three and nine month periods, had a 13% and 8% increase in net sales, respectively, as compared to the same periods in 2004 on a constant currency basis.
Key drivers of our operational results in our Asia Pacific region for the three and nine months ended August 28, 2005 were as follows:
Gross profit decreased 0.5% for the three months ended August 28, 2005. Gross margin was 44.6% for the three-month period, reflecting a decrease of 1.3 percentage points. Factors that decreased our gross profit in the three month period included:
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Partially offsetting these factors was an increase in net sales of our Levi’s® brand in the United States and of net sales in our Asia Pacific region, more premium positioning of our Levi’s® brand in our Europe region and lower sourcing and overhead costs. In addition, we experienced lower inventory markdowns, particularly in Europe.
Our gross profit increased 7.9% for the nine months ended August 28, 2005. Our gross margin was 46.4% for the nine-month period, reflecting an increase of 2.6 percentage points. Factors that increased our gross profit in the nine months ended August 28, 2005 included:
These factors were partially offset by the impact on our gross profit of the decrease in net sales in our U.S. Levi’s® and U.S. Dockers® businesses and the decrease in net sales on a constant currency basis in our Europe region.
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 gross margin percentage for the nine months ended August 28, 2005 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 6.4% in the three months ended August 28, 2005 and increased 4.0% in the nine months ended August 28, 2005 compared to the same periods in 2004. On a constant currency basis, selling, general and administrative expenses would have been approximately $1.8 million and $19.0 million lower in the three and nine months ended August 28, 2005, respectively. As a percentage of net sales, selling, general and administrative expenses were 31.4% in both the three and nine months ended August 28, 2005, as compared to 30.2% and 30.7%, respectively, for the same periods in 2004.
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Key factors impacting selling, general and administrative expenses in the three and nine month periods ended August 28, 2005 were as follows:
Partially offsetting the increased selling, general and administrative expenses were 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 $50.1 million and $155.3 million, or 4.9% and 5.2% of net sales in the three and nine months ended August 28, 2005, respectively, as compared to $53.3 million and $158.6 million or 5.4% of net sales, in the three and nine months ended August 29, 2004.
Long-term incentive compensation expense was $9.6 million and $18.9 million for the three and nine months ended August 28, 2005, respectively, as compared to $10.7 million and $37.1 million for the same periods in the prior year. The 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 44.9% and 59.7% for the three and nine months ended August 28, 2005 as compared to the same periods in the prior year. Other operating income is comprised primarily 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 and nine months ended August 28, 2005, royalty
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income increased $4.6 million and $15.7 million as compared to the same periods in the prior year. The increase was attributable primarily to our licensing additional Levi’s® and Dockers® brand product categories, and our starting Levi Strauss Signature® brand licensing programs for several product categories, during 2005. In addition, in the three months ended August 28, 2005, we recognized approximately $1.7 million of royalty income related to the termination of a Dockers® license agreement.
Restructuring charges
Restructuring charges, net of reversals of $5.0 million and $13.4 million in the three and nine months ended August 28, 2005 related primarily to current period activities associated with our 2004 U.S., Europe and Dockers® Europe reorganization initiatives. Restructuring charges, net of reversals, in the 2004 comparable periods of $28.1 million and $108.2 million primarily related to the indefinite suspension of an enterprise resource planning system installation and charges related to our 2004 U.S. organizational changes, 2004 Spanish plant closures and our organizational changes initiated in 2003 as part of our business transformation.
Operating income increased 8.6% and 74.9% in the three and nine months ended August 28, 2005. Operating margin was 13.7% and 15.8%, reflecting an increase of 0.8 and 6.6 percentage points for the three and nine months ended August 28, 2005, respectively.
The following tables show 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 and nine month periods ended August 28, 2005 to the three and nine month periods ended August 29, 2004 and results presented as a percentage of net sales:
$ Increase
(Decrease)
% Increase
North America (all brands)
Depreciation and amortization expense
Total operating income
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For the three and nine months ended August 28, 2005, the increase in total operating income period to period is primarily attributable to lower restructuring charges, net of reversals, and lower other corporate expense.
Regional Summaries. The following summarizes the changes in operating income by region:
The decrease in operating income for the nine months ended August 28, 2005 was primarily attributable to increased advertising and promotion expenses and lower net sales in our U.S. Levi’s® and U.S. Dockers® businesses. Partially offsetting the decline were higher net sales in our Levi Strauss Signature® business, higher royalty income, higher operating income in our Mexico business and lower returns, allowances and product transition and sourcing costs in the United States.
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The following tables summarize significant components of other corporate expense:
Annual incentive compensation plans—corporate employees
Post-retirement medical benefit plan curtailment gain
Corporate staff costs and other expense
Total other corporate expense
We reflect annual incentive compensation plan costs for corporate employees, post-retirement medical benefit plan curtailment gains and corporate staff costs, including workers’ compensation costs, in other corporate expense. The decrease of $9.5 million and $31.4 million in the three and nine month periods ended August 28, 2005, respectively, was primarily attributable to our reorganization and cost cutting initiatives, changes made to our benefit plans that have resulted in lower net expense and workers’ compensation reversals realized during the periods. Partially offsetting the period-over-period decrease were the $3.4 million and $27.2 million curtailment gains related to our post-retirement medical plan in 2004, higher costs with respect to our activities associated with Section 404 of the Sarbanes-Oxley Act and higher annual incentive compensation plan expenses in the 2005 periods. The increase in our annual incentive costs in both periods is primarily due to the implementation of an additional employee incentive plan in the current period as well as the fact that we accrued at a higher rate relative to expected company performance in the current year compared to the same periods in the prior year.
Interest expense for the three months ended August 28, 2005 decreased 0.5% to $63.9 million compared to $64.3 million for the same period in 2004. Interest expense for the nine months ended August 28, 2005 increased 0.5% to $198.6 million compared to $197.7 million for the same period in 2004. The third quarter decrease was primarily attributable to lower average borrowing rates. The increase for the nine months ended August 28, 2005 was primarily due to higher average debt balances, mostly related to the timing differences between our debt issuances and the related tender and redemption of a portion of our 2006 and all of our 2008 notes during the first half of 2005.
The weighted average interest rate on average borrowings outstanding during the three months ended August 28, 2005 and August 29, 2004, including the amortization of capitalized bank fees, underwriting fees and interest rate swap cancellations, was 10.30% and 10.54%, respectively. The weighted average interest rate on average borrowings outstanding during the nine months ended August 28, 2005 and August 29, 2004, including the amortization of capitalized bank fees, underwriting fees and interest rate swap cancellations, was 10.47% and 10.61%, respectively. The weighted average interest rate on average borrowings outstanding excludes interest payable to participants under deferred compensation plans and other miscellaneous items.
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During the three and nine months ended August 28, 2005, we recorded a $0.04 million and $66.1 million loss, respectively, on early extinguishment of debt as a result of our debt refinancing activities during the periods. The loss for the nine month period ended August 28, 2005 consisted of tender offer and redemption premiums and other fees and expenses approximating $53.6 million and the write-off of approximately $12.5 million of unamortized debt discount and capitalized costs. These costs were incurred in conjunction with our completion in January 2005 of a repurchase of $372.1 million of our $450.0 million principal amount 2006 notes and in March and April 2005 of a repurchase and redemption of all our 2008 notes.
Other (income) expense
Our foreign exchange risk management activities include the use of instruments 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 (income) expense, net”. At contract maturity, the realized gain or loss related to derivative instruments is also recorded in “other (income) expense, net”. The changes in foreign exchange management losses recorded for the three and nine month periods ending August 28, 2005 compared to the same periods in 2004 were due to different conditions in foreign exchange markets and changes in the foreign currency exposures being managed. For more information, see “Item 3—Quantitative and Qualitative Disclosures About Market Risk”.
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 (income) expense, net”. In addition, at the settlement date of foreign currency transactions, foreign currency (gains) losses are recorded in “other (income) expense, net” to reflect the difference between the spot rate effective at settlement date and the historical rate at which the transaction was originally recorded.
The increase in interest income for the three and nine months ended August 28, 2005 was primarily due to higher effective interest rates on our investments. Also contributing to the increase was a higher average investment balance for the nine month period ended August 28, 2005 as compared to the same period in the prior year.
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Our income tax expense was $39.8 million and $98.1 million for the three and nine months ended August 28, 2005 as compared to income tax expense of $17.8 million and $16.9 million for the same periods in the prior year. The increase for both periods in 2005 was driven by higher effective tax rates and an increase in our income before taxes as compared to the same periods in the prior year. Our income before taxes for the three and nine months ended August 28, 2005 was $78.0 million and $210.5 million, respectively, as compared to $64.4 million and $66.7 million for the same periods in the prior year.
Our effective tax rates for the three and nine months ended August 28, 2005 were higher than those in the prior year periods due to the fact that the our prior year rates benefited from the impact of a revision in our estimates of annual earnings for our domestic and foreign subsidiaries. Due to our inability to benefit losses in certain jurisdictions, the mix of income and loss by jurisdiction is a key driver in determining the ultimate effective tax rate. In accordance with FASB Interpretation No. 18, we adjust our annual estimated effective tax rate to eliminate the impact of foreign losses for which no tax benefit can be recognized for the full year. We then apply our adjusted estimated annual effective tax rate to our year-to-date pre-tax operating results, exclusive of the results in these foreign jurisdictions, to compute our tax expense for the period. As a result of the changes we made in our annual earnings forecast by jurisdiction as of the three months ended August 29, 2004, our 2004 effective tax rate decreased.
Our estimated effective tax rate for fiscal 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.
Examination of Tax Returns. During the nine months ended August 28, 2005, we reached agreement with the Internal Revenue Service to close a total of 14 open tax years:
In connection with the 1990 – 1999 settlement, we expect to make total payments to the Internal Revenue Service of approximately $100.0 million in the fourth quarter of 2005. These projected payments are included in our accrued income taxes as of August 28, 2005.
The Internal Revenue Service has not yet begun an examination of our 2000-2004 U.S. federal corporate income tax returns.
Certain other state and foreign tax returns are under examination by various regulatory authorities. We regularly review issues raised in connection with all ongoing examinations and open tax years to evaluate the
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adequacy of our reserves. We believe that our accrued tax liabilities are adequate to cover all probable U.S. federal, state, and foreign income tax loss contingencies at August 28, 2005. However, it is possible we may also incur additional income tax liabilities related to prior years. We estimate this additional potential exposure to be approximately $18.9 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 $18.9 million amount has not been accrued because it currently does not meet the recognition criteria for liabilities under generally accepted accounting principles in the United States.
Net income was $38.2 million for the three months ended August 28, 2005, compared to net income of $46.6 million for the same period in 2004. Net income was $112.3 million for the nine months ended August 28, 2005, compared to net income of $49.8 million for the same period in 2004. The decrease in the three-month period was primarily due to higher income tax expense, partially offset by higher operating income and other income. The increase in the nine-month period was due primarily to higher operating income and other income, partially offset by the loss on early extinguishment of debt, slightly higher interest expense and higher income tax expense.
Liquidity and Capital Resources
Liquidity Outlook
We believe we will have adequate liquidity in the remainder of 2005 and in 2006 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 August 28, 2005, we had total cash and cash equivalents of $210.2 million, an $89.4 million decrease from the $299.6 million cash balance as of November 28, 2004. The decrease was primarily driven by a planned build up of inventory in preparation for the fall/holiday season, reduced trade and employee payables, payments made in connection with our reorganization initiatives, partially offset by higher operating income, reduced trade receivables and the impact of our refinancing actions.
As of August 28, 2005, our total availability under our amended senior secured revolving credit facility was approximately $480.8 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 $376.8 million. In addition, we had liquid short-term investments in the United States totaling approximately $80.5 million, resulting in a net liquidity position (availability and liquid short-term investments) of $457.3 million in the United States.
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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 fiscal 2005 and the first nine months of fiscal 2006:
Selected Cash Requirements
Projected for
nine months endingAugust 27, 2006
(Dollars in millions)
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 (3)
Total selected cash requirements
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
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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 nine months ended August 28, 2005 and August 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 $98.7 million for the nine months ended August 28, 2005 compared to cash provided by operating activities of $149.2 million for the same period in 2004.
The increase in cash used for operating activities was primarily due to the following factors:
Factors that partially offset these increases were as follows:
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Cash used for investing activities was $12.5 million for the nine months ended August 28, 2005 compared to $2.7 million for the same period in 2004.
Cash used in both periods primarily related to investments made in information technology systems, and in 2005, to build an internal infrastructure in Asia through the installation of an enterprise resource planning system in the region. In the current period, this amount was partially offset by gains on net investment hedges and proceeds from the sale of property, plant and equipment primarily related to our restructuring.
Cash provided by financing activities was $22.3 million for the nine months ended August 28, 2005 compared to cash used for financing activities of $17.9 million for the same period in 2004.
Cash provided by financing activities for the nine months ended August 28, 2005 primarily reflected our issuance of approximately $1.0 billion in unsecured notes during the period. The increase was largely offset by the repurchases and redemptions of $918.2 million in aggregate principal amount of our 2006 and 2008 notes, the payment of debt issuance costs of approximately $24.6 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 in the 2004 comparable period primarily reflected required payments on the equipment financing and senior secured term loan as well as repayments on short-term borrowings.
Indebtedness
As of August 28, 2005, we had fixed rate debt of approximately $1.6 billion (71% of total debt) and variable rate debt of approximately $0.7 billion (29% of total 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 August 28, 2005, our required aggregate short-term and long-term debt principal payments for the next five fiscal years and thereafter. 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.
See Note 5 to our consolidated financial statements for further discussion of our indebtedness, including information about our senior notes issuances and our senior note repurchases and redemptions during the nine months ended August 28, 2005.
Term Loan Leverage Ratio. Our senior secured term loan requires us to maintain 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 August 28, 2005, we were in compliance with this ratio.
Revolving Credit Facility Fixed Charge Coverage Ratio. Our senior secured revolving credit facility requires us to maintain 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 August 28, 2005, we were not required to perform this calculation.
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, equity financing, equipment and real estate financing, securitizations and unsecured and secured note issuances.
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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. Net changes resulting from such translations are recorded as a separate component of “Accumulated other comprehensive loss” in the consolidated financial statements.
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) expense, net.”
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 these 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, we give substantial consideration 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.
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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 (“SFAS”) No. 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 SFAS 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 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.
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 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 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
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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 SFAS No. 123(R), “Share-Based Payment,” (“SFAS 123(R)”). Under this standard, all forms of share-based payment to employees, including stock options, will be treated as compensation and recognized in the income statement. This statement applies to all awards granted after the required effective date and to awards modified, repurchased or cancelled after that date. For nonpublic entities, this statement is effective as of the beginning of the first annual reporting period that begins after December 15, 2005, which for us will be as of the beginning of fiscal 2007. Early adoption is permitted. We are currently evaluating the impact that the adoption of SFAS 123(R) will have on our financial statements.
In June 2005, the FASB’s Emerging Issues Task Force reached a consensus on Issue No. 05-6, “Determining the Amortization Period for Leasehold Improvements” (“EITF 05-6”). The guidance requires that leasehold improvements acquired in a business combination or purchased subsequent to the inception of a lease be amortized over the lesser of the useful life of the assets or a term that includes renewals that are reasonably assured at the date of the business combination or purchase. The guidance is effective for periods beginning after June 29, 2005. We do not believe that the adoption of EITF 05-6 will have a significant effect on our financial statements.
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FORWARD-LOOKING STATEMENTS
Except for the historical information contained in this report, certain matters discussed in this report, including (without limitation) statements under “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,” “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 under management, 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 August 28, 2005, we had U.S. dollar spot and forward currency contracts to buy $299.2 million and to sell $222.9 million against various foreign currencies. These contracts are at various exchange rates and expire at various dates through November 2005.
We have entered into option contracts to manage our exposure to foreign currencies. At August 28, 2005, we bought U.S. dollar option contracts resulting in a net purchase of $58.2 million against various foreign currencies should the options be exercised. To finance the premium related to bought options, we sold U.S. dollar options resulting in a net purchase of $75.9 million against various currencies should the options be exercised. The option contracts are at various strike prices and expire at various dates through February 2006.
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.
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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 over financial reporting. These significant deficiencies and the actions we have taken to address them during the first nine months of fiscal 2005 are summarized as follows:
As of August 28, 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, as a non-accelerated filer, we will not be subject to the requirements until our annual report on Form 10-K for fiscal year 2007.
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PART II—OTHER INFORMATION
Item 1. Legal Proceedings
Wrongful Termination Litigation. There have been no material developments in this litigation since we filed our Quarterly Report on Form 10-Q for the period ended May 29, 2005. For more information about the litigation, see Note 9 to the consolidated financial statements contained in our 2004 Annual Report on Form 10-K filed on February 17, 2005.
Class Actions Securities Litigation. There have been no material developments in this litigation since we filed our 2004 Annual Report on Form 10-K. For information about the litigation, see Note 9 to the consolidated financial statements contained in the Annual Report on Form 10-K.
Comexma Litigation. There have been no material developments in this litigation since we filed our Quarterly Report on Form 10-Q for the period ended May 29, 2005. For more information about the litigation, see Note 7 to the consolidated financial statements contained in our Quarterly Report on Form 10-Q filed on July 12, 2005.
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, patent and 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.
Item 6. Exhibits
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SIGNATURE
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.
Date: October 11, 2005
(Registrant)
/s/ GARY W. GRELLMAN
Gary W. Grellman
Vice President and Controller
(Principal Accounting Officer)
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